Case of the Week

Case:

George was a man of humble beginnings. George was both resourceful and determined to succeed. He enrolled in chemical engineering and studied diligently. His diligence was quickly recognized by the faculty. After graduating with honors, he became a graduate assistant and earned a master's degree in engineering. He interviewed and became a product development engineer with a company that built emissions control equipment for automobiles. Soon, George met Helen and they married.

George started a company and initially did environmental consulting. As soon as he could gather and borrow the funds, he started a company that produced components for emissions control equipment. After a terrific struggle, the business took off and George began to manufacture probes for company smokestacks. When asked if that was a good business, George responded, "It is a great business. Companies buy my probes to measure their smokestack emissions. When the government regulations change, they have to upgrade and buy my newer probes!"

George incorporated the probe manufacturer as Green Probe. Enjoying being an entrepreneur, he contemplated the opportunity to purchase a company that built converters for automobiles. He bought the assets of that company and transferred them into a new business, Green Converter. Finally, George started a third company to build "smokestack scrubbers" that would clean the emissions from the smoke of power plants. Since there was a huge increase in the cost of energy, power companies began to build more plants and his "smokestack scrubbers" from Green Scrubber were in great demand.

Question:

Seven years ago, George funded a unitrust with the Green Converter stock and then the trustee sold all of Green Converter's assets to General Auto. George sold Green Probe to Major Power Company when he was 79. George and Helen are now 82 and know they need to sell Green Scrubber. Fortunately, MegaScrubber is very interested in purchasing Green Scrubber. So, George called their CPA and asked, "What should I do now? We don't want to pay a large tax. The unitrust worked fine before and I suppose that we could sell tax-free again. But the trust's value is over $9,000,000, and we do not need more income. We are swimming in a sea of cash. What should we do?"

Solution:

His CPA reviewed the situation and offered a suggestion. The existing unitrust permits additions, so George could add the Green Scrubber stock to the trust, but his CPA had another idea. George and Helen want to benefit their children, Bill and Susan with an inheritance, but they do not want to give a large gift of principal right now. His CPA suggested that George and Helen should decide on an inheritance target for their children. Part would be given during life and part would be distributed from George and Helen's estate. The lifetime gift would be a stream of income from a term of years unitrust funded with the Green Scrubber stock.

George and Helen liked the idea. They could give their Green Scrubber stock to a new unitrust that would pay to Bill and Susan and receive a large tax deduction. The stock was valued at $3,000,000. They funded a 5% unitrust paying Bill and Susan for a term of 20 years with the Green Scrubber stock and received a charitable deduction of more than $1,000,000. After four weeks, the trustee sold the stock to MegaScrubber, a company that had previously expressed interest in purchasing the company.

Each year the unitrust will pay about $75,000 to Bill and $75,000 to Susan. While there is a taxable gift of the value of the income to Bill and Susan, George and Helen need to choose if they will retain a testamentary power of revocation. Retaining a testamentary power of revocation allows the income stream to Bill and Susan to be an incomplete gift and thus not taxable at the outset. Retaining the right of revocation allows George and Helen to use their annual gift exclusion each year, but the trust will be included in George and Helen's estate value when they pass away. By not retaining the right of revocation, the gift will be completed in the year the trust is created and their lifetime exemption will apply to cover any gift tax due.

The gift tax return is due on this transfer on the following April 15. George and Helen can use their annual exclusions first each year and then part of their lifetime gift exemptions to cover the balance of the gift. If George and Helen do not exercise their right to revoke the gift to their children in their wills, the present value of the children's income interest will be included in the gross estate for estate tax purposes. If the 20-year term on the trust ends before estate inclusion, there will be no present value income interest remaining when George or Helen pass away, and the trust will simply distribute the remainder to charity with no estate tax consequences. Meanwhile, George's CPA will file the gift tax returns by April 15 each year. Based on their advanced age and the 20-year trust term, it is foreseeable that the trust will be included in their estate. If they choose to not retain the right of revocation, the gift is completed and a Form 709 Gift Tax return will be due in the year the trust is created, their annual exclusion would be applied in the year of the gift to reduce the lifetime exemption amount allocation. The trust would not be included in George and Helen's estate, and it may simplify matters because annual gift tax returns will not be required if they do not retain the right to revoke.

George and Helen are very pleased with this plan. They will use the $1,000,000 charitable deduction over six years and now have sold all three businesses with no net tax. Bill and Susan will receive a large inheritance over the next 20 years from the unitrust and will someday receive an additional inheritance from the estate of George and Helen. Best of all, the unitrust will endow George and Helen's favorite charity with more than $8,000,000 when George and Helen pass away. George thought, "We have come a long way from the farm. Life is good!"