Income taxes generated by gain on sales of appreciated property present a significant obstacle to the free flow of capital. There are numerous techniques to ameliorate the problem, such as deferred like-kind exchanges, tax shelters, “mixing bowls”, collars, and charitable remainder trusts. Each has its advantages and disadvantages. This article, however, deals only with one technique, the simulated charitable remainder trust.

Assume Mr. Client transfers $10,000 to a new LLC, gifts a nonvoting 99% interest therein to public charity1 (retaining 1% for himself) and then sells $1m of publicly traded stock2 with a zero basis to the LLC in exchange for an annual annuity of $47,479 payable for so long as either he or his wife (both age 50) is living. Assume the LLC then sells the stock for cash.

Based on interest rates in March, 2003, the income tax results would be that (i) Mr. Client would get a charitable deduction of $109,912, (ii) Mr. Client would have $24,223 of ordinary income and $23,256 of capital gain on receipt of each annuity payment,3 (iii) the LLC would have $100,012 of gain on sale of the stock, of which 99% would reported by the tax-exempt charity and 1% would be reported by Mr. Client, and (iv) the annuity payments would not be deductible for the LLC, but (again) 99% of the LLC’s income would essentially be tax-free income reported by the charity.4

For comparison purposes, Mr. Client’s gain on sale without the technique would be $1m and his after-tax cash on hand, assuming a 20% tax rate, would be $800,000. With the technique, the “cash on hand” (i.e., in the LLC) would be the full $1.0m5 and his income tax liability would be reduced by the charitable deduction. If Mr. Client were to invest the $800,000 on hand after tax without the technique at 5.93%, it would provide the same pre-tax cash-flow as the charitable annuity during the lifetimes of Mr. and Mrs. Client.

The LLC’s cash could be invested as Mr. Client chose. A possible investment would be to make a loan to a family partnership controlled by Mr. Client.6 Interest on such loan would presumably be deductible, but 99% of such interest income would be reported by the charity. The arrangement is quite flexible in that Mr. Client would be in a position to sell the annuity or otherwise amend the various agreements at a later date.

The charity will get 99% of whatever is in the LLC on dissolution. Stated another way, the annuity payments terminate on the death of the survivor, potentially generating a large loss for Mr. Client’s family and large gain for the charity. If that is a problem for Mr. Client, there are a couple of options to consider. One would be for the loan by the LLC to the family partnership to be self-canceling, a so-called “SCIN”. The interest rate on such loan would have to be higher to reflect the risk of premature cancellation. For example, the interest rate on a 29 year note which cancelled on Mr. Client’s earlier death would have to bear at least a 5.037% interest rate. Another option would be for the partnership to purchase a survivor life insurance policy.

“Crunching the numbers” over 20 years and assuming the use of a SCIN on a $900,000 loan by the LLC to the partnership leads to the conclusion that Mr. Client and his family partners are collectively much better off than having paid the taxes up front. To give an idea of just how better off, if (i) the $1m is invested solely in stock growing at 10% annually (i.e., no dividends), (ii) there is a 30% annual turnover rate on such investments taxable at a 20% rate, and (iii) if all positions are liquidated in 20 years, Mr. Client and his family would be in essentially the same economic position as if there had been a full 100% basis in the property. That is, the economic impact of an up-front capital gains tax which would have been paid if Mr. Client had simply sold the asset for cash is completely offset by the combination of (i) the up-front charitable deduction, (ii) the deferral of the capital gains tax, (iii) the effective conversion of some of the deductible interest paid by the partnership into the capital gain portion of the annuity, and (iv) long-term compounding. Comparable results are achieved over a wide range of growth rates. Further, the charity would benefit greatly.

Of course, there are risks associated with the technique. Nevertheless, through careful planning for the individual situation, the risks are not only manageable, but usually well worth running. Except in egregious cases, the technique should stand scrutiny by the IRS.

SIMULATED CHARITABLE REMAINDER TRUST

Step 1: Mr. and Mrs. Client contribute $10,000 to an LLC in exchange for a 1% voting interest and a 99% nonvoting interest.

Step 2: Mr. and Mrs. Client transfer the 99% interest to a charity as a gift.

Step 3: Mr. and Mrs. Client transfer $1m of stock with a zero basis to the LLC in exchange for an unsecured promise to pay $47,479 annually for so long as either is living (i.e., a charitable gift annuity.)

Step 4: The LLC sells the stock for $1m cash.

Step 5: The LLC purchases a $110k portfolio.

Step 6: The LLC lends $900k to a family partnership in exchange for a note which cancels on the death of Mr. Client.

1 A community foundation might be a good choice because such charities provide a “donor advised” fund. The donor does not have the right to control the disposition of the funds, but may have a high degree of confidence that the community foundation will follow his later expressed desires.

2 The technique works equally well with appreciated realty.

3 Mr. Client is reporting $899,988 of gain in installments over the joint life expectancy of himself and his wife. Note that installment reporting is not available on an installment sale of publicly traded securities, but that annuity treatment achieves a similar effect to installment reporting, except that the interest element is not front-loaded.

4 Unless the LLC’s income were considered “unrelated business taxable income”, which is relatively easy to avoid.

5 Plus the $10,000 contributed on formation and less administrative expenses.

6 Care is needed in the selection of the borrower. Ideally the borrower is not the same economic interest as Mr. Client and/or his wife. Also, it may be preferable to delay any such loan for some time period. The charity could also be the borrower.