Charitable Remainder Trusts: An Option to Consider

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1 miller nash llp Fall 2014 brought to you by the trusts & estates practice team Estate Planning Advisor Charitable Remainder Trusts: An Option to Consider Those wishing to sell and diversify highly appreciated assets (stocks, real estate) and those who have lots of taxable income should consider a charitable remainder trust ( CRT ) to minimize income tax on capital gains as well as gift and estate tax. Why? Because the CRT is not incometaxed, the sale of such assets does not create income tax on the capital gains. The capital gains will be taxable to the grantor (or the grantor s spouse) only as distributions are made as part of the annual distribution. In addition, the grantor receives a charitable deduction against current income that can be carried forward for up to five years. And the asset is out of the estate of the grantor for estate tax purposes. What are CRTs? by Kay B. Abramowitz kay.abramowitz@millernash.com In a CRT, assets are transferred to an irrevocable trust for the benefit of a noncharitable beneficiary who receives an amount from the trust for a certain period and for one or more qualified charities that receive the assets remaining in the trust. If all the requirements are met, the grantor receives a current income and gift tax deduction for the value of the charitable remainder interest and pays gift tax on the present value of the noncharitable interest going to someone other than the grantor. Transferred assets. The assets transferred to a CRT must qualify for a charitable deduction. Noncharitable interest. Typically, the noncharitable beneficiary is the grantor or the grantor and the grantor s spouse. But the noncharitable beneficiary can be another family member, such as a child, sibling, niece, or nephew. The gift to the spouse qualifies as a marital deduction, and the gift to another member of the family is a taxable gift that may be excluded by the annual exclusion ($14,000 per year) or applied against the federal exclusion (currently $5,340,000). Amount received by noncharitable interest. There are two types of CRTs and several variations on these two types. The charitable remainder annuity trust, or CRAT, must distribute to the noncharitable beneficiary a fixed amount or a fixed percentage at least annually. The annual distribution cannot be less than 5 percent or more than 50 percent of the initial net fair market value of the assets transferred originally to the CRAT. The charitable remainder unitrust, or CRUT, distributes to the noncharitable beneficiary at least annually a set percentage of the annual valuation of the trust assets. The annual distribution must be not less than 5 percent or more than 50 percent of the annual fair market value of the trust assets. A popular variation of the CRUT is NIMCRUT, which distributes to the noncharitable inside this issue (continued on page 6) 2 Oregon s Natural Resource Credit Can Slash Estate Taxes 3 To Gift or Not to Gift? 4 Where Is the Value in Exit Planning? 5 The Vacation Home: Planning for the Next Generation

2 Oregon s Natural Resource Credit Can Slash Estate Taxes by Ronald A. Shellan ron.shellan@millernash.com As of January 1, 2012, Oregon s estate tax adopted a very significant credit to owners of natural resource assets. In fact, for those who qualify, Oregon s Natural Resources Credit (the NRC ) will eliminate any estate tax on qualifying natural resources property ( NRC Property ). The NRC is available for three general classes of NRC Properties: forestlands, agricultural lands, and fishingrelated assets. More particularly, the NRC applies to forestland or forestland homesites, timber, crops, fruit or other horticultural products, forestry business or farm business equipment, livestock, nursery stocks, and fishing boats, gear, and equipment. It also applies to working capital used in the qualifying activity of up to 15 percent of the value of the assets (but limited to $1 million). The NRC is also available to estates owning an interest in corporations, partnerships, and limited liability companies that own NRC Property, if at least one member of the family participates in the entity s operation. There are, of course, a number of additional requirements and limitations to being able to utilize the NRC: 1. The adjusted gross estate (value of assets less debt and certain deductions) must be less than $15 million. 2. The value of the NRC Property must exceed 50 percent of the adjusted gross estate. 3. The NRC is also limited to the first $7.5 million of NRC Property. 4. The NRC Property must have operated for five of the last eight years by the decedent immediately before death or by a member of the decedent s family. 5. Following death, the NRC Property must be inherited by the decedent s family and must continue to be used in the farm, forestry, or fishing business for five of the eight years following the decedent s death. If the NRC Property is sold after the death of the decedent, there will be a recapture of the tax. An annual form must be filed certifying that the NRC If the NRC Property is sold after the death of the decedent, there will be a recapture of the tax. Property has not been disposed of. A tax-free exchange or condemnation of the NRC Property either before or after the death of the decedent is ignored if both the relinquished and replacement property was qualifying farming, fishing, or forestry property. We have been involved in one larger estate that made significant use of the NRC. We discovered quite a number of issues and technical problems with the drafting of the statute that needed to be resolved. We found that the Oregon Department of Revenue responded to our questions and took positions that logically interpreted the statute to follow the obvious intent of the Oregon legislature to not tax NRC Property. What practical planning can you do to take advantage of the NRC? You should review your situation with your tax advisor to determine whether you would qualify for the NRC and, as needed, adjust the ownership and operation of property to qualify for the NRC. If appropriate, adjust the amount of your cash, marketable securities, and life insurance that might be used to pay estate taxes to reflect the reduced Oregon estate tax bite. If you were considering gifting qualifying NRC Property to a family member, note that such a gift will not save Oregon estate taxes, which might have been a primary consideration in making such a gift. In some situations, it may make sense to exchange on a tax-free basis nonqualifying real estate assets into NRC Property to avoid Oregon estate taxes at death. It may also be important to provide in your will or revocable trust that any recapture of Oregon estate taxes be borne by the child or children who inherited the NRC Property. Finally, make sure that a family member, instead of an employee, materially participates in running the NRC Property if you can no longer do so. In the right situation, the NRC can significantly reduce estate taxes. For an estate that held exactly $7.5 million in such assets, the savings would be at least $750,000 in Oregon estate taxes (Oregon tax rates start at 10 percent for estates of $1 million and increase to 16 percent for estates of $9.5 million or more). But note that the benefit of the deduction may be reduced, since the estate taxes paid to a state are deductible for federal estate tax purposes. Because the NRC can result in significant estate tax savings, proper planning with a trusted tax advisor to utilize the NRC is strongly advised. 2 miller nash llp Estate Planning Advisor

3 To Gift or Not to Gift? by June M. Wiyrick Flores Your year-end tax planning should also be a time to consider whether or not you should be making gifts for estate and gift tax planning and, if you should gift, how those gifts should be made. Income vs. estate tax planning. In the past, advisors have encouraged clients to gift assets during their lifetimes to reduce their estate tax liability by transferring appreciating assets out of their estate and taking advantage of valuation discounts. Under our current federal and state estate tax rules, however, we need to consider not only the estate tax issues, but also the income tax issues related to gifting. What is the current law? The federal estate and gift tax exclusion amount is currently $5,340,000 and is indexed for inflation. The 2014 annual exclusion amount is $14,000 (this is the amount that you can gift to every person every year that is not subject to gift or estate tax). There is no limit on gifts for qualified medical and education expenses, so long as they are paid directly to the provider. (You can pay college tuition directly to the university, and there are no gift or estate tax consequences for those gifts!) As for state law, Oregon s estate tax exclusion amount is $1 million, Washington s estate tax exclusion amount is $2,012,000 (and is also indexed for inflation), and California does not have an estate tax. Oregon and Washington do not have gift taxes. I thought gifts and inheritances weren t subject to income tax. Generally, when a person receives a lifetime gift or inherits an asset, the mere receipt of those assets is not subject to income tax. But when the recipient sells the asset, there may be taxable gain. When someone receives a lifetime gift from a donor, the recipient s basis for income tax purposes is the donor s basis. For example, Mom bought Facebook stock for $45/share on January 1. On April 1, the fair market value of the Facebook stock is $60/share. On July 1, the fair market value of Facebook stock is $100/share. If Mom gifts the stock to Son on April 1, then Son s basis in the Facebook stock is $45. The gift itself is not subject to income tax. If Son sells the stock on July 1, Son will have $55/ share of taxable gain ($100 $45 = $55). If a person inherits an asset, then the recipient s basis is the fair market value of the asset as of the decedent s date of death. If Mom passed away on April 1, and Son inherited her Facebook stock, Son s basis would be $60/share. But if Mom passed away on July 1, and Son inherited her Facebook stock, Son s basis would be $100/share he would have taxable gain only if the sale price exceeded $100/share. Should I gift? It really depends on your personal situation and the reason why you re making a gift. If you re making a gift for estate tax planning, then an analysis needs to be done to determine which tax will be lower the income tax or estate tax. Under prior law, the federal exclusion amount was significantly lower and the tax rate was higher. The current law has increased the exclusion amount and decreased the estate tax rates. So under prior law, it was fairly certain that the estate taxes would be higher than any income taxes. Now, if the recipient intends to sell the assets and the donor has a low basis, then it may be more tax-efficient for the donor to retain the assets until death because the estate taxes may be less than the income taxes on the sale of the asset. If it is a low-basis, appreciating asset that the family intends to retain and not sell, however, then it may be more tax-efficient for you to gift that asset during your lifetime. Once I decide to make a gift, how should that gift be made? Future articles will discuss ways to make gifts. Estate Planning Advisor miller nash llp 3

4 Where is the Value in Exit Planning? by William S. Manne When we talk to business owners about the value of exit planning, we are talking about orchestrating a business exit that fulfills their unique financial and personal goals. Since tackling a task of this magnitude can be daunting, owners sometimes ask whether devoting the necessary time and money to this project is really worthwhile. To answer that question, we asked Kevin Short, an investment banker who works every day with owners of small and midsized companies, about the value of exit planning. Kevin advised that good exit planning can be the difference between a successful closing and a complete derailment of the sale process. When asked to explain, Kevin focused on the first three steps of the exitplanning process. When an owner sets objectives in an exit-planning context (Step 1), he or she does so methodically and proactively. Owners who wait until entering the M&A arena to decide how much cash they want and need from their companies do so reactively and are often blinded by attractive bait held out by less-than scrupulous buyers. In Step 2 of the exit-planning process, the owner and his or her advisors place a value on the owner s company. When an owner s first valuation experience happens in my office, and that owner is primed and ready to sell last Friday, learning that the company is not worth what he or she had hoped is a painful experience. Even more painful is the subsequent rededication of effort to building the value of the company. In Kevin s opinion, the element of exit planning that gives an owner the biggest bang for the buck is, without a doubt, Step 3 of the exit-planning process (build and preserve value). This step focuses on what we call value drivers that enhance the real value of a business. For example, one technique that can be used to motivate managers to remain with a company postclosing (a vital value driver) is a stay bonus. An effective stay bonus accomplishes three tasks: (1) it gives the key managers a reason to stay; (2) it is structured so that it increases the value of the company; and (3) it includes a penalty (usually in Every shareholder and every employee figures out leverage, and most intend to use it. the form of a covenant not to compete) that prevents key managers from taking key clients, vendors, or trade secrets with them, if they leave before or after the sale. Kevin related a very real story about an owner who, believing his loyal employees were happy and well compensated, was held hostage in the eleventh hour of a sale. Kevin s client was a week away from the sale of his company for $10 million. At this very late stage of the game, the buyer met with each of the key managers to reassure them that they d be retained by the new owners at their existing compensation levels. At its meeting with my client s top salesperson, the buyer was lavish in its praise about her performance and about how important her continued success was to the company s future success. When the buyer asked her to sign a covenant not to compete before the closing date, the salesperson asked for a break and headed straight for my client s office. She proceeded to remind my client that she d helped build the company to its current value during her tenure, and ever so generously consented to wait until the closing date to collect her $1 million bonus. My client paid the ransom. He understood that if the salesperson servicing his top four clients left the company, the buyer would likely scrap the deal. If the buyer did come to the closing table, it would reduce its purchase offer by far more than $1 million. As a result of this experience and many similar ones, Kevin s firm often recommends that owners get very aggressive in implementing stay bonuses with anyone who has a significant impact on a company s performance. Kevin elaborates: The stay bonus should apply to anyone and that might be the janitor whose cousin is your biggest client who has leverage against the company. And of course, the stay bonus should be tied to a covenant not to compete (or similar agreement), after the owner checks with legal counsel to ensure that he or she is creating a legally enforceable agreement. Another method to protect value is to review, and if appropriate revise, shareholder agreements (again, well in advance of any contemplated sale or transfer). If a shareholder agreement does not require a minority shareholder to sell when the majority shareholder does (known as a drag along right), majority owners can (and often do) find (continued on page 8) 4 miller nash llp Estate Planning Advisor

5 The Vacation Home: Planning for the Next Generation by Jack B. Schwartz For many families, a beach or mountain house yields many photos, adventures, and happy memories through the years. It also presents an important question: will the good times continue for the next generation? Although there are no guarantees, a family s careful planning can help smooth the way for the next generation s future enjoyment. Consideration of a few basic questions is a first step: Are all the children really interested in having access to the vacation property? Do they have the means to handle the expense of upkeep, maintenance, and improvements? Do they get along? Are estate taxes a concern? The answers to these questions could indicate which of the ownership alternatives briefly outlined below would work best of course, deciding on the right planning strategy will require careful thought as to the particular family situation and property involved: Co-Ownership as Tenants in Common. Leaving the entire property equally to a person s children results in the simplest form of ownership. With a tenancy in common, there are normally no restrictions on sales or transfers of an ownership interest, any owner can force a partition and sale of the property, and there is no provision for shared use or for expenses meaning that there should be high confidence in the children s ability to get along and to cooperate with each other. Trust. Parents can establish a trust to own the property. After their deaths, the trust will continue for the benefit of their children and future generations. The trust can provide limitations on transfers of trust interests, and provisions for the trustees to decide questions of use, maintenance, improvement, and the like. The trust may include funding to help defray future expenses. Note that if the parents estate planning strategy includes gifts of interests in the trust, the annual exclusion for present interest gifts may not apply. (continued on page 7) Miller Nash LLP is pleased to announce three great additions to our Trusts & Estates Team. Kay Abramowitz Counsel, Portland Trusts & Estates and Business portland central oregon seattle vancouver Lori Murphy Counsel, Bend Trusts & Estates and Business June Wiyrick Flores Counsel, Portland Trusts & Estates and Business Estate Planning Advisor miller nash llp 5

6 Charitable Remainder Trusts: An Option to Consider Continued from page 1 beneficiary at least an amount equal to the lesser of the unitrust amount or the current trust income and allows for a make-up in future years for any deficiency between the income and the fixed percentage. Term of CRT. The noncharitable beneficiary s interest may be for a term of up to 20 years or the life or the lives of one or more persons. Typically, the two lives are for a husband and wife, in which event the annuity or unitrust amount continues for the life of the surviving spouse. It is also common for a grantor to establish a CRAT or CRUT for other family members, such as older siblings or children. Qualified charitable beneficiary. The charitable remainder beneficiaries must be qualified as charities to which contributions would be deductible for income tax purposes. Amount received by charities. The remainder amount going to charity must be at least 10 percent of the net fair market value of the property contributed to the trust. This requirement will preclude the creation of a CRT for a young noncharitable beneficiary. Advantages of CRTs. Tax deduction. The grantor receives both income tax and gift tax deductions for the value of the remainder interest in a CRT. Reduction in estate tax. If the transferred asset is an appreciating asset, the estate of the donor is reduced by the asset s value. Annual payout. A CRT is exempt from federal and state income tax. Transferring appreciated property into such a trust converts appreciated property into an annual payout based on the entire value of the property, undiminished by federal or state income taxes. Flexibility. The grantor has the right to amend the trust to change the charitable remainder beneficiaries and to change the amount or percentage of the remainder that is distributed to them. Disadvantages of CRTs. Gift tax. The grantor is treated as making a taxable gift to the noncharitable beneficiary. If the noncharitable beneficiary is the grantor s spouse, the gift will qualify as a marital deduction. If the noncharitable beneficiary is someone else, it may qualify for the annual exclusion in whole or in part; if only in part, then a gift may be allocated against the federal exemption. Adherence to formalities. To get the benefits of the tax deductions afforded to the grantor by creating a CRT, attention must be paid to the formalities of the trust: The trust must be a written instrument that meets all the statutory requirements; Each CRT must have its own taxpayer identification number; and The trustee of each CRT must file an annual information return with the IRS. Examples. Sale of highly appreciated stock. The grantor transfers $500,000 of low-basis publicly traded stock into a 7 percent CRUT. The grantor and the grantor s spouse (age 65 and 64, respectively) are the noncharitable beneficiaries for their lives, and the remainder interest is a qualified charity. At the adoption of the CRUT, the grantor s charitable deduction is $108,980. The trustee of the CRUT sells the stock and reinvests, providing a stable income stream for the grantor and the grantor s spouse for life. The sale and reinvestment of the low-basis stock does not trigger income tax on the capital gains, as discussed above. Remainder to family foundation. The grantor transfers $1,000,000 of low-basis real estate into a 5 percent CRAT, retaining the income interest as the noncharitable beneficiary for 14 years, with the remainder at termination going to a family foundation. Upon adoption, the grantor has a charitable deduction of $367,239. The trustee of the CRAT sells the real estate and reinvests in other appreciating assets. The sale of the real estate does not trigger income tax on the capital gains as discussed above. 6 miller nash llp Estate Planning Advisor Estate Planning Advisor miller nash llp 3

7 The Vacation Home: Planning for the Next Generation Continued from page 5 Qualified Personal Residence Trust ( QPRT ). A QPRT is an irrevocable trust providing parents with a means of giving the vacation property to children while retaining use for a period of years. The value of the interest going to the children after the parents period of retained use is subject to federal gift tax (the unified credit, now $5,340,000 per spouse, is available). If the parents survive that period, however, the value of the property is not subject to estate tax. The donor parents can serve as trustees of the QPRT, and can reserve the power to choose successor trustees. Limited Liability Company ( LLC ). An LLC offers the most flexibility in planning for the future of a family property. The LLC operating agreement can provide for rights of use among family groups, sharing of expenses, and limitations on transfer of LLC membership interests to help ensure that the ownership of the property remains with family members. An LLC can also ease the making of gifts among family members membership interests can be transferred without the need for trust amendments or recording of deeds. By providing for the selection and powers of LLC managers, the operating agreement can ensure centralized decision-making and control when LLC interests are owned by many family members. If the ability of some family members to pay for maintenance and upkeep is a concern, the LLC can be funded with income-producing assets, or a parallel trust can be established for this purpose. Estate Planning Advisor miller nash llp 7

8 Where Is the Value in Exit Planning? Continued from page 4 themselves either unable to sell or held hostage by minority shareholders. According to Kevin, many entrepreneurs ignore both stay-bonus plans and shareholder agreements because they believe that other shareholders or employees will come along on closing day. Kevin s experience suggests that every shareholder and every employee figures out leverage, and most intend to use it. As a result of these and many other examples from his practice, Kevin believes that exit planning is indeed well worth the time and money that owners devote to it. If you d like to learn more about how exit planning might save you time and money, please contact us and request a no-charge consultation. Bill Manne chairs the firm s tax, trusts and estates, and business-owner exit practice teams and is also a certified public accountant. This article was previously published by Business Enterprise Institute in The Exit Planning Review. Estate Planning Advisor is published by Miller Nash LLP. This newsletter should not be construed as legal opinion on any specific facts or circumstances. The articles are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and any specific legal questions you may have. To be added to any of our newsletter or event mailing lists or to submit feedback, questions, address changes, and article ideas, contact Client Services at or at clientservices@millernash.com U.S. Bancorp Tower 111 S.W. Fifth Avenue Portland, Oregon Presorted First-Class Mail US Postage PAID Portland, OR Permit #1891