The 2010 Tax Act creates many new opportunities, but beware of unexpected traps
The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act) creates significantly more multi-generational trust planning opportunities. The 2010 Tax Act increases the gift, estate and generation skipping transfer (GST) tax exemption to $5 million per person through Dec. 31, 2012.1 The increased exemptions create a window of opportunity, making now an ideal time for transfer-tax planning. Asset values, particularly for real estate, are low. Interest rates remain at their lowest levels. There are, however, caveats. The 2010 Tax Act may create unexpected traps for the unwary practitioner.
Arguably, the key to taking advantage of the larger exemptions now available under the 2010 Tax Act is to understand that they may be limited or reduced should prior law apply retroactively. The problem is that the sunset provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act) would eliminate a number of GST tax planning tools like liberal severance, automatic allocation and late allocation rules.
According to Carlyn S. McCaffrey and Pam H. Schneider in their February 2011 article in Trusts & Estates,2 the 2010 Congress only delayed the problems associated with the “sunset” of the 2001 Act. A literal reading of the sunset provisions' “as if it had never been enacted” language could also mean there may be a “redetermination of the inclusion ratio for trusts” that used either (1) additional GST tax exemption amounts greater than the $1 million provided in the Tax Act of 1986, or (2) other GST planning tools that would cease to exist, possibly retroactively.
While we don't know what Congress will do to extend favorable GST tax provisions or create permanent GST tax exemptions or safe harbors, we do know that President Obama's 2012 budget proposal includes a GST tax exemption of $3.5 million and a limit to the GST tax exemption of trusts to 90 years. The proposal also targets valuation discounts and GRAT terms.3
Practitioners should be proactive and use proven strategies and planning techniques, but modify them to accommodate the possibility that either (1) there will be a sunset, or (2) future legislation will fail to address the GST issues. Practitioners should use the increased gift and GST tax exemptions in creative ways to help leverage the multi-generational transfer of assets of wealthier clients; however, they must do so carefully because of the possibility that the provisions of prior law may apply to taint GST transfers.4
Here are several important planning strategies for using multi-generational trusts under the 2010 Tax Act and defensive strategies that practitioners should consider to minimize the impact of possible changes in the law either in 2013 or beyond.
GST Tax Exemption
The Tax Act of 1986 gave birth to the modern day GST tax, a tax that's on top of the estate and gift taxes.5 Congress initially set a $1 million GST tax exemption, applicable to both direct gifts and transfers in trusts for the benefit of grandchildren and generations beyond. The GST tax exemption has grown to $5 million per person under the 2010 Tax Act.
A trust is deemed to be GST tax-exempt if the amount a grantor irrevocably transfers to a trust either by completed gift or testamentary transfer is equal to the amount of GST tax exemption allocated to that transfer. Thus, if a grantor transfers $1 million either by gift or at death to a trust, and then allocates $1 million GST tax exemption to the trust, the trust will be deemed to have an “inclusion ratio of zero,” and thus future distributions from the trust to beneficiaries will be exempt from all transfer tax as long as the trust may exist.6 In states like Alaska, Delaware and South Dakota, that transfer tax exemption may be forever.7
More importantly, the future growth of the assets in an exempt multi-generational trust is also exempt from transfer tax. This creates favorable opportunities for use of (1) life insurance purchases in multi-generational planning, (2) leveraged gift and sale transactions between the grantor and his trust, including sales of existing business interests, (3) investment growth in closely held family businesses and in business and investment succession models, and (4) leveraged asset transfers employing charitable gift strategies, which can also serve as complements to family foundations and other charitable entities that support long-term family legacy planning strategies at each generation.
Choice of Situs
Multi-generational trusts should have proper situs. To effectively advise clients, practitioners should be well versed with the laws of the most favorable multi-generational trust jurisdictions. Where the grantor resides is largely irrelevant for purposes of choosing trust situs and governing law. Shopping for the best jurisdiction for a particular client's situation can provide a bevy of significant benefits, including income and transfer tax savings, flexibility and better asset protection laws.
Currently, federal law looks to each state's law to define property interests in trusts, including the perpetuities law that governs the amount of time that trusts in each jurisdiction may exist. States such as Alaska, Delaware and South Dakota have no limit on the duration of trusts and no state income tax. In those states, trusts may last many generations and perhaps perpetually if the assets aren't dissipated. In total, 27 jurisdictions have extended the durational limits of trusts.8
The durational limit is just one factor to consider when deciding on a trust's situs. Other critical factors are: (1) the jurisdiction's ability to respond to the special needs of families and their fiduciaries, (2) the availability of private trust companies and special purpose entities, and (3) asset protection considerations and applicable law. Many practitioners acknowledge that the following states have the best overall state trust laws: Alaska, Delaware, Nevada and South Dakota.9 If the Obama administration is successful in its attempt to create a federal rule against perpetuities for GST tax purposes, notwithstanding its arguably impermissible violation of state property rights, the overall favorable general trust law environment of these jurisdictions becomes more important.
Separate GST Tax-exempt Trusts
Since no one knows what Congress will do, if anything, before the end of 2012 to establish a permanent fix to the transfer tax structure, planning with certainty for clients becomes more difficult. Presumably, the worst that could happen is that Congress merely allows the 2001 Act to sunset once more (as it did in 2010) and the exemptions for all transfer taxes would be reduced to $1 million per person (plus an indexed adjustment for inflation). What then happens to the character of transfers made by clients in excess of the $1 million exemption amount?
Beneficiaries of taxpayers who happen to die before the 2010 Tax Act expires or is otherwise changed by Congress, will be able to enjoy the higher exemption amounts. But for obvious reasons, it's not practical for practitioners to rely on this when formulating their clients' estate plans. Nevertheless, at the same time the planning must retain the flexibility that would provide clients with the benefits of the larger exemptions provided by the 2010 Tax Act, especially if Congress should unexpectedly retain or increase these enhanced exemptions in 2013 or beyond.
Be careful when using the GST tax exemption in excess of $1 million per person or $2 million per couple. McCaffrey and Schneider suggest that if an individual were to fund and allocate GST tax exemption in excess of $1 million per person to a trust under the present law, the use of a separate trust(s) should be considered.10 Allocation of the additional GST tax exemption to a separate trust(s) to create a separate zero inclusion ratio would create a safety valve in the planning in the event that the “as if it had never been enacted” rationale were applied retroactively to re-determine the inclusion ratio of the additional trust(s). For example, if Congress adopts the 2012 budget proposal, thus reducing the exemptions to $3.5 million, the prudent plan would be to use three trusts: one for the $1 million exemption, a second for an additional $2.5 million exemption and a third for the remaining $1.5 million exemption. This approach would provide a staggered safety valve at least until all the rules are clarified. If subsequent legislative developments render multiple trusts unnecessary or undesirable, practitioners can use techniques such as merger and decanting to consolidate the trusts.
Loans, guarantees and other arrangements (possibly the use of formula exemption allocations) among these multiple trusts could be used to further leverage the growth potential of the first exempt trust with insurance and other investments without compromising the zero inclusion ratio of the first trust or other potentially exempt trusts.
Mary establishes three separate irrevocable trusts for the benefit of her three children and her descendants. She funds and allocates GST tax exemption to three trusts, A, B and C in the following order: Trust A with $1 million, Trust B with $2.5 million and Trust C with $1.5 million. All of the trusts are grantor trusts with respect to Mary, and all have identical dispositive provisions. Trust A then purchases a life insurance policy on Mary's life, with Trust B and C lending Trust A the funds for the premiums as required. The life insurance policy is paid up over multiple policy years to avoid the modified endowment contract (MEC) rules. Mary's children are given a contingent general power of appointment over Trusts B and C in the event that the inclusion ratio for either Trust B or C is greater than zero (based on a possible re-determination of exemption amounts). If the inclusion ratios of either Trust B or C are finally determined to be zero, then those trusts can be consolidated with Trust A. If not, Trust A owns the insurance policy, and is therefore GST tax-exempt.
Some clients, while eager to save transfer taxes, may not be as willing to transfer assets without the ability to access them in case of a financial reversal. The retention of such rights usually defeats the tax benefits of any such transfer, even if such retained rights to distributions are merely within the discretion of a trustee or other third-party, since these so-called “self-settled” trusts are typically subject to the claims of creditors in most jurisdictions. That said, some jurisdictions may, by statute, permit the use of self-settled trusts that protect assets from future creditors' claims. Such trusts are very useful for clients who are in high-risk professions, like medical doctors, financial professionals and professional athletes because the assets transferred to a self-settled trust are deemed to be out of the reach of creditors even though the settlor remains a permissible beneficiary of the trust. Importantly, as explained below, transfers to these specialized self-settled trusts can be made completed transfers for tax purposes, thus allowing their use for wealth transfer tax planning.
The requirements are generally three-fold: (1) There's no pre-existing understanding or arrangement between the settlor or the trustee; (2) Creditors of the settlor are unable to access the trust's property interests as defined by state law; and (3) The assets weren't transferred to the trust fraudulently (generally determined by presumption after a statutory time period has expired).11 Alaska, Nevada and South Dakota are considered to have the best self-settled trust laws. Such trusts can be either complete or incomplete for gift tax purposes by design. In self-settled trust jurisdictions, the law provides that the grantor's creditors can't attach the assets in a self-settled discretionary trust and a transfer to the trust is deemed a completed gift. The trust assets also will likely not be included in the grantor's gross estate, unless the grantor retains some interest or power other than being eligible to receive trust distributions in the discretion of an independent trustee.12
Alaska's and Nevada's statutes are silent as to spousal and child support payments. Some commentators believe that this strengthens the argument that a transfer to a trust in these jurisdictions is complete for gift and estate tax purposes. While South Dakota permits a durational limit for spousal and child support, the beneficial interests in a discretionary trust aren't reachable property interests as defined by state law. Revenue Ruling 2004-64 indicates that the entire trust is included in the grantor's gross estate if any creditor of the grantor can attach the trust assets. Under South Dakota law, spousal and child support rights aren't enforceable as against discretionary beneficial interests, absent a fraudulent conveyance in the initial conveyance.13
While the funding of a self-settled trust may be accomplished in a variety of leveraged ways for tax planning purposes, one strategy is simply to use the $4 million additional exemption to fund a self-settled trust. This preserves the increased gift tax exemption amount, but allows the settlor to remain a permissible beneficiary of such assets. The settlor should retain sufficient assets to provide for his lifestyle and expenses so that he won't need to access the trust assets.
John funds a self-settled trust in South Dakota to benefit his three children and heirs by using the additional $4 million gift exemption. John is a discretionary beneficiary of the trust, but there's no prearranged agreement with the independent trustee. Under South Dakota law, John's creditors can't reach the trust assets to pay claims against John, and he has no existing claims when he funds the trust. John also has sufficient assets outside of the trust to provide for his personal needs. In this case, the transfer to the trust is complete for gift tax purposes even though John is a permissible beneficiary of the trust.
Grantor Trust Planning
A multi-generational trust and grantor trust combination is a very effective planning tool. The Internal Revenue Code's grantor trust rules allow the creation of a trust — an intentionally defective grantor trust (IDGT). A transfer to an IDGT is fully completed for gift, estate and GST tax purposes, but is a non-event for income tax purposes. From a federal transfer tax perspective, using a grantor trust may remove trust assets from the grantor's estate but requires the grantor to continue to pay the income tax on the income generated by the grantor trust assets. Moreover, capital gains aren't realized if the grantor sells an appreciated asset to the grantor trust because the sale is in effect to himself and thus a non-event for income tax purposes.14 In addition, the grantor's payment of the income tax doesn't constitute an additional gift to the trust.15
One planning strategy for 2011 and 2012 is to structure loans and installment sales with grantor trusts16 instead of making outright gifts for any amount in excess of $1 million. As explained above, this transfer should be completed with a separate trust. This approach permits the additional exempt amounts above the $1 million to be leveraged for even larger transfers (generally at a ratio of 10:1) in separate transactions.17 For example, say that the grantor establishes a trust with a $1 million seed gift. The trust can support an installment sale of $10 million. Assume that the trust has been funded with a 2.5 percent note-sale of $40 million in assets, and the assets are producing $1 million of ordinary income (subject to a combined state and income tax rate of 40 percent). The note interest payment is $250,000 and the grantor must pay the $400,000 income tax liability. This leaves $750,000 each year to be used in the trust for other planning purposes. This approach also permits the option of devising a later completed gift when the permanent exemption amounts become clear. This strategy also preserves the GST tax inclusion ratios for multi-generational trusts by allocating the initial trust equity with GST tax exemption. Practitioners should consider separate trusts and guarantees for amounts transferred in excess of $1 million.
This approach ensures a zero GST tax inclusion ratio for the multi-generational trust by allocating a GST tax exemption, which we're confident won't be reduced.
There are essentially six techniques that are commonly used to reduce transfer taxes and to transfer ownership and control of family entities with grantor trust planning and multi-generational planning. They are: (1) business entity planning; (2) installment sales transactions, self-cancelling installment notes (SCINs) and private annuities; (3) grantor retained annuity trusts (GRATs); (4) charitable lead trusts (CLTs); (5) split-interest gifts with capital replacement (charitable remainder unitrusts (CRUTs) and charitable remainder annuity trusts (CRATs)); and (6) insurance planning.
Often, combination strategies will be employed to meet a family's planning objectives. Each of the techniques has different rewards and risks and some are more useful in a multi-generational setting than others because of the way the GST tax exemption allocation rules work with respect to the estate tax inclusion period (ETIP).
- Business entity planning
How business and investment assets are owned and organized can have a significant effect on the efficient transfer of wealth. Asset protection factors, ownership and management considerations, succession and control all are important issues for family business and asset owners. Business structures may influence the determination of value for both buy-sell agreements and transfer tax. Limited liability companies (LLCs) and limited partnerships (LPs), limited liability partnerships and S corporations may be structured with voting and non-voting interests.
Minority interests that lack control and have limited marketability typically are valued at lower amounts than controlling majority interests. Such valuation discounts can vary between 20 percent and 40 percent, depending on a variety of market factors and restrictions within the agreement.
Depending on state law, restrictions in the business agreements may be considered in the valuation of these interests under IRC Sections 2702 to 2704 provided that the restrictions are less restrictive than state law.18 Choice of state law, therefore, is important as it may determine which restrictions in the business agreement can be used for valuation discount purposes under IRC Section 2704(b).
President Obama's 2012 budget proposal includes limiting discounts for the transfer of family owned entities. This type of proposal is nothing new, and the form of any such limits is unclear. Nevertheless, even if valuation discount limits are imposed, these business planning structures would still be available and can be important for wealth transfer planning because they facilitate the orderly transfer of wealth by allowing for structures that define the rights and responsibilities of heirs and can be used to limit exposure of such assets to claims of future creditors. Valuation discounts are significant because they not only reduce transfer taxes on family businesses, but also have the effect of leveraging the effective return on investment (ROI) of the discounted entity. This makes sales transactions work far more efficiently for the client and his family.
- Installment sales, SCINs and private annuities
Installment sales to an IDGT can significantly leverage the amount of assets that can be shifted in trust as part of an estate tax freeze transaction. Planning adjustments must be made as asset values either grow or diminish and as interest rates and life expectancy change. The benefit of installment sales is that they can be managed.
The use of multi-generational trusts that are also designed to be IDGTs can be an effective tool when transferring appreciated assets via an installment sale. The advantage is that a sale to an IDGT is a non-event for income tax purposes because of the grantor trust rules, yet the transfer is complete for gift, estate and GST tax purposes. If a closely held business interest is sold to the trust, the sale freezes the value of the interest and captures any future appreciation outside of the estate.
Installment sales of business entities or cash gifts are preferable to non-cash gift transfers to multi-generational trusts, especially if family limited partnership and LLC interests are used. Sale transactions are preferable to gifts because a sale for full and adequate consideration (fair market value (FMV)) significantly diminishes the chance that the government can make an estate tax inclusion argument under IRC Section 2036, as long as the grantor retains sufficient assets outside of the transaction and the special requirements of IRC Sections 2702 to 2704 are met.
The choice and type of sale transaction is largely a mathematical endeavor and is often driven by such factors as life expectancies of the parties, income projections, asset valuations and asset appreciation forecasts. Also relevant are the grantor's anticipated income needs, income tax issues, business operations and succession plans. Installment sales, SCINs and private annuities may be effective planning tools in the right situation because GST tax exemption may be allocated to the initial funding for these structures to create a zero inclusion ratio, notwithstanding subsequent sales. Which strategies are best?
Practitioners must plan an installment sale with an exit strategy in mind to reduce or eliminate actuarial and business risk. Unless the note principal is paid over the term of the note, the note value will be included in a client's gross estate, albeit likely at a discount to take account for the low interest rate. Exit strategies include: (1) full payment of principal, (2) the purchase of life insurance, (3) a SCIN, (4) a private annuity, or (5) a direct gift of the note to charity or through a CLT with the charity (possibly a family foundation).
If the additional exemption amount provided in the 2010 Tax Act can be used effectively, proportionately larger transfer and tax savings are possible.
Our client, John, has assets exceeding $50 million. Here are some examples of how the multi-generational trust could work:Example 3
John creates and funds a multi-generational trust with $1 million and allocates GST tax exemption in that amount to the trust. Under the installment sale guidelines most practitioners use, John can sell up to $10 million dollars in assets to the trust and take back a note at the prevailing applicable federal rate (AFR). Let's assume that the $10 million dollars in assets produce $1 million each year in annual income and that the long-term AFR, compounded semi-annually is 4 percent. Let's also assume that John's combined federal and state income tax rates are 40 percent. In this case, the note back to John for the installment sale would have to pay a minimum of $400,000 if the payment is to cover John's taxes on the $10 million income. John's payment of the taxes wouldn't be an additional gift to the trust because of the grantor trust rules. This would leave $600,000 of annual income to be used in the trust to purchase a life insurance policy on John's life or to retire principal on the note over time. Upon John's death, the note could be retired by the insurance death benefit or it can simply be donated to John's family foundation in exchange for a full charitable estate tax deduction.Example 4
Let's assume the same facts as Example 3, except John wants to use his remaining $4 million gift and GST tax exemption to fund additional transfers to a second trust (Trust 2). Because there's a possibility that the inclusion ratio in the second trust may be subject to re-determination, it's important that any equity growth occurs in the trust John created in Example 3 (Trust 1). Trust 1 can borrow and leverage equity transferred to Trust 2 for additional insurance purchases or use it for leveraged asset purchases. The key is that the growth factor in the insurance policy or investments is greater than the minimum AFR for the loan. Guarantees by Trust 1 for transactions by Trust 2 are also possible, as well as possible equity split-dollar ownership of an additional life insurance policy. Based on the 10:1 ratio discussed above, this would allow John to further leverage a $40 million wealth transfer of assets.Example 5:
Another approach to the one used in Example 3 would be for John to take back a note that cancels upon his death. That note wouldn't be included in John's estate. The note would have to be structured with an ordinary interest payment component plus a SCIN premium amount, which could be additional interest or a principal premium. This structure is similar, in effect, to a private annuity arrangement between the trust and John, although it has elements of a more typical installment sale previously described.Example 6:
Yet another alternative approach is for John to establish a private annuity in exchange for the transfer of assets to the trust. A private annuity is simply a contract between John and the trust, whereby John would be entitled to receive a set annuity payment for the rest of his life based on the Internal Revenue Service annuity tables.Example 7:
Let's assume a new set of facts that involves the combination of valuation discounts and installment sale strategies. John owns and transfers a 50 percent interest in a triple net lease property to a limited liability limited partnership (LLLP). The value of the LLLP's assets is $20 million. The lease payment is $1.5 million (7.5 percent ROI). John wants to sell the non-voting interests of the LLLP to a multi-generational trust, which is a grantor trust for income tax purposes. John's 50 percent interest in the triple net lease property isn't a controlling interest and, thus, let's assume that it will be subject to a valuation discount of 20 percent. When the non-voting interests are valued, they will receive another discount for lack of voting control and lack of marketability. Let's assume that this valuation provides a 30 percent discount for the non-voting interests. With both discounts, the value of the non-voting partnership interests would be approximately $10 million. The $1.5 million lease payment with respect to the discounted value of John's non-voting LLLP interest is a 15 percent ROI. John makes a $1 million gift to a grantor-type multi-generational trust, and then, months later, sells the $10 million non-voting interest to the trust in exchange for a note. Let's assume that the AFR is 4 percent so the minimum note payment if John only pays interest is $400,000 per year, yet the trust's lease is producing $1.5 million. The trust can use the difference to (1) pay a life insurance premium to pay off the note at John's death, (2) pay a SCIN premium so the note cancels upon his death, or (3) enter into a private annuity agreement that terminates upon his death.
The advantage of GRATs is that they're creatures of IRC Section 2702 and thus officially are sanctioned as a planning strategy. While GRATs can be effective in transferring assets to family members at reduced tax rates, they have significant limitations. The success of a GRAT strategy depends almost entirely on the requirement that the assets will appreciate at a rate greater than the rate the government assumes will apply in valuing the remainder interest. Once GRATs are set in motion, they're hard to unwind or reverse. This is a particularly difficult issue in volatile markets, in which precipitous or persistent asset depreciation can occur. Additionally, we believe that GRAT transactions should be avoided, if possible, in a multi-generational planning environment because: (1) they're gifts subject to the retained interest rules of IRC Section 2036; and (2) they have an open ETIP that only terminates at the end of the GRAT term. Thus, it's difficult to allocate GST tax exemption to the remainder of a GRAT with any certainty. Even so-called “Walton GRATs” or short-term rolling GRATs have the same problem. Although the shorter term mitigates the risk, these GRATs still retain the negative attributes.
Some practitioners suggest selling the GRAT income or remainder interest (depending on how the transaction is structured). While this approach in theory may eliminate the inclusion of the GRAT in the grantor's estate because he has sold the interest for fair and adequate consideration and so no longer retains it, practitioners should be concerned about the uncertain resolution of the ETIP problem when selling a GRAT interest to a multi-generational trust. One argument is that the ETIP terminates when the grantor no longer owns the interest because it's no longer in his estate. The counter argument, however, is that the purchaser steps into the shoes of the grantor with respect to the interest, and the interest is a future one that has been determined actuarially. Thus a modified ETIP still may apply.
The Obama administration's 2012 budget proposal targets the use of short-term GRATs and proposes a minimum GRAT term of 10 years. This would have a significant negative effect on the use of GRATs in estate planning, especially since the administration is also attacking valuation discounts.
A CLT is a vehicle that provides for either an annuity (CLAT) or unitrust (CLUT) lead income amount to charity for a term of years or the life expectancy of the donor with the remainder interest either retained by the donor (a grantor lead trust) or passing to the family (a non-grantor lead trust).19 A CLT can provide significant gift and estate tax savings for the donor and the donor's family. An unlimited amount of assets can be passed to children using a CLT. However, there are restrictions on the type of assets that can be held in a CLT and the CLT is subject to the private foundation rules.20
Often, high-income individuals have difficulty deducting the charitable gifts they make because of itemized deduction cutback rules. The advantage of a CLT is that it can be used to shift income from the grantor to charity over time, so the amount of income that passes to charity is effectively removed from the donor's IRS Form 1040 filing because it's reported in the trust's income tax return.21
If a client is giving several hundred thousand dollars away a year to his favorite charities, then the CLT can facilitate the transfer of annual gifts to those same charities while achieving a leveraged wealth transfer of the CLT remainder interest to the family.22
The disadvantage of a CLT is that the donor must give up the assets and derives no income from the trust. The donor must retain other assets that are sufficient to provide for the cost of living. Like the GRAT, the CLAT (the CLT's annuity form) has an ETIP that's open until the end of the trust period. Thus it's difficult to use CLAT remainder interests in multi-generational trusts.23
Once again, a possible solution to this ETIP problem is the sale of the CLAT remainder to a trust.24 Another possibility is to use a CLUT, because allocation of GST tax exemption to a CLUT may be made upon creation of the interest.
Recently, there's been great interest in the use of what's commonly referred to as a “shark-fin CLAT.” In this type of CLAT, the payment of a large portion of the income interest that the charity is to receive is delayed until the end of the CLAT term. This deferral allows a portion of the CLAT principal (and accumulated income) to be invested in life insurance, the proceeds of which can be used to pay the charity its delayed interest, with the remainder to the family thereby increased.25 Many commentators aren't persuaded that the IRS will accept this structure.Example 8:
John, a 60-year-old settlor, contributes $1 million cash to a CLAT. The CLAT immediately purchases a life insurance policy on John with a $900,000 single premium payment. The remaining $100,000 of the $1 million cash contributed to the CLAT is used to purchase a $100,000 municipal bond that pays 4 percent interest. The arrangement produces the following results: (1) The life insurance policy has a death benefit of $3,801,000. Thus, when John dies, the CLAT receives the $3,801,000 in life insurance proceeds, and $2,275,000 is paid to a designated charity. The remaining $1,526,000 passes to the non-charitable remainder beneficiaries designated in the CLAT; (2) The municipal bond earns interest of $4,000 each year, which the CLAT uses to make annual annuity payments to the designated charity. Consequently, even though the CLAT is structured as a grantor trust, thereby subjecting John to income tax on the income earned by the CLAT, John doesn't recognize taxable income because the CLAT income is tax-free municipal bond income. When the CLAT terminates on John's death, the remaining balance of the municipal bond is paid to the non-charitable remainder beneficiaries; and (3) Based on an assumed Section 7520 rate of 3.4 percent, the present value of the $4,000 annual annuity payments to the charity for John's life and the balloon payment to the charity at John's death of $2,275,000 equals $950,000. Thus, John is entitled to a charitable income and gift tax deduction of $950,000. Because of the gift tax charitable deduction, the taxable gift at the time the CLAT is funded equals the excess of $1 million over $950,000, or $50,000 (which can be sheltered by the current $1 million lifetime gift tax exclusion). Therefore, although the taxable gift is only $50,000, the non-charitable remainder beneficiaries ultimately receive a total of $1,526,000 and the municipal bond held in the CLAT, clearly a very favorable outcome.26
- Charitable split-interest income trusts
When a contribution is made to a CRUT,27 CRAT28 or charity in exchange for a charitable gift annuity,29 the income interest to the donor and typically the donor's spouse is for the lives of the donor and his spouse. In the case of a CRUT or a CRAT, the income interest can be for a term of years, not to exceed 20 years. A donor can contribute highly appreciated assets to the charitable split-interest trust. The donor receives an income tax deduction for the present value of the full FMV of the gift to charity. The donor also receives an income interest based on the value of the trust interest as valued on an annual basis for the entire trust term. While the income interest is taxable to the donor,30 the off-setting deduction can be significant, and the donor doesn't realize any capital gain tax when the gift is made or when it's sold by the trust to generate income.31
The disadvantage of these types of gifts to charity is that the remainder passes to charity, so there's nothing left for the family. One solution is to use the tax savings and a portion of the income to replace the value of the gift asset with life insurance (or capital replacement). A life insurance policy can be purchased in a multi-generational trust in an amount equal to what the client wants to provide for his family. In this way, the donor has given a gift to charity, retained an income interest for life and assured a gift of equal value to his family free of transfer tax.Example 9:
John owns 100,000 shares of Q Corp., a closely held C corporation. John is ready to retire and needs a fixed income that he can depend on. Q Corp. has a retained earning problem and would like to purchase John's shares. John transfers his Q Corp. shares to the local community foundation (CF), a qualified public charity, in exchange for an annuity that will pay him a 7 percent32 fixed income for his lifetime. The CF has no prior obligation to sell the shares to Q Corp. Q Corp. tenders an offer of $100 per share to redeem the stock, which is the FMV of the stock as determined by an independent qualified appraisal. John receives an income tax deduction equal to the value of the remainder interest that the CF will receive, based on the full FMV of his shares in Q Corp. John and the CF avoid any immediate liability for capital gains tax on the sale of the contributed shares. John's annuity interest will also be based on the $10 million FMV. Thus, John's annual payment from the CF is $750,000. Part of John's annuity payment will be considered a return on principal, part will be a capital gain and part will be ordinary income.33 Before John sold his shares of Q Corp., it was paying annual dividends of approximately 2.5 percent per year or $250,000. Now, John's income is three times that amount. John may elect to purchase insurance to replace any part of the gift he made to the CF. The policy can be purchased in a multi-generational trust, thereby funding the trust with a life insurance policy with a $10 million death benefit. Let's assume that John transfers $1 million to the trust and funds the trust over seven years to avoid the MEC rules. If the trust is otherwise properly structured, the death benefit will pass tax-free to the trust beneficiaries. Typically, a donor-advised fund (DAF) arrangement may be made with the CF with the proceeds of the charitable gift annuity, allowing John's family to make ongoing grants to the family's favorite local charities.
The charity to which the lead or remainder interest payment may be made can also be a family foundation, in which the family controls the distributions of all future charitable grants to qualified charitable causes in the community. Family foundations can be either granting agencies or private operating foundations, which the family uses to be directly involved in supporting specific causes in the community. The family charity can also be in the form of a DAF or field of interest fund with a public charity that hosts such funds, or with a CF, or even with the investment warehouses that sponsor DAF programs (for example, Fidelity, Bank of America and Citigroup).
- Insurance planning
When the 2010 Tax Act was passed, many practitioners worried that its provisions would result in a large number of clients no longer having taxable estates. The truth is that the 2010 Tax Act creates as much uncertainty as there was at the end of 2010. Life insurance can hedge against the unascertainable risks by preserving flexibility at a reasonable cost. Life insurance has always had a favored status in transfer tax planning. A life insurance policy funded in a properly structured irrevocable life insurance trust won't be included in the insured's estate, nor are the proceeds subject to income tax when received.34 Multi-generational trusts are ideal receptacles for life insurance planning, especially for larger policies because the death benefit is sufficient to benefit not only the children of the grantor, but also future generations.35
There are a variety of types of life insurance and funding strategies to consider. Trusts also must be made exempt for GST tax purposes. This caution is especially true when funding the insurance policy with gifts in excess of $1 million ($2 million for a husband and wife), notwithstanding the current increased exemption amounts. As discussed above, using separate trusts is likely the best approach for using exemption amounts in excess of $1 million and then bridging the trusts through loans and other strategies until this issue is clarified.
Policy selection depends on a number of factors including cost. The quality of the company is also important. For larger quantities of insurance, the underwriting and willingness of several carriers to participate is important. Five basic types of insurance are available: term, whole life, universal life, indexed universal life and variable insurance. Term insurance is temporary and so isn't favorable for transfer tax planning. The other types of insurance are like any investment: The choice depends on the amount of risk the client is willing to take for policy performance.
The trust document must permit the ownership and management of insurance policies, including exchange or replacement of such policies, if necessary. The purchase of policies on other family members to preserve the trust corpus at inter-generational levels may be appropriate. A trust advisor, in addition to the corporate trustee, can be appointed to manage the policies and to monitor their performance over time. The trust must be properly structured to ensure that no incidence of ownership is attributed to the insured to avoid inclusion of the proceeds under IRC Section 2042, or that the trust assets aren't brought back into the estate through some other IRC section, such as Sections 2036, 2038 or 2041. Since it's likely that the multi-generational trust will be designed as a grantor trust during the life of the grantor/insured, it's important that the grantor trust powers retained by the grantor don't trigger inclusion.36
The policy funding strategy is very important to the sustainability of the policy so it can serve its intended purposes. Traditional policy funding approaches with annual gifts and Crummey powers may not work effectively in a multi-generational trust. Using Crummey powers37 isn't considered the best approach because of the possible interaction between the GST rules and the grantor trust rules and the limitations on funding for larger policies.38 Some clients simply find other funding strategies better because they don't require the annual consent of others to be successful.
However, loans, split-dollar plans,39 insurance funded through installment sales40 and premium financed policies41 can be designed within the GST tax exemption parameters. The combination of life insurance and charitable planning can often provide the additional leverage needed to zero out estate tax liability even in the largest estate cases in which traditional funding approaches wouldn't meet the funding need.42
- Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act) (enacted Dec. 17, 2010).
- Carlyn S. McCaffrey and Pam H. Schneider, “The Generation-skipping Transfer Tax,” Trusts & Estates (February 2011) at pp. 33-34; 35.
- See Hani Sarji, “Estate Tax Confusion — Obama's Budget Proposal Sets Up Estate Tax Fight,” Forbes Blog, Feb 26, 2011; Also see Jonathan Blattmachr and Michael L. Graham, LISI Planning Newsletter #1779 (Feb. 21, 2011) at http://leimbergservices.com.
- See supra note 2, pp. 30-31. The application of the generation-skipping transfer (GST) tax beyond 2010 was also uncertain despite the statement in Section 901 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Act) (known as the “sunset provision”) that the provisions of the 2001 Act, including Internal Revenue Code Section 2664, don't apply after 2010. The uncertainty stemmed not only from the impossibility of predicting whether and how Congress would act, but also because of the ambiguities inherent in the language of Section 901(b) of the 2001 Act. The 2010 Tax Act, unfortunately, resolved none of this uncertainty. If Congress fails to provide a different set of rules, subsection (b) of Section 901 of the 2001 Act will now apply beginning in 2013, rather than its originally planned starting date of Jan. 1, 2011. The subsection states that the IRC shall be applied and administered to GSTs that take place after 2012 as if the 2001 Act had never been enacted (this is commonly referred to as the “had never been enacted” rule). This subsection clearly means that the several helpful provisions of Chapter 13 that were added as part of the 2001 Act, such as the qualified severance rules of Section 2642(a)(3), will no longer apply in determining the amount of GST tax payable on a post-2012 GST.
- A GST tax was included in the Tax Reform Act of 1976, but was eliminated shortly thereafter because the provisions of the legislation were deemed to be unworkable. Nonetheless, the groundwork set by the committees and other efforts formed the basis of the GST tax and the corresponding GST tax exemption that exists today. The 2001 Act provided useful tools to practitioners to correct GST planning errors and oversights. Automatic allocation rules and trust severance tools were put in place to help in practical ways, but like all of the provisions of the 2001 Act, they were scheduled to sunset in 2011. That sunset is merely postponed to 2013.
- IRC Section 2632(b).
- See generally Richard A. Oshins and Steven J. Oshins, “Protecting and Preserving Wealth into the Next Millennium [Part Two],” Trusts & Estates (October 1998) at p. 68; Daniel G. Worthington, “The Problems and Promises of Perpetual Trusts,” Trusts & Estates (December 2004) at p. 15.
- For a comparison, see Daniel G. Worthington and Mark Merric, “Which Situs is Best,” Trusts & Estates (January 2010) at p. 60; see also Daniel G. Worthington and Daniel Mielnicki, “In Defense of Multi-generational Trusts,” Trusts & Estates (January 2011) at p. 54.
- Ibid. The Worthington and Merric article, ibid, provides a comprehensive four-page table on pp. 64-67 that compares the 27 major trust jurisdictions and their laws.
- Supra note 2; the GST tax exemption under the 2001 Act provides a safe harbor for other transfers. We simply don't know how additional GST allocations for additional transfers will be treated in the future. The suggestion is to create separate trusts for additional amounts to prevent the possible taint of existing GST tax-exempt trusts. Insurance and other asset leveraging tools should be used predominantly within the original exempt trust so growth and accumulations are sheltered as well.
- See Revenue Ruling 77-378, 1977-2; Private Letter Ruling 200944002 (Oct. 30, 2009); PLR 9837007 (Sept. 1, 1998).
- See Blattmachr and Graham, supra note 3. See, e.g., Estate of Uhl v. Commissioner, 241 F.2d. 867 (7th Cir. 1957); Estate of German v. United States, 7 Ct. Cl. 641 (1985); Revenue Ruling 2004-64, 2002-2 C.B. 7.
- The key to protection against a marital claim of a property settlement imputation of income for child support or alimony, or a spouse suing through a minor beneficiary, isn't to have a property interest in the first place. Only South Dakota provides the four elements of a common law discretionary trust. Mark Merric, “DAPT Presentation on Marital Claims,” at p. II. E.-9 (2010).
- Rev. Rul. 2004-64, 2002-2 C.B. 7.
- See Todd Steinberg, Jerome Hesch and Jennifer Smith, “Grantor Trusts Supercharging Your Estate Plan,” 32 Tax Management Estate, Gifts and Trust Journal, at pp. 66-75. The “grantor trust” is a trust owned by the grantor (or another person) for income tax purposes. Although a transfer to the trust may be complete for gift, estate and GST tax purposes, the grantor may remain the income tax owner of the trust by retaining certain of the grantor trust powers that don't otherwise cause inclusion for transfer tax purposes. See IRC Sections 674-677 (typically one or more of the administrative powers described under Section 675 are used); see also Rev. Rul. 85-13, 1985 C.B. 184.
- Ibid. The 10 percent equity rule is a guideline to make the sale a commercially reasonable transaction from a debtor/creditor perspective. Guarantees and other financing devices have also been used.
- For example, IRC Section 2704(b) states that if an interest in an entity is transferred to or for the benefit of the transferor's family member, any applicable restriction is disregarded in valuing the transferred interest; Treasury Regulations Section 25.2704-2(b) provides that an applicable restriction on the ability to liquidate an entity that's more restrictive than the state law default restriction is disregarded. A number of states have amended their partnership laws to accommodate more restrictive partnerships for purposes of Section 2704.
- A non-grantor trust is subject to income tax as a complex trust under IRC Sections 661-663 and 642(c). The charitable lead trust (CLT) receives an unlimited income tax charitable deduction for the annuity or unitrust interest paid to charity, to the extent that the charitable distribution is paid from gross income. CLTs won't typically have taxable income. It's also possible to create an intentionally defective grantor-type trust in which a person other than the grantor is the beneficiary. When the grantor retains only a Section 675 administrative power, the grantor can receive an income tax deduction up front for the value of the charity's income interest. The disadvantage is that the grantor pays the tax on income the trust realizes on an annual basis for the CLT term.
- CLTs are subject to the private foundation rules against self-dealing (IRC Section 4941), rules on taxable expenditures (IRC Section 4945(d)) and if the charitable deduction, which is allowed, is in excess of 60 percent of the fair market value (FMV) of trust assets, the prohibition against excess business holdings (IRC Section 4944).
- Assume a non-grantor-type CLT.
- The Internal Revenue Service issued revenue procedures in 2007 and 2008 providing annotated forms for various types of CLTs. Rev. Proc. 2007-45, 2007-29, Internal Revenue Bulletin 89 (for inter vivos charitable lead annuity trusts (CLATs); Rev. Proc. 2008-45, 2008-30, IRB 224 (for inter vivos charitable lead unitrusts (CLUTs)).
- Special valuation rules apply to allocating GST tax exemption to CLATs under Section 2642; no allocation of any portion of the transferor's GST tax exemption may be made until the end of the estate tax inclusion period. See Treas. Regs. Section 26.2642-3.
- Compare PLR 200107015 (Feb. 20, 2001). In PLR 200107015, the IRS was asked to consider the federal gift and GST tax consequences of the assignment of a vested remainder interest by a beneficiary of a testamentary CLAT.
- The IRS forms for CLATs provide that the “governing instrument of a CLAT may provide for an annuity amount that is initially stated as a fixed dollar or fixed percentage amount but increases during the annuity period, provided that the value of the annuity amount is ascertainable at the time the trust is funded.” Rev. Proc. 2007-45, 2007-9, IRB 89, Section 5.02(2). However, compare Richard L. Fox and Mark A. Teitelbaum, “Validity of Shark-Fin CLATs Remains in Doubt Despite IRS Guidance,” Estate Planning Journal, October 2010.
- Fox and Teitelbaum, ibid. at pp. 4-5 (example).
- A CRUT is an irrevocable trust created under the authority of IRC Section 664. This special, irrevocable trust has two primary characteristics: (1) once established, the CRUT distributes a fixed percentage of the value of its assets (on an annual or more frequent basis) to a non-charitable beneficiary (usually the settlor of the trust); and (2) at the expiration of a specified time (usually the death of the settlor), the remaining balance of the CRUT's assets are distributed to charity. The trustee determines the FMV of the CRUT's assets at the time of contribution and thereafter on the applicable valuation date. The fixed annuity percentage must be at least 5 percent and no more than 50 percent of the FMV of the assets in the corpus. The remainder (the amount expected to go to charity) must be at least 10 percent of the FMV of the assets contributed to the CRUT. IRC Section 664(d)(1) sets the federal income tax requirements for a CRUT.
- A charitable remainder annuity trust (CRAT) is similar to a CRUT. It's an irrevocable trust that enables the grantor to retain a fixed annuity income for his lifetime or a fixed term of years, claim a current income tax deduction and make a future gift to charity.
- See “Charitable Gift Annuities, Planned Giving Design Center,” at www.pgdc.com/pgdc/charitable-gift-annuity#bfn3; see also The Philanthropy Protection Act of 1995 (H.R. 2519, P.L. 104-62); The Charitable Gift Annuity Antitrust Relief Act of 1995 (H.R. 2525, P.L. 104-63); and The Charitable Donation Antitrust Immunity Act of 1997 (H.R. 1902, P.L. 105-26).
- Taxation of CRT income is under the four-tier system — first ordinary income, then capital gain, then tax-free income and finally return of principal.
- IRC Section 664 et al.
- As determined by the American Council on Gift Annuities rate table.
- Palmer v. Comm'r, 82 T.C. 684 (1974); PLR 8307134 (Nov. 19, 1982).
- See generally IRC Sections 2042 and 1001 (a); Samuel A. Donaldson, “Burning Questions (and Even Hotter Answers) About Grantor Trusts,” 45 Heckerling Tax Institute on Estate Planning (Tina Portuando ed., 2010) at p. 15. Most irrevocable life insurance trusts (ILITs) are grantor trusts since the trust instruments typically provide that income may be applied toward the payment of premiums insuring the grantor's life (or a spouse's life, IRC Section 677(a)(3)). Giving the trustee this discretion doesn't constitute “incidence of ownership” to the grantor. The trust instrument must specifically allow the application of trust income for this purpose.
- While typically, insurance is purchased for its death benefit, normally cash may be taken out of a policy income tax-free in the form of loans or withdrawals prior to the death of the insured. Another consideration in the funding of the policy is to avoid the modified endowment contract rules, especially if the trustee may need access to cash values of the policy for any reason. Policies may also be exchanged for like policies if there's a better product that exists. This provides some measure of flexibility for the family.
- See discussion, Donaldson, supra note 34.
- Crummey v. Comm'r, No. 21607 (9th Cir. 1968).
- Donaldson, supra note 34, at A10. The concern stems from IRC Section 678(a). It says that the beneficiary (not the grantor) will be treated as the owner of the trust if the beneficiary has a “power exercisable solely by himself to vest the corpus or the income of any portion of a testamentary or inter vivos trust in himself …” In Rev. Rul. 81-6, 1981 C.B. Section 620, the IRS concluded that a beneficiary was taxable under Section 678(a) because the beneficiary held a Crummey power, even though the beneficiary was a minor and thus unable to exercise the power without the appointment of a legal guardian; see also Treas. Regs. Section 1.61-3(a)(3). On the other hand, Section 678(b) appears to provide that Section 678 doesn't apply “with respect to a power over income … if the grantor of the trust … is otherwise treated as the owner under the provision of this subpart other than this section.” The Crummey power is typically a power over principal and not over income. So not everyone is convinced that Section 678(b) makes the safe use of Crummey powers in grantor trusts. But compare PLR 200606006; PLRs 200729005-200729016; and PLR 200840025. These PLRs aren't binding on the IRS with respect to the Crummey power rules and Rev. Rul. 81-6 only applies to the general rule under Section 678(a).
- Michael F. Amola, Kristen E. Simmons and Robert C. Slane, “Utilizing Private Split Dollar in Estate Planning,” NAEPC Journal, www.naepc.org/journal/issue06o.pdf. Private split-dollar plans can be an effective way of funding life insurance policies by lending an amount to fund the policy to an ILIT. The grantor retains a note or equity interest in the policy. The policy can be on a life other than the grantor. The key is to plan an effective exit strategy from the split-dollar arrangement.
- See Steinberg, Hesch and Smith, supra, note 16; see Donaldson, supra note 34. The income generated by trust assets in excess of the amount needed to fund installment note requirements is available to finance an annual premium. If the trust has a zero inclusion ratio by virtue of the original allocation of GST tax exemption to its initial funding, then the trust assets are exempt, including the death benefits of a life insurance policy purchased in the trust.
- See Michael Gallop, “Benefits and Risks of Insurance Premium Financing,” 33 Estate Planning, No. 11, at pp. 23-28. While premium financing can be an effective way to purchase life insurance, there are a number of risks that are associated with them. The key to a successful premium financed plan is to match the financing with the right policy and to have an exit strategy developed from the onset of the plan.
- Our thanks to Professor Jerome Hesch for his valuable assistance with this article. A more thorough discussion of many of the examples included in this article and a spreadsheet analysis using software developed by Daniel Mielnicki and Prof. Hesch, will provide a comparison of planning techniques. Spreadsheets and details will be included in a forthcoming book to be published in late fall of 2011.
Daniel G. Worthington, left, is CEO and managing member at Worthington Everidge Group LLC and Family Office USA, LLC in Orlando, Fla. Daniel D. Mielnicki is a shareholder at Berger Singerman in Boca Raton, Fla.