Let’s Look at Compound Interest—Part 2

Last time, we looked at two concepts: compound interest and present value.

Turns out they’re two sides of the same coin. If you grasp the idea of compound interest, you also grasp the idea of present value, maybe without realizing you do.

Compound interest tells us what $1 (or $1 million) will grow to after n years if invested at a given interest rate i. $1 will grow to $(1 + i)n.  $1 million will grow to:  $1,000,000(1 + i)n.

Present value tells us what $X to be received in n years is worth today, in today’s dollars, if we assume money can be invested at a given interest rate i, which is routinely called the discount rate when talking about present value (PV).

The PV of $X dollars to be received in n years, assuming a discount rate of i, is:   $x/(1 + i)n.  The quantity (1 + i)n is called the compound interest factor.

Note what is obvious: PV is equal to the amount of money to be received at the end of n years divided by the compound interest factor corresponding to n years and i rate of interest.

This is why compound interest and present value are two sides of the same coin.

Now a homework problem the solution to which will be given next time. Here’s the problem: Your VP for development asks you to determine the present value of a $1 million bequest to be received under the will of a living individual aged 79. Question: What two assumptions do you need to make to determine the present value?

Hint: Answer the question asked, not some other question.

Click here to read part three.

by Jon Tidd, Esq

Let’s Look at Compound Interest

Compound interest theory is at the center of financial analysis.

What is compound interest? It’s the interest earned on money invested over time. Invested at some fixed interest rate.

Let’s assume $1 is invested at 6% interest (.06 mathematically) for exactly one year. At the end of the year, the $1 has grown to $1 + $1(.06), or $1.06.

Now, let’s assume the $1.06 is left invested at 6% interest for a second year. At the end of the second year, the $1.06 has grown to $1.06 + $1.06(.06).

This sum can be re-written as: ($1.06)(1 + .06).  Which can be re-written as: ($1.06)(1.06). Which equals $(1.06)2.

So now we see the pattern. If $1 is invested at 6% interest for n years, the $1 will grow to $(1.06)n. More generally, we can say that if $1 is invested at some interest rate i for n years, the $1 will grow to $(1 + i)n.

If i = 4% (.04) per year, and n = 50 years, $1 will grow to $(1.04)50, which equals $7.11, rounded to the nearest whole cent. I calculated the $7.11 amount using Microsoft Excel.

We’ve just gotten the key to solving half of compound interest problems. What is the other half? The other half are present value problems.

A present value (PV) problem is stated this way mathematically, for example: What is the value today (PV) of $7.11 to be received in 50 years assuming 4% interest?

The answer to the question is:  PV = $7.11/(1.04)50.

What is $7.11/(1.04)50?  It’s $7.11/7.11, which equals $1.

Chew on all this for the next week, and then we’ll dig a little deeper and gain a deeper understanding of compound interest.

Click here to read part two.

by Jon Tidd, Esq

Time to Simplify Charitable IRA Beneficiary Distributions?

The process of receiving fund left through IRA designations is often time consuming, complex, expensive and, in some cases, in violation of the custodian’s fiduciary duties and federal tax law.

For example, many IRA custodians or administrators have adopted a process that requires charities to establish an “inherited IRA” in order to receive their charitable IRA beneficiary distributions as intended by the IRA account owner. Unfortunately, this procedure was not designed with charitable beneficiaries in mind and places an unreasonable burden on qualified charities to collect IRA gifts from deceased donors. The IRA custodians apparently developed this administrative process in response to tax reporting requirements.

The rank-and-file employees of the IRA custodians often have little or no knowledge of the applicable law regarding charitable beneficiaries and often take the position that the standard process must be followed in order to receive a charitable IRA gift.

As a result, there are now several grassroots efforts underway in the charitable sector to address this situation. The most recent effort involves seeking an IRS Private Letter Ruling to clarify the process and a judicial proceeding to provide legal precedent. In addition to myself, the effort is being organized by Jeff Comfort at Oregon State University Foundation, Lisa Smith at Hadassah and Michael Kenyon, President and CEO of the National Association of Charitable Gift Planners.

You can download the prepared letters from me and the National Association of Charitable Gift Planners for more information about this effort and how charitable organizations can help by clicking here.

by Jon Tidd, Esq

Charitable Remainder Trusts Have Three Life Stages

three stages of tree growth

The three stages are

1. the drafting of the trust instrument

2. the funding of the trust and

3. the administration of the trust

The drafting stage: IRS has provided specimen agreements for annuity trusts and unitrusts, which makes the drafting of CRAT and CRUT documents relatively easy. But there are some cautions here.

  • Some lawyers who draft such documents work from 20-year-old or older agreements they’ve got archived on their computers. These old agreements sometimes are not quite right
  • Some lawyers who draft CRAT and CRUT agreements are over their heads because of the gift transaction—such as a CRAT to be funded with multiple assets.

The funding stage: The funding stage is usually taken as a given. But it can be tricky, especially if the donor is going to use multiple assets to fund the trust. The key to avoiding problems in the funding stage is for the donor’s lawyer to monitor the funding. I’ve seen spectacular instances in which the donor’s lawyer did not monitor the funding, and things went spectacularly wrong.

The administrative stage: One rarely finds errors (problems) in the administrative stage if the trustee has been a professional trustee deeply experienced in managing CRUTs and CRATs. The situation can be quite different if the trustee has lacked such experience or the donor has been the trustee.

Consequences of errors: Pure drafting errors are often fixable. They are the easiest type of errors to fix.

Funding errors are sometimes fixable, sometimes not, depending on the error. A fix is likely to ring up the cash register in lawyer’s fees.

Administrative errors typically are not fixable and often disqualify the trust as a CRAT or a CRUT, which can be disastrous. A classic example here is the donor who, as trustee of her CRAT, decided not to take a payout for some years.

The devil is in the details, and qualified legal counsel and administration is critical to avoid potential problems at all three stages of CRT.

 

By Jon Tidd, Esq

Gifts for Which There Are No Tax Benefits

Gift planning has focused traditionally on squeezing maximum tax benefits out of a gift arrangement.

There are, however, some good gift arrangements for which little or no tax benefits are available. “Good” here means good for the donee organization.

Let’s consider some specific examples.

Donor contributes a valuable painting she painted: Donor’s income tax charitable deduction is limited to her cost basis in the painting (usually, cost of materials), which may be negligible. But the value to the donee may be immense. Same goes for a royalty-producing copyright, such as a copyright to a popular song.

Donor contributes a patent on one of his inventions: Donor gets a federal income tax charitable deduction for a declining percentage of the patent royalties the donee receives over the next 10 years. The more royalties, the better the outcome for the donee and the better the tax outcome for the donor.

Donor gives Charity rent-free use of space in a building Donor owns: This gift may be valuable to the donee, but it is tricky from a tax standpoint.

  • Donor gets no federal income tax charitable deduction for this gift (because of the partial interest rule).
  • But Donor has made a taxable gift for federal gift tax purposes. This may or may not be a problem for Donor, depending on her overall gift and estate tax situation.

Donor sets up a non-charitable remainder trust that is to provide for himself and his immediate family: When the trust terminates years in the future, whatever remains in the trust will go to Charity.

  • This may or may not be a great gift arrangement from Charity’s standpoint, in terms of gift counting.
  • But it’s better than nothing.

For more information on these types of gifts, check with your SHARPE newkirk rep.

By Jon Tidd, Esq

Questions & Answers

  1. WHY DOESN’T THE DONOR REALIZE GAIN WHEN GIVING AN APPRECIATED ASSET SUCH AS APPRECIATED STOCK?

  • Gain is realized only on the sale or exchange of an appreciated asset. Note that a gift annuity funded with appreciated stock involves a sale or exchange (it’s a kind of bargain sale). Note too that a gift of mortgaged real estate is treated as a sale for an amount equal to the mortgage debt.
  1. WHY DOESN’T THE DONOR REALIZE GAIN WHEN PAYING AN ENFORCEABLE PLEDGE WITH APPRECIATED STOCK?

  • The donor would realize gain if the pledge were considered a debt for federal income tax purposes; but IRS does not consider an enforceable pledge a debt for federal income tax purposes.
  1. IS A DAF SUBJECT TO THE SAME TAX RULES AS A PRIVATE FOUNDATION?

  • No, provided the DAF is a “public charity.” A community foundation DAF, for example, is such a critter. So are the gift funds set up by the financial institutions. Public charities are not subject to a slew of “don’t-do-thats” (such as the prohibition against self-dealing) that apply to private foundations.
  1. IS IT ALL RIGHT FOR AN INDIVIDUAL AGED 70.5 YEARS OR OLDER TO TRANSFER $ FROM A 401(k) PLAN TO AN IRA AND THEN MAKE AN “IRA ROLLOVER” GIFT FROM THE IRA?

  • Not clear. The transfer from the 401(k) to the IRA is simply an end run around the tax law. It has no independent, nontax, financial purpose. The IRS might attack this maneuver using the step-transaction doctrine.
  1. WHAT IS THE STEP-TRANSACTION DOCTRINE?

  • It’s an oft-used way for the IRS to disregard the form of a series of transactions and treat the series according to their cumulative substance. It comes into play when one of more of the individual transactions lack economic substance apart from saving taxes. Only a tax expert is qualified to size up a potential step-transaction problem. Many tax scams that arguably look good on paper run afoul of the step-transaction doctrine.

If you have questions and want answers, contact your SHARPE newkirk rep.

By Jon Tidd, Esq

IRS Has Issued New Gift Substantiation Regulations

These regs are important. They deal with gift receipts and qualified appraisals, documents on which IRS auditors focus. The new regs take effect January 1, 2019.

Without a correct gift receipt, Donor will have his or her entire federal income tax charitable deduction disallowed on audit. Same result as to an appraisal that doesn’t meet the definition of a “qualified appraisal.”

Here’s just one change that’s critically important:

  • Under current regs, an appraisal must state the date of gift or the expected date of gift to be a “qualified appraisal.” The appraisal also must state the FMV of the donated asset as of the date of gift or the expected date of gift.
  • Under the new regs, the appraisal still must state the date or expected date of gift. But the new regs require the appraisal to state the “valuation effective date” and the FMV as of that date.

What is the “valuation effective date”? It’s the date of gift if the date of the appraisal is after the date of gift. If the appraisal date is before the date of gift, it’s the date of gift or a date no earlier than 60 days before the date of gift.

Wow.

The compliance rate with the new regs is going to be about zero. I believe this because the compliance rate with the current regs is about zero.

Gift officers don’t have to study and understand the new regs in depth. But gift officers do need to be mindful that important changes are coming that will, in some cases, adversely affect donors.

If you have questions about the new regs, and you may have a lot, be sure to consult with a competent advisor, and make sure to suggest that donors of noncash gifts do the same.

By Jon Tidd, Esq

Working With Life Estate Gifts

Life estate gifts involve the gift of a personal residence or farm subject to a retained life estate. The retained interest also can be an estate for a term of years.

“Estate” means the exclusive right to occupy or the right to rents (e.g., in the case of a farm leased to a tenant).

“Personal residence” means a house and accompanying land owned by the donor and used by the donor as his or her residence. It does not have to be the primary residence, but it must not be rental property.

In my experience, this sort of gift is uncommon. Which is puzzling, because it’s a good fit for many potential donors: a current charitable deduction with no current out-of-pocket outlay and no necessary change of life style.

There can be problems with this kind of gift, however:

  • The donor is going to have to get a qualified appraisal.
  • If there’s a mortgage on the property, the gift will be a bargain sale.
  • It’s possible the donor at some point will let the property fall into disrepair.
  • It’s also possible the donor will begin at some point to make demands, such as a demand to replace a broken window or a demand to remove a broken tree branch.
  • The donor may fail to make property tax payments.

A side agreement is needed to avoid donor-relation problems, but even the best side agreement is no guarantee that problems will be avoided, particularly if the donor’s mental state deteriorates.

You should either have experience or have an adviser who has experience dealing with this sort of gift if you’re going to work with a prospective life estate donor.

If you want guidance on this sort of gift, be sure to check with your Sharpe Group rep.

By Jon Tidd, Esq

Finding Missing Money

When working on an estate where you are the primary beneficiary, it can be worth checking www.missingmoney.com for lost assets. This is a joint website set up by 42 (so far) state unclaimed property agencies to help find missing assets. Just plug in your or your organization’s name and see what pops up. It also offers links to the federal government for unclaimed U.S. savings bonds and links to other countries, states and Canadian provinces.

I’ve lived in the same location for 24 years. I entered in my name and found missing assets I’ll soon get back. I did the same thing for a Sharpe client that has had several physical and mailing addresses. I located 6 unclaimed assets they are now recovering.

This arose recently when our client heard from a firm offering, for a fee, to collect $74,000 from the estate of a deceased woman. For some reason, they had not located the charity and the assets were turned over to the state. This arises when the charity’s name is wrong or the executor somehow missed an asset. As long as you pay nothing until you receive the funds, this can be a smart decision. Some firms want as much as a 50% “finder’s fee,” so do negotiate the fee. Don’t agree until you have checked www.missingmoney.com to make sure that this is not something you can collect on your own. Over the years, I’ve paid this type of finder’s fees many times. It sounds odd, but these can be legitimate firms to work with.

Keep in mind that paying a finder’s fee to collect a gift already made is quite different from paying a finder’s fee to generate a gift.

By John Jensen

Working With Baby Boomers

Everyone who has worked on lots of planned gifts from Baby Boomers, hold up your hands.

Just as I thought.

Sure, there are gift plans that fit. Lead trusts in some cases. Term-of-years CRTs. Deferred payment gift annuities. Virtual endowments.

The writer hasn’t seen more than a few window shoppers and at most only a couple of buyers among Baby Boomers.

There are several reasons for this. In no particular order:

  1. Baby Boomers are dealing with their own kids. Ever read the news story about the 30-something who has moved back home?
  2. Baby Boomers as a group haven’t saved. They’ve spent.
  3. The huge wealth transfer hasn’t occurred. If and when it begins, many Baby Boomers are likely to stash their inheritances.
    • They’ve got their own retirements to fund.
    • They’re going to live long lives.
    • They’re going to be expected to pay for their grandkids’ education.

Sure, there are good planned gift prospects among Baby Boomers.

But in 2018, the oldest Baby Boomers turn age 72. That’s on the young end of the planned gift donor age spectrum. For this reason alone, Baby Boomers as a group aren’t yet in prime planned gift territory.

Consider targeting the oldest Boomers, perhaps 66 to 72, with ideas about gifts that address the concerns of people who have recently retired or are likely to be retiring.

This blog is mainly about how to direct your marketing efforts. If you’ve got a good planned gift prospect who’s a Baby Boomer, go for it. The only caution is, try not to settle for a benefit that ripens into cash on the table only at the Boomer’s death. Your organization could be waiting a long time.

By Jon Tidd, Esq