If a client is planning to sell a business, the sale could result in a huge capital gain. But there’s a way to reduce the tax bill, provide for a comfortable retirement and help out a favorite charity – all in one shot.
Strategy: Have the client donate the business interest to a charitable remainder unitrust (CRUT). The CRUT can sell the business later, which will generate cash that can be reinvested elsewhere. However, the client can’t prearrange the sale of the business at the time it is donated to the CRUT.
Example: Ed Caldwell’s business is worth $3 million. He has zero basis in the company stock, so a sale would result in a $450,000 federal income tax bill at the current 15% tax rate for long-term capital gains – not even counting any possible state and local income taxes. Instead, Ed donates the company stock to a CRUT. Typically, the trust promises to pay Ed – or his spouse or both – a stream of income that can last a term of years or lifetime (or lifetimes). After the trust’s termination, the remainder goes to the charity named by Ed.
With a CRUT, the donor receives an annual payment equal to a percentage or trust assets (5% is the minimum). The higher the percentage, the more income the donor can expect to receive and the smaller the charitable deduction. The CRUT must project that the charity will ultimately receive a remainder value equal to at least 10% of the current value of the business.
Suppose that Ed’s charitable intent is minimal. Depending on his age and the current level of interest rates, he and his spouse might specify a 9% trust payout as long as either lives. (We’ll assume the 9% figure for the rest of this example.) With a 10% projected charitable remainder, Ed would get a charitable deduction of $300,000 (10% of $3 million). If he can’t use the entire write-off right away, this $300,000 write-off can be spread over the current year and the following five years.
The payout: Donating company stock to a CRUT is not a taxable event. Subsequently, someone interested in buying the company can purchase it for $3 million. Since a charitable trust owes no tax, it will have $3 million to invest, perhaps in a portfolio of publicly traded stocks.
Because the trust owes no capital gains tax and has $3 million to invest, Ed starts out with an income payout of $270,000 from the trust (9% of $3 million). Depending on how the trust invests its money, some of the income he receives may be passed through as favorably taxed capital gain or a return of principal.
Each year, Ed’s income will fluctuate, depending on the trust’s investment performance. If the trust assets balloon to $3.5 million in year two, his income will rise to $315,000. On the other hand, if the assets fall to $2.5 million, Ed receives $225,000.
This cycle will continue as long as either spouse is alive. Depending on how the trust assets are invested, the payout is based on the 9% figure. Thus, if the trust assets eventually dwindle down to $100,000 the payout will be just $9,000.
Advisory: The IRS often disputes CRUTs. Make sure the arrangement satisfies the strict letter of the law.
Perks for CRUT donors
A CRUT can provide several potential benefits to donors, including the following:
- A stream of income for life or a specified term of years
- A current charitable tax deduction
- Possibility of multiple beneficiaries
- Reinvestment of assets transferred to the trust
- Ability to choose the trustee
- Flexible investment options for the beneficiary.
Reprinted with permission from The Tax Strategist, October 2008. For continuing advice on this and numerous other tax strategies, go to www.TaxStrategist.net. Receive 2 FREE Bonus Reports and a 40% discount on The Tax Strategist when you use Promo Code WN0013.