Can charity make retirement tax-free?

Jul 11, 2014
by DTN

Q: In one of your recent columns about farm tax planning, you discussed a couple retiring from farming without heirs and looking to dispose of $750,000 of machinery to a young neighbor [run in the June 23 issue of WLJ]. You explained that a sale was taxed immediately, and the only option to stretch out the income was a long-term lease, allowing time for a reduction in value to reduce the amount of recaptured depreciation.

What are your thoughts about a charitable remainder trust in this instance? The couple could create a lifetime income stream and use the deduction to offset that income. Perhaps they could also set up a wealth replacement trust (life insurance) to benefit the children if they have concerns about leaving those sale proceeds.

A: On occasion, we have used a charitable remainder trust (CRT) to dispose of machinery. But that has been a situation where there is a public auction, not a targeted sale to a specific young neighbor. The trustee of a charitable remainder trust needs to conduct an independent sale of any donated assets. A CRT is not a fit where a nephew or a neighbor is targeted to be the purchaser.

The CRT definitely has its uses. It is a two-step process: The machinery is conveyed by bill of sale to a trustee, with the second step being the trustee independently conducting the sale (i.e., an auction). The sale is tax-free because it is conducted by a charitable trust. The CRT terms require payment of an income stream back to the donor who created the trust. We generally design that income stream over 10 years or so in order to spread out the income. The term can be as long as 20 years, or alternatively the trust can be designed to pay lifetime income.

A key tax caveat, however, is that the trust, based on its original design, must be projected to leave at least 10 percent of its original value to charity. It is hard to gain a 10 percent rate reduction by spreading income out, so there is generally a net dilution of wealth here. The tax savings from a deferral on the machinery sale generally do not exceed the 10 percent carve-out to charity. That is the result under today’s current low interest rates. When we get back to an era of more increased interest rates, the economics of the CRT improves for the donor.

However, there is normally no charitable deduction with a CRT funded with machinery. By the time a retiree’s auction occurs, the machinery is generally fully depreciated. The charitable deduction for this type of asset is effectively limited to the remaining tax basis, and that is a zero. Basically, whether it is raised grain or depreciated machinery placed in a CRT before sale, the strategy is about gaining income deferral, not producing a charitable deduction. The use of the CRT strategy for raised grain, however, does provide a self-employment tax reduction benefit.

And the life insurance strategy is fine if there is an actual risk of diminished wealth for the kids if you die early. But there’s no economic magic to life insurance (unless you want to outsmart the insurance company by dying early). If you survive to normal mortality, you have simply prepaid for the wealth that will transfer via the life insurance policy, but with that wealth reduced by the insurance company costs and profits. Insurance is great for risk protection; that is its purpose. It is not so great for building wealth for the next generation if there is not a risk from early mortality. That said, if the 40 percent estate tax is in play, parking wealth in an insurance trust outside of the estate can be efficient in terms of wealth to the kids. — Andy Biebl, DTN Tax Columnist