I Overview
Part I of this series focused on tax reduction and deferral strategies for trial attorneys with contingent fee income using private placement variable deferred annuities in lieu of fixed annuities for structured settlement payments. Part 2 of this series focused on the use of closely held insurance companies (aka captive insurance arrangements) to provide tax reduction and deferral of contingency fee income. In Part 2, the captive insurer can function as a multi-line insurer (property and casualty as well as life insurance) and issue the structured settlement annuities for contingency fee deferrals referenced in Part I of this series.
The latest installment uses a split interest charitable trust – a charitable lead annuity trust (CLAT) with a few “bells and whistles” to reduce taxable income from a contingency fee along with providing tax deferral and future estate tax savings. At the same time, the CLAT provides important philanthropic benefits for the underlying charitable causes of the trial attorney. The structure also provides a mechanism to provide current income from the CLAT corpus.
It is not uncommon for trial attorneys to enjoy windfall income events after much trial and tribulation in the pursuit of justice in settling a case. Plaintiff’s firms have considerable expenses in the course of preparing for trial. . In [i]many cases, trial attorneys have “spiked” income events as a result of a settlement or jury verdict. The income can be quite substantial.
As previously noted, trial attorneys have limited in their ability to reduce and defer taxable income. Deferred income in qualified plans such as a defined contribution plan has a contribution limit of $50,000 in 2012 and a salary cap of $250,000. Additionally, most trial attorneys have not utilized structured settlement annuities which are conservative fixed deferred annuity products issued by large life insurers.
Why Now?
The tax environment for high income tax payers is set to undergo a substantial change. The top federal marginal tax rate is scheduled to increase to 39.6 percent in January 2013. High income tax payers will incur an additional 3.8 percent tax on unearned income for taxpayers with AGI in excess of $250,000. High income tax payers are also subject to a phase out of personal exemptions and itemized deductions which have the effect of increasing the marginal rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate.
The top marginal estate tax bracket is also set to increase to 55 percent. At the same time the exemption equivalent for federal estate and gift taxes is decreasing from $5.12 million to $1 million per taxpayer. The bottom line is that “earned income” as the trial attorney’s largest asset, is highly taxed much like any deferred compensation asset or pension plan. The combination of income and estate taxes on this windfall income can be as high as 75-80 percent. The trial attorneys work too long and too hard with too much uncertainty to retain so little of the settlement contingency fee after considering taxes.
The CLAT is a very effective strategy for reducing and deferring taxable income while “giving back” to meaningful philanthropic causes – a win-win for the trial attorney and society at large.
II What is a CLAT?
A CLAT is a split interest trust. CLATs have been used in advanced philanthropic tax planning for decades. Jackie Onassis put the technique on the map in a major way when she passed away.
The CLAT provides for a payout to a charity(ies) for a term of years or the taxpayer’s lifetime. At the end of this term, the remainder interest in the CLAT passes back to the taxpayer or a family trust. CLATs are not subject to any minimum or maximum payout requirements. The governing instrument (trust) of a CLAT must provide for the payment to a charitable organization of a fixed dollar amount or a fixed percentage of the initial net fair market value of the assets transferred to the CLAT.
The taxpayer as the settlor of the CLAT is able to take an income tax deduction when the CLAT is a grantor trust for income tax purposes. The CLAT can also be structured so that the taxpayer is able to get a gift tax deduction on the transfer to the CLAT. Grantor trust status means that the taxpayer is treated as the owner of the CLAT’s taxable income, i.e. the trial attorney is taxed on any trust income during the CLAT term of years.
Generally speaking, the taxpayer’s income tax deduction is limited to 30 percent of adjusted gross income (AGI). Any unused tax deduction may be carried forward for an additional five tax years. The tax deduction is determined actuarially based upon the amount of annuity payable to the charity and the length of time of the payout as well as the interest rate factor – the IRC Sec 7520 rate. The IRC Sec 750 rate is equal to the mid-term applicable federal rate times 120 percent. This rate is at an all-time low of one percent in September 2012.
The CLAT plan design is structured so that the value of the remainder interest, i.e. the amount that passes back to the taxpayer or his family trust, is equal to zero. This value of the remainder interest is treated as a taxable gift to a family trust.
The governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded. The annuity payments may be made in cash or in kind.
In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the IRC Sec 7520 rate (currently 1.0 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.
Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year) varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies. Backloading the CLAT refers to a series of annual “annuity” payments that increases by a fixed percentage per year (such as 120% or 150%).
CLATs do not have any statutory limitation on the length of a term. The Treasury regulations simply require that a CLAT have a “specified term” of years. If the grantor intends to zero-out the gift to the grantor’s non-charitable beneficiaries, the longer the term the smaller the charitable annuity payments need to be each year and potentially more wealth will be transferred to the non-charitable beneficiaries.
III The Trial Attorney CLAT Strategy
Step 1 – Trial attorney receives the contingency fee as taxable income and contributes the fee as a charitable contribution to the CLAT.
Step 2 -The trial attorney forms a CLAT for a term of years payable to a Donor Advised Fund (DAF) or other public charity(ies). A donor advised fund (DAF) is a form of public foundation that may benefit one or more charities of the trial attorney’s choice.
Step 3 - The CLAT provides for an annual fixed payment to the Donor Advised Fund each year increasing by fixed percentage (120-150%) each year for term of years such as twenty years, with a large payout to the Donor Advised Fund in the final year of the term of years (Year 20). The CLAT is designed to be “zeroed out” meaning that the amount of the charitable deduction for income and gift tax purposes is equal to the amount transferred to the CLAT.
Step 4 –Trial Attorney forms a Family Trust designed to maximize the exemption equivalent for federal estate, gift and generation skipping transfer (GST) taxes. This capital contribution is a small percentage of the overall contribution to the partnership. The trial attorney makes a gift to the trust to fund the family trust.
Step 5 - The trustee of the CLAT forms a preferred partnership with the trustee of the trial attorney’s family trust. The preferred partnership contributes capital to the partnership (charitable contribution) in exchange for a preferred partnership interest which provides with a preferred cumulative return on partnership income of 4-4.5 percent per year and a preferred liquidation right equal to its contribution.
Step 6 – The trustee of the Family Trust contributes capital to the partnership in exchange for the common interests of the partnership. The common interests are entitled to the excess return above the preferred partnership interest – excess income in excess of 4.5 percent and any growth above the preferred partner’s interest.
Step 7 – The partnership invests part of its investment capital into a private placement life insurance contract. The policy is funded over a four year period. The policy is a non-MEC (modified endowment contract). This policy status allows for tax-free policy loans and withdrawals.
Step 8 – The investments of the preferred partnership are managed by an investment management LLC created by the trial attorney and his family. The terms of the investment management agreement are arms-length providing the investment management LLC with fee terms similar to other alternative investment management partnerships – a management fee equal to two percent of assets under management and 20 percent of any investment profits.
IV Strategy Example
A.The Facts
Joe Smith, age 50, is a partner is a plaintiff's law firm. Joe has a professional corporation. He is married and has three children. He has accumulated $1 million in the firm's qualified retirement plans. His combined marginal tax bracket for federal, state and city purposes is 40 percent. His annual income after bonuses has averaged $3.5 million per year. Joe's lifestyle requires a net income of $500,000 per year. He has a family trust that owns a life insurance policy on his life for $2.5 million. Joe expects to earn a $10 million this year from a contingency fee on a medical malpractice case.
Joe plans to practice law until he is age 70. Joe and his wife have a number of important charitable causes including their church, respective alma maters as well as a defense fund for indigent members of their community.
B.Solution
Joe forms a CLAT with a twenty year term. The CLAT provides for increasing annuity payments each year that increase by 150 percent. Based on the initial contribution of $10 million, the initial CLAT annuity to Joe’s Donor Advised Fund – The Smith Family Foundation – is $2,146. The projected final payout to the Smith Family Foundation is projected to be $4.75 million. The CLAT is a “zeroed” out CLAT providing for no taxable gift to the Family Trust of the remainder interest at the end of the twenty year CLAT term. Joe also receives an income tax deduction of $10 million.
Joe may also take an income tax deduction equal to 30 percent of his adjusted gross income. Joe’s AGI including the contingency fee is $12 million. Joe claims a $4 million charitable deduction on Schedule A of his Form 1040. The charitable contribution is not an AMT (alternative minimum tax) preference item. The excess deduction of $6 million is carried forward for five additional tax years.
Comment
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In order for Joe to transfer wealth from the CLAT to the family trust, it is important to keep the following two concepts in perspective. First, if the assets of a ‘‘zeroed out’’ CLAT do not have a total return that exceeds the IRC Sec 7520 rate (currently 1.0%), then no assets will remain in the CLAT at the end of the term. The term “zeroed out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.
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Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the ‘‘path of the returns.’’ In reality, the investment return is not static (a fixed return in every year) varying in some cases from day-to-day over a period of years. . From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies
The trustee of the CLAT contributes $9.6 million to a new preferred partnership in exchange for all of the preferred partnership interests. The preferred partnership interests provide for an annual cumulative return of 4.5 percent per year as well as a liquidation preference equal to its initial contribution to the partnership of $10 million.
The Smith Family Trust contributes $400,000 in exchange for all of the partnership’s common equity interests. The family trust will be entitled to all partnership income and growth in excess of 4.5 percent. Additionally, upon liquidation of the partnership, the family trust will be entitled to any excess partnership assets above $10 million.
The assets of the partnership will be managed by the Smith Family Investment LLC. This arrangement provides for a management fee equal to two percent of partnership assets under management and twenty percent of any investment profits within the partnership. The trustee of the CLAT will use its preferred partnership distributions to make its annual CLAT payments to the Smith Family Foundation.
The partnership will invest in a private placement life insurance (PPLI) contract. PPLI is an institutionally priced variable universal life contract that provides for complete investment flexibility. The partnership will invest a portion of its capital each year over the first four years -$1.25 million per year for Years 1-4 for a total of $5 million. The policy has a death benefit of $20 million. The balance of the CLAT portfolio will be invested in a diversified investment portfolio with several managers.
The investment income within the PPLI contract will accumulate on a tax-free basis. The general partner of the Preferred Partnership can tax a tax-free loan of the policy each year to distribute to the trustee of the CLAT. The trustee of the CLAT may use this partnership distribution in order to make the CLAT payment. The death benefit will also be paid to the partnership on a tax-free basis.
According to the terms of the preferred partnership, the partnership’s value in excess of the original contribution ($10 million) plus the cumulative preferred partnership annual income interest of 4.5 percent, accrues for the benefit of the common equity partner, the family trust. At the end of the CLAT’s term of years, Year 20, the remaining CLAT property will pass to the CLAT remainderman, the family trust.
After the liquidation of the partnership, an excess of amount (assuming an investment return of 8 percent on a diversified portfolio), $30 million passes to the family trust after all of the payouts to Charity. The ultimate payout to the Donor Advised Fund over the twenty year period is projected to be $17.3 million.
The strategy has a powerful effect. The CLAT strategy provides a charitable deduction equal to the contribution. The charitable deduction is useable in the current year with any excess deduction being used in the following five tax years. Any charitable gift to the family trust has been “zeroed out “for estate and gift tax purposes. In order for the CLAT strategy to work, the CLAT’s investment return only needs to exceed the benchmark, the IRC Sec 7520 rate (currently 1.0 percent). The preferred partnership transfers excess investment return to the family trust.
The layering of PPLI into the strategy does two things. First, PPLI provides a tax-advantaged investment return for the partnership which is owned by the Family Trust and CLAT. Second, PPLI leverages the transfer of wealth to the family trust through the tax-free death benefit. Additionally, the use of a family investment management LLC allows the trial attorney to earn arms-length management fees on the assets under management in the structure. In this case, a 2% management fee and 20% of investment profits is used.
This fee structure allows the trial attorney through the investment management fee to earn a management fee of $200,000 in Year 1 plus an additional $200,000 in performance fees in the event the partnership enjoys a ten percent - $400,000.
Summary
The CLAT strategy is designed to accomplish several important objectives- (1) Income tax Reduction (2) Income Tax deferral (3) Wealth Transfer and most importantly (4) Philanthropy. The combination of techniques – (1) Back end loaded CLAT payments (2) Preferred Partnership and (3) PPLI, all have strong statutory authority. This strategy is another option to use along with the strategies to Part I and Part II of this series for trial attorneys in order to minimize the erosion of taxes on trial attorney contingency fee income.
