Based on Federal Reserve statistics, an estimated 300,000 to 500,000 Americans now have mega-estates of $10 million or above. Most charities with gift planning programs have 20 to 60 potential donor prospects with estates at this level. These families are able to provide added economic security for children and many have thought carefully about the best way to provide a substantial inheritance.

Because the transfer of large amounts of principal, especially to younger heirs, has a long history of harmful effects, many of these multi-millionaire parents plan to distribute income to children. A preferred concept is to provide the child a generous income inheritance stream totaling $2 million to $8 million over his or her lifetime.

The 5% Unitrust Solution

With the goal of providing income, the question becomes, how much income should be distributed and how can we provide that distribution for life with reduced income taxes for our child?

A very logical solution is a 5% charitable remainder unitrust. Why is 5% the right income? If financial advisors are asked to suggest an optimum withdrawal rate for a retirement plan, most will suggest 4% to 4.5%. Based on a Monte Carlo analysis, for almost any reasonable market conditions, a 4.5% withdrawal will provide a growing retirement for the life of the child.

The benefit of a 5% charitable remainder trust is that it pays out slightly more than the optimum rate recommended by financial planners, and also includes a very important ability to diversify tax-free. If appreciated assets are transferred to the charitable trust, they can be sold without payment of capital gains tax. This 5% unitrust provides the best possible solution for investment flexibility and maximum growth.

But wait, there is more. Because the unitrust can be invested to produce dividends from equities, and long-term capital gains are taxed at a lower rate, 60% or more of the total payout can be low-tax income. While some of the distributions from the trust are high-tax amounts from bond interest, the majority of the unitrust payments will be low-tax amounts from dividends and capital gains.

Therefore, the 5% unitrust is an excellent financial planning strategy for children. It permits both tax-free diversification for maximum growth as well as reduced income tax on payouts. Special bonus: it provides a secure income for the life of the child since the principal cannot be withdrawn and spent.

Double Tax Challenge

The problem with creating a 5% unitrust in a $10 million to $40 million estate is that the income stream could be subject to double taxation. There could be estate taxation on the present value of the unitrust income stream and then income tax on payouts to children. The 5% unitrust plan works well if there is no estate tax, but the double tax makes it quite unattractive.

Solution - Lead Trust and Unitrust

The obvious "zero tax" solution for a large estate is to fund the charitable remainder unitrust with the principal from a charitable lead trust. The lead trust can be funded during life or in the estate at death. At the same time, a 5% unitrust can be created for a child. The unitrust may be unfunded or may receive initial funding during the life of the parent. However, the living lead trust or testamentary lead trust will then make additions to the unitrust.

An excellent benefit of this plan is that appreciated assets transferred from the lead trust to the charitable remainder trust may then be diversified without further capital gain taxation. This allows a parent to create a living lead trust with appreciated property, give an annuity to charity for a term of years and then diversify the appreciated assets tax-free in the remainder trust.

Mega-Income Inheritance

This plan can transfer very substantial sums to children. Assume that Mr. and Mrs. Investor are each age 70 and have children ages 42 and 44. The investors have an estate approaching $20 million and desire to create a mega-income inheritance plan for their two children.

As illustrated in the accompanying chart, they transfer $8 million to a family limited partnership (FLP). Most of the assets are liquid securities, plus one parcel of development real estate. The assets are discounted 25% in the FLP to $6 million. The $6 million FLP is placed in the lead trust and an annuity of $559,800 is paid to charity for the lesser of two lives or 10 years. Typically, the lead trust will last for 10 years. However, if both parents pass away in less than 10 years, the trust will terminate and the corpus will be distributed to the 5% unitrust at that time. To view the chart, click here.

Assuming that Mr. and Mrs. Investor live for 10 years (quite likely since one of the two is likely to live to age 80), $7,323,266 is distributed to a 5% unitrust. This amount is then diversified tax-free and pays a 5% income to the two children for their lifetimes. Over the next four decades the trust income starts at $366,163 and approximately doubles during that time. The total income is almost $19 million during the lifetimes of the two children.

The charity also enjoys great benefits. The lead trust distributions total $5.6 million and there is a $14 million charitable remainder distribution from the unitrust.

This illustration shows how a lead trust can leverage the exemption. The parents used less than $1.6 million of their $2 million in gift exemptions when the trust was created. If they so desired, they could also set up testamentary lead trusts with the remaining $12 million in the estate and move the entire $20 million estate through to the 5% unitrust for the two children.

Mega-Leverage Potential

For individuals with even larger estates, the combination of lifetime and testamentary lead trusts together with the $3.5 million estate tax exemption in 2009 could enable the husband and wife to move $30 million or more through to the 5% unitrust with zero gift or estate tax. With the favorable gift and estate tax results, tax-free diversification and financial growth of the unitrust, it is possible to distribute up to $50 million in tax-favored income to children over their lifetimes.

Legacy For Children and Charity

The evidence suggesting that large inheritances should be distributed over time as income continues to mount. With substantial income streams, the economic security of the children is significantly enhanced. Those children who desire to build assets can invest the after-tax income. The net result will be overwhelmingly favorable.

Finally, there is a significant legacy advantage to the plan. Children will understand that at the time they pass away, tens of millions of dollars will be transferred to charity. Many parents may also choose to create the mega-income inheritance plan by funding the lead trust during life. Because the target inheritance amount for children can be easily achieved through this plan, the parents will then be able to transfer a substantial amount of the estate through a direct bequest to charity. An added option is to create a donor advised fund or supporting organization with the children making grants to charity during their lifetimes.