Part Two, Charitable Trusts and Hawaii Law

Welcome back to Malama Kupuna, caring for our elders. Well we’re talking this week about charitable giving, and just before the break I was talking about RMDs, a key topic relating to charitable trusts and Hawaii law.

If you’re 70-1/2 or older, you know what an RMD is. An RMD is a required minimum distribution, which is the amount that you have to start taking out of your IRA once you reach age 70-1/2, or you’re going to be subject to a 50 percent penalty on what you should have taken out but didn’t take out.

And the way the RMD is calculated is that there are what they call actuarial tables out there, that supposedly tell us how long we’re going to live once we reach certain ages, and what it is is just an average of the experience in the United States, concerning people who reach age, in this case, 70-1/2. And what those tables tell us is that once you reach age 70-1/2, you’re probably going to live another 16 or 17 years.

So what you have to do in the first year of your RMD is take out 1/16 of what’s in your IRA. The next year you have to take out 1/15 and so on, so that over the years, you take out what’s in your IRA in theoretically equal annual installments. Now, when you take out that RMD, you’ve got to pay tax on it. Well this year and this year only, unless Congress changes the law, you can have that RMD go to your favorite charity instead of coming to you.

Why would you do that? Well, if that RMD goes to the charity. you don’t have to take it into income. You don’t have to pay income tax on it. If you were to take the RMD, pay the income tax, and give a net amount to your favorite charity, you’d actually end up giving less to the charity. So financially, in almost every circumstance, it’s better to have that RMD directed to your favorite charity.

Now as I was saying earlier, the RMD to charity rule applies only this year. Under current tax law, this is a goody that’s going to go away as of the end of 2013. Now, over the past several years, this is a benefit that’s been extended time and again, and hopefully Congress will just go ahead and make it permanent, maybe this year. But it’s unclear whether that’s going to happen or not.

So don’t count on the RMD being something that you can use to make those charitable gifts. But if you’re going to make a charitable gift anyway, in other words if you tithe to your church where there’s an annual amount that you give to your favorite charity, think about using that RMD. It can make an awful lot of good sense to do that.

Here’s an important principle. Never, ever sell an asset in order to make a gift to charity. The reason is that when you acquire an asset, it becomes what’s called a capital asset. When you sell that asset, you have to pay capital gains tax on the difference between your basis, which is usually the purchase price for that asset and the sale price.

Now, if instead of selling the asset, paying the capital gains tax, and giving a gift to charity, if you give that asset, whether it’s stock or real estate or whatever it is, if you give it to charity, the charity can sell it and not have to pay any capital gains tax, and you get a deduction for the full fair market value of that asset.

Let’s say, you have $100,000 worth of stock in XYZ Corporation, but your basis in that stock is very low. Let’s say, it’s zero because it was gifted to you many, many, many years ago. So you’ve got $100,000 asset that you could sell, pay the capital gains tax on, and give the rest to charity, and get a deduction for that net amount. Or, you could give that entire portfolio of stock to the charity, get a deduction for the full amount.

A capital gains tax is a very complex topic, but let’s just say for purposes of illustration that the capital gains tax between federal and state is 20 percent. And for most of us, it’s not. It’s going to be a lot more than that, but it just makes the math easy for me. So let’s say I’ve got this $100,000 portfolio, I sell it, I pay the 20 percent tax, and then I can give the remaining $80,000 to my favorite charity. Or, I can give the $100,000 portfolio to charity, and get a deduction for the full amount.

Which would I rather do? What if I don’t want to give the full amount of that stock portfolio to my favorite charity, what if I want to give 10 percent? Well, what I can do is actually give that 10 percent in stock to the charity, get the deduction for the 10,000, and then the other 90,000, I can pay the tax and pocket the rest.

So there are just a lot of options. But remember, never, ever, ever sell an asset in order to raise the funds to make a charitable gift. Think about giving that capital asset rather than selling it and giving the net proceeds. Now, that principle of never selling an asset in order to make a charitable gift carries into a really important strategy that we use called a charitable remainder trust.

A charitable remainder trust is an irrevocable trust that you create for the purpose of giving yourself an income stream, yet providing maybe a very substantial gift to charity after you’re gone. The way it works is this. If you’ve been watching this show for any length of time, you know that I like to use various things to illustrate different kinds of trust.

And I use the little lauhala box to illustrate the irrevocable trust. Any time you create an irrevocable trust, what you do is you take some stuff, you take some assets, and this could be cash, it could be stock, it could be real estate, and you put into the irrevocable trust, and then you put a lid on. And what the lid means is that you really have given it away.

Maybe you’ve maintained some right with respect to the assets in this trust. For example, maybe you’re retained an income stream for the rest of your life, but you can never, ever, ever touch that principal again. The way the charitable remainder trust works is you take an asset, let’s say, you’ve got a piece of land on the big island. You have a zero basis in it, but it’s worth $100,000.

If you were to sell that property, then you would pay the capital gains tax, and you could use the net proceeds to give you an income stream for the rest of your life. Let’s say that you’re interested in that income stream, or how about this as an alternative?

You take that property, you put it into the irrevocable trust, the charitable remainder trust. The charitable remainder trust then sells the asset, receives the $100,000 proceeds, and then can pay you an income stream based on that $100,000, rather than based on the $80,000 that you would have had, had you just sold the asset, and then used the remaining proceeds to produce that income stream.

Now the catch with the charitable remainder trust is that once that income stream is pau, whatever is left in the trust goes to the charity. Now you can define the income stream in a lot of different ways. One of the ways you can define it is in terms of a set dollar amount every year. That kind of trust is called a charitable remainder annuity trust.

Alternatively, you can set it in terms of a set percentage of the value of the trust estate every year. That kind of trust is called a charitable remainder unitrust. And it just depends on whether you’re comfortable with a dollar amount, or you’d rather have a percentage that may go up over time. Of course, it could also go down over time. It just depends on what kind of payout you would prefer.

Now I mentioned that once that income stream is pau, the remaining assets go to charity. That income stream can come out for your lifetime. It can come out for the life of yourself and your spouse. It can come out for a term of years. You can say, “Well, I want the income for 20 years, but then I want the remainder to go to charity.” All of those are viable options.

When you create that trust, you get a charitable deduction for that remainder value, and what that remainder value is, is going to depend on what that likely income stream is. If you’re older, that’s going to be a larger charitable gift. If you’re younger, it’s likely going to be a smaller charitable gift. But once that income stream is gone, the asset goes to charity. In other words, it does not go to your family.

So one of the kinds of things you can do with that enhanced income stream is you can take it and use it to fund an insurance policy, for example, for your family members so that, in effect, the value that you’ve given away can come back to your family by way of insurance proceeds. And that can be a really clever way to do your charitable giving and still provide for your family.

Now there’s something that is a variation on the theme of the charitable remainder trust which is a gift of a remainder interest. Here’s an example of the way you can give a remainder interest to charity. You can say, “Well, I really like this house. I really like living here. I’d really like to give it to my favorite charity, but if I give it to the charity now, I’m not going to have a place to live.” No problem.

What you can do is you can give the house to your favorite charity, but reserve to yourself the right to live there for the rest of your life, or you can reserve that right for yourself and your spouse. But then, once that life term is up, then that asset is going to go to your favorite charity. When you make that initial gift, even though you’re reserving a life estate, you get a current income tax deduction, and you go to your reward knowing that that piece of property is going to your charity after you’re gone.

Another variation on the theme is something called a charitable gift annuity. A charitable gift annuity is where you give, let’s say, a sum of cash to charity. The charity then will pay you an income stream, based on the value of what you’ve given to the charity. And then once that income stream is up, because you’ve passed away or because of the passage of time, let’s say, you set it by a number of years, then what’s left in that annuity goes to the favorite charity.

Not all charities are set up to provide charitable gift annuities, but they can be a really, really great option if you want to make the gift, but you still need that income stream, you still need those assets to be working for you during your lifetime. In the state of Hawaii, if a charity is going to offer a charitable gift annuity, it’s got to register with the state. It’s got to make sure its actual safeguards are in place.

For example, segregating the assets so that the person who’s made the gift is pretty sure they’re going to be able to get their income stream. So that’s why not all charities are set up or geared up to be able to provide charitable gift annuities. But it’s a wonderfully helpful strategy for individuals who need that income stream and for charities that are set up to provide them.

Now another variation on the theme of the charitable trust is something called the charitable lead trust. The charitable lead trust is sort of the opposite of the charitable remainder trust. With the charitable lead trust, that charitable benefit is paid out first, and then whatever is left goes to the family members.

Charitable lead trusts are a pretty complicated topic in and of themselves that would warrant a whole separate show, but let me just explain very quickly that what we’re able to do under the law is we get to pretend an artificially low income stream into this charitable trust, no matter what the payout stream is.

So in other words, you can set up a charitable lead trust that says that the payout to charity is going to be five percent of the value of the assets in that trust every year. But you get to pretend under the rules that are currently in place that the charitable lead trust is earning an artificially low income stream. As of the month of April, 2013, you get to assume, no matter how much it’s really making, you get to assume that it’s only making one point four percent. In May, that percentage goes down to one point two percent.

So what we can do is we can figure out when that income stream essentially would zero out the assets in the trust, and then the trust agreement says that once the trust is zeroed out, whatever is left goes to your family, and the assumption that we get to pretend is that the value is zero at that time. But if you’ve got a trust that’s paying out five percent but earning eight percent, it’s actually growing over time.

So you’re making maybe a very substantial gift to your family members after that income stream is up. So this is another way that you can essentially zero out the estate tax entirely. Because of the ways that we can make charitable gifts, estate taxes really are 100 percent optional. So as I was saying earlier, you can give the amount that you can give tax free to your family members, and you can have the rest go by way of a charitable lead trust to your grandchildren, your great-grandchildren, much later on, and have that gift to charity go in the meantime.