8th Annual Estate Planning Update
Using Gifts and Trusts for Wealth Transfers
By: John Legaré Williams, Esq. © 2011 All Rights Reserved
September 7, 2011
Table of Contents:
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Using Gifts and Trusts for Wealth Transfers
An epic part of President Obama’s extending the Bush tax cuts was enacting an unprecedented “sea change” of cuts, in the federal gift tax. You may be aware that from about 2001 to 2010 the estate tax credits ratcheted up from $1 million in 2001 to $3.5 million in 2009. Then in 2010 the estate tax was repealed. However, during this entire time period, the gift tax limit remained capped at $1 million. Even during 2010 when the estate tax was repealed entirely, the gift tax limits remained at $1 million. As 2011 approached, it was uncertain whether Congress would do anything to enact new legislation to avoid the “sunset” which would have reinstated the estate tax at the $1 million credit level per donor. Congress did act (although Republicans wanted to get rid of the estate tax entirely), and the compromise reached not only set the estate tax credit at $5 million per donor, but more significantly, set the gift tax at $5 million per donor during his or her lifetime. The law passed was limited to 2011 and 2012, which means it also sunsets in 2013. This move known in short-hand as the Tax Relief Act of 2010, has provided a unique opportunity to make tax free gifts in amounts unheard of previously. In this section I describe a few techniques to take advantage of this window of opportunity, especially the dynasty trust to pass wealth to multiple generations free of estate tax.
The reason this is seen as a window of opportunity is because of the concern Congress will either do nothing before 2013 whereby the lifetime gift exemption will automatically revert back to $1 million or Congress will enact a new law that is not as favorable as a revenue generator for either gift taxes or estate taxes. Throughout history Congress has repealed and reenacted estate taxes four times, not including this latest round, each time during war time. The estate tax was first enacted in 1796 when we were on the brink of war with France, then re-enacted in 1861 during the American Civil War, re-enacted again 1896 during the Spanish American War and finally reenacted again in 1916. The federal estate tax is not going away.
Making lifetime gifts has significant advantages over waiting until death, because gifts freeze the value of an asset at an earlier point in time, to reduce the size of the overall estate at death. Additionally, the tax on a gift is “exclusive” of the size of the overall estate. This means that any tax paid on a gift over $5 million would also reduce the size of the taxable estate at death. In contrast, the dollars paid to the IRS for an estate tax are “inclusive” in the overall size of the estate, making the bequest at time of death more expensive. Also since most states do not have gift taxes, but many have estate taxes, the gift tax may be a way to avoid state taxes. This section would not be complete without a mention that in the past the estate and gift tax rates have been as high as 55% (back in 2009), in the current environment, the tax rate is only 35%.
There are, however, five pitfalls with the taxable gift during lifetime that a practitioner should be aware of:
1) Pay it later. Generally in tax law it is better to postpone a tax then pay it sooner because by the time it comes to pay the tax, it may have been reduced or eliminated. Plus the taxpayer has access to the funds in the interim. In the planning below, making “taxable gifts” is not recommended, rather the suggestion is to take full advantage of the tax-free gift limits at the end of 2012.
2) Basis. Basis is the cost to purchase an asset. When assets are sold, the difference between the cost and sale price is taxable capital gain. When a beneficiary receives an inheritance the beneficiary gets a “step-up” in basis. Assuming assets appreciate over time, making bequests at the time of death helps to minimize future capital gains taxes for the beneficiary. This way when the asset is sold by the beneficiary, the cost-basis is the value at the date of death of the decedent (minimizing capital gains taxes of about 20% including federal 15% and state tax 5%). In the contrast, when a donee receives a gift the basis gets “carried over” from the donor, meaning that the cost-basis is the original cost to the donor. This results in a higher capital gains tax burden for the gift recipient when the asset is sold eventually (higher than the recipient/legatee/devisee/beneficiary of a bequest in liquid assets, tangibles or devise of real property who received the “step-up” in basis).
3) Motivation. Most people like to retain their money while they are alive as a safety-net. It is difficult motivating people to depart with their money, no matter how much they may love their children or grandchildren.
4) Fraudulent Transfer. The other problem with giving away too many assets while one is alive is if the donor has creditors, it could be construed as a voidable transfer.
5) Clawback. What Congress giveth, it may also taketh away. It is theoretically possible that in 2013 or thereafter, Congress can retroactively unwind the gift tax allowance, thereby converting what was a tax free gift into a taxable gift and resulting tax. Most commentators are confident this will not happen because apparently Congress has never retroactively imposed a “clawback” tax in this way for various policy reasons. Essentially Congress wants people to rely on current tax law to allow them to make personal and business decisions. The ripple effect of a clawback would far outweigh any benefit from the increased revenues.
A. Small Gifts and the annual gift tax exclusion:
Before we get into the “high-octane fun” of the “lifetime” exclusion, it is important to also mention “de minimis” gifts which are small gifts that do not require reporting on a gift tax return. Nothing new here, it is just chocolate and vanilla gift strategies for everyone.
One item that was not changed with either the Bush Tax Cuts or the Obama 2-Year Extension is the annual gift tax exclusion. About 10 years ago, this annual exclusion used to be $10,000 per year and has slowly been raised to $13,000 per year. This is a “tried and true” method of giving away assets tax free. The biggest problem is the cap. While the gift tax is per donor, the annual exclusion is per donee. This allows a married couple to give away $26,000 per year to each individual. These donees typically include children, spouses of children, and grandchildren.
This annual gift exclusion is a great way to transfer wealth without the need to report gifts on a gift tax return. It is a great way for less wealthy clients to whittle down their estate without losing control of most of their assets.
Gifts must be completed at least three years before death or they get added back into the estate of the decedent as being gifts in anticipation of death. The old way to unwind gifts was to look to the health of the decedent at the time of the gift. Fortunately, the IRS determined that the three year rule was a simpler and objective way to administer the gift and estate tax, than a subjective and heavy fact dependent inquiry into whether the gift was “in contemplation of death.”
These annual exclusion gifts also do not count against one’s lifetime gift allowance. This also allows assets to appreciate in the name of children, grandchildren and their spouses.
Related to this annual exclusion is an allowance to pay for the education of another without it being a reportable gift. To take advantage of this, the donor must make a payment directly to an educational institution and can even prepay for an education. Just be careful because if the student withdraws the payment may not be refundable.
B. Asset protection trusts
The asset protection trust is primarily for the benefit of the settlor and therefore this topic does not seem to fit squarely into this section of the seminar on “wealth transfer” since there is no immediate transfer. However, the benefit of the asset protection trust is to preserve assets from creditors to provide a future legacy. Also Delaware has a particularly compelling statute that attracts wealthy people from all over the country, so it is something which is beneficial and related to the other topics in this section.
The asset protection trust is a self-settled trust whereby the client is both settlor and beneficiary (but not trustee). In most situations, the trustee should not be an immediate family member, such as spouse, child or parent. The trustee has the power to make discretionary distributions. The assets cannot be assigned as collateral for a loan by the settlor.
The asset protection trust, unlike the rest of this section is not a gift. Instead it has features like a traditional revocable trust, except that it is irrevocable and has creditor protection features.
The asset protection trust is best suited to wealthy people in a high-risk business or profession who do not have foreseeable liabilities that exceed his or her assets which would remain after a transfer.
Under 12 Del C. Section 3570 et al, the settlor must wait a four year statutory period after funding to benefit from the “asset protection” features of the trust. If a creditor’s claim arises before creating a Delaware APT, that creditor must bring suit within four years after created or, if later, within one year after the creditor discovered (or should have discovered) the trust. A tort claim creditor can access the funds at any time for an injury caused by the settlor personally.
The assets can even survive the settlor’s bankruptcy petition if the trust is established for 10 years under the 2005 Bankruptcy Reform Act. See Section 548 (e) of the Bankruptcy Code.
In order to qualify as a Delaware asset protection trust, the trust must have a Delaware individual or Delaware trust company as a qualified trustee. The qualified trustee can serve alongside an advisor trustee who has more, most if not all, the management responsibilities. The Delaware statute under title 12 section 3570 sets forth the minimal jobs for the Delaware trustee. Delaware trust banks charge at a minimum of $5000 per year to be trustee and tend to be stingy with distributions to keep more assets under management. If an entity is the trustee, it must have Delaware trust powers (approved by banking commissioner).
Under the Delaware law, only “super creditors” are allowed to access funds, including child support, spousal creditors, and tort claim creditors. This is for public policy reasons.
As a rule of thumb, it is advisable not to put more than 1/3 of assets into the trust. The reason for this is to avoid being seen as abusive. The fraudulent transfer statute is designed to protect actual and foreseeable creditors. If transfers are made when creditors are known or foreseeable (not only judgment creditors and cases in litigation, but matters that reasonably be anticipated to result in litigation). Therefore it is wise not to fund an asset protection trust to avoid current creditors.
Why not use an offshore asset protection trust? Although offshore asset protection trusts seem attractive, they have a whole host of other problems. First they are not secret because failure to disclose those assets to the IRS can have significant consequences. Second, if a creditor obtains a judgment and an order from a court in the US to disgorge those assets which is refused, the settlor can be jailed until those assets are turned over to the creditor. I have never heard of a US creditor being incarcerated to compel production of US based assets from a domestic asset protection trust.
When setting up a trust for someone outside Delaware, it is important to consider additional features to help strengthen the Delaware nexus and perhaps provide another layer on the onion of protection. That is to use a Delaware LLC to hold the assets in the asset protection trust (provided it has safeguards to keep the settlor from controlling the assets in the trust). Additionally, for liquid cash assets, it may be wise to set-up a Delaware bank account, which is exempt from attachment/garnishment by creditors. Delaware is the only state in the country which provides this protection to bank accounts.
Although a two level structure may be advisable, adding additional layers beyond two is not advisable because that structure alone may look like it is an attempt to avoid a creditor. Such a complex structure, may look like a Rube Goldberg chain-reaction apparatus and appear fraudulent.
You may have heard that all you need is an LLC to protect personal assets. This may be referred to a “poor man’s asset protection trust.” However, the reasons this may not be effective exceed the scope of this seminar. The LLC standing alone, even with “charging order” protection is nowhere near as protective as an asset protection trust.
The asset protection trust us best suited for liquid assets. Although it is tempting to hold real estate assets in a Delaware LLC and have the assets of that LLC held in an asset protection trust, it may not be wise because generally real property is governed by the law where it is located (since these trusts are mainly for non-Delawareans, that place may not be Delaware). The protection afforded to an asset protection trust under Delaware law may not trump the most significant contact -- the home state’s real property contact.
Another type of asset protection trust which has a slightly different structure can be set-up by non Delaware residents to avoid state income tax on the sale of a business. The purpose of this is to change the domicile of the business owner from his or her home state to make the tax nexus the trust’s home, or Delaware. For example, a business sold for $10 million where the owner lives in a state like New York, he or she would have a 5% state tax on that sale as a capital gain. As an alternative, that business owner should transfer the ownership to a Delaware Asset Protection trust (this type would need a distribution committee of at least three non-spouse contingent beneficiaries on that person’s estate plan). This example is based on a revenue ruling from the IRS that was approved. In this situation, setting up a Delaware asset protection trust should save that individual $500,000, because Delaware does not tax non-resident trusts. This is not a new trust, nor were the tax benefits effected by the recent Tax Act of 2010. Instead this is a sophisticated way to structure tax-wise business sale transactions out of state.
C. Dynasty Trusts
The Dynasty Trust is about preserving wealth for future generations, and not keeping it for oneself. It is about avoiding the estate tax and generation skipping tax at multiple generations. Delaware repealed the rule against perpetuities, allowing anyone to set-up a trust that will last forever. Delaware can set-up these forever trusts because it repealed the rule against perpetuities (except for real estate which is capped at 100 years, rather than the old-rule of lives-in-being plus 21 years). In December 2010 Congress raised both the gift tax limit and generation skipping transfer tax limits to $5 million. Or for a couple, the total amount for both is $10 million. This trust can be protected forever! This is your opportunity.
With the recent tax law changes, settlors have a small window (until December 31, 2012) to do some very significant planning for future generations to preserve millions of dollars in future estate taxes. This is a very favorable environment. In this section, I will describe how to use the Dynasty Trust for up to a $5 million “gift tax free” gift.
There was a recent article in the News Journal which did a pretty good job describing dynasty trusts. The sensational headline was something along the lines of “Delaware allows wealthy to give away $100 million tax free.” The truth as explained in the article is that the limit is $5 million. The article assumed husband and wife each gave $5 million to dynasty trust and those assets grew at a rate of 9% over 50 years. In that period of time the assets would grow to be worth $100 million. If the couple had not set-up the dynasty trust it is possible that the growth of those assets would have been “cut down” once or twice by estate taxes on them and their children leaving about 25% of that amount for the future generation. So in their example this trust could have saved $75 million or so in taxes. That is a big selling point of the Dynasty Trust.
Like the asset protection trusts, the Dynasty Trusts should only be funded without foreseeable outstanding creditors, where the creditors are not otherwise adequately secured by other assets of the settlor. Again, it is not recommended to put more than about 33% of one’s assets into this type of trust, in the case a creditor questions such a transfer.
It is also significant that the donor must outlive the transfer by three years or the “gift” will be brought back into the settlor’s estate.
Like the asset protection trusts, the Dynasty Trusts are also irrevocable trusts and also have the Delaware situs requirements since they are also set-up under 12 Del. C. Section 3570 et al. However “Dynasty Trusts” are not set up to preserve assets for your own benefit. Dynasty Trusts are designed for “leveraged gifting”. The goal behind a dynasty trust is to avoid estate taxes on transfers of wealth to future generations.
In 2011 and 2012, Congress passed a law allowing individuals to make tax-free lifetime gifts of up to $5 million. This was a radical departure from the historical gifting limits, which had never been higher than $1 million. Even in 2010 when the estate tax was repealed, the gift limit remained capped at $1 million. Some were able to time their death in 2010 to coincide with the repeal of the estate tax, such as George Steinbrenner, passing $1 billion of his estate, including his interest in the New York Yankees to his son. However, for the rest of us, we don’t have such luck to have such great fortunes or to be able to time our deaths.
Prior to Congress passing the “2 year” estate and gift tax compromise at the end of 2010, which gave us the current structure, the laws would have reverted back to the $1 million estate tax credit or lifetime gift tax limits. That is also the case with 2013. It is expected that Congress will extend the current tax plan, but it is possible, if Congress does nothing that it will revert back.
Although I do not have a crystal ball, even with the current deficit concerns, it is unlikely that the estate tax credit will outright become a casualty of the efforts to raise revenues because the amount of money generated by an estate tax is such as small fraction of the tax base. In general the estate tax was intended to keep the great industrialists in check from run-away wealth and not to be a significant source of income for the US treasury. Some Democratic Senators and Democratic Congresspersons suggest that the limit should be $3 million. Since the Republicans want the estate tax repealed, chances are that the floor of a future estate tax will be $3 million or more.
Dynasty Trusts benefits also may be a way to save state death taxes. Most states do not tax gifts, no matter how large. Therefore gifting assets into a Dynasty trust is a way to avoid the “state” death tax. The state death tax is a result of states “decoupling” from the federal government. When a state decouples it usually requires a filing of a 706 tax return and the payment of state estate tax if the assets exceed a certain level, such as $1 million, as is the case in New Jersey. This way a decedent may face a state death tax while not having to pay a federal estate tax or even file the form.
One other advantage of the Dynasty Trust is that it is a completed gift filed with a gift tax return. Gift tax returns, in general, are less likely to be audited. Be sure to include all appraisals and valuations when funding such as gift. Once three years passes and there is no audit, the statue of limitations has run for all things, except fraud.
D. Family LLCs
Setting up an LLC with both voting and non-voting units/interests are a popular way to make gifts during the parent’s lifetime, while not losing control of an asset. The asset is valued and then discounted for non-marketability and control discounts, to allow gifts of the non-voting interests over time in increments to children or other beneficiaries.
Typically parents will retain all voting units of 1-5% and then hand over year-by-year the non-voting units to children of 95-99% so that the interests stay at or under the $13,000 level. Often these gifts are made over time to avoid the imposition of a tax. The concern is a new line of cases holding that the discounts were not applicable because the gifts had so many restrictions they were not completed gifts. These cases termed the “Fisher Price Cases” included Price v. Commissioner, T.C. Memo 2010-2 denying the annual exclusion for gifts of limited partnership interests because the donees had neither the right to income nor substantial present enjoyment of the property, primarily because income was not paid each year, and a partner had to obtain the unanimous consent of all of the partners to sell their partnership interests. Fisher v. U.S. 105 AFTR 2d 2010-1347 (S.D. Ind. 2010) denied the annual exclusion where the donees could transfer their interests at a time, merely subject to a right of first refusal. Although the court did not explain its reasoning, it was likely because the LLC could pay with non-negotiable promissory notes.
Therefore it may be a good idea to send out “Crummey” notices to the beneficiaries allowing them the ability to opt out of the non-voting LLC interest gift for cash during a window of a couple months or the limited time repurchase of the LLC interest by the grantor during that same period of time. The Crummey notice is an annual letter to beneficiaries, signed by beneficiaries notifying them of their right to access funds for a limited period of time.
It is also wise not to place prohibitions on transfers or the requirement for unanimous consent. It would be a good idea to regularize distributions and specify that the manager owes fiduciary duties. It is important that the LLC gifts confer present economic value on the recipients.
A related strategy is to pledge credit worthiness (signing a guarantee), not considered a taxable gift. This allows a child’s LLC to be the title holder on the property with a signature guarantee by the parent. As the mortgage payments are made, the equity will grow in the name of the child.
E. Qualified personal residence trust (QPRT)
The qualified personal residence trust is another way to make a gift of a personal residence at a discount. At the outset, a gamble has to be made that the taxpayer will live for at least a certain number of years. Typically this period is 7 or 9 years. What that allows is for the parent-taxpayer to live in the home for a certain period of time. After that period of time the decedent loses the right to live in the residence and it becomes the property of the beneficiary of the trust. The beneficiary receives the property at a substantial discount because the value is “frozen” in time, plus reduced by the waiting period where the beneficiary does not have access. Therefore the future value of the house may only be 60-80% of the present value.
As a practical matter, at the end of the trust, if mom or dad has “won the bet” and outlived the period, then the child-beneficiary typically allows mom or dad to stay in their residence, but there must be a landlord-tenant relationship (with a signed lease), so that mom or dad must be paying an appropriate rent as agreed to in the lease agreement for the right to stay there. Otherwise, the QRPT will look like a sham, defeating the valuation discount goals. If the parents do not pay rent, this plan will lose in a challenge by the IRS under Section 2036 and Van v. Comm’r, T.C. Memo 2011-22.
F. Generation Skipping Transfer Tax
In the above section on Dynasty Trusts, there was a mention of multiple layers of estate tax. Prior to the generation skipping transfer tax, if a taxable gift was made to grandchildren, then it was only taxed as a gift to children. This created a loss of revenue and a loophole in the tax system, which was filled by the generation skipping transfer tax. While in 2009 the “GST” tax exemption was $3.5 million, as mentioned above, it is currently $5 million. However, if this tax is imposed, it is a “double” taxation penalty on gifts to grandchildren, because it assumes the tax was paid not only by the parents, but also by the children which results in a much higher tax rate on gifts to grandchildren. Therefore it is not wise to make taxable gifts to grandchildren in excess of the generation skipping tax limits.
G. Community Foundations: all purpose charitable beneficiary
Maintaining a private foundation is cumbersome. However, the trend is moving away from private management to community fund management. This cuts down on the administrative expenses and headaches in maintaining a private foundation.
When a non-profit corporation is established it must submit a 1023 application to receive a preliminary tax determination letter from the IRS. In the 1023 application, the applicant must list what percent of its contributions will come from a single source or small group and not the general public. If it only comes from a small group, then the donors to the non-profit are only able to deduct up to 50% of their adjusted gross income as a tax deduction on their personal 1040 tax return. For a private foundation that amount is limited to 30%. In addition to having a board of directors, the foundation needs an accountant and must distribute so much of its funds every year. That percentage of funds which must be distributed is lower if the fund is managed by a community foundation. This enables the fund more flexibility in management and reduces the administrative burden.
In Delaware most people think of the Delaware Community Foundation as the preeminent organization to manage such funds. According to the Delaware Community Foundation, the types of funds that can be managed are:
1. Donor-Advised Funds
2. Designated Funds
3. Nonprofit Endowment Funds
4. Field-of-Interest Funds
5. Scholarship Funds
6. Unrestricted Funds
The general rules that such grants must follow are:
a. Grants Shall Follow Donor's Intent
b. Grants Will Normally Identify the Name of the Fund
c. Grants Must Not Provide a Financial Benefit to Donor
d. Donor Generally Cannot Control Timing of Grants
e. Board May Identify Specific Charitable Needs of the Community
It is important to note that the Board of Advisors can be family members and make recommendations, but ultimately it is the board’s decision to make distributions. This independent board is one of the features that qualifies such funds as public charities, for tax purposes, as opposed to private foundations.
Either the Board of Directors or the Governing Body of the supporting organization may terminate the relationship upon such notice as is prescribed in the agreement between the Community Foundation and the supporting organization. Termination may cause the supporting organization to lose its public charity tax status and be reclassified as a non-operating private foundation.
H. Other trusts and wealth transfer ideas beyond the scope of this seminar:
a. An Installment Sale to a Grantor Trust – with similar economic benefits to a Grantor Retained Annuity Trust (GRAT).
b. For very large estates the sale to an intentionally defective grantor trust (IDGT) may be another strategy for taxpayers willing to accept a moderate amount of risk because of the combination of transfer tax and income tax benefits.
c. A Charitable Lead Trust is an irrevocable, taxable, split interest trust. The donor funds a trust that will pay an income stream to a charity(s) of their choice for a specified term. At the end of the trust term, remaining trust assets revert to the donor, or are transferred to one or more non-charitable beneficiaries designated by the donor.
d. For real estate, stock or other assets that have increased substantially in value but are not producing an income stream to avoid a significant capital gains tax without selling, a Charitable Remainder Trust (“CRT”) may be established during the donor’s lifetime or at his/her death. The donor can choose a fixed stream of income (CRAT) or a variable payout (CRUT).
e. A section 2503(c) minor's trust is established to hold gifts for a child until the child reaches age 21. Many parents find that using the UTMA/UGMA meets needs as well as a 2503(c) minor's trust. The concern with all of these is that the trusts are treated as the child's asset for financial aid purposes, and so have a high impact on need-based financial aid eligibility. Typically, parents would be better off establishing section 529 plans for their children.