Extreme Makeovers for the Grantor Charitable Lead Trust, Part 7 - Diving into Dividends
Case:
Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly represents class action lawsuits against large, multinational corporations. As a result of the high stakes and high dollar amounts involved, it is not uncommon for a jury to award a judgment of over $100 million. In fact, Lynn is among a select group of attorneys with ten or more successful judgments over $100 million. Accordingly, Lynn is an extremely wealthy woman. In addition to her salary, her firm represents most class action lawsuits on a contingency basis. In other words, the firm receives between 15% and 40% of any favorable judgment (plus costs). As a result, the firm's share of a victory is very substantial.Recently, Lynn won a major trial against a financial institution. The jury awarded her clients $20 million, and the firm's share was approximately $6 million. As a result of the successful conclusion, Lynn received a $1 million bonus. While extremely pleased with this large bonus, Lynn shudders at the thought that over $400,000 would go to Uncle Sam.
In addition to this year's bonus, Lynn regularly earns about $500,000 a year, which places her in the highest federal and state income tax brackets. The $500,000 represents her annual salary of $450,000 and annual dividend income of $50,000. Not surprisingly, Lynn desperately wants to minimize her tax liability. She, therefore, is meeting with her tax advisor, Frank Thomas, to discuss her options.
Lynn's primary goals are tax reduction and some basic retirement planning. Lynn is also open to charitable giving if it can help her accomplish her primary goals.
Question:
What plan may accomplish Lynn's goals? What are the upsides and downsides to the plan?Solution:
Frank suggests that Lynn fund a grantor charitable lead annuity trust (CLAT) for a period of 5 years with $1 million of her dividend producing stocks. The payout rate on the trust would be 5% or $50,000 per year that would be payable to her favorite charities. The creation of such a trust would produce a charitable income tax deduction of approximately $225,000. With adjusted gross income of $1.5 million this year (bonus plus salary plus dividends), Lynn may deduct up to $450,000 or 30% of AGI this year. Therefore, assuming a combined federal and state tax rate of 40%, Lynn would save $90,000 in taxes!Since this plan is a grantor trust for income tax purposes, Lynn would be taxed on all the trust income. The trust income each year would be $50,000 of dividend income. In the past, dividend income was taxable at ordinary income tax rates and, thus, not very desirable for grantor CLATs. However, dividend income is taxable at 15%. This significantly reduces high-income earners' tax liability on dividend income. Therefore, Lynn would have to realize $50,000 of dividend income each year, which results in a tax liability of only $6,500 each year. For Lynn, the immediate $90,000 of tax savings this year easily outweighs the annual $6,500 tax bill over the next five years (totaling $32,500). Therefore, before even taking into account the time value of money, Lynn's five-year CLAT saves her $57,500!
Frank further explains that at the end of the five-year term the trust assets would return to Lynn. The $1 million original contribution may rise or fall depending on stock performance. With a 6% overall return, Lynn may receive $1,056,000 when the trust terminates. Accordingly, the return of over $1 million would provide Lynn with a wonderful retirement nest egg. The money could be invested for future use or accessed immediately if Lynn so desired. Again, the CLAT provides Lynn with great flexibility. Finally, $250,000 would be distributed to Lynn's favorite charities. She is amazed at this enormous additional benefit.
In the end, Lynn is completely happy with Frank's plan. She would cut her tax liability significantly, retain flexibility and much of her wealth while contributing a generous gift to her favorite charities. While always philanthropic, Lynn's CLAT would make her a major donor overnight - a title that brings a very warm smile to her face.