Very wealthy and sophisticated clients deserve only the very best and most sophisticated planning techniques. Not only do they deserve these techniques, they need them. The federal estate and gift tax system is designed to tax the wealthy on the transfer of assets from one generation to another, during life and at death.
The tax system has limited exemptions for both lifetime transfers and transfers at death and those exemptions do not increase with the size of an estate: the bigger the estate, the larger the tax. The primary objective of most sophisticated wealth transfer plans is to transfer as much wealth as possible to the intended beneficiaries, paying the least amount of estate and gift tax possible. A major part of the implementation is to use the available exemptions in the most beneficial way possible.
Following are summaries of sophisticated strategies that may benefit some of your ultra-wealthy clients. Strategy #1: Dynasty trust planning
A “dynasty trust” is an irrevocable trust designed to last for as long as possible under the state perpetuity laws. In some states a trust can be established to last forever. It is called a “dynasty trust” because, when properly structured, it can create a family dynasty that can last for many generations.
This strategy is attractive to the ultra-wealthy for several reasons. First, it appeals to their sense of well-being by ensuring that future generations remember them and their accomplishments. Second, the strategy can yield significant tax benefits because, when properly structured, the assets in the trust avoid estate taxes at every generational level.
Under current law, each individual is allowed a generation skipping transfer tax (GST) exemption in the amount of $2 million; married couples have a total of $4 million. People may allocate their GST exemption amount at death or during life. However, because the federal lifetime gift tax exemption amount is only $1 million per person, most married couples chose to use only $2 million of the exemption during their lives. Any remaining GST exemption can be allocated to assets at death.
Of the different ways to fund a dynasty trust, the easiest is to gift $2 million to the trust. Once the trust has the money, it may purchase life insurance to leverage assets in the trust. The life insurance can be purchased on the grandparents or parents, which can increase what the grandchildren get, but will probably limit the benefit of the trust to the parents/insureds.
Depending on the size of the estate and the individual considerations of the clients, they may only want to use a portion of their lifetime gifting exemptions for this strategy. The rest of their exemptions can be used for other strategies. If they are interested in creating a “dynasty trust” with significantly more assets, they may want to explore Strategy #2.
Strategy #2: Sale of assets to an Intentionally Defective Grantor Trust
An intentionally defective grantor trust (IDGT) is an irrevocable trust designed to be effective for estate and gift tax purposes (i.e., it is outside the estate) but defective (i.e., ignored) for income tax purposes. Under this strategy, one client is the grantor (creator) of the trust. He or she will gift a significant amount of money (typically about 10%) of what will be transferred to the trust.
Let’s assume that your client “seeds” the trust with $1 million. The same client then sells $10 million of assets to the trust for a note, leaving the trust with $11 million of assets. All the growth on the assets, over and above the interest due on the note, is outside the estate and goes to benefit the trust beneficiaries. Interest due on the note is usually set at the appropriate applicable federal rate (AFR) for the term of the note, which the IRS publishes monthly.
For this strategy to be effective, the assets inside the trust must appreciate (or generate income) at a rate above the interest amount due to the grantor on the note. Clients could also consider selling assets that have a discount associated with them, typically limited partnership interests, non-managing LLC interests or non-voting S-corporation stock.
For example, let’s assume that the $10 million of assets purchased by the trust represent limited partnership interests, discounted at 30%. That would mean that the underlying assets in the partnership could be worth $14,285,714 if the partnership is liquidated. Assuming these numbers, the grantor would have (before growth) transferred $4,285,714 of assets from his or her estate.
Furthermore, to meet the current long-term interest rate of 5%, the trust assets would only have to generate about 3.5% of income annually. Excess earnings on the trust property could be used to buy life insurance, the proceeds of which could be then used at death to repay the $10 million loan, thus leaving the other assets intact and eliminating the need to liquidate the partnership. If the note is repaid before the death of the insured, the life insurance proceeds enhance the plan by adding to the amount of wealth transferred.
The only gift necessary for this strategy is the seed money, thus making it an effective gift tax leveraging strategy. Furthermore, generation transfer tax exemptions can be allocated to the initial seed money to make the trust a dynasty trust–a very big dynasty trust!
Strategy #3: Private split-dollar with Grantor Retained Annuity Trust rollout
This strategy yields maximum gift tax leverage and enables clients to purchase large amounts of life insurance with only minimal gift tax consequences.
First, the clients set up an irrevocable life insurance trust (ILIT). The trustee purchases a survivorship life insurance policy for a specific amount of death benefit. The life insurance trust then enters into a private split-dollar agreement with the insureds. Under the agreement, the insureds are entitled to an interest in the policy equal to the greater of their premiums paid or the total cash value of the policy.
The insureds pay most of the premium and the life insurance trust pays only a small fraction of the cost (derived from IRS Table 2001 or an alternate term rate of the insurer). Because the trust is only responsible for a fraction of the premium, only minimal gifts are required and significant gift tax leverage can be accomplished. In fact, it is sometimes possible to structure the trust’s share of the premium to be lower than the allowable annual gift tax exclusions.
At the same time the clients create the life insurance trust and enter into the split-dollar arrangement, they create a grantor retained annuity trust. A GRAT is a specially drafted trust whereby the grantor retains an annuity (generally, a fixed annual payment) for a number of years and the trust is entitled to whatever property is left at the end of that annuity stream.
For gift tax purposes, the value of a gift to a GRAT is determined by subtracting the actuarially determined value of the annuity from the full value of the property contributed. By creating an annuity stream valued at an amount equal to the value of the property contributed to the GRAT, it is possible to fund a GRAT without any gift tax liability (most of the time the annuity stream is valued at slightly less than the full value of the property so that a gift tax return is required and the statute of limitations will begin).
In this strategy, the remainder beneficiary of the GRAT is the life insurance trust involved in the split-dollar agreement with the insureds. Assuming the assets transferred to the GRAT appreciate in value, there may be significant assets left when the annuity stream ends.
At the end of the annuity stream, the assets left in the GRAT will pour over to the life insurance trust. The trust will then use all or a portion of the GRAT assets to roll out (repay) the insureds their interest in the life insurance policy. End result: the insurance policy should be fully funded and outside of the estate.
The primary advantage of this strategy is gift tax leverage. Unfortunately, there are complex tax rules that make this strategy unattractive for generation-skipping tax (GST) purposes.
Strategy #4: Private foundation
Given the limited number of estate tax exemptions and deductions available, there will very likely be some level of estate tax levied upon the estate, unless the estate is transferred to a charity. The ultra-wealthy are prime candidates for setting up their own charities, termed private foundations. By establishing a private foundation, clients are afforded the choice of paying tax to the government or giving money to a charity that perpetuates their charitable beliefs.
Because the amount of the estate that is transferred to charity does not pass to the family, clients may want to replace the value of the assets given to the charity with life insurance. Some clients can simply use their annual exclusions and/or lifetime gift tax exemption to fund an irrevocable life insurance trust (ILIT) to replace the assets.
However, it is unlikely that the annual exclusions and lifetime exemptions would provide enough insurance for many high net worth clients. For these clients a private foundation serves as a complement to the strategies discussed in this article.