There are a variety of "advanced" or "sophisticated" estate planning devices which estate planners can employ for the purpose of reducing, or entirely eliminating in some cases, the federal estate tax which an individual's estate must pay on his or her death. The common elements among all of these techniques are (1) making value "disappear" in the individual's estate by means of the valuation reduction ("discounts") created for the assets in the individual's estate, (2) shifting growth, and sometimes, income out of the wealthier family member's estate, (3) leveraging the benefit of discounts and the lower gift tax rate on gifts made, and (4) exempting assets and growth on these assets forever from estate and generation-skipping transfer tax.
Many of these techniques offer advantages beyond transfer tax savings, e.g. satisfying an individual's wishes to benefit charities, fostering the orderly transfer of the family business or ranch to family members, protecting beneficiaries from creditors and angry spouses, and more.
Included in the following list of techniques is the "Bypass Trust," which is so common place today among spousal estates of more than $2,000,000 in value that some estate planners would hardly consider it an advanced planning technique. Nevertheless the use of a Bypass Trust at the death of the first spouse to die will yield a huge amount of estate tax savings (at least $920,000 and often considerably greater) to the total family estate. The Bypass Trust only can be used in the estates of married individuals.
The Bypass Trust (sometimes also referred to as the Credit Shelter Trust or Exemption Equivalent Trust) is a technique by which the Survivor (the "Survivor") can leverage the deceased spouse's Applicable Exclusion Amount ("AEA"). Each individual is allowed by the tax code an AEA to apply against his or her gross taxable estate. Such gross taxable estate includes any property or contractual benefit (IRA, life insurance, etc.) which passes to another person or institution at death. The AEA is also applied automatically against any lifetime transfers of property ("gifts") made by an individual. Pursuant to the 2001 federal tax act, the AEA rose to $1,000,000 for years 2002 and 2003, to $1,500,000 for years 2004 and 2005, to $2,000,000 for years 2006 through 2008 and to $3,500,000 for year 2009. Assuming this tax act is not amended, which is highly unlikely, there will be no estate tax in year 2010, but in year 2011, the estate tax returns, and the AEA will be $1,000,000 for year 2011 and years thereafter. The federal gift tax AEA remains at $1,000,000 under the tax act, and will not disappear in year 2010.
If a Bypass Trust is not established with assets of the deceased spouse ("Decedent") at his or her death, all, or most, of the Decedent's estate will pass to the Survivor (assuming the typical spousal plan). The estate passing to the Survivor will not be taxed because an estate tax marital deduction is given by the tax code to any estate received by the Survivor. However, the deceased spouse's AEA is effectively lost because now the Survivor ends up with all of the family estate. Given a continued life span of more than a few years and sufficient income, the Survivor's augmented estate should grow considerably, which will further exacerbate the estate tax problem that will exist at her death. Presently the federal estate tax, which is taxed at $780,800 for estates with net value of $2,000,000 (unless any portion of gross value covered by the decedent's remaining AEA) and for all incremental net estate tax value at a flat 46% rate.
With a Bypass Trust incorporated into the spousal estate plan, assets equal in value to the AEA of Decedent is funded into such Bypass Trust after the Decedent's death. The Survivor can be given rights to income of the Bypass Trust, and even principal if her health, education, maintenance and support justify such principal distributions. The Survivor can be given a special power to appoint the Bypass Trust to certain family members or charities if the spouses wish. Because the Survivor's rights to the Bypass Trust are limited (but not much), the tax code states that such Bypass Trust (and all growth in its assets) are not subject to estate tax at the Survivor's death.
The Bypass Trust must be thought out and planned for in the estate planning instrument (either Will or Revocable Trust). For smaller spousal estates between $2,000,000 and $4,000,000, a disclaimer technique can be set up in the instrument. This will give the Survivor a chance to review the estate after the Decedent's death, and then, if he or she wishes, disclaim a portion of the Decedent's estate which, by the terms of the instrument, will pass into a Bypass Trust. In larger spousal estates, some type of pre-planned formula (there are several formula varieties) will exist in the instrument, which will mandate the creation of a Bypass Trust if asset value, non-spousal gifts and amount of Decedent's remaining AEA provide so by the terms of the formula. More choices, sub-Trust allocation flexibility and no fear of failing to timely execute a qualified disclaimer (within nine months of the Decedent's death) are the advantage of a formula Bypass Trust over a disclaimer Bypass Trust.
To see a schematic of the Bypass Trust, click here.
A QPRT is an irrevocable Trust established for a certain number of years. The owner of the residence is the grantor of this Trust. During the term of the QPRT, the grantor retains the right to live in the residence. After the term has expired, the QPRT dissolves and the remainder beneficiaries (the grantor's children, probably) become fee simple owners.
The key to this technique is that the grantor is deemed to have made a completed gift at date of creation of QPRT. The value of the gift is reduced to reflect the time the remainder beneficiaries have to wait for outright ownership of the property. The age of the grantor, the length of the term and the AFR (applicable federal rate) at time of creation all factor in to compute the value of the gift. If the grantor does not outlive the term of the QPRT, the entire transaction is unraveled, the value of the residence comes back into the grantor's estate, and the gift is canceled. The big advantage of a QPRT is that the residence, at a substantially reduced value, plus all appreciation between date of QPRT creation and DOD, are taken out of the grantor's estate at the time of his death. Typically, the beneficiaries will rent the residence back to the grantor after the expiration of the term of the QPRT.
The residence must be under exclusive control of the grantor in order to qualify for inclusion in a QPRT. It can not be partially rented out. An individual can also have a QPRT for one vacation home. In the event the residence is sold during the term of the QPRT, the QPRT will remain valid if a new personal residence is acquired within two years of the sale and before the expiration of the QPRT term. The tax benefit of the QPRT can also be salvaged if the Trust document provides that the sales proceeds are converted into a qualifying annuity Trust (Grantor Retained Annuity Trust).
One disadvantage of the QPRT is that the remainder beneficiaries will take a carry-over tax basis in the residence (i.e. the presumably low tax basis of the grantor at time of funding) instead of a presumably higher tax basis at the date of death of the grantor, if the residence had been left to the beneficiaries at the grantor's death.
The Grantor Retained Annuity Trust ("GRAT")
The GRAT concept is similar in function to a QPRT. Instead of a principal residence, cash, securities or any other investment is used to fund the GRAT. Again, the idea is to make a gift to a family member at a substantially reduced value, and, again, the grantor must outlive the GRAT term for this plan to work.
Two situations exist which create the most benefit for the GRAT. One is when an appreciating asset is used for the GRAT asset. Examples are a stock option that will be exercised for a large gain by the remainder beneficiaries after the GRAT term expires. Another asset might be undeveloped real estate which will yield great profit if subdivided after the GRAT term expires. The other situation is when the actual rate of return on the GRAT asset during the GRAT term is greater than the date of funding AFR rate which must be used for computing the gift valuation deduction.
One possible disadvantage of this technique is that the grantor loses the right to the income after the term expires (not a disadvantage if the grantor does not need the income). Another disadvantage is the beneficiaries take a carry-over income tax basis in the GRAT asset/s, instead of the DOD tax basis otherwise allowed by the tax code. In large estates, the grantor's losing the right to the income is a benefit in that he or she has effectively "assigned the income" to another, a result which is typically difficult to accomplish under tax law.
The Charitable Remainder Trust ("CRT")
There are several varieties of CRTs, all of which accomplish similar results. A CRT usually is set up during a person's life. During that life, this person (the "grantor") receives a certain amount of cash each year. This amount can be in the form of an annuity (e.g. 6% of initial Trust value), or in the form of an percentage of the Trust value at a given date each year (e.g. 6% of Trust principal value on January 1 of each year). This form is called a "unitrust" amount.
At his death, all remaining value in the CRT typically passes to the charity (or other qualified non-profit organization such as a church or school). However, the grantor can set up the CRT so that upon his death, the annuity or unitrust amount will continue on for the life of the Survivor (or even children). This remainder value going to the charity is not subject to estate tax because of the estate tax charitable deduction. If the Survivor is the intervening beneficiary, the estate tax marital deduction will apply. However, any annuity or unitrust amount going to non-spouse, non-charity beneficiaries will be subject to federal estate tax based on actuarial valuations.
Besides the estate tax avoidance benefit provided, the CRT also provides that (1) in the year of creation, the grantor receives an charitable income tax deduction (subject to AGI limitations with 5-year carryover) and (2) any appreciated assets sold by the CRT are not subject to capital gains tax because the CRT is a tax-exempt entity.
Certain mathematical rules established by tax law must be satisfied in order for the CRT to qualify as a tax-exempt entity. The two main rules are: (1) For all CRTs, the valuation of the charitable remainder interest must be at least 10% of the principal value of the CRT. The tax code does not want the grantor to set up a CRT, and provide for a intervening remainder interest to spouse and children which may likely deplete the CRT before these beneficiaries die, leaving the charity virtually nothing. (2) For CRATs only (Charitable Remainder Annuity Trust), there must be greater than a 5% chance that the CRAT will not be totally exhausted at the death of the grantor (and other intervening beneficiaries). Because the CRAT payment is a set sum of money each year, regardless of the principal value of the CRAT each year, it is possible that the yearly CRAT payment will exceed the actual rate of return earned by the CRAT each year, thereby reducing the CRAT in value each year.
CRTs often result in a win-win situation for the grantor, especially if appreciated assets are funded into the CRT. Here is a typical scenario: A grantor can fund an appreciated asset which is not producing enough income for his needs (e.g. a farm leased out for only 2% net per year) into the CRT, and receive an immediate charitable income tax deduction for gift (computed on the actuarial value of the grantor's life expectancy). The Trustee of the CRT (who can be the grantor) can decide to sell the appreciated asset at no realization of capital gain. The CRT cash proceeds can be wisely invested, yielding a much higher rate of return than the farm. Much of this return will be passed to the grantor who is the present income beneficiary. When the grantor dies, the remaining value of the CRT is passed to the charity free of estate taxation. And, perhaps most importantly of all, the charity receives a substantial benefit.
One disadvantage of a CRT is that the ultimate beneficiaries of the CRT will not be the children (or other desired beneficiaries) of the grantor. However, if the grantor is insurable, he or she can obtain a life insurance policy, premiums being paid for with the increased income generated by the CRT, which will name the children as beneficiaries. Also, it is likely that the increased income received by the grantor during her lifetime will result in her having a larger estate available at her death than if she had kept the farm.
The Charitable Remainder Unitrust ("CRUT") comes in several different species, namely the NICRUT (the grantor receives the lesser of the unitrust percentage or net income during the year), the NIMCRUT (if net income is less than the unitrust percentage, the difference will be made up in future years), and the FLIP-CRUT (the NICRUT will switch to a standard CRUT upon the occurrence of a certain event in the future, such as the sale of a particular parcel of real estate).
The Charitable Lead Trust ("CLT")
The CLT, most commonly a Charitable Lead Annuity Trust ("CLAT"), is most appropriate when the grantor's income needs can be satisfied from sources other than the assets funded into the CLAT. The CLAT essentially is the opposite of the CRAT in that the charity receives the annuity income and the individuals (usually children or grandchildren) receives the principal balance after the CLAT term ends.
The CLAT works like this: The grantor establishes an irrevocable Trust for a term of years. During this term, a charity (or other non-profit institution) receives an annuity amount established by you. At the end of the term, the CLAT terminates and remainder beneficiaries then receive the CLT balance. The same concepts of gift value reduction discussed above for a GRAT apply here. A 10-year CLAT will produce the same results as a 10-year GRAT. A CLAT provides most benefit when the CLAT assets appreciate and when the actual rate of return on the CLAT exceeds the AFR effective at date of funding.
There are two main differences between the CLAT and the GRAT. (1) The annuity income for the CLAT goes to the non-profit, not to the grantor. (2) The grantor does not have to outlive the term of the CLAT. The CLAT will continue in force even if the grantor dies.
The "life" portion of the transfer (value of CLAT assets at date of funding less the value of remainder interest) is eligible for a charitable income tax deduction only if the grantor chooses to report the annuity income on his or her personal income tax return.
Unlike a CRT, the CLAT is not a tax-exempt entity, so the sale of an appreciated Trust asset by the CLAT Trustee will not avoid capital gain. Also, when the CLAT property ultimately goes to the remainder beneficiary, it will take the lower carry-over tax basis with it.
The FLP is an aggressive technique which can yield substantial tax and non-tax benefits. Large valuation discounts for the transfer of fractional ownership interests in a FLP, represented by limited partnership interests (and not the assets owned by the FLP) will result because of the lack of control and lack of marketability attached to these interests. This area of tax law has been hotly litigated for the past decade, with the IRS losing most cases until recently when the IRS based its attack on the theory the taxpayer/creator of FLP had retained sufficient interest in the FLP to allow a judge to conclude the taxpayer created the FLP soley for the purpose of reducing his estate tax.
A 2005 tax court case did provide a standard which the court would like satisfied before the FLP will be respected by the tax law. If the taxpayer/creator can document at least one non-tax reason for creating a FLP and if the distribution of FLP profits and recognition of FLP losses are realized by each general partner and each limited partner in proportion to each partner's ownership interest in the FLP, the FLP is likely to pass muster with the court (and with the IRS). Setting up the FLP and then later providing for gifts to donee family members need to be done carefully, but such work is not enough. The post-formation actions of the general partner/s of the FLP must be done appropriately and consistent with the reality of the partnership entity. As a general rule, the taxpayer should have sufficient income sources outside of the FLP to survive upon, and not rely just on distributions from the FLP.
The typical FLP plan begins with a parent (or parents or grandparents) creating a limited partnership. Real estate, securities and cash (not residences) are assets usually transferred into the FLP by the parent. The parent will be the sole general partner of the FLP usually, and the owner of most of the limited partnership units. He then will gift limited partnership units to the kids at discounted values. For instance, he may gift limited partnership units equal to $18,462 in actual value and report a discounted value of $12,000. A 35% discount is fairly conservative in most cases. The parent may also gift his Applicable Exclusion Amount ("AEA") at a discounted value in year one, and then gift the $18,462 of limited partnership units in subsequent years.
As general partner, the parent can retain sole management control of the partnership, which can be an important non-tax benefit of the FLP. The kids, as limited partners, can not vote on how the FLP is run or when it will terminate. The kids can not use the funds or assets in the FLP, and the FLP agreement will typically limit their ability to sell or transfer their interests. The kids will not get distributions unless the general partner approves, although pursuant to the 2005 tax court case mentioned above, the general partner should not make distibutions to himself unless the other partners receive distributions proportionate - with all such distributions being made proportionate to ownership shares. The kids can not use the FLP interest as collateral on a loan.
At the parent's death, his limited partnership shares which will pass to the kids by his Will or Living Trust will also receive a discount based on the lack of control and lack of marketability doctrines. The discounts taken both for life-time gifts and post-death transfers of limited partnership interests will have the saluatory effect of allowing a large amount of actual estate value transfer to the parent's kids free of gift or estate tax.
The language found in the limited partnership agreement (which can not be more restrictive than state statutory law for limited partnerships) will provide for a limited right to transfer the limited partnership interests, thus making the interest less valuable on a willing-buyer, willing-seller basis. Some cases and revenue rulings have allowed discounts up to 60%, although 35% to 40% discounts seem to be more in the safe range. Critical to the success of the FLP is the use of expert "discount" appraisers to value the discounts of the transferred limited partnership interests. However, one IRS estate tax attorney for the Northern District of California has told this author that he will not challenge a "reasonable" discount, probably in the area of 30 to 35% (depending on the underlying assets owned by the FLP), in FLPs valued at less than $5,000,000, which do not obtain "discount" appraisals. Such appraisals can be garnered at a later time if the IRS does challenge the discounts taken.
Other non-tax advantages of a FLP include the inability of a spouse or girl/boy friend of a child from becoming a limited partner (important in the case where a divorce or other problem may exist in the future or now), insulating the LP interests and distributions from creditors of the limited partners, creating an efficient way of centralizing management of a family business (real estate and other holdings), and more.
A family limited liability company ("FLLC") can be used instead of a FLP in most states, including California. In certain case, a FLLC may provide advantages that a FLP can not.
The disadvantage of a FLP (or a FLLC) is that it is expensive to set up correctly. A top attorney must be hired to ensure that the multitude of FLP tax traps are avoided, and as mentioned above, expensive expert "discount" appraisers, who have a proven track record with the IRS, must be hired for the larger FLPs.
Irrevocable Life Insurance Trust ("ILIT")
The typical purpose for the use of an irrevocable life insurance Trust is to remove the cash value and death benefit value from the taxable estate of the insured person. If the insured has no control over the insurance policy, i.e. can not revoke, can not change beneficiaries, etc. the tax law will not include the death benefits in his estate for federal estate purposes at his death. An independent Trustee will manage the ILIT, pay the premiums, etc. It is possible for the insured to make contributions to the Trustee for inclusion into the ILIT. The Trustee may use these funds, plus growth on them, for payment of premiums on life insurance on the life of the insured. If the beneficiaries of the ILIT are given a limited right of withdrawal from the ILIT, typically in the form of a "Crummey Power" for a window period of 30 days or so, it is possible for the gifts to the Trust to fall within the $12,000 per beneficiary/per year exclusion from gift taxation.
The greatest benefit associated with the ILIT is when the ultimate beneficiaries are grandchildren (and other descendants below the grandchild generation) of the insured person. At the time each funding contribution is made to the ILIT, the insured person will allocate a portion of his generation-skipping transfer ("GST") tax exemption (which is currently $2,000,000) to the cash gift on a timely gift tax return. Over twenty years, the insured person can make gifts totaling $240,000 per beneficiary, a cash pot completely covered by his GST tax exemption. Assume gifts are made to only one grandchild. Assume the life insurance policy is for $3,000,000. At the insured person's death, the estate (life insurance death benefits) generated by $240,000 of premiums will be $3,000,000, all of which will be GSTT exempt. Bottom line: the $3,000,000 will pass free of both estate tax and GST tax to the grandchild, or to a Trust for a child, with remainder to grandchild, or perhaps to a Dynasty Trust arrangement where grandchild, great-grandchild, and further descendants will enjoy the benefits of the non-taxed estate.
A Dynasty Trust is a multiple generation-skipping transfer (GST) Trust designed to optimize the exclusion from the GST tax. A Dynasty Trust is used to transfer assets to multiple generations with transfer tax being paid only at the initial transfer to the Trust, thus avoiding both estate and GST tax at the transfer of assets at each subsequent generation.
A Dynasty Trust will generate the most benefit for a Trust established under the law of states which have repealed the common law rule against perpetuities. A Dynasty Trust which never terminates provides for amazing savings in the transfer taxes because of huge amounts of Trust value that may be accumulated free from both the estate and the GST tax. In a state like California, which still recognizes the rule against perpetuities (which will force termination of the Trust in approximately 90 years), a large amount of accumulated tax-free benefit nevertheless can be recognized. The California residence may, if he or she wish, establish a Dynasty Trust under the law of one of the states which has repealed this common-in-law rule.
Among the states that have repealed the rule against perpetuities, Delaware, Alaska and Florida in particular have a favorable and sophisticated body of estate and trust law. A Dynasty Trust established in one of those states will take advantage of the repeal of the rule against perpetuities and take maximum advantage of the federal GST tax exclusion.
While the income of most Trusts is subject to state income taxes because the Trusts are set up locally in states that tax such income, Delaware, Alaska and Florida do not tax such income.
The potential tax savings can be illustrated by comparing the following three estate plans:
Assume that a set of parents possess $6 million in estate value. They wish to benefit their children and generations of descendants beyond. The second parent to die lives for 30 years after the beginning date of this example.
First plan - no GST Trust. The parents will invest their $6 million estate outside of any Trust, i.e. they will not transfer any money into a Trust while they are alive. Assume no GST Trust planning will be involved at any subsequent generation below the parents.
Second plan - standard GST Trust. The parents will transfer (give) their $6 million to an irrevocable "standard" GST Trust, with each child having a GST sub-Trust share. A standard GST Trust will be funded with assets equal to the parents' GST exclusions of $2 million each. At the death of a child, that deceased child's children will become the beneficiaries of the child's GST sub-Trust. The GST Trust (and sub-Trusts) will continue to exist until the "rule against perpetuities" of the state where the Trust is established requires the Trust to terminate and all assets distributed outright to the then-beneficiary. This old common-law rule generally results in a maximum Trust period of 90 years.
Third plan - Dynasty GST Trust. The parents will transfer (give) their $6 million to a Dynasty GST Trust, with each child having a Dynasty sub-Trust share. The Dynasty GST Trust will never terminate if established under the law of a state which has repealed the common law rule against perpetuities. A Dynasty Trust that never terminates can result in amazing savings in transfer taxes because of the huge amount of Trust value which may be accumulated free from the imposition of both GST tax and estate tax over many generations.
In both the second and third plans, the intervivos transfer by the parents of $6 million to an irrevocable Trust for the benefit of their descendants will result in a net transfer of $4 million because federal gift tax of $2M will be paid on the transferred asset value. No GST taxes will be imposed on either plan at inception because each parent will allocate his or her maximum $2 million GST exclusion to the net value of transfers into theTrusts.
Compare the economic results for each plan. In the first plan (no Trust) over a first generation lifespan of 30 years, the $6 million outside of Trust is projected to grow to $25 million - but will be subject to estate tax at the deaths of both parents resulting in a transfer to the children of only $13 million net. In the second plan (standard GST Trust), the $4 million in the GST Trust will compound to $18 million. In the third plan (Dynasty GST Trust), the $4 million Dynasty Trust also will compound to $18 million. Neither the GST Trust nor the Dynasty Trust will be subject to estate tax at the deaths of the donor parents because the GST assets are no longer in the parents' estates.
If the compounding continues for another 30-year term (an assumed generation), in the first plan (no Trusts), the funds held outside of Trusts will grow to $36 million. In the second plan (standard GST Trust), the Trust assets will grow to $52 million. In the third plan (Dynasty GST Trust), the Trust assets will grow to $60 million. The assumption is that the Dynasty Trust is formed in a state which does not tax its income, while the standard GST Trust is formed in an income-tax state like California. Neither the GST Trust nor the Dynasty Trust is taxed at the subsequent transfer to grandchildren, thus the funds continue to grow for a third generation. The $36 million outside of Trust (first plan) is reduced by estate tax of $16 million, resulting in a net transfer to the grandchildren of $20 million.
The asset value under each plan will continue to grow during the grandchildrens' lives - another assumed 30-year period before the next transfer is made. 90 years after the beginning date of our example, a transfer of the original $6M estate value (to the fourth generation - the great-grandchildren) will result in the following:
In the first plan (no Trusts), the assets outside of Trust will grow to $100 million, but this amount will be reduced by $45 million in estate taxes over three generations, resulting in a net transfer of $55 million. In the second plan (standard GST Trust), the assets will grow to $250 million. At the 90-year mark, this $280 million pot will be distributed outright, free of trust, to the then-beneficiaries of the Trust. When these beneficiaries die, this value will be subject to a transfer tax. In the third plan (Dynasty GST Trust), the asset value will stay in the Dynasty Trust which does not have to terminate. There is no violation of the rule against perpetuities in a state like Delaware, Alaska or Florida which has repealed the rule. The $6 million has compounded to $390 million and this sum will be passed on to the next generation/s free of gift, estate or GST taxes.
These economic results among the first, second and third plans are remarkably different, to repeat: $55 million, $280 million, and $390 million, respectively, which ultimately will be passed on to generations below.. At the least, a standard GST Trust established under California law should be strongly considered, given the difference between $55 million and $280 million which can be passed down to at least three, possibly four generations.
Because circumstances may change during the long period of either a standard or Dynasty GST Trust, flexibility should be built into the Trust, typically by giving the beneficiary a broad special power of appointment, or by establishing a Trust protector to make objective decisions to respond to unanticipated changes in circumstances. The beneficiary, when he reaches a certain age of maturity, perhaps should become Trustee of his own separate (sub) Dynasty Trust.
Assumptions. This example assumes the following: A federal estate tax, a GST tax and a gift tax; a $2M exclusion against estate and GST tax initially, which has grown to a permanent $3.5M exclusion; a flat $1M exclusion against gift tax; a federal estate, GST tax and gift tax rate of 45 percent; an average 10 percent pre-income tax rate of return over the period of the Trusts; state income tax rate of 7.5%; Delaware or Alaska income tax rate of zero; an after-tax return of 5.6 percent in the standard GST Trust (due to inclusion of state income taxes); an after-tax rate of return in the Dynasty Trust of 6 percent (higher than the standard GST Trust because no state income tax applies), and a federal income tax rate of 35 percent.
In a state like California, which still recognizes the rule against perpetuities (which will force termination of the Trust in approximately 90 years), a large amount of accumulated tax-free benefit nevertheless can be recognized. The California resident may, if he or she wishes, establish a Dynasty Trust under the law of one of the states which has repealed this common-in-law rule.
Among the states that have repealed the rule against perpetuities, Delaware, Alaska and Florida in particular have a favorable and sophisticated body of estate and trust law. A Dynasty Trust established in these states can take advantage of the repeal of the rule against perpetuities and take maximum advantage of the federal GST tax exemption.
While the income of most Trusts is subject to state income taxes because the Trusts are set up locally in states that tax such income, Delaware, Alaska and Florida, and a few other states, do not tax such income. If income is distributed out to a beneficiary who lives in a state which has an income tax, like California, such income will be taxed on the beneficiary's personal income tax return.
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Installment Sale to a Defective Grantor Trust ("DGT")
A Defective Grantor Trust ("DGT") is not included in a grantor's estate for estate tax purposes, but which because the grantor intentionally has reserved certain administrative powers over the Trust, has its income tax attributes reported to the grantor, not to the Trust. A Defective Grantor Trust is an irrevocable Trust. Under the Grantor Trust rules found in the tax code, the grantor must report the income and deductions of the Trust, as his own on his personal income tax return. For a high net worth taxpayer, this can be a terrific benefit because he can both move the Trust property, and its subsequent appreciation, out of his estate for estate tax purposes, and also further diminish his estate by paying the income tax on net income of the Trust. The administrative powers which make the Trust "defective" are "intentionally" planned by the drafter.
The sale of property to the Trustee of the DGT on an installment sale basis, secured by the property, is intended to avoid any gift in connection with the sale. No gift will be deemed if the note is paid at the tax code section 1274 rate. This technique is an attractive alternative to a GRAT. It resembles a GRAT in the sense that if the income and appreciation on the property exceed the section 1274 rate, a gift tax-free transfer to Trust beneficiaries will occur. In this respect, this technique is superior to the GRAT because the section 1274 rate is almost always lower than the federal AFR, which is determined under tax code section 7520 (120% of the federal mid-term rate).
The sale to the DGT does not incur capital gains tax because such sale has been made to the seller's own Grantor Trust.
The installment sale to the DGT is better than the GRAT in these other ways: (1) the grantor-seller does not have to survive the term of his retained interest in GRAT, and (2) the GST exemption can be allocated to the DGT upon creation, not have to wait until the GRAT term expires.
One trap must be avoided. At least 10% of the purchase price must be made with funds owned by the DGT. This means that the donor must fund into the DGT cash or other assets equal to at least 10% of the value of the asset to be subsequently sold to the DGT. If this caution is not heeded, the IRS may be successful in arguing a step transaction has occurred and that donor in actuality has funded the property into the DGT, and has withheld an income interest in the DGT. This argument would place the entire DGT into the donor's estate for estate tax purposes.
This technique typically involves a parent selling an asset to a child in exchange for a note. The note requires that payments be made on an installment basis, and if the parent dies before the note is paid off, no further payments are required. Thus, if the parent dies before the note is paid off, the unpaid portion is effectively removed from the parent's estate at no tax cost.
The parent reports the gain on the installment method, in most cases as capital gain. The buyer-child is probably entitled to an interest deduction.
The IRS will argue a gift has been made by the parent if the selling price is not adjusted upwards to account for the "cancellation premium" reflecting the chance the parent may die early. The amount of the cancellation premium is determined with reference to the tax code actuarial tables.
At the death of the parent, the tax law is unclear with the IRS likely to argue that the estate's first income tax return should report ordinary income for the canceled amount of note. The better view probably is that the decedent should recognize gain, in which case the decedent's estate will have an estate tax deduction for income tax paid.
This technique consists of a sale of property by, typically, a parent to a child in exchange for fixed periodic payments to be made for a term of years or until the parent dies. In either case, nothing is included in the parent's estate at death. The payments are made on actuarial tables set forth in the tax code regulations.
If the parent lives beyond his actuarial life expectancy, the payments will continue (where no term is set) which could be a detriment to the parent's estate because his estate will increase with each additional payments received, perhaps beyond the value of the property sold. The best situation is where the seller's life expectancy is expected to be shorter than his actuarial life expectancy. However, the seller can not be "terminally ill" which the tax code regulations define as having a more than 50% chance of dying within one year. Otherwise, a gift will be deemed having been made by the tax code.
Each annuity payment will be recognized as part return of tax basis, part ordinary income, and part capital gain (in some cases) under the tax code. No income tax is recognized at the death of the seller parent. The buyer child does not receive an income tax deduction.
A private annuity sale is like a GRAT in that the required payments are a fixed amount each year. Main differences are that income tax treatment of the seller-annuitant are determined under different rules than for a GRAT, and payments to the annuitant will generally continue for the life of the annuitant rather than for a certain term of years. Annuity payments can be made subject to a fixed term of years, thereby putting a ceiling on the payments. If there is such a ceiling, the annuity is converted into an installment sale with a contingent sale price when the annuitant's actuarial life expectancy is longer than the fixed term.
In general, a GRAT is preferable to a private annuity with a ceiling, primarily because the grantor can pay income taxes on GRAT property, thereby making a nontaxable gift to the GRAT. On the other hand, the private annuity has the advantage of getting the subject property immediately out of the seller-annuitant's estate without requiring the seller to outlive a fixed term as for the GRAT.
Charitable Conservation Easement
This technique can bring a three-fold tax benefit to the creator of the easement. In a nutshell, a landowner will voluntarily restrict the use of his property for a conservation-related purpose. Typically, the conservation easement takes the form of a written agreement between the donor and the donee organization which is recorded in the County Recorder's Office. The agreement will specify the types of uses that are restricted and types of prohibited activities. The donor usually will reserve certain specific rights to use the property, including limited development rights. The donor retains the rights to sell, lease, mortgage or otherwise convey the property to anyone he pleases, subject to the perpetual conservation easement. The end result: the property is protected from unwanted future development.
For an owner of valuable real estate to forever bind himself and all successors in interests to the land is an act which requires careful consideration and a strong conservation motivation. The donee organization's role in the easement is to monitor its use and see that the terms of the conservation agreement are being enforced. In Marin County, California, for instance, a non-profit organization like the Marin Agricultural Land Trust is a major donee organization for agricultureland which will be forever immune from any major development.
The three tax benefits that can result, if all requirements found in the appropriate tax code, are met are (1) a current income tax deduction, subject to a yearly limit of 30% of the donor's adjusted gross income, (2) a reduction in value in the subject property because the conservation easement by its nature makes this property a much less desirable property to acquire, (3) and, new as of the 1997 federal tax law, an estate tax exclusion at the death of the donor in an amount of 40% of the already reduced value of the property, subject to a maximum exclusion amount of $500,000.
Clients often combine several or many of these techniques in one estate plan. Married clients may decide to fund their residence into a QPRT, their growth stock (perhaps stock options with almost guaranteed gain upon exercise) into a GRAT, securities and real estate into a FLP or a FLLC, highly appreciated property which they wish sold inside a Charitable Remainder Trust, and on and on. Their overall estate plan would incorporate a joint Living Trust (with Bypass and QTIP Trust formula) within a Dynasty or standard GST Trust package. Many of the clients' wishes, both income and transfer tax (gift, estate and GST) concerns and non-tax concerns (retaining control of investments, keeping family estate out of the reach of creditors or in-laws, etc.) can be accomplished with the properly drafted estate plan.
All of the combined plans described below assume either that deaths occur before year 2010, when the transfer tax system is scheduled to terminate, or that some form of modified transfer tax system will be legislated into place prior to year 2010.
FLP (or other business entity) and GRAT. An example of one terrific way to leverage very large discounts is to combine gifts made to limited partners (typically children) with a GRAT. The gift of the limited partnership interests can be made to a term certain GRAT of 10 years. A gift of limited partnership interests representing $1,000,000 of underlying assets, at a 40% discount, will result in a discounted transfer value of $600,000. Assume the following: The applicable Section 7520 rate ("AFR") at date of GRAT is 6.6%, the donor is 60 years old, the yearly annuity paid to the donor is $139,756, and the FLP grows at an annual rate of 10% compounded. If the donor outlives the 10-year term, the total amount of value given away will be $366,365. No gift tax will be due on this gift because the total annuity amount returned to the donor's estate, adjusted for time value, offsets the value of the gift made. This an example of a "zero'ed out GRAT," a highly-desired result. A 2000 tax court case held that this technique is allowed. Based on the discounted gift value of $600,000, the grantor will receive an effective annuity of 11.67%. The GRAT is especially valuable if the assets funded into the GRAT grow faster than the AFR at time of funding. Stock options, quality growth stocks, quality real estate located in good areas are good candidates for the GRAT.
This technique is often used with Subchapter S corporations. In this plan, the director/parent first recapitalizes the corporation into 2% voting stock and 98% non-voting stock. Then, the parent gives non-voting stock to the children. This non-voting stock, possessing no control over the S corporation and having a limited market, will receive a substantial discount.
FLP and CLAT. An excellent way to leverage the Section 7520 rate for remainder interests. For example, assets valued at $12,000,000 are put into a Family Limited Partnership by a married couple. Then in March of 2006, the couple give limited partnership interests represented by $8,000,000 of underlying assets to a CLAT with a 20-year term. The discounted value of these gifted LP interests, computed at a 38% discount, is $4,960,000. The CLAT will pay 5% annually to the charity or charities. For twenty years, the charity will receive a yearly annuity amount established at $248,000 (5% of the discounted value, not the actual value) by the married couple donors.
The CLAT remainder interest, computed using a 5.4% Section 7520 rate (March of 2006), is $1,956,670. The value of the remainder interest of the CLAT is subject to gift tax, computed at the time of the transfer of the limited partnership interests into the CLAT. The donor married couples' combined gift tax AEAs of $2,000,000 completely cover the discounted value of the CLAT remainder interest gifts, making such gifts to the remainder beneficiaries non-taxable. The remainder beneficiaries are the married couple's children (or grandchildren) who were given the limited partnership interests.
The donors' GST exemptions also will be allocated against the CLAT remainder interest if a standard GST Trust or Dynasty Trust is the remainder beneficiary. Therefore, the remainder beneficiaries (children or grandchildren) will take the $2,000,000 discounted gift value, plus all accumulated growth and income earned for twenty years and less annuity payments made, free of any sort of gift, estate or GST tax.
Assume the CLAT grows an average of 7% per year (2% higher than the annuity payout rate of 5%). At the end of the 20-year CLAT term, the children (or grandchildren) will receive a total non-discounted value of $11,887,579 of limited partnership interests. Because such actual CLAT remainder value of $11,837,579 will be held in the FLP, the remainder value will be discounted by 38% to $7,370,299 in the hands of the children (grandchildren).
The remarkable result of this plan will be this: After twenty years, the children will hold FLP interests represented by $11,887,579 of underlying value. The parents gifts of limited partnership interests will consume only $2,000,000 of the parents' AEAs at the time the gifts were made. Over $9,887,579 of value will escape transfer taxation. Finally, during the course of 20 years, the charity will receive $4,960,000 of annuity payments. The married couple donors do not have to outlive the 20-year term of the CLAT.
ILIT and Dynasty Trust. Another combination of techniques is the funding of a Dynasty Trust or standard GST Trust with life insurance. Such Trust would be a form of an Irrevocable Life Insurance Trust. The transfer tax value of life insurance is relatively small. The transfer of the life insurance into the Trust therefore will use up a small amount of the donor's AEA and/or will be covered by the $12,000 per year per beneficiary exclusion rule. The donor's GST exemption to be allocated to the Trust will also be relatively small. When the donor dies, the Dynasty Trust or standard GST Trust will now hold a large amount of death proceeds, all of which are forever exempt from GST tax and estate tax. This a classic example of how to leverage the GST exemption for gifts into a remarkably large transfer taxing savings benefit.
FLP (or other business entity) and DGT. Selling limited partnership interests, discounted substantially in value, to a DGT on an installment sale basis can result in tremendous leveraging of valuation reduction. Benefits received will be the disappearance of asset value through discounting FLP interests, shifting the growth in the FLP to the buyer-children, reducing the estate of the parent-seller by means of his paying the income tax on FLP income received by the DGT.
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