Business Law
Diversification With A Simulated Charitable Remainder Trust

Simulated Charitable Remainder Trust

Introduction

Income taxes generated by gain on sales of appreciated property present a significant obstacle to the free flow of capital. While there are numerous techniques to reduce this burden (e.g., deferred like-kind exchanges, tax shelters, “mixing bowls,” collars, and charitable remainder trusts), this article focuses on one specific strategy: the simulated charitable remainder trust (SCRT).

Illustrative Example

Assume Mr. Client transfers $10,000 to a new LLC, gifts a nonvoting 99% interest to a public charity (retaining 1% for himself), and then sells $1 million of publicly traded stock with zero basis to the LLC in exchange for an annual annuity of $47,479 payable for as long as either he or his wife (both age 50) is alive. The LLC then sells the stock for cash.

Tax Results (based on March 2003 rates)

• Mr. Client receives a charitable deduction of $109,912.
• Each annuity payment results in $24,223 ordinary income and $23,256 capital gain.
• The LLC realizes $100,012 of gain on sale of stock:
  • 99% reported by the charity (tax-exempt)
  • 1% reported by Mr. Client
• Annuity payments are not deductible for the LLC, but 99% of its income flows to the charity tax-free.

Comparison Without Technique

• Gain on sale: $1,000,000
• After-tax cash on hand (20% tax rate): $800,000

With the SCRT, the LLC holds the full $1,000,000, plus the charitable deduction further reduces Mr. Client’s tax burden. If Mr. Client invested $800,000 at 5.93%, the after-tax cash flow would match the annuity stream.

Investment Flexibility

The LLC’s cash can be invested as Mr. Client chooses. For example, it could loan $900,000 to a family partnership. Interest on such loan would be deductible, but 99% of the interest income would be reported by the charity. The arrangement is flexible and can be modified later (e.g., selling the annuity or amending agreements).

Charity’s Interest

The charity receives 99% of LLC assets upon dissolution. Since annuity payments terminate at the survivor’s death, this could result in a significant gain for the charity and loss for Mr. Client’s heirs. Options include:

• A self-canceling installment note (SCIN) — with a higher interest rate to reflect cancellation risk.
• Purchasing a survivor life insurance policy.

Long-Term Results

Crunching the numbers over 20 years (assuming a SCIN loan of $900k, 10% annual stock growth, and 30% turnover taxed at 20%):

• Mr. Client and his family achieve nearly the same position as if they had 100% basis in the property.
• The upfront capital gains tax is effectively offset by:
  1. Upfront charitable deduction
  2. Deferral of capital gains tax
  3. Conversion of some deductible interest into annuity capital gain
  4. Long-term compounding
• The charity also benefits significantly.

Risks

As with any planning technique, there are risks. However, with careful design, the risks are manageable and often well worth undertaking. Except in extreme cases, this technique should withstand IRS scrutiny.

Notes

• A community foundation may be ideal, offering a donor advised fund.
• This technique works with appreciated realty as well as stock.
• Mr. Client is effectively reporting $899,988 of gain over joint life expectancy, similar to installment reporting (though structured as annuity treatment).
• Unless considered “unrelated business taxable income,” the LLC’s income remains exempt.
• Careful borrower selection for loans is important. The charity itself could even be the borrower.