There are now more than 9 million millionaire households in the U.S., including families with $5 million to $25 million in net worth, the Federal Reserve reports. That’s twice as many as a decade ago, and the number is growing every day.
Increasingly, these new millionaires are baby boomers in their 40s and 50s, and a growing number are even in their 20s and 30s. Many of them want to use their wealth to make life better for their families–not just their children, grandchildren and great grandchildren, but their parents as well.
Those with very significant net worth often use dynasty trusts to transfer wealth to both succeeding and preceding generations. Boomers are not only concerned about their heirs, they’re also concerned about their parents’ well-being later in life. A survey sponsored by Putnam Investments found that 1 in 5 adults aged 45 and older support their parents financially. Boomers are providing that support while also caring for children and sometimes grandchildren, making them the main course within the “sandwich generation.”
Including parents as current beneficiaries poses some complications when designing and implementing a dynasty trust. However, the core advantage of creating a dynasty trust remains the same: maximization of the generation-skipping transfer tax (GSTT) exemptions so as to eliminate estate taxes at all future generational levels for as long as possible.
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Affluent people who want to see their families enjoy their generosity sometimes elect to fund their dynasty trust with a “gift and note sale” strategy. Under this strategy, the grantor of the trust typically uses some or all of his lifetime gift tax exemption to seed a trust with an initial gift. Generation-skipping tax exemptions are allocated to the initial gift to avoid the imposition of any possible generation-skipping transfer tax. After the trust is seeded, the trustee purchases other assets, typically at a discount, from the grantor in return for a note.
It’s important to structure a grantor trust so there is no gain upon the sale of the assets to the trust and to prevent the interest paid by the trustee to the grantor from being interest income. Any potential income tax liability is avoided because the grantor of the trust remains liable for the income tax on the trust assets. In layman’s terms, the trust is respected as a separate entity for estate and gift tax purposes but is ignored for income tax purposes.
The transfer tax benefits of a gift-and-note sale strategy are almost entirely dependent upon the appreciation and income of the assets sold to the trust. If the assets that were sold to the trust outperform the interest rate on the note, wealth is passed to the trust. Therefore, careful consideration should be given to the type of assets purchased for the trust in order to minimize the likelihood of the trustee being unable to meet its interest obligation.
Family limited partnership (FLP) units or non-voting S-Corporation stock are often the preferred assets to be sold because their value can often be discounted for a lack of control and/or a lack of marketability; and they often have steady and predictable income.