Most clients (usually readers of this column), when I ask, “What is your charitable intent?” respond with something like, “Nothing significant.” But when asking the same clients, “What is your level of interest if I can show you how to use the tax law to enrich your family, while giving to charity and saving taxes at the same time?” then the reply is something like, “Show me,” or “I’m interested.”
The case study that follows uses a $10 million target endowment, but don’t get hung on the numbers (they can easily be lowered or raised to exactly fit your dollar goals).
Now, the facts. Ben and Mary, both age 65, want to create a $10 million endowment at Favorite Charity to honor their deceased son. They don’t feel comfortable making this large gift during their lifetime. They fear inflation and don’t want to reduce the income level (dividends and interest) of their conservative investment portfolio. Also, they would like to find some way for the gift not to reduce the inheritance of their three surviving children.
Ben and Mary are willing to commit the full $10 million to a charitable plan now, as long as their two goals – maintaining income level and not reducing the inheritance of their kids – are fulfilled. They are in a 35 percent income tax bracket and 55 percent estate tax bracket, using 2011 rates. (Even if the rates change, the strategies used in this study remain the same.)
Following is the four-step plan we implemented for Ben and Mary.
Step one. They bought a joint and survivor annuity (pays as long as either is alive) for $4 million that yields 6.6 percent, or $264,000 (6.6 percent times $4 million), per year. The prior annual earnings of the $4 million was only $108,000. So, the $264,000 is $156,000 more than the old annual earnings of $108,000 (that was fully subject to income tax). Now, a great bonus: 59.4 percent of the $264,000 ($156,816) is income tax-free. After considering the income tax savings, Ben and Mary will have an additional $156,000 per year of spendable income (as an inflational hedge).
Step two. Favorite Charity buys a $10 million SPLI (the premium of $3 million gifted by Ben and Mary) to fund the endowment when both Ben and Mary have passed on. Note: a unique way of paying for life insurance, called single premium life insurance (SPLI), is used in this case study. SPLI means you pay only one premium when the life insurance policy is purchased, and you never pay another.
Step three. Ben and Mary enjoy income tax savings of $1,050,000 for the $3 million gift in step two. They created an irrevocable life insurance trust (ILIT) to buy a $10 million second-to-die, 15-year pay premium policy (pay the same amount each year for 15 years, and then premiums stop). The annual premium is $212,800 per year, or a total of $3,192,000 (15 years times $212,800). The $1,050,000 income tax savings (plus interest earned on the savings), together with the additional $156,000 every year in step one, easily cover the annual premium payments.
Step four. You might call this the “extra-cautious step.” We asked Ben and Mary to keep the extra $3 million in a separate, interest-earning, investment account. Remember, Ben and Mary were willing to commit $10 million to the four-step plan. Well, we only used $7 million ($4 million in step one and $3 million in step two). The extra $3 million serves as protection for any small amount that may be needed (doubtful) to pay the premiums in step three and as a hedge against inflation (very likely).
Note: as the years go by, if inflation or some other need requires Ben and Mary to increase their annual spendable income, a portion of the $3 million in the separate account can be used to purchase a new annuity. If inflation does indeed raise its ugly head, the new annual dollar annuity amount would be larger for two reasons: inflation increases annuity rates (amount paid each year) and of course, as Ben and Mary get older, the rate for a commercial annuity also rises a bit each year. Let’s summarize the plan created for Ben and Mary:
1. Their after-tax annual income for the $4 million is more than doubled (step one).
2. Favorite Charity will get $10 million (step two).
3. Their family will get $10 million (step three), tax-free.
4. The real economic value of the $10 million committed to the plan (after 50 percent estate taxes) is only $5 million. In effect, we turned $5 million into $20 million ($10 million each for Favorite Charity and the family). And, of course, there still is an extra $3 million as a contingency in step four.
One final point. The $20 million to Favorite Charity and the family was divided 50/50 by Ben and Mary. You can change the ratio to 60/40, 70/30, whatever, to favor Favorite Charity or your family’s wealth. Just go to my Web site and click on “Personally Designed Philanthropy.” Hope you’ll have as much fun reading it as I had writing it.
Irv Blackman is a certified public accountant who lives part-time on Marco Island and specializes in estate planning, business succession and asset protection. E-mail him at firstname.lastname@example.org or call 417-9732. His Web site is taxsecretsofthewealthy.com.