Bad News Bear Markets Aren’t Always Bad News

Vaughn W. Henry

Has the stock market handed you lemons? Make lemonade. As it turns out, not all stock market gyrations are bad things. Recent declines in equity portfolio values actually may present some excellent opportunities for tactical estate and gift planning.

Consider the charitable lead trust (CLT), an inverse of the better-known charitable remainder trust (CRT). How does a lead trust function? A donor transfers cash or assets, preferably appreciating assets, into a trust with the intention of supporting a charity and then returning the asset to the family. Commonly used to “zero out” an estate and popularized by Jackie O’s unfunded testamentary CLT, it’s a tool that helps preserve family wealth and control social capital.

The lead trust works best in a low interest environment when contributed assets are temporarily depressed in value, but are still liquid enough to make the required “lead” or income payments to charity on a regular schedule. The donor has a choice about using either a fixed dollar contribution (CLAT) or a fixed percentage contribution (CLUT) in order to meet the requirements for a qualified lead trust. Unfortunately, there is little IRS guidance and no prototype documents available to guide advisors. Even with those hurdles, the bear market presents an ideal opportunity to gift assets that have intrinsic worth, but are temporarily at a lower value.

While the IRS and Congress have been trying to tighten restrictions on "estate compression tools" (legal structures that deflate an asset's fair market value, like the family limited partnership or FLP), it’s darn hard to argue with a valuation that’s created by an active public market. The IRS makes an argument that publicly traded stocks have an established value, are easily partitioned, and that aggressive FLP discounting taken for minority interests, lack of control, and lack of marketability in those limited partnership units may be abusive. The lead trust offers a solution to passing family wealth. A stock portfolio of $1 million that suffers a 35% - 40% decline due to erratic and emotional market behavior has presented the owner with a legal and timely way to reduce the family's estate and gift tax bill.

Is there any risk to creating a charitable lead annuity trust? If the CLT investments earn less than the government’s applicable federal mid-term rate (§7520 120% Annual “AFR”), then the trust will produce a remainder significantly less than what was originally contributed. If the trust manager takes a long-term view and maintains a tax-efficiently managed portfolio, then the subsequent growth passes tax free to heirs. Currently, with the government’s low AFR and the stock market decline, a charitable lead annuity trust is an excellent planning tool. Create these trusts far enough ahead of time and inheritances pass with no tax cost at all. And since the assets placed into trust are (we hope) in a temporary decline because of market fluctuations, the family inherits a solid portfolio with the capacity to grow significantly.

Consider the charitable lead annuity trust if you are:
- already giving enough to charity to exceed schedule A deduction limits
- interested in supporting charity with pre-tax earnings
- living on modest income, but have an appreciating estate
- interested in preserving appreciated assets for heirs but may have already used up lifetime gifting exclusions (your applicable exclusion amount, $1 million in 2002 and 2003)
- trying to diversify and still discount estate values
- dealing with unforeseen income, don’t need it and would like to pass it on
- planning an estate for heirs as a “deferred inheritance trust” or “accelerated inheritance”
- selling a business and now that the contract is signed and found out that it’s too late for one of those “CRT things”, and would like to give the kids the proceeds
- willing to have your kids wait a bit in order to save tax on an inheritance

George Smith (55 years old, married with 3 children) had one of his diversified portfolios heavily weighted with technology stocks worth $2.5 million at the peak of the market, and this year after his average values have already declined more than 65%, his portfolio is worth $850,000. George feels his portfolio still holds some outstanding stocks and views this as a buying opportunity, but he wants to solve estate tax problems too. Advised to think strategically and solve several problems at one time, George plans to create a 20-year non-grantor charitable lead annuity trust with his temporarily depressed portfolio. This CLAT stipulates that $69,400 (8.166% of the initial fair market value) will go to his church’s capital fund to build a day care center and nursery named for his wife. In this way, he funds his charitable interests and after 20 years, the portfolio and all of its growth will pass to his family at zero cost in gift and estate taxes. The family's only cost is the wait for assets they are in line to inherit anyway. By passing assets without any tax cost, the appreciated portfolio should be worth $1.74 million (based on an AFR of 5.2%) if the underlying funds just experience average market performance. This will save the family unnecessary estate taxes and still provide for George’s philanthropic interests in a very tax efficient manner.

Year Beginning Principal 10% Growth Payment to Charity Remainder to Heirs 1 $850,000 $85,000 $69,411 $865,589 2 $865,589 $86,558 $69,411 $882,736 3 $882,736 $88,273 $69,411 $901,599 4 $901,599 $90,159 $69,411 $922,348 5 $922,348 $92,234 $69,411 $945,172 6 $945,172 $94,517 $69,411 $970,278 7 $970,278 $97,027 $69,411 $997,895 8 $997,895 $99,789 $69,411 $1,028,274 9 $1,028,274 $102,827 $69,411 $1,061,690 10 $1,061,690 $106,169 $69,411 $1,098,448 11 $1,098,448 $109,844 $69,411 $1,138,882 12 $1,138,882 $113,888 $69,411 $1,183,359 13 $1,183,359 $118,335 $69,411 $1,232,284 14 $1,232,284 $123,228 $69,411 $1,286,102 15 $1,286,102 $128,610 $69,411 $1,345,301 16 $1,345,301 $134,530 $69,411 $1,410,420 17 $1,410,420 $141,042 $69,411 $1,482,051 18 $1,482,051 $148,205 $69,411 $1,560,845 19 $1,560,845 $156,084 $69,411 $1,647,519 20 $1,647,519 $164,751 $69,411 $1,742,860 Total   $2,281,080 $1,388,220 $1,742,860

© 2002 -- Vaughn W. Henry Gift and Estate Planning Services Springfield, IL  62703-5314 217.529.1958 -- 217.529.1959 fax VWHenry@aol.com     www.gift-estate.com