Ducking Taxes With A Dynasty Trust

Dynasty trust are back in the news. Dynasty trusts are the province of the ultrawealthy, and are not likely to impact you or me much.

However, allow one or two favorable turns of fate and you or I might find ourselves interested in such things. Let’s hope for the best.

What sets up the discussion is three main issues:

(1)  Estate taxes

(2)  Generation-skipping taxes

(3)  The rule against perpetuities

Estate taxes are also called death taxes and apply to your net worth (everything you own less everything you owe) at death. If you own too much, you owe estate tax – short and sweet. Granted, it is getting harder and harder too own too much. The threshold for 2017 is $5.49 million per person, or almost $11 million per married couple.

I would say that – if you have accumulated $11 million – you have done well.

The estate tax intends for every generation to pay tax.

Let’s say that you are worth $15 million. The estate tax will apply. Your assets go to your child. Let’s presume that the assets inherited bounce back to $15 million (remember: there were taxes at your death) and the exemption remains at $5.49 million. The estate tax presumes that your child will pay tax again, repeating a virtuous cycle.

Well, an advisor can break that cycle pretty quickly: have some of the assets go to the grandkids. That skips the estate tax on (at least some of) the assets upon your child’s death.

Congress figured this out too and introduced the generation-skipping tax (GST). Its purpose was straightforward: to tax the assets that skipped tax when your child died. Those assets would otherwise have “skipped” a generation of estate tax.

A favored and common way to transfer assets across multiple generations is through use of a trust. There are more varieties of trusts than there are flavors of  Baskin Robbins ice cream. We however are looking at one trust and one only: the shy and elusive dynasty trust, which has rarely been captured on camera.

Tax archeologists believe that the dynasty trust evolved in response to state liberalization of the rule against perpetuities. Trusts themselves are created under state law, and all 50 states used to prohibit a trust from existing more than 21 years after the death of the last beneficiary who was alive when the trust was created.

To rephrase: the law (1) looked at the beneficiaries born when the trust was created; (2) took the youngest beneficiary; (3) waited until his/her death; and (4) said “All right, boys and girls, you have 21 years to finish this”

The point is that the trust had to eventually wrap up its affairs. It could not be “perpetual.”

In that context, the estate tax – GST tax value meal worked relatively well in identifying and taxing transfers of intergeneration wealth. No matter how complex, trusts simply had to give up the ghost eventually.

However, several states have since either modified or abolished their rule against perpetuities (Alaska and Nevada come to mind). A trust created in one of these jurisdictions can last for … who knows how long.

This has tax implications.

Because the trust is not required to terminate, tax planners can more easily get around the estate and GST combo that worked well enough in an earlier, simpler era.

It is relatively easy to avoid the estate tax issue: the planner simply does not give the beneficiary so much authority that the trust would be pulled into the beneficiary’s estate at death. While a minefield, it is a relatively well-trod minefield.

The GST is a bit more complicated.

I now go where many tax nerds would refuse to go: to give a quick overview of how a dynasty trust and the GST interact. We are venturing to the Mordor of tax practice.

Here goes:

(1)  You have a GST exemption equal to your estate tax exemption. Therefore, if the estate exemption is $5.49 million, your GST exemption is the same amount.

(2)  Meaning you can transfer $5.49 million across as many generations as you like without triggering the GST.

(3)  Rule (2) is not interpreted the way you expect when using a trust.

a.     One would think that trust distributions over $5.49 million to a skip beneficiary would trigger the GST tax.

b.    But not necessarily. The planner instead applies the $5.49 million test at a different point in time. Instead of waiting until the trust actually writes checks to a grandkid or great-grandkid decades from now (that is, the distribution date), the planner measures at the moment the settlor puts money into the trust.

c.     Here is an example. Say your great-grandkid is 15 months old, and you put $5.49 million into a dynasty trust. You next burn your $5.49 million GST exemption on the trust.

d.    We calculate a ratio: GST Exemption Used/Total Gift. Let’s give the ratio a name. We will call it “Jackson.” In our example, Jackson is $5.49 million/$5.49 million or “1.0.”  

e.    We next calculate a second ratio: 1.0 – Jackson. We will call this the “inclusion ratio.” Our inclusion ratio is 1.0 – 1.0 or zero (-0-).

f.      Tax nirvana is an inclusion ratio of zero (-0-).

                                                              i.     The magic to an inclusion ration of zero (-0-) is that future distributions from this trust are exempt from any more GST. That happens because you are multiplying [it doesn’t matter the number] by zero.

                                                            ii.     If the inclusion ratio was 45%, then 45% of future distributions from the trust would be subject to GST.

g.     To press the point, if the trust is worth a quantazillion dollars decades from now but has an inclusion ratio of zero (-0-), it is still exempt from GST.

                                                              i.     There are of course ways to ruin this outcome. One way is to put more money into the trust. The result would be to increase the denominator with no increase in the numerator. The resulting inclusion ratio would not be zero. A tax planner would tell you to NOT DO THAT.

To recap, the change in some states concerning the rule against perpetuities allowed planners to devise near-immortal trusts.

And the estate, gift and GST exemptions have been increasing every year and are now at $5.49 million per person. A married couple can of course double that.

Take the near-immortal trusts, stir in the big-bucks exemption, add a few spices (like family limited partnerships or remainder annuities) and you have a very nice tax tool for keeping wealth within the family across generations.

Marty McFly and Future Interests In A Trust

Let’s talk about gift taxes.

Someone: What is an annual gift tax exclusion?

Me: The tax law allows you to gift any person on the planet up to $14,000 a year for any reason without having to report the gift to the IRS. If you are married, your spouse can do the same – meaning you can team-up and gift up to $28,000 to anybody.

Someone: What if you go over $14,000 per person?

Me: It is not as bad as it used to be. The reason starts with the estate tax, meaning that you die with “too many” assets. This used to be more of an issue a few years back, but the exclusion is now north of $5.4 million. There are very few who die with more than $5.4 million, so the estate tax is not likely to impact ordinary people.

Someone: What does the gift tax have to do with this $5 million?

Me: Congress and the IRS saw gifting as the flip side of the coin to the estate tax, so the two are combined when calculating the $5.4 million. Standard tax planning is to gift assets while alive. You may as well (if you can) because you are otherwise going to be taxed at death. Gifting while alive at least saves you tax on any further appreciation of the asset.

Someone: Meaning what?

Me: You will not owe tax until your gifts while alive plus your assets at death exceed $5.4 million.

Someone losing interest: What are we talking about again?

Me: Riddle me this, Batman: you transfer a gaztrillion dollars to your irrevocable trust. It has 100 beneficiaries. Do you get to automatically exclude $1,400,000 ($14,000 times 100 beneficiaries) as your annual gift tax exclusion?

Someone yawning: Why are we talking about this?

Me: Well, because it landed on my desk.

Someone: Do you make friends easily?

Me: Look at what I do for a living. I should post warnings so that others do not follow.

Someone looking around: How about hobbies? Do you need to go home to watch a game or anything?

Me: There is a tax concept that becomes important when gifting to a trust. A transfer has to be a “present interest” to qualify for that $14,000 annual exclusion.

Someone resigned: And a “present interest” is?

Me: Think cash. You can take it, frame it, spend it, make it rain. You can fold it into a big wad, wrap a hundred-dollar bill around it and pull the wad out every occasion you can.

Someone: What is wrong with you?

Me: Maybe it’s just me that would do that.

Me: I tell you what a “present interest” is not: cash in a trust that can only be paid to you when some big, bad, mean trustee decides to pay. You cannot party this weekend with that. You may get cash, but only someday … and in the future.

Someone: Hence the “future?”

Me: Exactly, Marty McFly.

Someone surprised: Hey, there’s no need ….

Me: Have you ever heard of a Crummey power?

Someone scowling: Good name for it. Fits the conversation.

Me: That is the key to getting a gift to a trust to qualify as a present interest.

Someone humoring: What makes it crummy?

Me: Crummey. That’s the name of the guy who took the case to court. Like a disease, the technique got named after him.

Someone looking at watch: I would consider a disease right about now.

Me: The idea is that you give the trust beneficiary the right to withdraw the gift, or at least as much of the gift as qualifies for the annual exclusion. You also put a time limit on it – usually 30 days. That means – at least hypothetically – that the beneficiary can get his/her hands on the $14 grand, making it a present interest.

Someone: I stopped being interested ….

Me: Have you heard of a “in terrorem” provision?

Someone: Sounds terrifying.

Me: Yea, it’s a great name, isn’t it? The idea is that – if you behave like a jerk – the trustee can just cut you out. Hence the “terror.”

Someone: I cannot see a movie coming out of this.

Me: Let’s wait and see what Ben Affleck can do with it.

Me: I was looking at a case called Mikel, where the IRS said that the “in terrorem” provision was so strong that it overpowered the Crummey power. That meant that there was no present interest.

Someone: Can you speed this up?

Me: The transfer to the trust was over $3.2 million ….

Someone: I wish I could meet these people.

Me: The trust also had around 60 beneficiaries.

Someone: 60 kids? Who is this guy – Mick Jagger?

Me: Nah, his name is Mikel.

Someone: I was being sarcastic.

Me: Mikel was Jewish, and he put a provision in the trust that beneficiary challenges to a trustee’s decision would go to a panel of 3 persons of Orthodox Jewish faith, called a beth din.

Me: I suppose if the beth din sides with the trustees, the beneficiary could go to state court, but then the in terorrem provision would kick-in. The beneficiary would lose all rights to the trust.

Someone: So some rich person gets cut-off at the knees. Who cares?

Me: The IRS said that the in terrorem provision was strong enough to make the gift a future interest rather than a present interest. That meant there was no $14,000 annual exclusion per beneficiary. Remember that there were around 60 beneficiaries, so the IRS was after taxes on about $800 grand. Not a bad payday for the tax man.

Someone: Sounds like they can afford it.

Me: No, no. The Court disagreed with the IRS. The taxpayer won.

Someone backing away: What was the court’s hesitation?

Me: The Court felt the IRS was making too many assumptions. If the beneficiaries disagreed with the trustees, they could go to the beth din. The beth din did not trigger the in terrorem. The beneficiaries would have to go to court to trigger the in terrorem. The Court said there was no reason to believe the beth din would not decide appropriately, so it was unwilling to assume that the beneficiaries were automatically bound for state court, thereby triggering the in terrorem provision.

Someone leaving: Later Doc.

Joe Kennedy and Generation-Skipping Trusts

We recently had an issue with the generation-skipping tax (GST). What is it? First of all think gift or estate tax. Pull your thoughts away from income taxes. Gift or estate tax is assessed when you either (a) gift property or (b) die with property. One would think would be sufficient, but there was a loophole to the gift and estate tax that Congress wanted to fix. That fix was the generation-skipping tax.

Let’s explain the loophole through a story. Joseph P. Kennedy (1888-1969) was a bank president by age 25. He made his chops through insider trading before the government ever thought of a Securities and Exchange Commission (SEC). He had the foresight to unload his stocks before 1929, and then added to his fortune by shorting stocks during the Great Depression. Frankly, this guy was THE Gordon Gekko of his time. Today he would be in jail with Bernie Madoff. In an example of the irony that is Washington D.C., he became the first chairman of the SEC.

Let’s continue. By the mid-thirties his fortune was closing in on $200 million. Joe had a problem: he wanted to pass the money on to his descendants, but the estate taxes were usurious. For much of his wealth years, estate taxes were 70% or more. Granted, there was an exclusion amount, but Joe had long since accumulated substantially more than any exclusion amount. What was Joe to do?

Here is what Joe did: he had multiple generations skip the estate tax entirely. How?

Joe did this by using trusts. In 1926 Joe set up his first trust for Rose and the children. He created another in 1936, and then another in 1949. This last trust was the one through which Joe would transfer to his 28 grandchildren. We have talked about dynasty trusts in the past, and Joe was apparently a believer. A dynasty trust will run as long as state law will allow (there is a legal doctrine called the “rule against perpetuities”). A dynasty trust can go to the grandkids, then the great-grandkids, then the great-great…. Well, you get the idea.

John F. Kennedy (JFK) was Joe’s son and a trust beneficiary. He was also the 35th President of the United States. JFK’s trust provided him income for life, as well as the right to withdraw up to 5% of the trust principal annually. It must have been a fairly sizeable income, as JFK donated his presidential salary to charity. Upon JF’s death, his interest in Joe’s trust was not taxable to his estate (which is pretty much the point of a skip trust). Joe’s trust then skipped to JFK’s children, John F. Kennedy Jr and Caroline Kennedy. By the way, JFK had never updated his will, and upon his death he left no provision for his children. It is possible that – had he lived – JFK would have settled his own skip trust, and then his children would have had TWO generations of skip trusts providing them income.

Eventually this technique came to Congress’ attention, and in 1976 they passed their first attempt at the GST. The law was very poorly drafted, and Congress kept postponing the law until they ultimately repealed it – retroactively – in 1986. In its place Congress substituted a new-and-improved GST.

What is it about the GST? First, it is not the easiest reading this side of Joyce’s Ulysses. Second, much of estate planning is done using trusts. This introduces trust techniques such as fractionalization (i.e., assets going to multiple individuals), control (i.e., the beneficiary can request but the trustee can reject), and timing (i.e., the grandchildren have to wait until the children are deceased).  Third, unlike the gift or estate tax, the GST may not be payable at the time of gift or death. The GST can spring up years later when the trust distributes or terminates. Try having that conversation with a client….

Let’s go through some examples.

(1)    You gift your grandchild $100,000 as a down-payment on a house.

a.       OK, that seems pretty simple. You have a skip.

b.      Let’s step through the taxation of this transaction:

                                                               i.      You are out the $100,000.

                                                             ii.      You paid the gift tax.

                                                            iii.      What happens if you pay the GST for your grandchild?

1.       SPOILER ALERT: The recipient (not the payer) is liable for the GST.

2.       Your payment of the GST is treated as an ADDITIONAL gift!

(2)    You set up a trust for your grandchild. You settle it with $100,000.

a.       On its face I would say you have a skip.

(3)    Let’s modify the trust. Say that you give a life estate to each of your two children. Your three grandchildren are residual beneficiaries.

a.       Is there a skip? Yep.

b.      How do you value the skip?

                                                               i.      Let’s do ourselves a favor and “skip” that question for a moment.

c.       When do you value it?

                                                               i.       At the time the trust is created?

                                                             ii.      When the children both pass away (leaving only the grandchildren)?

                                                            iii.      When the trust actually distributes to a grandchild?

ANSWER: at the death of the second-to-die child

(4)    Let’s press on. The grandchildren are not yet born when you fund the trust. Attorneys refer to them as “contingent” beneficiaries.

a.       Is there a skip? Probably.

                                                               i.      Probably? What kind of weasel answer is that?

1.       The truth is that there may never be grandchildren, or the grandchildren may not live long enough to benefit under the trust. In that situation, there is no skip. Otherwise there would be a skip.

b.      How do you value the skip?

                                                               i.      I tell you what I would do: I would allocate $100,000 of my GST exemption to the trust when settled. I would file a gift tax return and prominently announce to the IRS that I am allocating $100,000 of my exemption. This makes the trust GST exempt, now and forever. It will not matter how much the trust appreciates in the future, or if, when or to whom it distributes.

c.       When do you value it?

                                                               i.      If you followed my advice, when you funded the trust.

Now before you worry about the GST, remember that one has to skip a certain amount of money to even step onto the GST field. For 2012 you would have to skip more than $5 million. If there is no change in the tax law, in 2013 that amount will drop to $1 million. Still, $1 million will keep most of us out of GST trouble.

The estate tax was Congress’ effort to slow-down the accumulation of familial wealth, and the GST was an effort to close a loophole in the estate tax. Its purpose was to ensure that accumulations of great wealth were taxed at least once every generation. Congress did not want the establishment of an inherited class, somewhat like the House of Lords in England. How many Paris Hiltons – or William Kennedy Smiths – do we as a nation want to tolerate?

The irony of GST tax law is that wealthy had little incentive to establish dynasty trusts before 1986. There were several states, including Idaho and Wisconsin, which allowed trusts to be perpetual. Many states have since followed suit, liberalizing their state statutes to allow long-lived (although maybe not perpetual) trusts in an effort to attract the high-wealth investments out there. There was a study in the mid-2000s which estimated that more than $100 billion had flowed into states allowing these long-lived trusts. It appears that Congress has created a bit of a cottage industry.

Gifting And The Rest of 2012

I met with a client last week who has a child with special needs. His daughter has a syndrome I cannot remember, except that it is quite rare and was named after a physician who practiced at Children’s Hospital here in Cincinnati. He is concerned about her welfare, especially after he passes away. We wound up talking about gifting and expected changes in gift tax law.

Let’s talk about the gift tax today.

There is an opportunity to gift up to $5,120,000 without paying gift tax, but this expires at the end of 2012. If you are married, then double that amount (10,240,000). If you exceed that amount, then gift tax is 35%. The $5,120,000 is set to drop to (approximately) $1,360,000 in 2013, and the 35% rate is slated to increase to 55%. If you are in or above this asset range, 2012 is a good time to think about gifting.

Here are some gifting ideas to consider:

(1)   Use up your $13,000 annual exemption per donee. This is off-the-top, before you even start counting. If you are married, you can have your spouse join in the gift, even if you made the gift from your separate funds. That makes the exempt gift $26,000 per donee.

(2)   Let’s say that gifting appeals to you, but you do not want to part with $5,120,000. Perhaps you could not continue your standard of living. I know I couldn’t. One option is to have one spouse gift up to $5,120,000 without gift splitting. This preserves the (approximately) $1,360,000 exemption for future use by the other spouse.

(3)   By the way, gifting between spouses does not count as a taxable gift. Should one spouse own the overwhelming majority of assets, then consider inter-spouse gifting to better equalize the estates. This is more of an estate planning concept, but it may regain interest if the estate tax exemption decreases next year.

(4)   Consider intrafamily loans. The IRS forces you to use an IRS-published interest rate, but those interest rates are at historic lows. For example, you can make a 9-year loan to a family member and charge only 0.92% interest. Granted, the monies have to be repaid (or gifted), but the interest is negligible.

(5)   Consider a family limited partnership. We have spoken of FLPs (pronounced “flips”) before. A key tax benefit is being able to discount the taxable value of the gift for the lack of control and marketability associated with a minority interest in the FLP.

(6)   Consider income-shifting trusts to move income and asset appreciation to younger family members. A common use is with family businesses. Say that you own an S corporation, for example. Perhaps the S issues nonvoting stock and you transfer the nonvoting stock to your children using Qualified Subchapter S trusts.

(7)   Consider a grantor retained annuity trust (GRAT). With this trust, you receive an annuity for a period of years. The shortest period I have seen is 2 years, but more commonly the period is 5 or more years. The amount you take back reduces the amount of the gift, of course, but not dollar-for-dollar. I am a huge fan of GRATs.

(8)   Consider a qualified personal residence trust (QPRT, pronounced “Q-pert”). This is a specialized trust into which you put your house. You continue to live in the house for a period of years, which occupancy reduces the value of the gift. If you outlive that period then you can continue to live in the house, but you must begin paying fair market rent to the trust.  I have seen these trusts infrequently and usually with second homes, although I also can see a use with a principal residence in Medicare/Medicaid planning.

(9)   Consider a life insurance trust (ILIT, pronounced “eye-let”). This trust buys a life insurance policy on you, and its purpose is to keep life insurance out of your estate. You might pay the policy premiums on behalf of the trust, using your annual gift tax exclusion. This setup is an excellent way to fund a “skip” trust, which means the trust has beneficiaries two or more generations below you. The “skip” refers to the generation-skipping tax (GST), which is yet another tax, separate and apart from the gift tax or the estate tax.

(10)  Consider a dynasty trust if you are planning two or more generations out. This technique is geared for the very wealthy and involves an especially long-lived trust. It is one of the ways that certain families (the Kennedy’s come to mind) that family wealth can be controlled for many years. A key point to this trust is minimizing or avoiding the generation-skipping tax (GST) upon transfer to the grandchildren or great grandchildren. The GST is an abstruse area of tax law, even for many tax pros.

OBSERVATION: You could incur both a gift tax and a GST tax. That would be terribly expensive and I doubt too many people would do so intentionally.

Although not frequently mentioned, remember to consider any state tax consequence to the gift. For example, does the state impose its own gift tax? If you live in California, would the transfer of real estate reset the assessable value for property taxes?

It is frustrating to plan with so much uncertainty about tax law. We do know that – for the balance of this year – you can gift over $5 million without incurring a gift tax liability. That much is a certainty. If this is you, please think about this window in combination with your overall estate plan. This opportunity may come again – or it may not.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.