Philanthropic Options for Transferring Wealth to Family Members

Last July, the IRS issued an unusual Private Letter Ruling to a husband and wife, both still alive, who requested a ruling for the proposed plan for distribution of their estates at their respective deaths.  (PLR 201129049 dated July 22, 2011.)  This important ruling highlights some charitable giving options advisors and their clients have for transferring wealth to family members.  In fact, the IRS essentially gave us a blueprint - in this case of how to transfer a corporation to the next generation, while passing tax dollars to a family foundation, rather than to the federal government. 

Specifically, the IRS ruled that the receipt by a private foundation of a promissory note would not constitute an act of self-dealing.  A closely-held corporation planned to give the foundation the promissory note in redemption of non-voting stock left to the foundation by a descendant's estate. 

With this ruling in mind, let's look at two family wealth transfer planning options which use the following tools: promissory notes, life insurance, charitable lead annuity trust and a private family foundation. 

Option #1

The following strategy is designed to take care of a Promissory Note in the Client's estate if he passes away within the next nine years and before the Note is paid off.


The strategy is an alternative to purchasing a life insurance policy to pay estate taxes associated with having the Note in the estate if the client were to die within nine years.

Create a Testamentary Charitable Lead Annuity Trust (CLAT) now.  Upon the death of the surviving spouse, the CLAT is funded with the Promissory Note.  Also, at that time the Trustee can then decide the CLAT term and payout rate to the foundation.  Depending upon the CLAT Trust term and payout rate, estate taxes can be significantly reduced or eliminated.  After the CLAT term, the Note passes to the children who then simply tear it up. 

Life Insurance Idea

If purchasing life insurance seems to be a more simple straightforward approach for handling the Promissory Note, the client may want to consider 1 of 2 approaches below.

1. Purchase a nine year term life insurance policy.

2. Purchase a term life insurance policy for, say, a 20 year term that also has a convertible-to-permanent life insurance feature in the policy (which does not require a new medical exam prior to the conversion).  After the first nine years, the client can sell the policy under a Life Settlement arrangement that may enable him to not only recover all the prior nine years of premiums but also a significant percentage of the face amount, making it compare quite favorable to other types of investments. 

Option #2

The following strategy is designed to take care of any other remaining assets in the client's estate that they want to pass to their children.  Typically, these would be specific assets that for financial and non-financial reasons the clients want to have remain in the family's ownership and control for future generations. 


Briefly, this philanthropic estate planning strategy is a testamentary method for transferring specific assets to children tax free, while funding a family foundation, through a testamentary Non-Grantor Charitable Lead Annuity Trust (CLAT).  Typically, the plan operates upon the death of the surviving spouse. 

Step 1 - Create a Testamentary CLAT now.  After the death of the surviving parent, the Trust is funded.  The Trustee can then decide the Trust term and payout rate to the foundation.  Depending upon the Trust term and payout rate, estate taxes can be significantly reduced or eliminated.  After the Trust term, the trust assets pass to the children. 

Step 2 - The parents grant an option for, say, $2,500 to each child.  Each child now owns an option to purchase an equal share of the selected assets (option assets) from the surviving parent's estate.  The options are usually exercisable for nine months from the date of the death (the option period).  The option can be exercised during the option period to purchase an option asset at its fair market value (see Private Letter Rulings 201129049, 200927041, 200722029, 200024052, 199930048, 199924069 and 9724018).  In certain situations, there is no need to sell options to the children because they will have similar arrangements under customary business succession plans (i.e., pursuant to buy/sale agreements for closely-held businesses, partnerships and limited liability companies.  See Private Letter Rulings 200207028 and 200207029). 

Step 3 - Each child may exercise their option and purchase option assets with cash (perhaps from insurance proceeds), or an installment note (a balloon payment type), or a combination of the two.  Notes used to purchase option assets must bear interest at the applicable federal rate for such notes, determined under IRC §1274(d), and should be secured by the option asset purchased or an amount acceptable to the seller (see Private Letter Rulings 201129049, 200927041, 200722029, 200124029, 200232033, 200233031, 200635015, 200635016, and 200635017).

Comment: The options bind the current and successor executors and trustees of the surviving parent's estate, and if the option assets are distributed to the CLAT, the options will apply to the option assets of, and will bind the trustees of, the CLAT.

Step 4 - The CLAT term will end before the Promissory Note balloon payment is due.  The Note will pass to the children and no balloon payment will have to be made. 

Comments Regarding the Self-Dealing Rules

Like Private Foundations, the CLT is governed by the self-dealing rules under IRC §4941.  Certain exceptions to the general rules can be found under Section 53.4941(d)-1(b)(3) of the Foundation and Similar Excise Taxes Regulations.  This Section excepts certain transactions carried out during the administration of an estate ("the Estate Administration Exception") from the definition of self-dealing.  Specifically, Section 53.4941(d)1(b)(3) provides that the term "indirect self-dealing" shall not include a transaction with respect to a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate or revocable trust (including a trust which has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if:

1. The administrator or executor of an estate, or trustee of a revocable trust either:

- Possesses a power of sale with respect to the property,

- Has the power to reallocate the property to another beneficiary, or

- Is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust);

2. Such transaction is approved by the probate court having jurisdiction over the estate (or by another court having jurisdiction over the estate [or trust], or over the private foundation)

3. Such transaction occurs before the estate is considered terminated for Federal income tax purposes pursuant to paragraph (a) of section 1.641(b)-3 of the regulations (or in the case of a revocable trust, before it is considered subject to section 4947 of the Cold);

4. The estate (or trust) receives an amount which equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust)

5. With respect to transactions occurring after April 16, 1973, the transaction either:

- Results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up

- Results in the foundation receiving an asset related to the active carrying out its exempt purpose

- Is required under the terms of any option which is binding on the estate (or trust)

Life Insurance Planning

Typically, life insurance is a common component in many estate plans.  Suppose your client previously bought life insurance years ago to pay future estate taxes.  However, since the life insurance purchase, the client's estate is much larger today and the insurance coverage now needed is unavailable because it's too expensive or the client is uninsurable.  The client's estate can sell the children all of the assets in exchange for an interest only promissory note.  The children can pay the interest payments to the CLAT using the insurance proceeds and/or the investments earned on the insurance proceeds, rather than using the insurance to pay estate taxes. 

Another life insurance option would be to buy only enough life insurance to cover the promissory note interest payments, rather than to buy enough life insurance to pay higher estate taxes. 

By: Dan Rice, Co-founder of CTAC

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