Using Charitable Tax Planning to Help Hulk Hogan and Other Settlement Recipients Mitigate Tax Submission Holds in Settlements
Overview
I grew up in the Panama Canal Zone watching “ Lucha Libre” (Wrestling) on Panamanian TV every Sunday morning with my brother eating empanadas. To this day, I remember the names of the wrestlers. Our favourite was El Idolo. On our sporadic visits to the U.S., we had the opportunity to see Bo Bo Brazil, Gorgeous George and Bruno San Martino. Needless to say, it was a good childhood, a little bit The Wonder Years with Latin music instead of Woodstock!
Vince McMahon may be seen by many as a circus barker, but regardless of the label, he is a billionaire whose wife ran for the U.S. Senate, while living in Greenwich, Connecticut next to the socialite of socialites, Bunny Bixler (Auntie Mame). One of the greatest in his stable of wrestlers, was Hulk Hogan aka Terry Bollea. Hulk was recently awarded $115 million in a verdict for his invasion of privacy suit related to the unauthorized release of his sex tape. The jury awarded Hogan $55 million in economic damages and $60 million for emotional distress. He also received an additional $25 million dollars in punitive damages to make the total award $140 million.
The first question might be how much money Hulk Hogan will end up with. One of the problems that Hulk Hogan faces is that the deductibility of the attorney’s contingency fee of 40 percent or $56 million which is most likely deductible only as a miscellaneous itemized deductions. These deductions are reduced by the smaller of 80 percent of the itemized deductions affected by the limit (taxes paid; interest paid; charitable contributions; job expenses), or 3 percent of the amount by which the taxpayer AGI exceeds $309,900 on a joint tax return. The income including his lawyer’s fee would be subject to taxation at the AMT rate of 28 percent. As a result, the Hulk would only net $44.8 million or 32 percent of the total award. Most of us could live for the next five lifetimes on this amount!
This article reviews the use of a creative combination of planned giving techniques as a reversal to the tax outcome listed above. The Strategy weaves non-charitable planning into the mix in order to provide a thirty year deferral on the taxation of income that would be taxed as ordinary income. The strategy provides tax-free use on 95 percent of the deferred amount during the thirty year deferral period.
The charitable planning combination replicates the insurance split annuity with tax advantages. In this case a portion of the investor’s funds are allocated to a PIF which provides a series of tax benefits – (1) Substantial income tax deduction (2) Tax exemption on the sale of an appreciated asset (3) A lifetime income for one or multiple generations and (3) Charitable gift tax deduction.
A portion of the funds are allocated to a Charitable Lead Annuity Trust (CLAT). The CLAT provides a substantial income and gift tax deduction and provides an income to the taxpayer’s donor advised fund or charity of choice for a term of years, with the CLAT remainder interest passing to the taxpayer or
Taxpayer’s trust, after the term of years.
The Charitable Split Annuity
The charitable split annuity concept is a combination of charitable planning techniques – the charitable lead annuity trust (CLAT) and the pooled income fund (PIF). The CLAT is designed as a grantor trust. The CLAT provides payment to the taxpayer’s donor advised fund for a term of years. The annuity payout is designed to maximize the charitable deduction which is limited to 30 percent of AGI. The unused deduction may be carried forward for five tax year. The annuity payment scheme may be structured to backload the payments, i.e. small initial payments growing by a fixed percentage each year. This payment scheme allows the CLAT corpus to grow over a term of years back to its original amount or more.
The second part of the charitable split annuity concept is a contribution of assets to a pooled income fund (PIF). The PIF income interest may be designed to provide an income over a single or joint lifetime over multiple generations, concurrently or consecutively.
- Pooled Income Fund
A pooled income fund is a trust that is established and maintained by a public charity. I.e. 501(c)(3) organization. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned “units of participation” in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.
Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor’s deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.
A cash contribution to a PIF is subject to an income tax deduction threshold of fifty percent of adjusted gross income (AGI). Appreciated assets are subject to the thirty percent of AGI threshold. Excess deductions may be carried forward for an additional five tax years. The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.
Each year, the fund’s entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, or multiple lifetimes, consecutively or concurrently. The taxpayer does not recognize gain or loss on the transfer of property to the PIF. If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Midterm Rate The rate for the 2016 tax year is 1.2 percent.
In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow
Charitable Lead Annuity Trust (CLAT)
There are two basic types of living charitable lead trusts. These are the grantor lead trust and the non-grantor, or family lead trust. In the case of a grantor lead trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed a deduction in the year the trust is established for the actuarial value of the annuity or unitrust income stream to be paid to the charity.
A CLAT is a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT can be designed to produce a deduction equal to the contribution. The deduction (including cash contributions) are limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.
The CLAT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. The CLAT does not have a limit for a term of years. A CLAT may be created lead trusts for thirty or thirty five years, with the CLAT remainder to grandchildren at the expiration of that term.
Strategy Example
- The Facts
Hulk, age 62, is a Florida resident. He is the recipient of a $140 million settlement. Hulk is on his second marriage and his second wife is 41. The Hulk’s wife from his first marriage is 56. He has two children from his first marriage, a daughter age 28 and a son age 26. Hulk’s son settled a civil suit in 2011 for $5 million. The family owes an additional $1.5 million to the injured party.
The Hulk’s first marriage ended badly after twenty five years amid allegations of womanizing and physical abuse. Hulk’s journey is one of biblical proportion, a la King David in the Old Testament. He was the King of the Jungle as a twelve-time WWF champion; Hollywood star with his own reality TV show and several movies and a long-term first marriage. He even managed to end his wrestling career relatively free of serious injuries. The end of a twenty five year marriage estranged his two children and ex-wife. He married a much younger woman and then suffered incredible public humiliation for the release of a sex tape by his former best friend of a sexual tryst between Hulk and his former best friend’s wife. Hulk would like to make things right with his ex-wife and children for the blessing of the large settlement by adding a little sweetener to the pot.
- Solution
Hulk implements two different strategies in regard to the settlement in order to mitigate upfront taxation. He implements a monetized installment sale for a portion of the settlement equal to $100 million of the total $140 million settlement. This strategy effectively involves the transfer of the settlement to an intermediary who in turn enters into a settlement under the same terms with the defendant. The initial transfer to the settlement is transferred to the intermediary by installment sale, with interest only payments and a balloon payment in Year 30. The installment note interest rate is a fixed 2.25 percent. The intermediary will make these interest payments to the Hulk.
The defendant will make a $100 million payment to the intermediary and who arranges for a $95 million loan to the Hulk. Hulk makes a $56 million payment to his lawyers, He invests the balance of the loan, 39 million in a Nevada asset protection trust. He and his children are discretionary beneficiaries of the Trust. His second wife is also a discretionary beneficiary of the Trust as long as she remains married to Hulk. The loan is transacted in a manner that it is not a taxable gift to the trust. The $21 million tax that would have been paid in 2016, has a present value (discounted at 5%) of $4.9 million in Year 30.
The balance of the payments, $40 million is made directly to Hulk. Hulk allocates $20 million to a PIF for the benefit of his ex-wife and children. The income interest will continue for the lifetime of his ex-wife and then continue concurrently for the lifetime of both children. The projected income is $800,000 per year. The income tax deduction is equal to 55 percent of the contribution, or $12 million. The deduction is equal to 50 percent of the Hulk’s AGI. Any excess deductions may be carried forward for an additional five year tax years. The transfer will be a completed gift for gift tax purposes. The divorce decree had a provision for the transfer of additional funds. Even though the divorce was completed in 20011 and the transfer occurs outside of the three year window, the transfer is considered to be made in satisfaction of the property settlement agreement. The income interest will continue for the lifetime of both Hogan children.
Hulk creates a CLAT with a twenty year term with a $20 million contribution. The CLAT is structured as a grantor trust. The deduction is equal to $20 million and is limited to 30 percent of AGI. The IRC Sec 7520 rate for April 2016 is 1.8 percent. The projected investment growth rate within the CLAT is 7.5 percent per year. The CLAT payments to Hulk’s donor advised fund. The income tax deduction is equal to the initial contribution and is limited to 30 percent of AGI.
The excess deduction may be carried forward for five additional tax years. The CLAT payments will increase by 20 percent each year for sixteen years. The projected remainder interest at the end of Year 20 is $46.5 million and will pass to a family trust established for his children. The initial payment to the donor advised fund in Year 1 is $140,000. The final payment in Year 20 is $4.5 million. The assets are outside of his taxable estate. Hulk’s total income tax deduction is $32 million which can be used up to $20 million on AGI of $40,000 in 2016.
Summary
Hulk Hogan has endured an incredible journey that would rival any of the characters in the Old Testament. He went from rags-to-riches back to riches, but not without pain and suffering which was mostly self-induced. He underwent public humiliation in his recent trial to being awarded enough money for several lifetimes. The question what move does he have in his wrestling trunks designed to neutralize his opponent the IRS? His signature move was the Atomic Leg Drop usually employed to end the match. He is not my client (but he is free to call me!) and is a hypothetical of what might be done if he were my client. The techniques in the article would provide him with a tax version of the Atomic Leg Drop, or at least double the amount of money received in the settlement on an after-tax basis.
This article outlines a combination of strategies designed to provide current access to a large portion of the settlement on a tax-free basis in a manner that it outside of his taxable estate but available for discretionary income purposes and beyond the reach of creditors. The balance of funds are distributed in a tax-advantaged manner to bury the hatchet with his ex-wife and provide for his children regardless of what comes next in his journey. The results of the strategy from an after–tax standpoint dramatically exceed the “do nothing” approach even though $44 million is nothing to sneeze at. Nevertheless, why settle for $35 million when you can access $100 million on a tax-free basis.
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Gerald Nowotny – Osborne & Osborne, PA
266 Lovely Street
Avon, CT 06001
United States
860-404-9401
TaxManDotCom.com
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Photo credit: ^ndrew via VisualHunt.com / CC BY-NC
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