Nobody likes to pay taxes, but most of us like to take baths.  Unless the bath is the kind where money flows out of your pocket and down the drain.  If you feel like paying taxes is a lot like seeing your money go down the drain, you will be glad to know that there is currently a very exciting—historic, even—estate planning opportunity that can help make the IRS take a bath after your demise instead of your loved ones.  The opportunity comes along with some alphabet soup that you will need to understand.  The specific letters are AFR and CLT.  We will get to the soup after some preliminary explanation.

Odd as it sounds, there is actually a tax on the privilege of owning stuff when you die.  It is called the estate tax.  You may know that the Federal estate tax went on vacation in 2010, so the estates of people who died last year got to pass estate tax-free.  Unfortunately, the estate tax has spent its vacation taking steroids and working out, and it will be back in 2011, possibly bigger and badder than it has been in a long time.  The way the estate tax works is that you add up the value of everything a deceased person owned, and send a substantial portion of it to the IRS, except to the extent that some exclusion or deduction applies.

The Code gives each of us an exclusion (which I like to call the “coupon”) from the estate tax.  Unless Congress changes the law after this goes to press, your coupon is worth $1 million.  It enables you to pass on $1 million worth of assets estate tax-free.  Current law says that 55 cents of every dollar of value over your coupon amount goes to the IRS as estate tax.  If Congress gets its act together by the end of 2010, your coupon will be worth more than $1 million and the tax rate will be less than 55%.  In any event, the strategy outlined here will still be viable for those of us lucky (or unlucky) enough to have “taxable” estates.

In addition to the coupon, the Code gives married couples an unlimited marital deduction so estate tax can be postponed until both Mom and Pop are gone.  Notice that the marital deduction doesn’t get rid of the tax—it just postpones it.  The coupon does get rid of the estate tax to some extent, but it is not enough to eliminate the estate tax for many families.  If you own a home, a life insurance policy, and a retirement plan, you have to be concerned about the estate tax.  One thing you can do during your lifetime to minimize the estate tax burden on your loved ones is to give some of your stuff to them.  Another approach is to make gifts during your lifetime or at death to your favorite charities.  If you like your descendants and a charity or two more than you like the idea of paying estate tax, there is a very effective way to give all of your assets to loved ones and charities, and nothing to the IRS.

The Internal Revenue Code allows an unlimited estate tax charitable deduction.  So if you think your favorite charities will spend your money more wisely than Congress (and what are the odds of that?), you can bequeath all of the assets that would have been taxed at your death (i.e., everything over the coupon amount) to charity.  But what if you want to give your descendants more than the first $1 million (or whatever the coupon amount happens to be at the time)?  That’s where the AFRs come in.

Among other things, the applicable federal rates set the rate of return that the IRS requires you to assume will be earned on the assets of a trust that pays an income stream to charity for a set amount of time.  The rate has been hovering around 2%, and even dipped to 1.8% last December.  Here's why this is significant.  You can put assets in a trust (either during your life or after you are gone) that will pay an income stream to charity for a set number of years, and then pay whatever is left to your loved ones.  If the AFR is less than the payout rate, but the actual rate of return is greater than the payout rate, the IRS will take a bath, and your loved ones will have the last laugh.

If you fund the trust while the AFR is 2%, you are allowed to assume that the rate of return on the trust is only 2%, NO MATTER WHAT THE ACTUAL RATE OF RETURN IS.  If the trust agreement requires a payout to charity of 5% per year, but it is only earning 2% a year, then logic tells you that your trust will eventually run out of money.  But what if the trust assets earn 7% a year instead of 2%?  A trust that earns 7% but pays out 5% to charity every year will grow over time.  This may not seem all that exciting until you see how these payouts and rates of return work together.  Let’s go back to the bath analogy.

Imagine sitting in a leaky bathtub.  If you do nothing, eventually you and your rubber ducky will be the only things left in the tub.  In order to maintain the water level up to your chin (that's where I like it), you will need to add water to the tub as fast as it is going out.  If you add water faster than it is leaking out, the water level will rise, and eventually the tub will overflow.  Imagine the flood that would result if you took a nice long bath (say 25 years) with hot water filling the tub faster than it is leaking out.  Now imagine that instead of an overflow of water, you had an overflow of money.  This is exactly how a special kind of estate planning tool called a charitable lead trust (CLT) works to take advantage of a low AFR.

You put assets (think hot water) into a CLT (think bathtub).  The trust agreement says that each year, 5% of the value of the assets will be paid to charity (5% of the water in the tub will leak out).  Meanwhile, let's say that the trust assets are earning income (the faucet is turned on and the tub is being filled) at the rate of 7%.  If the AFR is 2% at the time we created the CLT, then the law allows us to say that the trust will grow (the tub will fill) at a rate of only 2%.  Net result?  If payments are made to the charity monthly, WE GET TO PRETEND that the trust will be completely exhausted (the tub will be drained) in about 26 years, even though it will have far more in it at that time than when the trust was created.  The best part is that all of the trust assets will go to your loved ones, and not a cent will go to the IRS.

Twenty-six years is a very long time for a bath, but not that long for a trust.  If you are OK with giving your children something now (or upon your death) and letting them (or your grandchildren) wait for an even bigger payout at the end of the trust, then a CLT may be very attractive to you.  Assuming a 2% annual compounded return (which would be the difference between a 5% payout and a 7% actual rate of return), the principal of the trust will have grown about 167% in 26 years.  That’s not a lot from an investment standpoint, but all of those funds will go where you want them to go instead of being confiscated by the IRS so they can be spent by Congress.  All of the original trust principal (which your loved ones would have had to share with the IRS), PLUS all of the “overflow” (the actual net income of the trust in excess over the payout to charity), goes to your loved ones.  Before the bathwater gets any cooler, let’s put dollars and cents to the concepts and see how this works.

Let's say that you have $2 million worth of assets to pass on, and you don't want to pass any to Congress.  If the coupon amount is $1 million, you can pass $1 million to your kids and put the other $1 million in a CLT that provides a nice income stream (about $50,000 a year) to your favorite charities for 26 years.  At the end of the 26 years, if the trust earns 7% a year, there should be about $1.67 million to be distributed to your children (and/or grandchildren), and $0 to pay to the IRS.  If you had not used the CLT, current law says that your loved ones would have had to come up with $550,000 in cash, within 9 months after your death, in order to satisfy the IRS.  The CLT puts about $1.3 million into the hands of your favorite charities, and about $2.67 million (your coupon amount plus the $1.67 million remaining in the CLT) into the hands of your favorite loved ones.  That’s almost $4 million in distributions out of a $2 million estate.  The best part is that none of the $4 million goes to the IRS.  This kind of strategy may have a limited shelf life, so if it seems attractive, you should talk with your trusted advisors about implementing it in the near future.

Please note that this example is grossly simplified.  You would need your own professional advisors to calculate how a CLT strategy would work in your particular case.  But you can see how charitable lead trusts can pack a powerful tax planning punch.  They work well in times of low AFRs, whereas other strategies work better when the AFRs are higher.  And remember two additional points:  the AFR that applies to your situation is the one in effect when you part with the assets (i.e., you either die or give them away), and the AFRs change as often as monthly.

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