High net worth individuals have faced growing challenges with the impact of higher taxes on ordinary income and long-term capital gains, as well as the 3.8% Medicare tax on net investment income. As tax rates continue to move higher, so too does the cost of ignoring the tax consequences of financial transactions on long-term wealth accumulation. Faced with growing tax bills, high net worth individuals have become more sophisticated about incorporating tax planning strategies into their overall financial plans, and are turning to philanthropy to help offset, defer or mitigate taxes.
The high-tax environment and the increased awareness of the long-term impact taxes have on wealth accumulation present a significant opportunity for nonprofits with planned giving programs. The tax benefits of life income vehicles are more valuable to high net worth individuals today than at any time over the past decade. At the same time, strong equity returns over the past five years have replenished equity portfolios with appreciated assets. With donors increasingly looking for the tax-mitigating benefits of life income vehicles, the ingredients are in place for an influx of gifts for planned giving programs.
By utilizing tax-efficient investment techniques, planned giving programs can unlock hidden value for their existing donors and differentiate themselves to tax-savvy prospective donors and their advisors.
Charitable Remainder Unitrusts
Charitable remainder unitrusts (CRUTs) play an important role in estate, tax and retirement planning for high net worth individuals. Donors use CRUTs as a beneficial estate planning technique that allows them to support organizations whose missions align with their personal passions. While a donor may establish a CRUT for many reasons, four widely acknowledged motivators include:
Fulfilling philanthropic intent
Creating an income stream for life
Receiving a current-year income tax deduction
Deferring capital gains on appreciated assets
A donor realizes the first three benefits when the gift is established. The fourth benefit — capital gains deferral — is realized over the donor's remaining lifetime. Therefore, it is often overlooked or not used to its full potential by trustees and investment managers. In fact, the tax benefit of the capital gains deferral can be significantly diminished or lost entirely if a CRUT is not managed tax efficiently.
Tax-efficient investment management techniques, as a supplement to appropriate diversification and disciplined adherence to asset allocation, can significantly impact the total after-tax distributions received by the donor. To see this impact, it is important to understand the rules surrounding the taxability of distributions from CRUTs.
The Impact of Short-Term Capital Gains
CRUT distributions are taxed based on a four-tier, worst-in-first-out distribution hierarchy, with undistributed balances carried forward to subsequent tax years. The four tax tiers are:
Ordinary income/short-term capital gains
Long-term capital gains
Return of principal
To the extent a trustee or investment manager can reduce the amount of distributions taxed at the ordinary income rate, he or she increases the amount of the long-term capital gains deferral that donors actually get to use over their lives. A trustee or investment manager that manages a CRUT using a process that generates large amounts of ordinary income or short-term capital gains can inadvertently block distributions from the lower tax rate, long-term capital gain tier.
In order to quantify the impact of portfolio activity — specifically, short-term capital gains on after-tax beneficiary distributions — we calculated the taxes owed for a hypothetical trust.
This example assumes varying amounts of realized short-term capital gains. As illustrated in Exhibit 1, the potential impact on the after-tax distribution, or taxes owed, between a "Low Short-Term Capital Gain" portfolio and a "High Short-Term Capital Gain" portfolio is substantial. The difference amounts to $123,552 over a 20-year time period for a $1,000,000 trust. This represents a 15% decrease in the after-tax distribution amount and a 32% increase in taxes paid over the life of the trust.
Based on this example, it is clear that trustees and investment managers have the opportunity to add value for CRUT donors by utilizing tax-efficient investment techniques.
Exhibit 1: Potential Impact of Short-Term Capital Gains on a CRUT over 20 Years
Footnotes: $1,000,000, 5% CRUT, 7% annual return (2% income yield, 5% capital appreciation), ordinary income and short-term capital gains taxed at 42.6%, long-term capital gains taxed at 20%. Low short-term capital gains: 25% of annual capital appreciation in CRUT is realized short-term capital gain. High short-term capital gains: 100% of annual capital appreciation in CRUT is realized short-term capital gain.
Tax-Efficient Investment Techniques
Now that we see the potential negative impact of realizing short-term capital gains when managing CRUTs, the question is: what can be done to be more tax efficient? Fortunately, several simple and effective techniques can be used.
1. Harvest tax losses
Opportunities to take capital losses, especially short-term capital losses, should be taken unless the cost of doing so (whether in trading costs or foregone returns of not being fully invested) outweighs the tax benefit.
Short-term capital losses can be used to offset current year, short-term capital gains, with any excess losses carried forward for use in future tax years. This serves to shrink the ordinary income tax tier, allowing more of the lower tax-rate, long-term capital gains to be distributed to the income beneficiary.
Long-term capital losses can offset current-year, long-term gains with any excess offsetting prior-year, undistributed long-term capital gains. This is advantageous in situations where a relatively small undistributed long-term capital gains bucket can be eliminated, enabling the tax-free tiers (e.g., tax-exempt interest, principal) to be distributed to the income beneficiary.
2. Less is more when it comes to trading
Trading is essential to maintaining overall asset allocation, managing liquidity and implementing tactical changes to a portfolio. Yet trading also involves costs in the form of commissions, bid/ask spreads, fees and time out of the market.
The realization of capital gains via the sale of securities involves an additional cost in the form of taxes. Therefore, trading less frequently, by widening rebalancing tolerances or holding more cash, is a viable option when managing CRUTs.
Tax costs should also be considered when selecting managers or investment vehicles within each asset class. Evaluating managers in each asset class by looking at their long-term track record relative to an appropriate benchmark helps to enforce discipline by reducing the temptation to switch managers and chase short-term performance.
3. Pay attention to cost basis methodology
Investors have many options for determining how gains and losses will be calculated when a security is sold. The most common cost basis methodologies are:
There is no right or wrong answer when it comes to selecting a methodology, because each CRUT has unique characteristics and tax considerations. However, some rules of thumb can be applied.
As described earlier, the avoidance of realizing short-term capital gains can be advantageous to donors by allowing them to receive the benefit of the capital gains deferral embedded in the trust. Therefore, FIFO is usually a safe choice for CRUTs, because it relieves the oldest tax lots first. It does not guarantee a CRUT can avoid short-term gains altogether, but it makes the realization of long-term gains much more likely. Minimize Gain is also a good choice, because it seeks to simultaneously minimize overall realized gain and relieve long-term tax lots first. LIFO and Highest Cost are poor choices for CRUTs, because they have the greatest potential to produce short-term capital gains.
4. Beware mutual fund capital gain distributions
Mutual funds are an attractive investment vehicle for CRUTs, because they generally offer low minimum investments, daily liquidity, transparency and broadly diversified market exposure.
However, one potentially unattractive trait of mutual funds is that they are required to distribute income and capital gains to shareholders each year. This can lead to unexpected, and sometimes hefty, capital gains for investors. CRUT managers should be aware of upcoming distributions and avoid the purchase of mutual funds that will be distributing capital gains in the near future. "Buying capital gains" is particularly relevant around the end of the calendar year, when most equity mutual funds distribute their prior-year capital gains. Faced with this situation, CRUT managers should carefully weigh the costs and benefits of waiting to purchase the fund until after the mutual fund distribution date.
Tax Efficiency as a Tool to Add Value for CRUTs
The proper use of tax-efficient investment techniques can add significant value when managing CRUTs. For trustees and investment managers, however, prudent and effective investment management cannot be a "set it and forget it" endeavor. To realize the maximum amount of tax benefits for the donor, particular attention must be paid to portfolio construction, trading and liquidity requirements. Tax-efficient investment management techniques, when used as a supplement to appropriate diversification and disciplined adherence to asset allocation, can generate real value over time. For charitable organizations with planned giving programs, ensuring that tax efficiency is incorporated into their investment process can help to differentiate themselves in the eyes of today's donors and their advisors.