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Saturday October 3, 2015

Article of the Month

Portability Part II - Deceased Spouse and Surviving Spouse

The American Taxpayer Relief Act of 2012 made permanent a $5 million estate tax exemption (indexed for inflation) and portability of the applicable exclusion amount between spouses. In 2015, the combined applicable exclusion amount is $10.86 million. Part I of this series provided an overview of the rules governing the portable applicable exclusion amount and the effect those rules have had on the need to establish a traditional bypass trust. It concluded that many couples will avoid establishing a bypass trust and rely on portability to transfer amounts to a surviving spouse. As a result, many surviving spouses will have large estates. In addition, the American Taxpayer Relief Act increased income tax rates for many taxpayers. The top rate levied on passive ordinary income is now 43.4% while the top capital gains rate is 23.8%.

These changes have caused many couples to shift their focus from estate planning to income tax planning for the surviving spouse. In some cases, estate planning for a surviving spouse may be needed as well. The exclusion amount transferred from a deceased spouse does not grow over time. So, during the time between the first and second spouse’s deaths an estate might grow larger than the combined exclusion and require planning to save estate taxes. In addition, if a surviving spouse remarries then he or she can only use the deceased spouse unused exemption amount (DSUEA) of the last predeceased spouse. Part II of this article will examine two case studies in order to explain three income and estate tax planning strategies that may help a surviving spouse avoid unnecessary tax.

I. Case Study

Bill and Sue, both age 76, own a nice home in Colorado that is worth $900,000. Bill also owns an IRA valued at $5.9 million and stock in a business (Company) valued at $600,000. Sue has an IRA valued at $2 million. The stock provides an annual dividend of 4%.

Bill and Sue’s income in 2015 is $383,091, $359,091 from Bill and Sue’s IRAs and $24,000 in dividends from the Company stock. This places Bill and Sue in the 33% federal income tax bracket and the 4.63% Colorado income tax bracket. Their combined federal and state income tax rate will be approximately 36.1% ($138,295.85). Additionally, the dividend income will cause Bill and Sue to pay an additional 3.8% ($912) tax on that net investment income.

Bill has had a recent health scare and is updating his estate plan to provide for Sue and ensure a nice inheritance for their two adult children. He knows that his and Sue’s IRAs will be more than enough to provide for Sue’s monthly expenses when he passes away. However, once Sue reaches retirement, the required minimum distributions for the IRAs will increase and in Sue’s later years she may be burdened with a significant amount of income tax. Bill and Sue have supported the government generously over the years. Bill would like to provide Sue with some flexibility over the amount she receives from his IRA, thereby reducing the amount of income tax she will be required to pay.

Additionally, Bill would like to provide for a cause he and Sue care deeply about. He is on the Board of Directors for Charity, a nonprofit that provides scholarships to disadvantaged youth. Bill would like to leave any remaining IRA to Charity after Sue passes away. Bill and Sue have two children, but they are established in their careers.

Finally, Bill and Sue’s combined estate is worth $9.4 million. With a combined estate tax exemption of $10.86 million in 2015, significant growth in estate assets could subject Bill and Sue’s estate to tax upon the death of the surviving spouse. He is wondering whether there is a way to plan for this possibility.

Bill talks with his attorney, James, and the gift planner at Charity, Michael, to see if there is a way to reduce Sue’s income tax burden and reduce the value of their combined estate. James explains to Bill that establishing a testamentary unitrust with his IRA would accomplish many of his goals.

II. Strategy 1

Testamentary Unitrust funded with IRA

An IRA is a great asset to own during life. A traditional IRA provides the benefits of tax-free contributions and growth as well as both retirement income and liquidity for the IRA owner. However, an IRA is a poor asset to pass on to family members. The IRA is included in the IRA owner’s estate and thus may be subject to estate tax. In addition, the beneficiary of the IRA will pay income tax on any distributions from the account. Therefore, with the top federal estate tax rate at 40% and the top federal income tax rate at 39.6% (43.4% on passive income), a significant portion of the IRA may be reduced by taxes before any is paid to the beneficiary. Even if the IRA payouts are stretched over a long period of time, the payments will be added to the beneficiary’s taxable income and could place him or her in a higher income tax bracket.

A testamentary net income plus makeup charitable remainder unitrust (NIMCRUT) is an excellent planned giving solution for clients that have a large IRA, want to provide for a spouse or children and have charitable intent. A testamentary NIMCRUT is a tax-exempt trust. The donor may transfer an IRA to the trust at death and receive an estate tax deduction for the present value of the charitable remainder interest. The assets may then be reinvested inside the trust tax-free, avoiding income tax on the value of the IRA and retaining the benefit of tax-free growth. The trust will pay to the beneficiaries the lesser of the trust’s net income or a fixed percentage of the assets in the trust valued each year. This structure allows the trustee of the unitrust to control income by investing either for income or growth. Therefore, funding a testamentary NIMCRUT with an IRA to benefit a spouse gives the spouse flexibility either to accumulate or take distributions from the IRA. This is a great income tax planning strategy for a surviving spouse.

Bill speaks with James who suggests that in order to provide Sue with income flexibility and provide a nice gift to Charity Bill could establish a testamentary NIMCRUT with his IRA. Bill likes this idea and decides to move forward.

James drafts a two-life NIMCRUT for Bill and Sue. The trust is unfunded, which James explains is permissible under state law. Bill selects the unfunded trust as the beneficiary of his IRA and sends the appropriate beneficiary designation form to his IRA custodian. Sue signs a consent form for the beneficiary designation.

When Bill passes away, the IRA (less costs for establishing the trust) is distributed to the NIMCRUT. Bill’s estate is entitled to a charitable deduction of $3.64 million. The trust pays out the lesser of net income or 5% of the trust’s value as determined on January 1 of each year. If Sue needs income, the trustee of the unitrust will invest for income and allow the trust to pay out the full 5%. Since Sue has some additional expenses in Year 1, she receives the full 5% or $295,000. If additional income would place Sue in a higher income tax bracket and she doesn’t need income presently, then the trustee of the unitrust can invest for growth. This strategy takes full advantage of the tax-free growth available inside the unitrust during Sue’s life.

In addition, James explains to Sue that if the trust is invested for growth in early years it will build up a makeup account that allows for larger distributions in later years if needed. This “income control” unitrust provides Sue with the income flexibility she needs in retirement after Bill passes away. In addition, Bill and Sue reduced the value of their estate well below the combined exclusion amount.

Sale and UT

For surviving spouses who would like to downsize current living arrangements, a sale and unitrust is a great tax saving strategy. This plan allows a client to receive an income tax deduction and provides income for life or a term of years to the client or other beneficiaries. In addition, the client receives a lump sum distribution of cash from the portion of the property sold outside the trust. This “sale portion” typically produces a capital gains tax liability for the client. Fortunately, the client can use the deduction received for funding the unitrust to offset all or a portion of the capital gains tax liability. The client may even be interested in a “zero-tax” result where the smallest amount of property is transferred to the unitrust sufficient to produce an income tax deduction capable of offsetting all of the capital gains tax liability on the sale portion.

The sale and unitrust is a popular option with surviving spouses because it generates immediate liquidity and retirement income while also providing an offsetting deduction. The unitrust is usually funded with appreciated property, making the charitable income tax deduction an appreciated property deduction subject to the 30% of AGI deduction limit.

Assume that Bill passed away two years ago in 2013. He set up a testamentary NIMCRUT for Sue with his IRA worth $5.9 million. He left the Company stock and the home in Colorado to Sue as well. After Bill passed away James made a portability election as the representative for his estate. In 2015, Sue’s house is now worth $1.3 million and the Company stock has grown in value to $800,000. She also has an IRA worth $2 million.

At age 76, Sue is considering selling her home and moving into a retirement community where she can be involved in social activities with peers. She now approaches James with a new request. She very much likes the idea of benefiting Charity. However, she also wants to provide for her and Bill’s two children. In addition, selling her home would put her in a very high tax bracket this year.

Sue meets with James to see if there is any way to sell her home without paying capital gains tax, reduce her income and provide for her children. James suggests combining a sale and unitrust.

Under this plan, Sue will contribute a 61% undivided portion of her home and all of her Company stock to a 5% FLIP Unitrust to benefit her children for a term of 20 years. The trustee of the FLIP CRUT and Sue jointly sell the home for $1.3 million. Sue receives $507,000 (39% of the sale proceeds) and the FLIP CRUT receives $793,000. This plan provides Sue with enough to purchase a small place in a retirement community.

In addition, the trustee of the FLIP CRUT sells and reinvests the $800,000 in Company stock. The total value of the CRUT is $1,593,000. The trust pays income of $79,650 per year to her two children. Additionally, Sue receives an income tax deduction of $579,286, which she can take up to 30% of her AGI for the year. She can carry forward any unused deduction for an additional five years. This deduction is more than enough to offset the tax Sue will owe on the $156,000 of taxable capital gain she recognizes on the cash received from the sale. Sue saves $105,672 in capital gains tax on the sale of her home and Company stock inside the trust. Since Sue will no longer be receiving income from the Company stock, she will no longer have any tax (including the additional net investment income tax) on that income.

Through a sale and unitrust, Sue is able to downsize her home tax-free, provide an income stream to her children for life, receive a sizeable charitable deduction to offset additional tax and provide a nice gift to Charity.

III. Strategy 2: Testamentary Gift Annuity

If an IRA owner’s spouse is fairly senior then a testamentary gift annuity may be preferable to a unitrust. The high fixed payout and low administrative cost of a gift annuity are favorable when compared to a unitrust. In PLR 200230018, the IRS ruled favorably on an IRA owner’s request to fund a testamentary charitable gift annuity. A PLR, though not a precedent, is useful in gauging the view of the IRS given a certain set of facts. The PLR ruled that the IRA is included in the owner’s estate, but that the estate will receive an estate tax deduction for the charitable gift portion of the annuity. In addition, the estate is not taxed on the ordinary income from the IRA. Instead, each payment made to the annuitant will be taxed as ordinary income. The testamentary gift annuity can be established by specifying the annuity arrangement on the beneficiary designation form provided by the IRA custodian. Alternatively, the IRA owner can sign a gift annuity contract with the charity during life and specify on the beneficiary designation form that the charity is the beneficiary of the IRA subject to the annuity contract. The contract will typically provide that the annuity rate will be decided by the age of the annuitant upon the date of the IRA owner’s death.

Jim, age 96, and Rachel, age 85, have been married for nearly 65 years. They are taking distributions from Jim’s IRA valued at $800,000. Jim and Rachel are both in excellent health for their ages which is why Jim wants to find a way to provide Rachel with fixed income for the rest of her life and he wants to make a nice gift to support their favorite charity. Jim speaks with his attorney, Alex, and the gift planner at his charity of choice, Michael. Michael and Alex suggest that Jim establish a testamentary charitable gift annuity with Jim’s IRA to benefit Rachel and then the charity. Rachel will receive a fixed payment between 7.8% and 9% from the gift annuity depending on her age at the time of Jim’s death. Jim's estate will receive an estate tax deduction for the present value of the charitable gift portion of the annuity. When Rachel passes away, the remaining IRA will go to Charity.

Jim and Rachel’s two children would have to pay ordinary income tax at a combined tax rate of nearly 40% if they received the IRA. However, Charity will not have to pay any tax. As a result, Jim and Rachel’s cost for making this charitable gift is only $0.60 per dollar gifted. Jim and Rachel’s two children will receive a home worth $400,000 and a stock portfolio worth $200,000. These assets will pass to them with a stepped-up income tax basis.

IV. Conclusion

The introduction of the increased estate tax exemption and the portable applicable exclusion amount means that surviving spouses may have very large estates. Many surviving spouses will need to employ income tax and estate tax planning strategies to avoid significant tax. A testamentary NIMCRUT, testamentary gift annuity and a sale and unitrust provide great advantages for a surviving spouse looking to control income and provide efficiently for both children and charity.

Published October 1, 2015
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Previous Articles

Portability Part I - Deceased Spouse and Surviving Spouse

Charitable Gifts Using Life Insurance

Charitable Planning With IRAs—Part II

Charitable Planning With IRAs—Part I

Gifts of Farms