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A Trust To Help Clients Create A Dynasty

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The Ming Dynasty ruled China for 276 years. The dynastys demise in 1644 was due, in part, to the depletion of the imperial treasury.

If the dynastys rulers had access to todays financial planning strategies for preserving wealth, there is no telling how many generations of this powerful family could have occupied the throne of the Middle Kingdom.

Like the Ming Dynasty, wealthy American families encounter wealth transfer problems of their own. Currently, there are two roadblocks to passing a familys treasure ad infinitum to subsequent generations: (1) state anti-perpetuity laws, and (2) the generation-skipping tax. Most states have anti-perpetuity rules that only permit a trust to remain in existence for 21 years plus nine months beyond the lifetime of those trust beneficiaries who were alive when the trust was created. These are called “RAP” states since they have rules against perpetuity.

Be aware, however, that currently there are approximately 19 non-RAP states. These are states that allow a trustee to continue to manage trust assets ad infinitum, generation after generation. The assets in the trust need never vest in the trust beneficiaries. Lets call them the “perpetuity states.”

A taxpayer, regardless of where domiciled, can create a trust in any “perpetuity” state and transfer and/or re-title his or her property to an irrevocable trust in that state. The only requirement is that the independent trustee of that irrevocable trust be a resident of, or do business in, that perpetuity state.

Creating a perpetual trust, however, is only one part of the multi-generational wealth continuation solution. Perpetuity by itself does not address or solve the problem of the generation-skipping tax (GST) that may be incurred whenever property is transferred to someone more than one generation removed or to someone 37 or more years younger than the donor. That GST can be a devastating tax.

First, the 2003 GST is a flat tax of 49% that is paid in addition to the standard gift tax that may be due when property is transferred without adequate consideration. Second, the GST paid by the donor may itself be considered another gift made by the donor that is also subject to taxation up to the top 49% marginal bracket rate.

Just as the Ming Dynasty needed a shield to preclude the dissipation of its wealth, so do todays estate owners. The current uncertain tax environment only increases and intensifies the need for a pre-emptive tax planning strategy. That effective strategy or shield is the Generation Skipping Perpetuity Trust (GSPT), created in one of the available perpetuity states to build a permanent protective shield around a taxpayers assets to avoid excessive depletion of estate assets.

The Economic Growth & Tax Reform Reconciliation Act (EGTRRA) of 2001 enhanced the value of GSPT planning by indexing the generation-skipping tax exemption to the very same scheduled increases of the IRC Section 2505 estate exemption equivalent. That means the $1.12 million GST exemption in 2003 will increase to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009. The exemption amounts can even be doubled with a split gift. A split gift occurs when a taxpayers spouse elects to also allocate his or her GST exemption to a spouses gift.

EGTRRA also allowed for automatic allocations of the GST exemption to all generation-skipping transfers whether those transfers are direct gifts to a grandchild or indirect gifts to a trust for a grandchild. Still, it is recommended that a timely gift tax return (Form 709) with a notice of GST allocation always be filed with each and every gift to the GSPT trust to avoid any future conflict.

Lets examine how the GSPT strategy works. Business owner Tom Barry can leverage his lifetime GST exemption into a $50 million legacy GSPT that effectively can avoid potential estate, gift and generation-skipping taxes in a most cost- and tax-effective way for all future generations.

Step 1: Tom lives in Connecticut but decides to establish his multimillion-dollar GSPT in a perpetuity state like South Dakota with a resident institutional trustee. South Dakota is one of the most favorable perpetuity states because any income generated by the trust there is not subject to state income taxation.

Step 2: The South Dakota trustee applies for a $50 million survivor increasing death benefit life insurance policy on Tom and his spouse, Marie. Normally, Tom would have to make a gift to the trust of the approximate $2.8 million that the trustee needs to pay the premium. He would also need to allocate his GST exemption to that premium gift to forever exempt all trust assets from the GST. But even with a split gift there would only be enough exemption for approximately one years premium. How can we substantially discount the annual premium for gift and GST purposes? Tom said he wants to use his corporate pocketbook to pay the premiums. That gives us the key to a solution described in Step 3. The life insurance policy is designed to have an increasing death benefit so that at the death of the surviving spouse, an enhanced death benefit of $50 million plus the cash surrender value of the policy is paid tax-free to the trust.

Step 3: The split-dollar arrangement between the GSPT and the corporation is a nonequity collateral assignment agreement to avoid any adverse tax consequences implied in final split-dollar regulations. Toms computed taxable economic benefit for the GSPT interest in the $50 million split-dollar survivorship life insurance using IRS Notice 2001-10 rates is only $270. This is treated as additional compensation to Tom, not the $2.8 million corporate paid premium. The $270 and not the $2.8 million premium is also the amount of gift that Tom is considered to have made to the trust under the split-dollar plan. Tom also only needs to allocate $270 of his GST exemption to shield all future trust assets from any future GST consequences whenever distributions occur to future generations.

The increasing death benefit rider can ensure that the trust ultimately will be able to retain $50 million for intended legacy planning. The corporations interest in the split-dollar plan may be satisfied with the enhanced portion of the death benefit that is equal to the total cash surrender value of the policy.

The key to successful split-dollar applications is how the termination and the payback of the corporate interest under the split-dollar agreement is to occur should termination be prior to death. The reimbursement of the corporate interest can be accomplished in the following ways:

(1) The GSPT could be the remainder beneficiary of a Grantor Retained Annuity Trust (GRAT) asset that is used to reimburse the corporation for its interest in the split-dollar plan. The gift that Tom is considered to make to the GSPT could be discounted by 70% or more depending on the terms of the GRAT. However, Tom could not apply his GST exemption to that GRAT remainder gift until the end of the GRAT term, when the GRAT expires.

(2) When the split-dollar plan is terminated the corporate interest could be secured with an interest-only promissory note, executed between the trustee and the corporation. The notes principal could be payable at the death of the surviving spouse. Should the corporation forgive any payment when due, Tom would be charged as receiving compensation.

(3) The GSPT could be made a limited partner of a family limited partnership (FLP) by making additional discounted gifts over time of partnership interests to the GSPT. Proper allocation of the GST exemption also would be made to these present interest gifts. The GSPT could then use its acquired income interest in the FLP to reimburse the corporation its split-dollar interest.

Final split-dollar regulations were published in the federal register on Sept. 11, 2003, and require premium payments made on all “equity” split-dollar plans implemented after Sept. 17, 2003, to be treated as loans. Nonequity split-dollar plans, as the one proposed above will continue to be subject to taxation under the standard economic benefit rules with the term insurance element valued under the recommended valuation tables published in Notice 2001-10.

Step 4: Tom files a 709 gift tax return with a notice of allocation of a portion of his GST exemption to the $270 trust gift. This is really what makes an irrevocable life insurance trust a generation-skipping dynasty trust.

Taxpayers need not suffer the “Ming Dynasty” depletion syndrome. With proper planning, you can help your clients create dynasties of their own by selecting a perpetuity state and by proper allocation of the GST exemption.

John S. Budihas, CLU, ChFC, CFP, is a business, estate and trust planning consultant for Hartford Life Insurance Company in Sarasota, Fla. He can be reached via e-mail at [email protected]

Reproduced from National Underwriter Life & Health/Financial Services Edition, November 7, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.