The 2000 presidential campaign seems to overshadow the important stuff going on in Congress, viz., repeal of the Federal Estate Taxes. If the Estate Taxes are repealed (and that hasn’t happened, as of the date this article is written, which is, July 20, 2000[1]), it appears we might still be faced with additional income taxes, which will require us to keep more sets of records. And our heirs will have “one more tax” to pay, which will be in the nature of additional income taxes. Since brevity is the essence of clarity, let me give you my concluding thoughts at the beginning of the article, so you won’t have to read this any further if it is of no interest to you: charitable remainder trusts may be of more value if the estate taxes are repealed.

As things now stand, when a person dies, the heirs inherit the property at the fair market value at the date of death – thus, the heirs will have a new tax “cost” basis, and there are no additional taxes on the “step-up” in basis. That will change, however, if the estate taxes are repealed, for Congress will probably eliminate the benefit of the set-up in basis. Thus, my heirs will acquire my estate, without an estate tax, but their cost basis will be the same as mine, for income and capital gains purposes. If I paid $70,000 for commercial real estate in 1985, and depreciated it as a business property, my heirs inherit my cost basis: after I die, and assuming the estate taxes are repealed, there will be no estate tax to be paid. However, when the commercial real estate is sold by my children, they will have two income taxes to pay:

(a) Capital gains tax based on the difference between their sales price (let’s say $150,000) and my purchase price ($70,000). If long term capital gains rates remain at 20%, then that part of the tax bill will be $16,000 ($150,000 – $70,000 = $80,000 x 20% = $16,000).

(b) In addition, they will be taxed at ordinary income tax rates, for all of the depreciation I have taken on the property (e.g., $50,000) – this tax is called “recapture of depreciation”. If my children are in the 28% income tax bracket, this tax will be $14,000 ($50,000 x 28% = $14,000).

Thus, the total income tax to be paid when the commercial real estate is sold by children is $30,000 ($16,000 + $14,000 = $30,000).

So how might we plan around this scenario? I might create a Charitable Remainder Trust, to eliminate the income taxes for me and my heirs. First, I would locate and retain a sharp accountant and lawyer to help create the trust; I would probably ask them to modify one of the forms the Treasury Department has promulgated (that ought to save some legal and accounting fees). The agreement would provide that during my lifetime, and during the lifetime of my spouse, the trustee would pay me 5% of the fair market value of property every year (I will have to pay income taxes on this annual payment). Secondly, I will have the property appraised, on an annual basis (this requirement is part of the agreement, which is a Charitable Remainder Unitrust, as opposed to a Charitable Remainder Annuity Trust). Third, I will be able to take an income tax deduction for donating the property to charity, based on some very complicated calculations (the amount of the deduction depends on the value of the property, the life expectancies of me and my wife, using a variable rate of interest established by the Treasury Department). And finally, I will have to find a good charity, which will own the trust property after my wife and I die.

Once the trust has been established, the trustee can then sell the commercial real estate, and pay no income tax (the CRT is, in effect, treated as a private foundation, but the CRT is not required to attain tax exempt status, by filing a Form 1023). Thus, there are no capital gains taxes to pay, nor are there any ordinary income taxes to pay for recapture of depreciation. The proceeds from the sale will be retained until both my wife and I are deceased.

When both my wife and I are deceased, the charity named in the trust will inherit whatever is left in the trust corpus. As a technical note, the charity is required to receive at least 10% of the value of the CRT, and this qualifying determination will be made before the trust is established.

All of this sounds good, but notice what has happened: I no longer own the commercial real estate – after the trust has been created, all my wife and I own is the right to receive income while we are alive. Once we are deceased, the charity inherits the trust corpus. So my children will not inherit the $150,000 commercial real estate. To replace this “lost wealth”, I will probably arrange for the purchase a life insurance policy for $150,000 (perhaps a second to die policy), and arrange for the policy to be owned by an irrevocable life insurance trust, or by my children directly. If the estate taxes are repealed, then I might decide to own the policy myself (as things now stand, if I have any incidents of ownership over the policy, it is counted as part of my taxable estate, for estate tax purposes – to keep the policy out my taxable estate, it must be owned by someone else, viz., my children or the trustee of an ILIT).

So what have we done with this process? First, we have eliminated any income taxes on the sale of the commercial real estate. Second, we have provided an income stream (which is taxable as income) for me and my wife. Third, my wife and I will be able to deduct part of the gift’s value, as a charitable donation. Fourth, the charity will receive an inheritance when my wife and I die. And fifth, my children will inherit (without income or estate taxes) the face value of a life insurance policy.

With these benefits, there are also some burdens: I have to purchase a life insurance policy to replace the wealth I have transferred to the CRT (more insurance premiums), and I have limited my income from the commercial real estate to a minimum of 5% per year, of the value of the trust estate. I will have more tax returns to file (the CRT will have to file income tax returns), and I will have to pay more legal and accounting fees to create the CRT. The charitable remainder beneficiary will have to receive a minimum amount of property placed in the trust, after I die (Congress has set the amount as 10% — which means, I can’t use all of the trust assets for myself while I am still alive). And the trustee of the CRT must have the trust property appraised each year (in order to compute my 5% annual payment).

So there you have it. Whether or not Congress repeals the estate taxes, charitable remainder trusts are important estate and income tax planning tools. So let’s wrap this article up with this thought: if Congress repeals the Estate Taxes, leaving our heirs with Capital Gains Taxes and ordinary income taxes to pay on the sale of capital assets, it would appear that Charitable Remainder Trusts will play a more prominent part of the estate planning process. After all, who wants to pay taxes?

[1] When the estate taxes are “repealed” in 2010, $1.3 million in assets will receive a step up in basis. Assets left to ones spouse will receive a step up for $4.3 million. Congress adopted EGTRRA in 2001. If Congress extends the repeal of the estate taxes in 2010, there will be no more estate taxes. However, there will still be a federal gift tax in place.

©2000 James H. Beauchamp