Whether you started a company that went public, went to work for a start-up that went public, or just took a chance and invested in a company that has really taken off, you are probably holding highly appreciated shares of stock. Even if you have millions or thousands of dollars on paper, you wouldn’t throw 20% or more of it away, would you? Of course not. Well, that is what capital gains taxes will be on such stock (and there’s nothing preventing Congress from raising the rates back to ordinary income tax rates in the future).
To avoid the tax burden appreciated assets may create for you, you can use a charitable remainder trust. You can give appreciated stock to a charity of your choosing and receive a write-off for your donation. The stock will be sold by the charity with no capital gains taxes paid by either you or the charity. Then, the charity will reinvest the proceeds in securities or annuities that provide growth and income. You receive the income annually. When you pass away, the principal is left to the charity.
The Economics of Charitable Giving Illustrated
Lauryn, a 50 year old orthopedic surgeon, makes $350,000 per year and has $1,000,000 worth of Microsoft stock. Since she purchased the stock for $200,000, she would have to pay capital gains tax on the $800,000 of gain. Assuming she pays $160,000 (20%) in capital gains taxes, the stock is only really worth $840,000 to Lauryn. This $840,000 could then generate $58,800 annually, if you assume a return of 7%. Assuming a capital gains and dividend tax rate of 20%, Lauryn will pay tax of $12,338 on her investment earnings ($58,800 x 20%). Her net income on her live on the interest strategy would thus be $46,462 ($58,800 – 12,338).
Moreover, assuming Lauryn is in the 40% estate tax bracket and she holds this principal until her death, her estate might incur an estate tax of $336,000 (840,000 x 40%). Hence, the portfolio will only be worth $504,000 (840,000 – 336,000) to her heirs.
If Lauryn gifts the stock to a charity through a charitable remainder trust, she will get a deduction of approximately $282,000 (according to the IRS uniform gift & annuity table) which can be written off against income. If you assume she pays 40% in state and federal income taxes, this write-off will create approximately $112,800 ($282,000 x 40%) of ordinary income tax savings to Lauryn which may be distributed over a period of six (6) years ($18,800 annually) depending on her adjusted gross income and the type of gift she makes.
Additionally, the $1,000,000 gift creates an annual income from the trust of $80,000 before income taxes ($1 million x 8.0% unitrust interest rate) for Lauryn. Again, assuming an effective tax rate of 25% on these earnings, Lauryn will pay tax of $20,000 per year on her Charitable Trust earnings ($80,000 x 25%), and her net earnings from the Charitable Trust payment will be approximately $60,000 per year net of tax ($80,000 – 20,000). This does not even factor the annual approximate tax savings of $18,800 for the first six (6) years generated by the strategy, as explained in the prior paragraph (Note: the taxation of earnings from a Charitable Trust can vary, and the rate of 25% used in this example is for illustrative purposes only).
We can see that the charitable gifting option is worth nearly $14,000 more per year to Lauryn than the living on the interest and earnings from investment option, and this occurs apart from the additional $18,800 in ordinary income tax savings generated by the strategy. However, you probably noticed that in the charitable gifting scenario, Lauryn’s heirs will not be left the principal of $840,000 (which will be worth $504,000 after estate taxes of 40% are paid).
Donor’s Heirs Can Be Better off As Well
If Lauryn has an estate tax issue, however, her heirs are actually better off in the “Charitable Gift” scenario as well. Why? Because Lauryn took the $60,000 Charitable Trust payment, net of income taxes, and used this payment to purchase a wealth replacement life insurance policy. Let’s see how this works, assuming Lauryn has a net income of $50,000 per year from her Charitable Trust payment:
Starts with Charitable Trust payment $80,000*
Income Taxes on Charitable Trust Payment (20,000)
Trust Legal and Accounting fees per year (2,000)
Payment Net of Income Taxes and fees $58,000
Gifts $54,000 per year to ILIT ($54,000)
Purchases life insurance in the ILIT with face value of $2,500,000
Estate tax due at death $0
Amount left to children and grandchildren $2,500,000
The entire transaction can be summarized in the table below:
Repeat for 18Years
Account Balance at Death: $4,860,000
Net to Estate Less Tax @ 35 %: 3,159,000
Net to Charity: 0
The Trade Off is nearly $46,462 of after-tax annual income and $504,000 to her heirs or $60,000 of after-tax annual income and $2,500,000 to her heirs. It is an obvious choice.
Of course, this solution can work with many different assets, not just highly appreciated stock. However, this solution is not ideal for everyone and the IRS has tables which dictate how great the personal benefit can be on a charitable gift. Further, these estimates are based on current assumptions of taxes, interest rates, and life expectancies. Each case will be different, but the philosophy is the same, and it can be a very favorable philosophy if done properly.