Testamentary Gifts to Help Children and Grandchildren 

Several types of charitable techniques are available to donors whose planning goals are twofold: one, to provide benefits to the donor's favorite charitable organizations, and two, to financially assist the donor's children and grandchildren. The most common technique to accomplish these twofold goals is the nonreversionary charitable lead trust, in which the income from the trust is paid to a charitable organization for the term of the trust. At the termination of the trust, the assets are distributed to the donor's family.

A second technique to accomplish both goals uses the combination of a testamentary charitable bequest and an irrevocable life insurance trust to benefit the donor's children and grandchildren. Differences exist between the two techniques in terms of the timing of the children's/grandchildren's inheritance and in the form of the charitable organization's interest—one technique provides income to the charitable organization and the other provides principal. This article serves to explain and illustrate each of these two techniques.


Charitable Lead Trust
The lead trust provides income to the charitable organization, and it provides the means to transfer the donor's wealth to the heirs upon the termination of the trust. A charitable lead trust can be designed in one of two ways: a nonreversionary lead trust or a reversionary lead trust. The type of charitable lead trust most suited for wealth transfer to children and grandchildren is the nonreversionary lead trust—so called because at the end of the trust term, the assets are distributed to the donor's chosen beneficiaries (normally the family). A reversionary lead trust is designed so that the assets will eventually revert to the donor—hence the term reversionary lead trust.

In the trust document, the donor determines the amount of income payable to the charitable organization each year. The higher the amount of income payable to the charitable organization or the longer the length of the trust term, the higher the estate tax charitable deduction for the donor's estate.


Illustrating the Charitable Lead Trust Technique
Marlene Smith, age 59, is a widow with an estate of $10 million. She wants to provide for her grandchildren more than for her own children because her two children are both wealthy in their own rights. She has six grandchildren (ages 2 to 11) and she feels very strongly about establishing a trust to provide funds for her grandchildren's future.

To accomplish her goals, Marlene decides to establish a charitable lead unitrust upon her death (testamentary lead trust). The income payments are set up to be 6.5 percent of the trust annually for 9 years. With an IRC Section 7520 rate of 3 percent, this charitable lead trust can be established upon Marlene's death with zero estate and generation-skipping transfer (GST) tax costs. In other words, Marlene can establish a nonreversionary charitable lead unitrust, fund it with $10 million, and at the end of 9 years, the assets will be distributed to her grandchildren and her estate will pay no estate or GST taxes on the transfer. The trust will provide a charitable estate tax deduction of $5 million (the present value of the charitable income interest) and the remaining $5 million in her taxable estate will be offset by the unified credit (assuming current rates and tax laws).

If the trust assets grew during the nine-year period at a rate of 8 percent, the grandchildren would receive approximately $12 million at the end of the trust term. The slight increase in trust assets from the initial contribution of $10 million to $12 million is due to using a growth assumption higher than the income paid (8 percent versus 6.5 percent).

The nonreversionary lead trust provides Marlene the ability to meet both her goals. The income from the lead trust will furnish her favorite charitable organization with needed revenue for six years and at the end of that time, Marlene's grandchildren will have complete access to the trust principal.


Charitable Bequest Coupled with a Life Insurance Trust
The best type of planned gift for transferring the donor's wealth to his heirs is the charitable lead trust. Unfortunately, many donors shy away from this type of gift unless they are “super-wealthy.” Reasons for this may vary, but a common reason is the fact that the charitable lead trust provides no immediate benefit to the donor or the donor's family. This means the donor's estate must have plenty of other assets available for heirs in order for the donor to feel comfortable giving up total control and access over these donated assets.

Because most other types of charitable gifts do not readily benefit children or grandchildren, coupling a charitable bequest with a life insurance trust can resurrect the needed funds for the children/grandchildren. A charitable bequest can fulfill philanthropic wishes with a gift to the charitable organization, and the life insurance trust can be established to secure income or principal solely for the benefit of the donor's children or grandchildren.

The donor can purchase a life insurance policy on his or her life or a policy on the life of the donor and the donor's spouse (a second-to-die policy). A policy covering both spouses is almost always less expensive than a policy covering just one life. The downside of the second-to-die policy, however, is the death benefit will be paid later upon the death of both spouses rather than potentially sooner at the death of the donor, if the donor were to die first.

The life insurance trust can be designed with as much flexibility or control in distributing income or principal to the beneficiaries as the donor chooses to include. Unlike a charitable remainder trust, in which the donor may commonly name himself or herself as the trustee, the donor should never be the trustee of the irrevocable life insurance trust. If the donor has control over the trust by serving as trustee during his or her lifetime, the trust assets would be includable in the donor's estate for federal estate tax purposes. Hence, with all life insurance trusts, the donor should nominate someone other than himself or herself as the trustee.

Upon the donor's death (or the second death if both spouses are insured under one insurance policy), the life insurance death benefit is paid to the trustee of the life insurance trust. The trustee then uses the insurance proceeds according to the trust's terms. The donor can choose the type of distribution method he or she prefers for the children. The trust distributions are usually spread out over a number of years, especially when the beneficiaries are quite young, thus discouraging quick liquidation of assets due to financially immature beneficiaries.

The most valuable benefit of using life insurance, which is almost always income tax–free to the beneficiary, is that it is received free of estate taxes, provided the life insurance is properly owned outside the insured's estate. The children will receive their inheritance free of both estate and income taxes and the estate will receive a charitable estate tax deduction for the gift to the charitable organization. The donor will have met two goals: providing financially for children or grandchildren and making a contribution to a favorite charitable organization—in the most tax-efficient manner possible.


Illustrating a Charitable Bequest Coupled with Life Insurance

Dan, aged 65, decides to make a direct bequest of $900,000 from his 401(k) account to his favorite charitable organization. He always thought, however, that his three children should also benefit from his 35 years of hard work at the town plant.

After meeting with his attorney to plan his estate, Dan was advised about the tremendous amount of taxation applied against pension, 401(k) and IRA accounts. In fact, he was disappointed to learn that nearly 60 percent of his 401(k) account could be confiscated by federal estate and income taxes (depending on the particular tax brackets), leaving his three children with $378,000 of the original $900,000 (assuming a 35 percent estate tax bracket and 35 percent income tax bracket).

To combat the excessive taxation, the estate attorney suggested that Dan purchase a $900,000 life insurance policy on himself. The life insurance policy will be owned not by Dan, but by an irrevocable life insurance trust. The trust document will provide that each child receive one-fourth of the trust principal amount immediately following Dan's death. After that, at every five-year interval the trust will distribute funds to each of the children. One-third of the trust will be distributed five years following Dan's death, and one-half of the remaining trust will be distributed 10 years following Dan's death. The balance will be distributed 15 years following Dan's death. This technique of staggered trust distributions will help prevent Dan's children from quickly depleting their inheritance, as many beneficiaries with lump-sum inheritances have been known to do.


Type of Gift
Donor Benefits
Benefits to the Charitable Organization
Benefits to the Children/ Grandchildren
Testamentary Charitable Lead Trust
The present value income interest to the charitable organization qualifies for a charitable estate tax deduction the donor's estate. Deferred benefits (beginning at the death of the donor) go to the charitable organization in the form of income from the charitable trust for the length of time the trust is in existence. Remainder interest of trust will pass to family (or individual) beneficiaries upon the termination of the charitable lead trust. The length of the trust's existence will vary; therefore, the timing of the children's inheritance will vary as well.
Charitable Bequest Combined with Life Insurance
Estate tax charitable deduction for the full value of the asset bequeathed to the charitable organization. Life insurance trust can be estate tax free to heirs if properly owned outside the donor's estate. Deferred gift of the outright bequest is given at the time of donor's death. There are none from the direct bequest. Instead, the children/grandchildren benefit from the life insurance trust. The life insurance trust will provide the inheritance for the children/ grandchildren.


Dan will need to convert a portion of his financial portfolio each year into enough cash necessary to pay the life insurance premiums. To the extent Dan has annual exclusion gifts available to use, he can use up to $13,000 per year per trust beneficiary. So, for example, if Dan's premiums equal $45,000 per year and Dan has three children as trust beneficiaries, Dan could use $39,000 ($13,000 x 3) of gift-tax-free exclusions. The remaining $6,000 of premiums would require use of his $5 million gift tax exemption. If Dan is married and his spouse hasn't used any of her annual gift tax exclusions, the amount they could use is doubled to $78,000 per year. (Note: Under current pension laws, if Dan is married, his spouse would need to consent in writing before he could name someone other than his spouse as the beneficiary of his 401(k) account.)

This technique will provide $900,000 of 401(k) money to Dan's favorite charitable organization, and because of its tax-exempt status, the organization will receive it income tax–free. Dan's estate will receive an estate tax charitable deduction of $900,000. The life insurance trust will provide $900,000 of income tax–free life insurance to his children and grandchildren. The life insurance will also be estate tax–free if properly owned outside Dan's estate in an irrevocable life insurance trust. Thus, Dan's dual goals will have been achieved with the most tax-efficient strategies possible.


Summary
Donors can still transfer wealth to their families without feeling they have to give up their philanthropic goals. Several charitable techniques can provide benefits to both family and favorite charitable organizations, fulfilling all of the donor's good intentions. Charitable lead trusts are the primary gift designed for this type of donor. An alternative, but equally effective, technique combines a testamentary bequest to a charitable organization with an irrevocable life insurance trust structured to solely benefit the donor's heirs. With modifications, these planned giving techniques can also be used during the donor's lifetime. As always, the donor must weigh individual charitable and familial considerations before deciding on the type of gift.

For more information, please contact Steve Brier at (866) 204-8102 or sbrier@willamette.edu.