Disinherit the IRS with Year-End Tax Tips

Estate tax expert and author E. Michael Kilbourn today outlined a series of tax issues that investors need to understand as the year comes to an end.

According to Kilbourn, a “net investment income tax” (Obama Care/Medicare tax) is imposed on taxpayers with investment income (i.e., unearned income) whose modified adjusted gross income exceeds certain IRS set thresholds.  Commonly referred to as a Medicare contribution or surcharge, this tax is in addition to taxes imposed on a taxpayer’s earned income to fund social security and certain Medicare benefits. This net investment income (NII) tax is equal to 3.8% times the lesser of:

– The taxpayer’s net investment income, OR
– The excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount (e.g., $200,000 threshold for individuals, $250,000 threshold for married couples filing joint returns)

The NII tax of 3.8% also applies to most trusts and estates, and it is on the lesser of:

– The trust’s or estate’s undistributed net investment income, OR
– The excess of AGI over the dollar amount at which the highest income tax bracket applicable to a trust or an estate begins ($12,150 for 2014)

Because the surtax kicks in at $200,000/$250,000 of AGI before deductions, and the new 20% capital gains rate applies at $405,100/$457,600 of taxable income after deductions, anyone who faces the 20% rate must be subject to the surtax, for an actual rate of 23.8%. For those in the wide middle brackets – and subject to the 15% long-term capital gains rate – the Medicare surtax might apply (bringing the rate up to 18.8%).


In addition, Kilbourn warns taxpayers to be aware of the phase out of personal exemptions and itemized deductions for high-income taxpayers: If an a taxpayer’s AGI exceeds $254,200 for individuals and $305,050 for married filing jointly the phase outs are as follows:

– “Pease limitation” on itemized deductions
– Itemized deductions phased out by 3% of income over above threshold, up to 80% of total deductions
– Losing 3% of deductions at 33% rate equals a 1% increase in the tax rate
– Personal Exemption Phase out (PEP)
– Personal exemptions are phased out by 2% per $2,500 over above threshold, up to 100% of exemptions
– Marginal impact also approximately 1% increase in tax rate per exemption

To take advantage of capital gains and losses on stock sales for 2014, shares must be sold by December 31, 2014.  Be sure to take into account the capital gains rates and the 3.85 NII tax  – both discussed above. Kilbourn suggests examining your 2014 short-term gains and losses and long-term gains and losses and determining your capital gains and loss carry-forwards to ensure that you aligning them to the greatest extent possible.  Note that you may be able to use up the $3,000 of net capital losses to offset ordinary income for 2014 as well. Review with your advisors whether accelerating deductions into 2014, or postponing them to 2015, makes the most sense.

Do not forget about the Alternative Minimum Tax (AMT), he said. The AMT imposes a minimum tax rate over certain taxable income thresholds.  The exemption amounts for this year are $52,800 for individuals and $82,100 for married couples filing jointly, but note that these exemptions begin to phase out when alternative minimum taxable income reaches $117,300 for individuals and $156,500 for married couples filing jointly.  If you are subject to AMT and have the ability for defer income from 2014 to 2015 – to get below the threshold, consider deferring if you may not be subject to AMT in 2015.  If you are not subject to AMT, consider accelerating the types of income (i.e., exercising incentive stock options) that would have negative AMT consequences.  Also, consider accelerating deductions (i.e., property tax payments) that would not provide an equivalent tax benefit in a year in which you were subject to AMT.

To avoid capital gains taxes and the 3.8% surtax on net investment income, he suggests considering gifting appreciated property to charity (as opposed to selling the property and recognizing the gain, and contributing cash to charity).  You get an income tax deduction equal to the fair market value of the property (subject to AGI limitations), and the charity can sell the property and pay no capital gains because it is a tax-exempt entity.  It is critical that the appreciated property qualify as long-term capital gain property (held for more than one year); otherwise, your deduction will be limited to your basis in the property.

Understanding Life Insurance

Life insurance is based on the statistical odds that one person among a group of insureds will die. Life insurance is simply a group of people sharing the same risk and funding the dollars needed when a member of the group dies, which gives rise to the analogy of a lottery winner—only in this case—eventually, everyone wins. The first to die are paid by the last to die. So, let’s consider a group of a thousand men who are each 45 years old. Insurance company mortality tables assume that they are all in good health today, but project that none will live to age 100. The mortality chart shown in Table 5-1 predicts the chances of a person’s death in any given year between ages 45 and 100.

Let’s assume the money earns no interest. If all participants die according to statistical probability, and each member contributes the appropriate amount, there will be enough funds to pay each participant’s beneficiaries his or her share of the account. Those who die early will benefit most on the basis of the ratio of their contribution to the proceeds. Those who die later will still receive proceeds, but they will have paid more compared to those who died early.

When interest earnings are factored in, the last to die will still have to pay more into the fund than the first. However, the compound interest earnings will offset the need for them to place the full value of their expected benefits into the pot.


The Cumulative Cost

Many people don’t count the cost of insurance over an extended period of time—they only focus on the cost today! However, what happens when you add up the total cost of insurance (the mortality costs) from today until life expectancy?

Assume you are part of a group of 45-year-old males. The sum of the mortality costs to life expectancy is 74.7 percent of the face amount for a 45-year-old male. So, if you wanted to own $1 million of insurance starting today and you paid the annual mortality costs every year until your life expectancy, you would pay $747,000.

This cost has been measured for over 20 major insurance companies and the cumulative rates all come out within dollars of each other. Actuaries (the mathematicians trained to calculate the cost of insurance) all work from the same base of statistics. Every insurance carrier must mathematically be near the same target; a carrier that isn’t has violated the fundamental theory of risk sharing.

But let’s look at what happens if you are unfortunate enough to live until two-thirds of the initial group is dead. This is called the first standard deviation from the mean. The standard deviation is the next statistical breaking point from the average age of death (usually 6 to 8 years later). Let’s add up all the mortality costs for $1 million of insurance at one standard deviation. The total equals 119 percent of the face amount. That’s right—you would have to pay $1,196,000 for $1 million of coverage if you died at the two-thirds point.

It gets worse. What if you should live two standard deviations (when 95 percent of the group is dead) beyond the mean? The ratio of mortality costs to benefits increases to 240 percent. That means you have paid $2.4 million for $1 million of insurance. It’s expensive to live a long time if you want to retain your insurance.


Consequences of Aging

What would you do if you were 80 years old and your insurance premium notice came in the mail telling you to pay $150,000 this year for your $1 million policy? Most people would say they wouldn’t pay it and would throw the notice away. They would let the policy lapse and laugh at the absurdity of paying $150,000 that year. However, let’s change the scenario. Suppose you just came back from your physician and knew you had only 6 months to live. Now what would you do?

The ability to choose to keep your policy on the basis of health conditions creates adverse selection against the insurance company. Deciding whether to keep the insurance solely on the basis of probability of death ruins the mathematical principle. Insurance must have statistical randomness to protect the integrity of the product. There must be an incentive for healthy insureds to stay in the pool.

In the early 1800s, only people who were near dying retained insurance. And because there were no healthy insureds left to pay premiums, what happened? If you guessed bankruptcy, you are correct. Virtually all insurance companies now in business started after 1820. That’s because so many of the older companies went out of business due to this adverse-selection problem. So the insurance companies called in the actuaries and told them to solve the problem. The actuaries sat with their abacuses and determined there was only one solution—the box.


The Box

The actuaries developed a solution that made retaining lifelong insurance possible: Insurance companies had to help insureds prefund their insurance premiums so they could afford to retain their coverage throughout their lives. As you have seen, if they only offered insurance premium plans on a pay-as-you-go basis, no one would ever be able to keep his or her insurance in old age.

That’s where the box comes in. The box is an individual account in an insurance policy. It holds all the premium payments the insured makes. From the box, the insurance company pays the annual cost of insurance (mortality costs) and policy expenses.

Unfortunately, the cost of funding the box without interest was still too expensive. So the actuaries had to add an interest element to the box. The insurance company invests the premiums it receives (net of expenses) and then allocates the net earnings to the box after management fees. The amount allocated varies according to the insurance contract.

In 1913, Congress passed the Sixteenth Amendment, authorizing the collection of income taxes. The insurance industry successfully sought regulatory relief to allow the money in the box to grow without tax. Thus, the government actually subsidizes the cost of insurance as a contribution to the welfare of society.


Box Designs

Once the concept of the box was developed, insurance carriers began to design different configurations. A policyholder could purchase an insurance contract, which required premiums for specific periods, say, 20 years or until age 65. As the market developed different needs, the carriers responded with appropriate policy designs. One type is called whole life. The premiums are fixed on the basis of a guaranteed interest rate the carrier is offering in the box.

Any excess interest earnings, adjustments to mortality experience and expense loads are credited and debited to the box through dividends. These dividends combine the earnings and costs together in one amount. This is often referred to as the bundled approach.

In the 1980s and 90s, most insurance carriers expanded their portfolios to include a product that allows the policyholder to determine the amount of premium and frequency of payment. This policy is called universal life. Although universal life can be mathematically designed to look more favorable than whole life (you pay a lower premium for the same coverage, for example), remember that the box still needs the same amount of money to accomplish the same objective over the same period of time.

It is important to understand that, if all the assumptions for whole life and universal life are the same (i.e., mortality table, expense loads and interest credit rate), the cost should be the same and the outcome should be the same. With whole life, there is little control over these assumptions and the premium is fixed according to the guaranteed interest rate in the contract.

With a typical universal life policy, the premium is based on the projected interest rate over the lifetime of the policy contract. If the guaranteed rate is 4 percent for a whole life contract and the projected rate is 6 percent for the universal life contract, then the annual premium you would pay will be lower for the universal life policy. Why? It is assumed that the higher interest earned in the box will make up the difference in premium deposits. However, when you factor in the dividend credit for the whole life policy, which will match the 6 percent performance of the universal life policy, both approaches should end up economically the same.

The main difference between whole life and universal life is the flexibility the policyholder has to skip premiums if he or she can’t afford to pay them in one or more years. However, this freedom may ultimately jeopardize the goal of lifetime coverage if insufficient premiums have been deposited—this would defeat the entire purpose of using the box in the first place.

If the projected lump-sum value of the box falls below the target, the insurance carrier is unable to fulfill the terms of the contract. Either the policy will be discontinued or the annual funding amounts will need to be increased. This is true for both universal and whole life policies, although individual companies deal with the problem differently.

If you have a whole life policy, you can be underfunded if you borrow too much from the box, fail to pay the interest on the policy loans or fail to pay your scheduled premiums.

With universal life, you become underfunded by failing to have enough in the box to pay the annual mortality costs. Ultimately, the result is the same. The policy will be canceled for insufficient funds.

There are many reasons why advisors favor one type of insurance over the other. However, in the end, the box must have enough money to pay the mortality costs or you will be faced with paying them yourself.


Types of Insurance Policies

There are five basic types of policies: Whole life, Universal life, Variable life, Indexed life and Term life. Each has a distinct purpose and the decision regarding which will work best depends on your personal situation and goals.

Whole life—sometimes called ordinary life, straight life or permanent insurance— is a traditional insurance policy designed to help consumers handle the high cost of insurance in later years when premiums would otherwise become prohibitively expensive to match the increasing risk of death. By averaging out premium costs and amortizing them over the projected lifetime of the policy, whole life guarantees a continued death benefit for the insured’s entire life. The fixed annual premiums are usually level for the life of the insured and are based on the insured’s age and health at the time the policy is issued.

Universal Life – universal life insurance was developed to overcome the primary disadvantages of whole life insurance. It is another type of cash-value-building policy that provides extreme flexibility by giving the policy owner (i.e., you, your spouse, your children or your trustee) the ability to set and vary premium levels, payment schedules and death benefits, within certain limits. This increased flexibility makes it easier to adapt universal life policies to changing needs and financial conditions. Like whole life, a portion of each premium goes to the insurance company to pay for mortality—the “pure” cost of insurance. The amount of premium paid in to the universal life contract that exceeds the pure cost of insurance plus company expenses is credited back to the policy owner with interest.

Variable Life – variable life insurance offers all the flexibility that universal life provides but with a unique difference: Cash values are invested in a separate account instead of the insurance company’s general account, at the policy owner’s direction. The separate account is made up of a variety of pooled investment divisions that are similar to mutual funds. The policy owner chooses among the various funds offered by the insurer, so investments can be concentrated in a separate account of common stocks, bonds and other assets that are more volatile, but may provide higher long-term results than does an insurer’s general account.

Indexed Life – indexed life insurance, sometimes known as equity-based life, is another form of the previously discussed universal life. Actually, all universal life plans are, in essence, “indexed.” The vast majority are indexed to the general account earnings of the insurance company selling the product. The insurance company collects your premium, deducts some expense charges and cost-of-insurance (mortality) charges and, then, puts the rest of the money into its general premium investment account. Next, this account is invested by the company’s investment department, usually into several different types of investments.

Term Life – Many people have purchased term life insurance it because it offers substantial benefits at low cost. However, as its name suggests, term insurance is beneficial only for a specific period of time or term. For example, a term insurance policy with a decreasing face amount may be ideal for protecting a young family while there is a mortgage on their home.

Multiple Life Policies – most policies are written on a single life, but there are situations in which a policy can and should cover more than one life. A policy covering two lives is known as a survivor or second-to-die life insurance policy and is typically used to insure a husband and wife, to provide liquidity at the second death and to cover taxes and other expenses. A second-to-die policy could also be used in business situations.


How To Buy Life Insurance 

Besides selecting the type of insurance and options you want, important considerations include how to find appropriate financial advice and how to evaluate specific insurance companies. In addition, you should understand how your age and health enter into the calculation of your premium and how the companies vary in their assessment of those factors in making insurance offers. There are many variables to consider before purchasing insurance.

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Protect Your Assets with a Charitable Remainder Trust

 Jeannine and Robert Dell have been retired for almost 10 years and now are very active as volunteers for various charities. This brings a great deal of joy to their lives. Robert spends two days a week building homes for the poor through Habitat for Humanity. He is also a member of the board for the Special Olympics. Jeannine is very active in the American Cancer Society as chairperson for the Special Events committee. Both of the Dells are active in their church.

Even though the Dells have a sizable stock portfolio, the income from their investments is not sufficient to allow them to contribute money to their favorite charities while maintaining their lifestyle. They were unwilling to sell any of their stocks to make charitable donations partly because they dread the idea of paying capital gains tax. So, in their estate plan they included a charitable bequest to be paid at the second death. This will allow them to benefit their charities, but they were still concerned about having enough assets to both provide for their children and satisfy their charitable intent.

When they learned a charitable remainder trust would help them sell their highly appreciated assets without capital gains tax, provide them with a much greater income, save taxes and create a lasting charitable legacy, they were ecstatic! They were even happier to learn that, with the addition of a wealth replacement trust, they could do everything without reducing the estate they planned to leave to their children.

As incredible as it may sound, it is possible to benefit yourself, your family and society at large. This synergy can be created through the use of a charitable remainder trust (CRT). A CRT is an irrevocable trust that receives gifts of property—usually appreciated stock, appreciated real estate—or other assets, such as artwork. The donor of the property typically designates him- or herself as the trustee. The donor and spouse generally are the income beneficiaries of the CRT for their lifetimes. This allows the donor-beneficiary to retain control of, and receive income from, contributed assets. Once transferred into the CRT, the assets are free from the claims of creditors. Upon the death of the income beneficiaries, any assets left in the CRT are distributed to one or more charities.

Individuals have long used CRTs to avoid capital gains taxes on the sale of highly appreciated assets. The flexibility of a CRT, however, can help you accomplish a wide variety of personal and financial goals. Properly structured, a CRT can protect your profits and gains, increase your income while reducing income taxes and estate taxes, eliminate property management headaches, diversify your investments, lower your financial risk, increase amounts left to your heirs, help you direct your social capital and make a lasting difference in your community.


Setting Up a CRT

There are two main steps in creating a CRT. First, work with a knowledgeable attorney to establish a CRT that will qualify under the Internal Revenue Code as a charitable trust that is exempt from taxation. Second, give one or more assets, such as highly appreciated stocks and/or real estate, to the trust. This transfer creates an immediate income tax deduction that you can use in the current tax year. If you cannot use all of the allowable deduction immediately, you can carry the deduction forward for five additional years. The total amount of the allowable deduction depends on the interest payout you have selected (usually between 5 and 12 percent), the government discount rate at the time of the transfer, and the term of the trust. This can be for one or multiple lives or for a term certain of no more than 20 years, but is usually the life expectancy of you and, if married, your spouse. Also, the amount you can deduct is limited to a percentage of your adjustable gross income (AGI). For example, if you contribute appreciated property to your CRT and have named one or more public charities as the remainder beneficiary, your deduction is limited to 30 percent of your AGI for that year.

After transferring your appreciated property to the CRT, you, as trustee, would typically sell the property (taking care to avoid any prearranged agreements) and reinvest the proceeds—perhaps in a variety of assets to obtain the benefits of diversification. Selling the contributed asset is often recommended for two reasons:

  1. Highly appreciated property, such as stocks, typically provides very little income.
  2. You avoid all capital gains tax when you sell the appreciated asset in the trust because of the tax-exempt status of the CRT.

This strategy allows you to reinvest the full amount of the sale proceeds rather than the net amount after tax, as would be the case if the property were sold without the CRT. The ability to reinvest the full value of the contributed assets into higher-yielding investments may increase your cash flow substantially.

When the trust is first established, you select the percentage of payout. This must be done carefully because once you choose the percentage it cannot be changed. The percentage selected must be at least 5 percent of the value of the assets in the trust. The actual dollar amount paid to you will be the value of the assets in the trust, as revalued each year, multiplied by your chosen payout percentage.

It might seem that selecting a higher percentage would produce a better financial result; however, this is not necessarily the case. A lower percentage creates a larger tax deduction, which puts money in your pocket immediately. Additionally, any earnings of the trust above the selected payout percentage accumulate tax-free and are added to the principal. Over time, a lower percentage payout can often produce more total income.

You can also select the charities that will benefit from the trust. You can name any number of charities when establishing your CRT and change them at any time. You may even choose your own family foundation or a donor-advised fund of a public charity (such as a community foundation) along with or in place of other charities.

Upon the death of the last income beneficiary, trust assets are distributed to the selected charities. Assuming the CRT is properly structured, no estate tax will be due.


Types of CRTs

There are three main types of CRTs:

1) Charitable Remainder Unitrust

In a charitable remainder unitrust (CRUT), distributions are based on a percentage of the value of the trust assets (the percentage chosen at inception). Each year, the value of the trust’s assets is re-determined and as the value of the assets fluctuate, so do the annual unitrust payments. This approach provides some protection against inflation, but it also presents some risk because the annual payments will be less than expected if the trust’s assets lose value.


2) Charitable Remainder Annuity Trust

In a charitable remainder annuity trust (CRAT), the amount of the payout is fixed. The payout selected must be between 5 and 50 percent of the amount contributed and there is no need to revalue the assets in the trust (as in the case of a CRUT) each year. If the income of the CRAT is less than the annual payout, the balance of the mandatory distribution is taken from principal.


3) Net Income with Makeup Charitable Remainder Unitrust

For those who do not need immediate income from the appreciated assets they contribute, a special type of CRUT is available. This variation of the standard CRUT is known as a net income with makeup charitable remainder unitrust (NIMCRUT). With a NIMCRUT, each year the trust pays to the donor the lesser of the unitrust amount specified in the trust document or all the trust’s income for the year. When the trust’s income is less than the unitrust amount, the trustee creates a “makeup account” for the amounts that remain unpaid each year based on the percent chosen times the trust value. This account accumulates (an accounting notation) until the trust’s actual income exceeds the chosen percentage payout, at which time the beneficiary receives the additional income. This arrangement continues as long as there is an accumulation in the makeup account.

To minimize the trust’s income (while it is not needed), the trustee invests the proceeds from the sale of contributed assets into non-income-producing investments such as zero-coupon bonds, variable annuities, growth stocks or raw land. Since these assets do not usually produce income, there is no annual payout and no income tax. When the donor desires the income, the trustee sells the investments and purchases income-producing assets such as bonds.

NIMCRUTs are commonly used for retirement planning. A person could make annual deposits of cash or other assets (i.e., appreciated assets) of any amount to a NIMCRUT and let the assets appreciate tax-free until retirement. When the donor retires, the trust’s investments would be repositioned to generate income. This arrangement avoids the restrictive Employee Retirement Income Security Act (ERISA) rules on qualified plans and enables the donor to retire at any age and start taking the income without penalty. Furthermore, there is no restriction on the amount that can be set aside, yearly or otherwise, when using this plan as a retirement strategy and it can even generate a small annual deduction based on a percentage of amounts contributed each year.



The grantor of a CRT is entitled to a deduction for assets that are contributed to the trust. The amount of the deduction is based on several factors: the term of the trust; the ages of the income beneficiaries if the payout is for life; the applicable federal rate at the time the assets are transferred to the trust; and the payout rate chosen by the grantor. Depending on these factors, the deduction can range from 10 to 60 percent of the value of the contributed asset or more.

Assets contributed to a CRT and subsequently sold will avoid tax on any gain that is realized. Losses, however, are not deductible. The income generated by a CRT is free from taxation while it is in the trust. When distributions are made, the amounts paid out are taxed on the basis of their makeup and a four-tiered accounting system that calls for ordinary income first, capital gains second, tax-free income third and return of principal last.


Wealth Replacement Trust

After you irrevocably place assets in the CRT, your heirs are effectively disinherited from receiving that property. Thus, a wealth replacement trust (WRT) is in order. A WRT is an irrevocable life insurance trust created to benefit your heirs. The grantor of the WRT funds the trust with a portion of the additional cash flow generated from the CRT and/or the tax savings generated by the charitable income tax deduction. After the grantor contributes funds to the WRT, the trustee purchases life insurance on the grantor to replace the wealth represented by the assets given to the CRT. In many cases, this strategy generates a larger inheritance for the grantor’s heirs than they would have received if the assets transferred to the CRT had remained in the estate and been subjected to estate taxes. In some cases, the income tax savings alone are enough to cover the cost of an insurance policy that replaces the full value of the assets. This means that the children will end up with more than they would have received otherwise and the IRS effectively pays the cost in the form of tax savings.


Estate Protection

In a recent estate planning case, a woman complained about the amount of estate taxes that would be due on her $22 million estate, which was made up primarily of one stock she had inherited from her father. The stock had gone up in value substantially in recent months. In fact, the woman remarked that her $10 million in stock value had increased nearly 22 percent in the prior two months (to $12.2 million). Her basis in this stock was very low, so she hesitated to sell any of the stock because of the income taxes that would be due. She transferred shares representing just the increase in the stock over the previous two months ($2.2 million worth) into a CRUT with a 10 percent ($220,000) payout. By doing this, the woman would avoid capital gains taxes on the sale of the stock and have enough income from the trust, after income taxes, to purchase a $6 million insurance policy that could be used to pay the estate tax on her entire large estate. Her decision to adopt the strategy was made easy when we discussed the many charitable causes she could help. In addition, by arranging to fund a family foundation with the proceeds of her CRT at her death, she could designate her grandchildren and future generations of her family as trustees—to run the foundation and carry on her charitable legacy, possibly for decades.

Through the use of charitable planning, the woman was able to use the recent appreciation in her stock to offset the estate taxes on her entire estate. In addition to the fact that her children will inherit her total estate intact, she received a current income tax deduction that generated sizable tax savings which she used to provide additional gifts to the current charitable causes important to her (see Figure 17-2).

Shortly after she completed the plan, the market value of her stock dropped over 35 percent from its high when she made the transfer and received her deduction. Thus, 35 percent of the stock value that created the funds to pay her estate taxes and create the charitable legacy would have disappeared had she procrastinated.


Private Family Foundation

With a CRT, you have unlimited choices regarding the charity (or charities) you name as the beneficiary and, if the trust is designed with you as trustee, you can change the beneficiary at any time. One option is to name a private foundation as the charitable beneficiary. A private foundation is a legal entity that qualifies under the Internal Revenue Code as a charity. Assets donated to the foundation (directly by you while you are alive and/or from your estate or CRT at your death) can accumulate and be disbursed (5 percent minimum per year) to other qualified charities in accordance with your wishes as outlined in the foundation documents. By creating a private foundation, you can direct your social capital long after you are gone and, if you desire, can include family members in the process. A private family foundation can focus on the interests of your children along whatever charitable lines you choose, keep future generations of your family together by uniting them at least annually for trust decision making and raise the standing of your descendants within their respective communities. Also, your children are entitled to be paid for their work in serving as trustees of the foundation.

Although a private foundation offers several benefits, it also has drawbacks. These include excise taxes on the net investment income of the foundation, burdensome recordkeeping and reporting requirements, a limitation on the amount of your deductions and other restrictions.


Donor-Advised Account

An excellent alternative to the private foundation is a donor-advised account of a community foundation or some other public charity. Donor-advised accounts operate much like private foundations: family members are able to direct the income and principal of the account, but they do so under the guidance of a host public charity or community foundation. This arrangement provides many of the benefits offered by a private foundation but costs substantially less to set up and administer. For most donors who want their families involved in their philanthropy, this alternative makes the most sense.disinheritfig 17-2.jpg

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Family Limited Partnerships and Family Limited Liability Companies

Don and Kate Bell had a typical estate planning problem. They were making maximum use of their gift tax exemptions with annual gifts of cash to each of their three children and seven grandchildren. However, given their large estate of over $20 million, they wanted to do more. They had already used up $1 million of their lifetime gift tax exemptions ($500,000 each), so they were limited to giving approximately $9 million more unless they also wanted to pay gift taxes.

The Bells were also concerned about making gifts of nonliquid assets, such as real estate. Such assets are not easily divisible. Don did not want to sell off his real estate, which had a low cost basis, and then end up paying capital gains tax as well as gift tax. Also, the properties were in excellent locations, increasing in value and producing a substantial amount of income, so selling now would not be wise. Don was successful because of his knowledge of real estate and his excellent management skills, so he wanted a plan that would allow him to stay in control of his real estate.

The Bells were introduced to the idea of a family limited partnership and learned how it would not only allow them to make leveraged gifts but also leave them in control of their money for their lifetimes. In addition, Don would be able to continue to collect a management fee if he felt he needed the income. As a bonus, the family limited partnership plan provided excellent protection for the assets in the partnership from the claims of creditors.

In 1953, Sam and Helen Walton put what little they had into a family partnership that included their four children. They called their partnership “Walton Enterprises.” From this partnership the well-known chain store, Walmart, evolved. Eventually, the partnership assets grew and included real estate, banks and a newspaper. In 1985, the Walton family’s wealth was estimated to be $20 to $25 billion. But when Sam Walton died in 1992, he owned only a 10 percent interest in Walton Enterprises. He had used a family partnership to transfer assets that grew to over $18 billion to other family members without gift or estate tax. To Sam Walton, the gift of a business opportunity to a loved one was much more valuable than a gift of cash. With a flat rate of 55 percent at the time of Sam Walton’s death, this advanced planning saved approximately $10 billion in estate taxes.

When individuals own business or investment assets whose value is high enough to potentially subject their estates to federal estate taxes, they are faced with the unappealing option of giving assets away at a substantial gift tax cost and, thus, giving up the income stream generated by the assets. By transferring these assets to one or more partnerships, individuals can maintain control of the assets and continue to receive at least a portion of the income and tax benefits of those assets. At the same time, they can give family members the assets in a tax-efficient manner and reduce—and in some cases even eliminate—the potential for federal estate taxes. If you would like an effective way to protect family assets and keep them where they belong while avoiding estate taxes, a family limited partnership may be for you.



A family limited partnership (FLP) offers the following benefits:

Allows the general partner (including the parents, for example) to remain in control of partnership assets, investments and distributions, even if the general partner share is 1 percent or less.

Creates a vehicle for transferring substantial amounts of wealth to family members at discounted values, significantly reducing estate and gift taxes.

Eliminates potential estate taxes on the appreciated value of partnership interests given to family members or to trusts for their benefit.

Ensures continuity of family management and an orderly transition from one generation to the next.

Provides a potential way to fund an insurance policy to help cover estate tax costs without having to use gift tax exemptions or pay gift taxes.

Provides income to the general partner through management fees and partnership distributions.

Provides a way to split income among family members.

Protects assets from the claims of creditors.

To different individuals, some of these benefits are more important or appealing than others. However, virtually everyone who is interested in estate planning wants to control assets and protect them from creditors. These are two of the most compelling reasons for using a family limited partnership.


FLP Basics

Although an FLP can be a complex planning strategy, the basic concept is relatively simple. Here, in essence, is how an FLP works:

  1. A husband and wife have business or investment assets (such as real estate) that they would like to share with other family members (children, grandchildren, parents, siblings) or even a favorite charity, but they still want to maintain control over these assets.
  1. A qualified attorney who is experienced in the preparation of FLPs and estate planning prepares a limited partnership agreement and a certificate of limited partnership for the couple.
  1. The certificate of limited partnership is then filed with the appropriate state agency. The filing, registration or recording fees vary from state to state costing from as little as $50 to as much as $5000…or more.
  1. Usually, at least initially, the husband and wife (or a trust, corporation or limited liability company controlled by them) serve as the general partners of the FLP.
  1. The couple transfers some of their assets to the FLP in exchange for both general partnership and limited partnership interests. A qualified appraiser then appraises these interests and, if necessary, the underlying assets of the FLP. The appraiser values the limited partnership interests on the basis of the terms of the FLP agreement and the types of assets in the partnership. Usually, the value of the limited partnership interests is substantially less than the value of the partnership’s assets, because the appraiser discounts the value of the limited partnership interests for lack of control and lack of marketability. These discounts can range from 25 to over 50 percent depending on the partnership agreement and the assets held in the FLP.
  1. If they choose, the general partners, who are also limited partners, give some or all of their limited partnership interests away. The gifts are usually made to family members, trusts created for family members, charities or short-term split-interest trusts, such as grantor retained annuity trusts or charitable lead trusts.
  1. The value of the gifts of limited partner interests is subject to the discounts determined by the appraiser. These discounts leverage the giving ability of the husband and wife, so larger gifts can be made on the basis of a discounted, or lower, value for gift tax purposes.
  1. No matter how small a percentage the general partners own, they always have full control over the day-to-day management of the FLP and the assets in it. In fact, the general partners determine if and when any distributions of income are made.
  1. General partners are entitled to a reasonable management fee for their management of the partnership. The fee varies depending upon the duties of the general partner, but typically ranges from 1 to 5 percent of the value of the assets in the FLP.


Partnership Classes

A family limited partnership is a legal entity formed under a state’s partnership laws. It consists of two classes of partners. The first are the general partners, who have total control of the day-to-day management of the partnership and are completely liable for the management obligations, debts and liabilities of the FLP regardless of their percentage ownership, just as if they owned the assets outright.

The members of the other class are the limited partners. They have no control over, or participation in, the day-to-day management of the FLP regardless of their percentage of ownership. Because of the lack of control, under state law they do not have any personal liability exposure for any of the obligations, debts or liabilities of the FLP. A limited partner’s exposure to loss is generally limited to the extent of his or her investment in the FLP.


The General Partner

Because the general partner controls the operation of the limited partnership regardless of the percentage ownership, the old control rule of 51 percent majority is really not applicable or necessary. Even a general partner with an interest of less than 1 percent still maintains 100 percent control.

An individual can be the general partner or several individuals can be the general partners. The downside to having individuals as general partners is the exposure to unlimited liability for the obligations, debts and liabilities of the partnership. Whether this is a problem depends on the nature of the partnership’s assets. If, for example, the FLP owns assets such as rental real estate, rental aircraft or any asset that could potentially cause a personal injury, the liability exposure of the general partner can be substantial. On the other hand, if the FLP owns only intangible assets (such as stocks, bonds or mutual funds), the general partner’s liability exposure is very limited. With intangible assets, the general partner’s only serious liability is for debts incurred by the partnership. Another potential problem with having individuals as general partners is that individuals die or can become incompetent. Most states’ laws provide that a limited partnership will terminate upon the death or incapacity of all the general partners.



Partnerships normally do not pay federal income taxes. Nonetheless, partnerships must still determine their taxable income, which is computed in basically the same manner as it is for individuals. Because the partnership does not pay income taxes, the partners are responsible for paying income taxes on partnership income. Tax liability accrues to the partners of an FLP even if income is not actually distributed to them. Generally, the partnership agreement controls the allocation of taxable income, loss, deductions and credits. When a partner is a member of the partnership for only a portion of the tax year, he or she is allocated only the portion of such items attributable to his or her tenure.

For income tax purposes, all items passed from the partnership to its partners retain the same character they had for the partnership. As an example, if the partnership receives tax-exempt income, the partner’s share of that income is also tax-exempt. The partner’s distributive share of such items as income credits, deductions and nondeductible partnership expenses is identified on IRS Schedule K-1 of Form 1065. The partners receive individual copies of Schedule K-1 to allow them to prepare their individual 1040 income tax forms.


Life Insurance

If an FLP owns and is the beneficiary of any life insurance on the life of a partner, the insurance death benefit will be included in the partner’s estate indirectly in an amount determined by the current value of the deceased partner’s partnership interest. So, if a deceased partner’s interest is 10 percent, the amount of death benefit included in the estate is equal to 10 percent of the proceeds.

To avoid inflating the deceased insured’s partnership interest by any portion of life insurance proceeds, a life insurance policy may be structured with adult children as owners from the policy’s inception. Alternatively, the children could create an irrevocable life insurance trust (ILIT) with each child contributing his or her pro rata portion of the life insurance policy’s annual premium from distributions from the FLP. Through an ILIT, the children, as grantors, could protect the policy’s cash value in the event of a grantor’s divorce or death. Trust design could also help ensure that policy proceeds would be available to help cover liquidity needs created by estate taxes at the death of the parents.


The Family Limited Liability Company Alternative

Legal developments can sometimes take a while to catch on with the public and limited liability companies represent a good example. Most states adopted laws allowing the creation of limited liability companies in the 1980s; but, until the IRS signaled their acceptance and courts confirmed their asset protection benefits, most attorneys continued to recommend using family limited partnerships for planning purposes. However, in recent years, the use of family limited liability companies (FLLCs) in place of family limited partnerships (FLPs) has become common, if not the norm.

While the benefits achieved by FLLC planning are the same as with FLP planning, FLLCs often require only nominal state filing fees compared to FLPs. Additionally, rather than requiring a general partner to serve and accept potentially unlimited liability for partnership liabilities, an LLC has no general partner. Instead, the LLC is typically managed by a designated manager who accepts no personal liability for LLC liabilities. As a result, there is no reason to create an entity (LLC, corporation or trust) to serve as the general partner.

Through careful planning, the same discounts for lack of marketability and lack of control achieved with FLP planning can be achieved through FLLC planning, with potentially less administrative expense and fewer complexities.


Planning Risks

Family partnership arrangements have been coming under greater scrutiny as their use has increased in recent years. The Internal Revenue Service will disregard a partnership as an entity if the principal purpose of the partnership is tax-motivated either at inception or during its operation. Thus, in the formation of an FLP, it is important to have a “business purpose” and to have the documents prepared by an attorney who specializes in estate planning and FLPs so that they will withstand any scrutiny by the IRS.


The costs involved in forming and maintaining an FLP should be considered, including:

– Attorney fees for forming the partnership and handling related legal matters (e.g., transferring assets).

– Appraisal fees for underlying assets and for the interests of the partnership given to the younger-generation family members.

– Continuing administrative fees and expenses for matters such as the FLP’s yearly income tax return (1065 partnership return and partnership K-1 forms).

– Transfer tax costs, such as documentary stamps when transferring real property into the FLP, and, possibly, title insurance costs.

– Registration fees, which, depending on the state in which the FLP will be registered, can range from $500 to over $5,000.

FLPs #1



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8 IRA Mistakes That Could Hurt Your Retirement

Today’s complex rules governing IRA agreements may impact your distribution options and estate tax requirements. In developing your retirement strategy, it is crucial that you and your advisor review the terms of your plan(s), especially your beneficiary-designation election. It is crucial to take the time to meet with your attorney and financial advisors to discuss how your choice of beneficiaries will fit into your overall estate plan. Through proper planning, you can ensure the maximum flexibility for yourself and, more importantly, your heirs—allowing them to stretch out the distributions and associated taxes over their lifetimes. Careful planning will help to ensure that you avoid the eight most common planning mistakes.


Not planning for the impact of estate taxes and income taxes.

Under the tax code, IRA assets are classified as “income in respect of a decedent.” As such, they do not get a step-up in basis at death. Thus, IRA assets are subject not only to estate taxes but also to income taxes. With proper planning, the income taxes can be spread over the life of the beneficiaries, but, unless the IRA is bequeathed to charity, the taxes must eventually be paid. One of the best ways to offset the taxes that will occur after death is to take a portion of the income (i.e., 1-3 percent) from the IRA to purchase a life insurance policy on the IRA owner or the owner and his or her spouse (survivorship policy) to cover the taxes.


Not being aware that estate taxes on the amount of the decedent’s IRA are deductible from the beneficiary’s income taxes.

Under Section 691(c) of the Internal Revenue Code, the beneficiary of an IRA can deduct the estate taxes that were attributable to the decedent-owner’s IRA from his or her income tax return. The deduction is available until used up, starting with the first distribution. This deduction often neutralizes income taxes on the minimum distributions taken by the beneficiary in the first few years after the death of the IRA owner. This is often overlooked by beneficiaries who end up unknowingly paying nearly 80 percent in combined taxes on IRA distributions.


Failing to name a beneficiary of your IRA.

Failing to name a beneficiary often means your estate becomes the beneficiary. It also means your IRA must either be distributed under the 5-year rule—if you die before your required beginning date (RBD), or over your remaining life expectancy under the IRS single life expectancy table based on your age in the year of your death (using the fixed-term method)—if you die after your RBD.


Not utilizing a custom beneficiary designation form.

IRAs are governed by a beneficiary designation form, not by your will. The form is filled out when the account is set up; IRA owners rarely have a copy of the form and it is not unusual to find that even the original has disappeared. A custom beneficiary designation form designed by your attorney will not only help you and your IRA custodian avoid misplacing information regarding your choices but will also help ensure that your IRA goes to the correct beneficiaries in the amounts and way you intend. Furthermore, a properly drafted beneficiary designation form will provide for alternative beneficiaries (i.e., grandchild) in the event one of the primary beneficiaries disclaims their share of the IRA.


Naming several beneficiaries to a single IRA account.

This could cause the youngest beneficiary to take out his or her share more rapidly than necessary. This is because the calculation that determines the required minimum distribution schedule for all the beneficiaries is based on the age of the oldest beneficiary. If one of the beneficiaries is a charity, the problem is worse. Because a charity has no life expectancy, the IRA must be emptied either under the 5-year rule—if death of the owner occurs before the owner’s RBD—or over the owner’s remaining life expectancy under the IRS single life expectancy table based on the owner’s age in the year of death (using the fixed-term method)—if the owner dies after his or her RBD. The best strategy is to divide the IRA into different accounts and name one beneficiary for each account. Alternatively, the beneficiaries will have a chance to divide the IRA into individual accounts for each beneficiary if it is done by September 30 of the year following the owner’s death—a step that can be easily overlooked.


Rolling out money from a qualified retirement plan to an IRA without getting a spouse’s written consent.

In certain qualified retirement plans, such as a defined benefit plan, if the plan participant is married and rolls out more than $5,000 from his or her plan, the law requires that the owner have spousal consent to do so. Without a signed spousal consent form, the entire distribution will be taxable.


Naming a trust as beneficiary without knowing all the consequences.

Most trusts qualify as beneficiaries of an IRA. However, several pitfalls await those who do not understand certain rules. For example, the IRA minimum distribution rules override trust rules, so, if an IRA doesn’t pay its required distribution to the trust (as beneficiary) every year, a 50 percent penalty (of the underpayment) is imposed. Also, if a trust receives the full minimum distribution from an IRA but does not pay it out to the beneficiaries because of a limitation in the trust, the payment will be subject to the much higher trust tax rates.


Failing to coordinate IRA withdrawals with Social Security benefits.

To maximize retirement income, it often makes sense to delay Social Security benefits until age 70 and draw from an IRA at retirement, if earlier. This accomplishes two things: it reduces the size of the IRA and it allows the retiree to receive a guaranteed 8 percent increase in their Social Security Benefits. This strategy could yield substantially more in retirement and is especially attractive when there is a younger spouse in good health.

Advantages of an Intentionally Defective Grantor Irrevocable Trust

Joseph and Ann Sullivan had been to an attorney who recommended that they use a grantor retained annuity trust to reduce their estate in order to pass a valuable piece of income-producing commercial real estate to their daughter, Becka. They were hesitant about the attorney’s plan because, if they died during the term of the trust, the trust would terminate. The property would be back in their estates and they would not accomplish their goal. In addition, they would not be able to include generation-skipping provisions in the trust with a grantor retained annuity trust, so the property would be subject to another layer of tax in Becka’s estate.

The grantor retained annuity trust would not address their concerns. A better solution was available through the use of an intentionally defective grantor irrevocable trust. Not only would this trust allow them to transfer any future appreciation to their daughter (effectively freezing the value of the real estate in their estate), but also the plan would take effect immediately. As a result, they would have a way to substantially leverage their generation-skipping exemption and the trust would provide an opportunity for additional significant planning benefits.

One of the primary goals of any good estate plan is to reduce your exposure to taxes while leveraging your gift, estate and generation-skipping tax exemptions.

Grantor retained annuity trusts (GRATs) hold assets and pay income to you as the grantor for a specified term. At the end of the term, the assets pass to your children or selected beneficiaries. Because you retain a right to income from the GRAT, as long as the assets’ growth exceeds the income payment, you are able to leverage your giving ability by discounting the value of the gift assets—thereby reducing any taxes due on the gift.

Another type of grantor trust that provides an opportunity for leveraging and receiving tax benefits, while keeping the trust property out of your estate, is the intentionally defective grantor irrevocable trust (IDGIT).

As part of the Internal Revenue Code since 1954, grantor trust rules stipulate that, if a trust document contains certain provisions, the trust’s income will be taxed to the trust’s creator—the grantor—rather than to the trust itself. Congress devised the rules thinking no sensible taxpayer would want to pay a trust’s tax bill, especially because individual tax rates at that time were higher than trust tax rates and the grantor cannot be a beneficiary of a grantor trust. But now, income tax rates are much lower than they were in 1954 and, thus, for someone focused more on estate taxes, a grantor trust, an IDGIT, can substantially increase the wealth passed to heirs.


IDGIT Basics

An IDGIT is simply a type of irrevocable trust drafted to trigger the grantor trust rules and force the grantor, rather than the trust, to pay income tax on trust income. That’s the “intentionally defective” part. Assets are moved into and become owned by the trust. The positive result is that those assets, and their future appreciation, are outside the grantor’s taxable estate. Paying the income tax on the trust’s annual earnings further reduces the grantor’s estate while netting another benefit: 100 percent of the earnings can accumulate inside the IDGIT, to the advantage of the trust beneficiaries, who are typically the grantor’s children.

Because the IRS requires that the grantor pay the trust’s tax, that payment is a legal obligation, not a gift, so no gift tax applies. In effect, value is shifted to the trust beneficiaries at the grantor’s income tax rate. This is preferable to having the IDGIT or its beneficiaries pay the income tax while leaving value in the grantor’s estate that would later be subject to estate tax.

Drafting the trust to be defective (so that it triggers the grantor trust rules) is a simple matter for a knowledgeable attorney. One way to do this is to provide that trust principal or income may be distributed to the grantor’s spouse. This arrangement has no estate or gift tax significance, but it automatically makes the trust a grantor trust.

Another way to accomplish this is to specify that the grantor retains the power to reacquire the trust corpus by substituting other property of equivalent value or by giving someone other than the grantor or current beneficiary of the trust the power to expand the class of beneficiaries. Such power is sometimes given to the grantor’s accountant or attorney and, even though the power may never be exercised, the grantor trust rules are triggered.

A good attorney will also provide an element of control by making it possible to “turn off” the grantor trust status, in case paying tax for the IDGIT becomes a financial burden for the grantor. This can sometimes be accomplished by giving a power holder (such as the accountant or attorney in the previous example), the right to renounce the power.


Selling Assets to an IDGIT

A grantor can transfer assets into an IDGIT by either gift or sale. Making a gift consumes the grantor’s various exemptions, but, if the grantor sells an asset to the IDGIT, there is no gift and therefore no gift tax. Furthermore, there is no recognition of gain and, thus, no capital gains tax when assets are sold to an IDGIT. For tax purposes, selling an asset to an IDGIT is the same as selling an asset to oneself: no tax.

If you have highly appreciated assets you would like to remove from your estate, you could possibly avoid all capital gains taxes as well as gift taxes by selling the assets to an IDGIT that you create. To leverage the transaction, the IDGIT could pay for the assets in the form of an installment note, payable over several years. The Internal Revenue Code allows you to charge a relatively low rate of interest on the installment note. This is a decided advantage, as it enables an IDGIT that is earning a market rate of return to invest the cash flow in excess of the low-interest note payments so that it can accumulate and grow and eventually be used to pay back the note principal. Also, because of the grantor trust rules, you do not have to recognize the interest on the note. So, there is no tax deduction for the trust and there is no taxable income for you, the grantor, for interest payments on the note from the trust. However, you are still liable for taxes on the income earned by the IDGIT, including any income earned by property sold to the trust.

The excess income over the note payments may be high enough to allow you to further leverage the value of the IDGIT through the purchase of insurance or some other growth vehicle. In addition, because the grantor pays the income taxes on trust income, the trust’s return is enhanced for the beneficiaries of the trust. Best of all, the payment of income taxes by the grantor is not considered a gift for transfer purposes.

To qualify for charging a low interest rate (such as the federal mid-term rate), the note will usually be written to last from three to nine years (referred to as a “mid-term” note as it is neither short-term nor long-term). Also, it should be properly documented with reasonable terms. It is a good idea to have separate representation of the grantor and the IDGIT, including actual negotiation of the terms of sale.



In many respects, a sale of assets on an installment note to an IDGIT is similar to a gift of assets to a GRAT. In a GRAT, the present value of the annuity payments to the grantor reduces the amount of the taxable gift, but the annuity payments, if not fully consumed, return value to the grantor’s estate. In an installment-note sale to an IDGIT, principal and interest on the note are paid back to the grantor over time and this also returns value to the grantor’s estate. However, when structured properly, using the following techniques, this repayment can be a substantially reduced amount. This, in turn, leaves more for heirs.


The Seed Gift

To help support the installment note and the viability of the strategy, it is advisable for the grantor to make a small seed gift to the IDGIT. It is generally recommended that this gift be at least 10 percent of the value of the assets to be sold. The seed property is important because the trust needs to have a measure of independence from the grantor. Also, it should not appear that the income distributed from the property sold to the trust is the sole source of funds being used to service the entire note. If the seed gift is too small, the IRS may treat the sale as a gift (not a desired result).


Sale of a Discounted Asset

The benefit of the IDGIT strategy can be further enhanced if the grantor utilizes the valuation discounts that are available for certain assets including shares in a corporation, units in a limited liability company or family limited partnership interests. Nonvoting shares, limited liability company units or limited partnership interests are given or sold to an IDGIT at their value as determined by a valuation professional. Generally, the fair market value of such interests is adjusted downward from their pro rata value of the underlying assets of the business entity. This is due to valuation discounts resulting from either lack of control, lack of marketability, or both—relative to those interests. If the interests are sold to an IDGIT, the valuation adjustment reduces the principal amount of the note while increasing the effective yield to the trust from the true value of the underlying assets.


Leverage with Life Insurance

The real power of this strategy comes when the trustee of the IDGIT uses the excess income created in the IDGIT to purchase life insurance. The income earned by the IDGIT over and above the amount needed to pay the installment note can go toward life insurance premiums on the life of the grantor, a beneficiary or some other relative. The premium payments will not result in gift taxes because the premiums are paid from trust income. The amount of insurance purchased can be substantial and can significantly increase the value of the trust assets that will eventually pass to the beneficiaries.

For example, Molly and Rick Crall (ages 70 and 66, respectively) were made aware of the fact that the anticipated excess income on the assets in their IDGIT would support a premium of $125,000 ($200,000 – $75,000) without the extra cash flow achieved through discounting or $155,000 ($200,000 – $45,000) with discounting. The smaller premium amount would be sufficient to fund a second-to-die insurance policy with a death benefit of approximately $6 million and the larger a death benefit of approximately $8.5 million, on Rick and Molly Crall (based on good health ratings and current assumptions of interest, mortality and expenses). On the death of the couple, the entire death benefit plus the value of the assets in the trust, including any direct gifts, would be available for the beneficiaries and exempt from both estate and GST tax.

Even without the discounted-sale approach, if Rick and Molly died immediately after repayment of the note at the end of year nine, the IDGIT would hold assets with underlying values in excess of $7.7 million ($1,400,000 appreciation on real estate + $390,000 seed capital and appreciation on seed capital + $6,000,000 insurance), 30 times the amount originally given as seed money to the trust and upon which the GST election was based. In other words, the $7.7 million is available for multiple generations with no further gift, estate or GST taxes, and only $250,000 of Rick and Molly’s combined $10.68 million GST tax exemption (as of 2014) was used. If Rick and Molly were to use the discounted sale approach, the total value transferred is substantially higher at more than $11.2 million.


Planning Risks

The income tax consequences of the premature death of the grantor are unknown. If the grantor dies while the installment note remains unpaid, the grantor’s estate may owe income taxes on any unrecognized gain in the transferred assets. The premise is that the IDGIT is no longer a grantor (defective) trust at the time of the grantor’s death. Therefore, the grantor’s estate would be taxed on the gain attributable to the unpaid portion of the note. On the other hand, it can also be argued that the grantor’s death should not be treated as a taxable event and the tax basis in the transferred assets would be carried over to the trust or its beneficiaries in the event of a subsequent sale. Whether gain should be recognized upon a grantor’s death is an unresolved issue at this point. However, in many instances the prospect of income taxation will not be significant to the beneficiaries of the IDGIT. In any event, if the beneficiaries sell assets, they would be subject to capital gains tax.

Another possibility is that the note will be considered what is called income in respect of a decedent, in which case the recipient of the note payments is subject to income tax on the remaining payments. Thus, like a GRAT, the note term should not extend beyond the grantor’s life expectancy; if it does, adverse tax consequences may apply. It is also possible that the grantor’s death will have no adverse income tax consequences. This is an unsettled area of the law.

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The Value of a Dynasty Trust

With five children and 10 grandchildren, Joseph Newman thinks of himself as a patriarch. Like many hardworking Americans, Joe and his wife, Deb, were interested in an estate plan that provided for more than one generation of their heirs. At their first meeting with a member of the Wealth Protection Network® team, much of the discussion centered on how to provide for their 10 grandchildren. The Newmans were disturbed to learn that not one but two taxes would apply to any sizable gifts (above their gift tax exemptions) made directly to their grandchildren.

It was estimated that at the moment Joe and Deb passed away, 40 percent of their estate would be lost to estate taxes. They were outraged when they realized that the IRS would confiscate another 40 percent when the remainder of their estate passes from their children to their grandchildren. Without a plan, the Newmans’ estate would be worth less than 22 percent of its value today after only three generations of taxation.

The Newmans were pleased to learn that, by setting up a trust and funding it while they are alive, the trust would enable them to leverage their various exemptions and avoid the estate taxes that would be due at each generation. Through dynasty trust planning, their estate remains intact for the benefit of their children, grandchildren, great-grandchildren and even later generations. In addition, Joe and Deb learned that the dynasty trust also protects the assets they leave in the trust for their heirs from the claims of creditors, predators and divorcing spouses.

If your years of hard work and diligent savings have yielded some wealth, the thought of having the IRS take a large bite (up to 40 percent) of these assets may be very painful. Unfortunately, as the wealth passes down the family tree, successive application of estate taxes may significantly erode the amount that later generations will inherit.

If you want to leave tax-free wealth to your children, grandchildren and future generations, consider using a generation-skipping trust. The name belies the true value of the trust because the only one that is “skipped” is the IRS. Therefore, a more appropriate name is the dynasty trust (also referred to as the D trust or descendant’s trust). Coupled with life insurance, the dynasty trust becomes a powerful tool for maximizing wealth for generations to come.

Consider the radically different results for the grandchildren in the following two examples, in which a grandfather wants to transfer $15 million:

No planning: At the grandfather’s death, federal and state death taxes reduce the $15 million by approximately $4 million. If the after-tax wealth passes to his daughter and remains intact during her lifetime, at her death the remaining $11 million will be further eroded by approximately $2.4 million in estate taxes, leaving a balance of $8.6 million for her children. Thus, the $15 million that the grandfather had at his death has been reduced to $8.6 million by the time it reaches his grandchildren. Because of the generation-skipping transfer (GST) tax, even if the grandfather left his entire estate directly to his grandchildren, they would receive only $8.6 million. This is true even if the grandfather took advantage of his GST tax exemption of $5 million ($5.34 million, indexed for inflation, as of 2014).

Comprehensive planning with a dynasty trust: To avoid the large estate tax bite for two successive generations, the grandfather leverages his GST tax exemption of $5 million ($5.34 million, indexed for inflation, as of 2014) through a dynasty trust. The terms of the trust allow the trustee to distribute trust property to his daughter, as needed, but the trust is not subject to estate tax when his daughter dies. After the daughter’s death, the property remains in trust for the benefit of her children and their descendants. With this planning, the grandfather is able to pass approximately $11 million (possibly more, due to growth) to his daughter, grandchildren and great-grandchildren.

Under federal and many states’ laws, all assets are subject to estate taxes when they pass from generation to generation. A dynasty trust, however, is designed to maximize your available estate and GST tax exemptions and keep assets from ever being subject to gift, estate or generation-skipping tax.


Dynasty Trust Basics

A dynasty trust is an irrevocable trust created for the benefit of the grantor’s descendants (children, grandchildren and so on) to which the grantor allocates all or a portion of his or her GST exemption. If the grantor is married and his or her spouse participates in making transfers to the trust, a total GST exemption of approximately $10 million (subject to previously noted increases) is available.

Once exempt from GST tax, the trust property, and all appreciation in value and income, remains free from further federal transfer taxes for the life of the trust. It is also free from the claims of creditors. Given the effects of compounding, a successfully invested trust can accumulate to a value of tens of millions of dollars, available to future generations of beneficiaries undiminished by estate or generation-skipping tax costs.



The primary objectives of a dynasty trust are:

– To receive cash or other assets as gifts that can be invested, used to pay the premiums of life insurance, or both, on either or both the grantor or the grantor’s spouse.

– To escape gift, estate and generation-skipping taxes on the assets and any growth therein (such as insurance proceeds) for the life of the trust.

– To maximize and leverage the available GST exemption amount, without paying gift tax, by investing in growth stocks, and similar instruments, or by purchasing life insurance on the life of the grantor or the lives of the grantor and his or her spouse, or both of these.

A dynasty trust permits wealthy individuals to preserve and create wealth to provide a lasting legacy for future generations. This is accomplished by transferring property to a trust for the longest possible period of time and structuring the trust so that no part of the principal that remains in trust will be included in the estate of any descendant.


Leveraging Your Exemption

A dynasty trust may be created during the grantor’s lifetime or at death. The advantage of the GST exemption is magnified if it is used during life because, once property is transferred to a dynasty trust within the exemption, all appreciation and accumulated income generated by the property is exempt as well. As a result, in most cases the trust holds more property when the grantor dies than could be placed into the trust within the exemptions at the grantor’s death.

By transferring property to a dynasty trust during life, the grantor makes a taxable gift, which may require the grantor pay gift taxes. In order to avoid gift taxes, many individuals prefer to fund a dynasty trust with gifts shielded from tax by using their annual gift tax exclusion amount ($14,000 per beneficiary in 2014) and/or their available lifetime exemption.


Benefits of a Dynasty Trust

A properly executed dynasty trust will provide several advantages for trustees and beneficiaries as it can:

– Receive cash or other assets as gifts that can be invested for the benefit of several generations of family members, free from the claims of creditors;

– Avoid gift, estate and generation-skipping transfer taxes on the assets and any growth thereon for the life of the trust; and

– Maximize and leverage the available GST exemption amount, without paying gift tax, by investing in growth stocks and the like and/or by purchasing life insurance on the life of the grantor or the lives of the grantor and his or her spouse.


Continuity of Exemptions

In addition to avoiding gift or estate taxes on the trust asset’s appreciation and accumulated income, lifetime funding of a dynasty trust offers other benefits. Because a dynasty trust is irrevocable, future changes in the transfer tax laws should not affect it. Thus, the grantor is assured of receiving the benefits of the GST exemption and any lifetime exemption amounts used in funding the trust, and those benefits should not be eliminated if the exemption is reduced in the future. As the GST exemption is adjusted, as noted earlier, it is possible to add to the trust beyond the initial GST tax exemption ($5.34 million in 2014, indexed for inflation annually). Of course, the income taxation of the trust income will be subject to the income tax laws and any changes to those laws.



To avoid the higher income tax rates that apply to trust income, the trust can be drafted so that any trust income is taxed to the grantor while alive. This is accomplished by designing the trust as a grantor trust subject to the IRS’s grantor trust rules. This provides an added benefit for the beneficiaries, as the trust can retain and invest funds that would have otherwise been paid out for income taxes.


Disadvantages of the Dynasty Trust

As with all planning strategies, there are a few drawbacks associated with an estate plan utilizing a dynasty trust. Because the dynasty trust is irrevocable, it is essential that both the grantor and his or her advisors have a clear understanding of its operation in light of the objectives involved before implementing a dynasty trust.

One problem with a dynasty trust is the grantor’s loss of income and net worth when he or she funds the trust. Once gifts are made to a dynasty trust by the grantor, the assets and the future income from them are irrevocably gone. However, a married grantor may name a spouse as a beneficiary of his or her dynasty trust, thereby benefiting indirectly from the trust as long as that spouse is alive. Thus, even though the dynasty trust is often referred to as a generation-skipping trust, it doesn’t have to skip or disinherit anyone.

Another drawback is the administration required with a dynasty trust. Choosing the right trustees and ensuring compliance with the rules regarding demand-right, “Crummey” beneficiaries is critical. In addition, the monitoring of life insurance and/or other investments owned by the trust is important to ensure that the goals of the dynasty trust are met.


The Rule Against Perpetuities

A dynasty trust is typically structured to continue in existence for the maximum period of time permitted under applicable state law. In most states, this legal maximum is limited by a doctrine known as the rule against perpetuities. Under this rule, the typical trust must come to an end after about 80 to 100 years. Thus, state law effectively limits the estate tax, creditor and divorce protection benefits of the trust vehicle to this period of time. At the end of the period, trust assets must be distributed and will be subject to estate or gift taxes—which often results in family holdings being sold. For example, the sale of the Boston Globe was prompted by the expiration of family trusts that had owned the newspaper since 1872.

Some states have adopted a statute that allows for a flat period of 90 or more years before a trust must terminate. Although it is not necessary for a dynasty trust to continue for the full 90 years, by doing so, the trust property can be sheltered from transfer taxes for the longest possible time. States that have adopted a flat period of years (from 90 years to 360 years, depending on the state) include: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Florida, Georgia, Hawaii, Indiana, Kansas, Massachusetts, Minnesota, Montana, Nebraska, Nevada, New Jersey, New Mexico, North Carolina, North Dakota, Oregon, South Carolina, South Dakota, Tennessee, Utah, Virginia, Washington and West Virginia.

States that have abolished the rule against perpetuities include: Alaska, Idaho, Kentucky, New Jersey, Pennsylvania, and South Dakota. Therefore, trusts created and/or administered using one of these state’s laws may continue forever and grow without the threat of the federal transfer tax system consuming a huge portion of trust assets. Other states have drastically increased the number of years before a trust must end. For example, Florida permits trusts to last for 360 years.

Of the states that have eliminated the rule against perpetuities, Alaska and South Dakota give a dynasty trust the best edge because they have no state income tax. In addition, Florida does not have a state income tax. If the trust is set up in one of these states, more of its income can stay in the trust without being subject to state income taxes so the trust will grow even faster.

As you can see, the state where the trust is set up can make a big difference.

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Dynasty Trusts #2