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Leveraging Charitable Deductions for Mitigating Taxes and Increasing Cash Flow

by James A. Lavorgna, J.D., LLM, CFP, TMBCP

Many charitable tax strategies are used to mitigate taxes but two  have been a favorite of mine for some time. They are the reversionary charitable lead trust and the charitable bargain sale.

Here are just a couple of stories about the everyday uses of these strategies.

Tax Mitigation Using A Reversionary Charitable Lead Trust

Charitable lead trusts may be structured to be “reversionary,” where remaining assets revert to the individual who created the trust, or they may be “non-reversionary,” where remaining assets funnel to a beneficiary other than the originator.

Charitable Lead Trust: Meaning, Pros and Cons, FAQs – Investopedia.com

When individuals with substantial retirement accounts consider converting traditional IRAs to Roth IRAs, they often face the challenge of a significant tax liability due to the conversion being treated as taxable income. This is usually a major drawback touted by Roth conversion critics.

However, in certain cases, we can counteract this drawback using certain charitable trusts.

Utilizing a reversionary charitable lead trust (CLT) can be a strategic approach to mitigate this tax impact. The tax deduction earned by funding a CLT can offset the income recognized during a Roth conversion, and any unused portion of the deduction can be carried forward for up to five years under current IRS rules. This carryforward applies to all charitable deductions.

Let’s explore this concept through some case studies:

Case Study#1: The Robinson Family and Mitigating Taxes through Roth Conversion and a CLT. Large contribution and high combined tax state.

The Robinson family, with a large traditional IRA, wants to convert their IRA to a Roth IRA. They are particularly interested in the tax-free growth and distributions that a Roth IRA offers. However, they’re concerned about the taxes due on the conversion. Here is how a reversionary CLT could help.

The Robinsons decide to convert $500,000 from their traditional IRA to a Roth IRA. This conversion increases their taxable income by the same amount in the year of the conversion.

Simultaneously, they set up a CLT with $1 million, specifying an annual payout of $40,000 to one or more of their favorite charities for the next 20 years.

The initial funding of the CLT allows the Robinsons to claim a charitable deduction for the present value of the expected payments to the charity. If this present value is calculated to be $600,000, at their combined federal and state income tax rate of 50%, they would potentially offset $300,000 of taxes in the year of the conversion.

If the Robinsons’ tax liability from the conversion and other income is less than the $300,000 tax offset, they can carry forward the unused portion of the deduction for up to five years, applying it to future tax liabilities.

Upon the conclusion of the 20-year term, the remaining assets in the CLT pass to the Robinsons’ beneficiaries. These assets have the potential to appreciate outside of their estate, providing tax-efficient growth and minimizing future estate taxes.

In this case study, the CLT’s immediate tax deduction helps to balance the tax due on the Roth conversions. Additionally, the Robinsons have the flexibility to convert more of their traditional IRA’s over several years, leveraging the carryforward deduction each year to strategically mitigate their tax liability.

Through this approach, they accomplish their objectives of tax-efficient retirement planning, supporting a charity they value, and arranging for a tax-advantaged inheritance for their beneficiaries. 

Case Study#2: The Joan Hansen Family:  Mitigating Taxes through Roth Conversion and a CLT for the already charitably inclined. Smaller contribution and lower combined tax state.

In a lower-rate tax state, Joan Hansen, a single woman with grown children, regularly donated approximately $15,000 per year to her church and local charities and she plans on continuing to do this for the rest of her life. Joan also has $400,000 in an IRA and another $800,000 in a 401(k) plan. She realizes that once she reaches age 73 and has to start taking required minimum distributions, the taxes could be substantial and she would like to lessen that burden as much as she can.

Joan set up a CLT, with a  charitable distribution of $15,000 per year over a 14-year term. At the time, it gave her approximately $200,000 charitable deduction that she is now using to offset distributions from her Roth conversions every year for the next six years. She set up the trust by simply moving $250,000 in-kind (in other words she did not have to sell any securities and pay any capital gains tax or disturb her current portfolio).

At the end of the 14-year term, the portfolio will revert tax-free to a non-charitable beneficiary, in this case, her children. 

Joan lives well from her pensions, annuities, and investments, and was able to convert large amounts of future taxable income and growth to tax-free lifetime growth. In addition, she was able to maximize and leverage both the dollars she was going to eventually leave to her children, as well as future donations she is going to make to her favorite charities.

Using the Charitable Bargain Sale and Leveraged Arbitrage for Tax Mitigation

The next clients, Mark and Carol Kenner, a husband and wife who needed additional life insurance and also long-term care coverage. They have no children but they were a little worried about cash flow over the next 10 years.

Mark recently retired and Carol was still working part-time as a nurse. Their house was paid off and Mark had a good pension and investments. Along with Carol’s part-time income, they were comfortable but Mark was still 10 years away from Social Security.

There were many choices; however, we looked at a hybrid policy that included a death benefit, guaranteed cash value to build back to his paid premium amount, and long-term care coverage.

The policy was available as a single premium, five or 10-year payment. They were both in their mid-50s and the single premium was approximately $100,000 for each of them. So both could be covered for a deposit of approximately $200,000.

The single premium was acceptable to both; however, I wanted them to be cognizant of the cash flow opportunities over the next 10 years before retirement. I asked them if I could show them a way to leverage that $200,000, guarantee their premium payments over the next 10 years, and then provide them with another 10 years of retirement income, would they be interested in seeing that scenario? The obvious answer was yes, so we explored the next technique, the charitable bargain sale.

A bargain sale to a charitable organization is the sale of a good or service to a charity for an amount less than the fair market value. A common bargain sale is a transfer of real estate to a charity. A bargain sale reduces the tax liability of the donating party because it is considered a tax-deductible sale.

Bargain Sale to a Charitable Organization – Investopedia.com

A charitable bargain sale is a contract issued by a 501(c)(3) charity that uses the installment sale rules and the bargain sale rules that are incorporated in the US tax code. In this arrangement, the donor (the client) transfers cash, securities, or real estate to a charity, which in turn keeps it or sells it in exchange for a charitable bargain sale contract.

The donor therefore eliminates some or all of the capital gains tax, receives a guaranteed tax-preferred income for a set number of years, and receives a tax deduction for part of the contribution.

In this case, we determined what the premium was on a 10-year pay plan for the insurance and tailored the monthly distribution from the charitable bargain sale to match. This particular charity reinsures the payment with an insurance company, so the client doesn’t have to worry about the payment guarantee.

That being arranged, we had one more step that I wanted to present. Instead of liquidating assets to generate the $200,000 (after-tax, which would have required at least $260,000 to be liquidated) I suggested using a collateralized loan against the securities portfolio.

I call this a leveraged arbitrage. The client borrows the money and uses the return on the portfolio to pay the principal and interest. At this time, the interest rate was approximately 5% on the loan. So in any year that the portfolio returned 5% or better, it was a positive arbitrage and that amount would pay the principal and interest. In the event that the portfolio received less than 5%, it would be a negative arbitrage and the client would have the choice of paying the loan difference in cash or liquidating some securities to pay for it.

This is how the scenario went. The client established a collateralized loan on their securities account. This avoided any capital gains tax. They took the $200,000 loan and paid it to the charity in exchange for the bargain sale with a 22-year term. This guaranteed payment for insurance policies for 10 years. At that time the policies were paid up and they still had 12 more years of tax-preferred income to be paid from the bargain sale.

In conclusion, the client took nothing out of their pocket and their opportunity cost is the interest paid on the loan minus the benefit from the tax deduction from the charitable bargain sale which was about one-third of their $200,000 payment.

By combining the leveraged arbitrage with the charitable bargain sale and insurance contract, we were able to meet all the client’s needs.

The clients in all these case studies were extremely happy with the outcome and results. This is the power of proper forward-looking holistic planning.

You can read more about additional strategies for this type of holistic planning in my book, Wealth Unleashed: Navigating Wealth and Taxation for Business Owners, Wealthy Families, and Their Advisors on Amazon at http://tinyurl.com/2cssvwwc.

Wealth Unleashed is an essential guide for business owners, wealthy families, and their advisors seeking to navigate the complexities of wealth and taxation with confidence and strategic prowess. Written by seasoned financial expert James A. Lavorgna, this book offers up-to-date insights into the virtual family office (VFO), an innovative model designed to maximize tax benefits and streamline wealth management.

Lavorgna’s 45-year journey in financial services culminates in this groundbreaking book that promises to transform your approach to wealth management. With a unique blend of real-life stories and actionable strategies, Wealth Unleashed delivers a powerful message: you can protect, grow, and transfer your wealth more efficiently than ever before.

About the Author

James A. Lavorgna, J.D., LLM, CFP, TMBCP, brings a lifetime of financial strategy expertise to the table. As a leading authority in global estate planning and asset protection, Jim empowers entrepreneurs and families to harness novel approaches to wealth planning. His credentials and articles span international forums, making him a trusted source for business and financial advice.Join the ranks of successful families, business owners and advisors who have turned the tide of their financial future. Embrace the change, relish the simplicity, and secure your legacy. Unleash the power of your wealth with Wealth Unleashed.

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