South Laurel Group - Blog #Taxes

What is a Donor-Advised Fund?

Thu, 16 Jun 2022 13:44:34 -0700

If you or your client has been lucky enough to have accumulated some wealth AND are in a situation where you are in a high-income tax bracket at the moment, you may want to investigate Donor-Advised Funds (DAFs). They offer a way to donate to the charitable causes of your choice while taking advantage of immediate tax deductions. A DAF is simply a private fund administered by a third party and created to manage charitable donations on behalf of an organization, a family, or an individual. The graphic below may help.

Benefits of Donor-Advised Funds

The most immediate benefit for donors is the ability to take advantage of a charitable tax deduction without the expense and overhead of setting up a private foundation. Unlike charitable bequests in a trust, the tax advantage is immediate and can be used to avoid capital gains taxes on highly-appreciated assets. In addition, most Donor-Advised funds can accept a wide range of non-cash assets, which can be helpful for those trying to donate highly-appreciated assets like stocks, options, interest in limited partnerships or cryptocurrency.

The funds grow tax-free and are then distributed to the charities of the donor's choice. It's fairly simple, which makes it nice for those who don't want to manage additional complexity.

Disadvantages of Donor-Advised Funds

There are a couple of clear disadvantages of these funds. Because of the tax advantages, the initial contribution is irrevocable. That means that, although you can change the recipient(s) of the funds, you cannot get your money back if it is needed. Also, while the donor can earmark where the donations should go, the managing institution ultimately controls the gift (hence, the term Donor-Advised).

Also keep in mind that DAFs generate money for financial institutions, just like other investment vehicles. And some financial institutions are less than forthcoming about all their fees, which can add up quickly. There is a reason why all the major investment houses (Fidelity, Schwab, etc.) push DAFs hard. It may be good for their clients in some situations, but they are also very lucrative.

There have also been a number of criticisms about DAFs in terms of financial institutions simply holding onto the money and racking up fees. While private foundations are required to pay out 5% of their assets annually, DAFs have no restrictions and can hold onto the funds as long as the deem fit. This skirts the original intent of streamlining charitable donations to worthy causes and makes these funds more of a tax play for donors and a source of recurring fee income for the financial services industry. It is worth asking the DAF about the percentage of funds donated annually and to whom.

Who Should Consider Donor-Advised Funds

If you are sitting on highly-appreciated non-cash assets such as stocks or other investments AND have sufficient current income to take advantage of a large write-off, DAFs may make sense for you. That last part is important - you can deduct up to 60% of Adjusted Gross Income (AGI) on your federal returns for cash contributions and up to 30% of AGI for stock contributions. Depending on the state, you might get additional tax breaks on your state returns. But if you don't have sufficient current income, some of these advantages may disappear.

What is a QTIP Trust?

Thu, 21 Apr 2022 18:35:18 -0700

Tax attorneys and accountants love their acronyms. Some seem deliberately designed to confuse the rest of us. For example, QTIP trusts. They have nothing to do with ear cleaning or model airplane construction. QTIP stands for Qualified Terminable Interest Property and a QTIP trust is simply an instrument designed to pass on property (in a limited way) to a surviving spouse without triggering the Federal Gift Tax. The recipient spouse has an income interest in the trust and does not have a power of appointment over the principal. Upon the recipient spouse's death, the principal is included in his or her estate for estate tax purposes.

Why would someone want to set up a QTIP trust? The most common situation is when the grantor (or creator of the trust) wants to provide a home (and any income deriving from the home) for a surviving spouse during that spouse's lifetime, but wants to direct the final gift of the property upon the death of the spouse. QTIPs are often employed for second or third marriages, when the owner of the property wants to provide for the current spouse but wants the property to ultimately go to one or more of the children from the earlier marriage(s). But there are other scenarios, as well, including leaving the remaining principal in the property to a charity or somebody else altogether.

In addition, QTIP trusts give the executor of the trust more flexibility to minimize estate taxes, depending on the tax code and the financial situation of the trustee at the time of the death. In other words, your executor can choose the estate tax treatment of the QTIP trust to reflect changes in the applicable tax laws or changes in the value of your assets since you last made your will. It may also be beneficial if the surviving spouse already has significant personal assets. In that case, the executor can take advantage of the graduated tax brackets in the estate tax law for both parties, in turn reducing the overall tax paid between both spouses.

There are some nuances to QTIPs, in both how they are set up and how they are administered. For example, the QTIP trust can be written to provide the greater of $5,000 or 5% of the trust assets to the surviving spouse annually. There can be other stipulations and conditions, depending on the specific situation. In any case, the surviving beneficiaries are entitled to a full, accurate accounting of the trust assets upon final disposition so care must be taken in setting up the trust and administering it properly.

The Build Back Better Act and Your Trust

Tue, 16 Nov 2021 09:18:21 -0800

As I write this, Congress and the Biden administration are wrestling over the massive Build Back Better Act. The bill (H.R. 5376) has gone through multiple revisions as various factions weigh in. At one point, it contained a number of changes to current law to fund some of the goals of the Biden administration. These changes included, at one point or another, some mix of the following:

Reducing the amount that individuals could gift during lifetime or bequeath at death before application of federal transfer taxes
Eliminating the so-called “step up” in basis that occurs at death and enables those inheriting assets to avoid tax on the capital gains accruing during a decedent’s lifetime
Taxing capital gains at death or sooner without need for a sale of assets

Understandably, estate planning professionals and clients concerned about passing down wealth with a minimum of taxes have been scrambling to think of ways to adjust plans to account for these changes. However, as of today (and this could certainly change) the Build Back Better Act (H.R. 5376) contains no modifications to the estate and gift tax exclusion amount or the basis step up rules. That is good news for all of the carefully planned trusts that currently exist out there.

But there are a number of caveats to this good news. The first, of course, is that Congress could change its mind and re-insert changes in the final bill. The second is that the current state of affairs was always meant to be temporary. The current $11.7M estate and gift tax exclusion was provided under a temporary law under the Trump Administration. Even without any act of Congress, the exclusion will be cut by about half effective January 1, 2026. Amounts in excess of the exclusion (probably about $6.5M indexed to inflation) will be taxed at the highest federal rate of 40%.

In addition, trust income will be subject to the "Millionaire's Tax" in the Build Back Better Act. The proposal is that there will be a 5% tax surcharge on income over $200,000 and an additional 3% on income over $500,000. These income limits are substantially lower than those for non-trust income.

Because of the chance that both the estate and gift tax exclusion will revert to the lower amounts in 2026 and that the trust income tax surcharges will take effect, estate planners are starting to look at re-structuring estate plans (particularly those for estates of more than $6.5M) to solve for the new tax situation. Trusts such as an A/B (or C) trust, which splits the original revocable trust into two trusts upon death (thereby lowering the amount of each trust below the new limit) might become popular again. They have restrictions and can be complex and difficult to manage, but the tax savings can be substantial. I will outline the specifics of A/B (C) trusts in a later blog post.

The upshot of all the above is that, if you are fortunate enough to have an estate that you project to be more than $6.5M (which is, admittedly, a bit of a champagne problem) you should be actively working with an estate planner who is tracking these changes and has a strategy for adjusting your plan to compensate. It is also a good idea to think about who you will use as a trustee - most non-professionals are not able to manage the complexities of administering these trusts.