C—The Insurance Funded Family Bank

The disturbing uncertainty that now exists for estate planners, given the on-again—off-again—on-again status of future estate, gift and generation-skipping transfer (GST) taxes has been well documented. As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, these taxes are scheduled for gradual reduction over the next several years, with total repeal in 2010, and full reinstatement in 2011 (at 2001 tax levels). It is almost universally believed that this obviously irrational schedule of changes will be further revised at some future point. All of this, of course, places estate plans at risk of becoming out of date as the rules continue to change. This state of affairs warrants a re-examination of the “family bank” or “dynasty” trust as a vehicle for multi-generational family wealth transfer without regard to transfer taxation.

Avoidance of Tax Uncertainty Through the Irrevocable Trust

An important strategy for elevating an estate plan above the vagaries of a shifting set of tax rules is the irrevocable trust. Among other important benefits, the transfer of assets during lifetime to an irrevocable trust for the benefit of the grantor’s heirs will provide transfer tax certainty: the transfer will be subject to gift tax when made, but the amount of the available exclusions, exemption and tax rate will be computable with certainty as part of the planning process. (By contrast, if the subject assets are retained by the grantor or placed in a revocable trust, the eventual income tax/transfer tax burden, and the net amount available to the heirs, will be dependent upon conditions existing as of the date of death, including the then value of the assets—and the then state of the estate tax and GST tax rates and exemptions.)

Assets held in an irrevocable trust are not subject to estate tax upon the death of the grantor. The GST tax is also not applicable at that point unless a grandchild or great grandchild accedes to a current interest upon the grantor’s death (as explained in more detail below). Thus, the trust may continue for the current benefit of the surviving spouse and the children, and the future benefit of subsequent generations, without regard to the state of the transfer tax law as of the grantor’s death. The need for constant updating of an estate plan, as the law changes—and the risk of unexpected death prior to updating—are eliminated with respect to assets removed from an estate by lifetime transfer to an irrevocable trust.  Of course, the irrevocable trust is not a panacea. The element which is critical to estate tax avoidance—absence of control by the grantor—is precisely the factor that makes such trusts objectionable to some estate planning clients. However, the new reality of instability in the estate tax rules now becomes an added factor which could tip the scale in favor of the irrevocable trust, despite the control issue: at least the tax consequences will be predictable. And proven techniques are available to mitigate the loss of control.

How Long Can Transfer Taxes Be Avoided This Way?

If, at the time of the irrevocable trust grantor’s death, the current income interests in the trust are acceded to by the grantor’s children, and not by any grandchildren (or members of any generation below that of the children), there will be no transfer tax triggered by the grantor’s death. However, as explained below, the GST tax will come into play any time that a member of a generation two or more generations below that of the grantor (e.g., grandchildren and great grandchildren) accedes to a current interest in the trust. On the other hand, even the GST tax may be permanently avoided if the trust is made GST tax exempt through application of the available GST tax exemption. Thus, transfer taxes can be avoided through several generations, as long as the GST-exempt trust is allowed under state law to remain in existence--and in some states such trusts are allowed perpetual life.

What is a Family Bank?

From this contextual background emerges the concept of the “family bank,” an irrevocable trust designed to create a pool of wealth that can benefit a family through multiple generations without diminution at each generational level by the normal wealth transfer taxes; i.e., the gift tax, estate tax and generation-skipping transfer tax. It is referred to as a family "bank" because, like a bank, the trust is a prime resource for the funding of the particular needs of the various beneficiaries in successive generations. Based upon its potential for compound growth of asset value over several decades for the benefit of a particular family, the family bank trust is sometimes referred to as a "dynasty trust." Because one of the principal planning elements is the avoidance of the generation skipping transfer (GST) tax, a family bank is also sometimes referred to as a "GST exempt trust."

How It Works

The basic concept is quite simple: The founder of the trust (the grantor) causes a trust to be created and transfers assets to the trust. The trust instrument spells out in detail who the beneficiaries are to be, their respective rights to benefits, how long the trust is to remain in existence, and what happens to trust assets when it terminates, several generations later. The principal challenges to achieving optimum long‑term results are the following:

·         avoiding or minimizing gift and/or estate tax on assets transferred into the trust.

·         avoiding or minimizing the generation skipping transfer tax potentially applicable with respect to distributions received by trust beneficiaries who are two generations or more younger than the original grantor`s generation.

·         structuring the trust to last as far into the future as possible, to benefit as many successive generations as possible, without violating the rule against perpetuities, if applicable.

Potential Long-Term Benefits

With the maximum marginal rate for the unified (gift and estate) transfer tax at 55 percent (declining in future years but not below 45 percent prior to the one-year repeal in 2010), and the generation skipping transfer tax at a flat rate equal to the maximum estate tax rate, the impact of these taxes when passing family wealth to each succeeding generation is obviously quite substantial. By avoiding these taxes through a family bank arrangement, the value of assets ultimately received by the original grantor`s distant future descendants can be several times greater than would result if the assets were passed directly, outside of the trust, to each next succeeding generation.

The Role of Life Insurance

As explained in more detail below, life insurance policies present a unique opportunity to create a multimillion dollar initial funding source for the family bank, with potentially no gift tax costs, through careful planning of gifts for the payment of annual premiums and leveraging of the GST exemption.

Understanding the Generation Skipping Transfer Tax

Perhaps the most important tax planning element in the creation of the family bank is avoidance of the generation skipping transfer tax, since this tax is potentially applicable, at a rate equal to the highest estate tax rate, to the value of any interest acceded to in the future by any grandchild of the grantor or member of a generation subsequent to the grandchildren`s generation. [See IRC §§2601-2663.]

The generation skipping transfer tax, although a separate tax from the "unified" estate and gift taxes, was instituted in 1976, retroactively repealed, then passed in 1986, as what might be considered a supplement to the basic unified transfer tax system. Given that a basic purpose of the estate tax is to impede the build‑up of massive family fortunes by imposing a significant tax on the accumulated wealth each time it passes to the next succeeding generation, the fruits of the system are reduced to the extent that a generation is skipped when property is passed.

In simple terms, if a wealthy individual passes property (at death or by gift during lifetime, or a combination) to his or her sons and daughters and they, in turn, eventually pass it to their children, the property will have been taxed twice by the time it arrives in the hands of the original donor`s grandchildren. If the original donor passes the same property directly to his or her grandchildren, it will have been taxed only once. Thus, the GST tax was instituted as a measure to avoid the loss of tax revenue resulting from such generation skipping transfers.

The GST tax is imposed on the value of a gratuitous transfer of property (whether by gift or at death) with respect to which an individual who is of a generation at least two generations younger than that of the transferor is given an interest. Such a recipient is referred to as a "skip-person," the most common examples being grandchildren and great-grandchildren of the transferor. Thus, for example, a trust which provides for the income to be paid to the grantor`s spouse for life, remainder to the grantor`s surviving children, would not involve the GST tax since there is no gift to any skip-person (i.e., no one more than one generation after that of the grantor). However, if the trust instead provided that upon the spouse`s death, the income is to be paid to the grantor`s children for life, then the remainder to the grantor`s grandchildren, the GST tax would come into play. This is because the trust creates an interest in a skip-person (one or more grandchildren of the grantor).

Since transfers to grandchildren can be made either directly or through trust arrangements in which the grandchild`s beneficial enjoyment of the property may be deferred, the GST tax is imposed at different points in time, depending on the type of transfers. There are three types of generation skipping transfers:

·         Direct Skip. A direct skip is any transfer to a skip-person that is subject to gift tax or estate tax [IRC §2612(c)]. For example, a taxable gift or a bequest to a grandchild is a direct skip. (The predeceased child exception provides that all direct skips to or for a grandchild of the transferor (or of the transferor`s spouse or former spouse) at a time when the parent of the grandchild who is the child of the transferor (or of his or her spouse or former spouse) is dead, are exempt [IRC §2612(c)(2)].

·         Taxable Termination. This involves a situation in which the original transfer created interests in more than one party, at least one of whom is a skip-person and at least one is a nonskip-person (e.g., income paid to the child (nonskip-person) for life, remainder to the grandchild (skip person)). In such a situation the GST tax is imposed upon the date of termination of the last remaining interest held by a nonskip-person, i.e., at the point when the property will pass to a skip-person (with no remaining subsequent interests in any non-skip person). In the foregoing example, the GST tax would be applicable upon the death of the child [I.R.C. §2612(a)].

·         Taxable Distribution. A taxable distribution is any distribution, other than a direct skip or taxable termination from a trust, if the distributee is a skip-person [I.R.C. 2612(b)]. For example, in a spray trust from which income or principal can be paid to children or grandchildren, any distribution to a grandchild is a taxable distribution.

Computation of the GST Tax

The GST tax is separate from, and in addition to, any estate or gift tax applicable to the property transferred to the skip-person. The GST tax rate is a flat rate equal to the highest rate in the estate tax rate schedule, currently 55 percent. Because of available exclusions and exemptions, not all generation-skipping transfers are fully taxable. The amount of the generation-skipping transfer actually subject to tax is based upon a so‑called inclusion ratio—the mechanical technique by which the GST tax $1 million lifetime exemption amount (currently $1,060,000) is utilized. [The inclusion ratio is equal to 1 minus the “applicable fraction." IRC §2642(a). The numerator of the applicable fraction is the GST exemption amount allocated to the property transferred. IRC §2642(a)(2)(A). The denominator of the applicable fraction is the value of the property transferred (with adjustment for a charitable deduction with respect to such property, and death taxes chargeable to and actually recovered from that property) IRC §2642(a)(2)(B)].  In the case of a trust, these mechanics work in such a way that the extent to which the current value of an interest received from a trust is taxed is dependent upon the extent to which the original transferor`s exemption amount was allocated to the gifts into the trust at the time they were made and based upon the property values at that time. (See example below under "$1 Million Lifetime GST Tax Exemption.")

Effect of Gift Tax Exclusion Upon GST Taxability

It is important to realize that a lifetime gift that creates an interest in a skip-person is potentially subject to GST tax even though the gift qualifies as excludable from gift taxation. In other words, not all gifts that are excludable from gift taxation (by reason of the $11,000 (as indexed) gift tax annual exclusion) are excludable from the operation of the GST tax. For example, if a donor were to make a gift of $22,000 to a Crummey trust from which the donor`s child and grandchild have Crummey powers and an income interest, each beneficiary would effectively be receiving a $11,000 gift, each of which would qualify for the $11,000 annual per donee exclusion from gift tax. However, the periodic distributions of income from the trust to the grandchild would be taxable distributions, subject to GST tax, with no GST tax benefit having been derived from the fact that the original gift was excluded from gift tax.

There are, however, certain limited situations in which gifts qualifying for gift tax exclusion are also excluded from GST tax [I.R.C. §2642(c)]. To the extent that a gift directly to a skip-person (a "direct skip") would qualify for the $11,000 gift tax annual exclusion, it also qualifies for exclusion from GST tax. A gift which qualifies for gift tax exclusion as a direct payment of educational or medical expenses of a skip-person also qualifies for GST tax exclusion. A gift to a trust, which qualifies for the annual $11,000 gift tax exclusion, is GST tax-free if the trust is for the exclusive benefit of one individual who is a skip-person, and the trust assets will be includable in such skip-person`s gross estate if the trust has not terminated before his or her death. Where the aforementioned requirements are not met, it is necessary to allocate an appropriate amount of the GST exemption, as discussed below, to annual exclusion transfers in order to exempt future generation- skipping transfers.

$1 Million Lifetime GST Tax Exemption

Each individual (transferor) is allowed an exemption from tax for up to $1 million or more in GST transfers. The GST exemption amount for years prior to 2002 is $1 million, as adjusted for inflation in years subsequent to 1997. As of 2001, the inflation-adjusted amount is $1,060,000. For the years 2002 and 2003, this amount is subject to further adjustment for inflation. The exemption amount is scheduled to increase to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009 [I.R.C. §2631(a)]. The exemption is automatically allocated to generation skipping transfers made during the transferor’s lifetime until the entire available amount is used up. Any unused balance is applied to any generation-skipping transfers made at death. In the case of an outright gift directly to a skip-person (e.g., a cash gift to a grandchild), the GST tax is applicable as of the date of the gift, and the GST exemption is allocated dollar for dollar to the amount received by the skip-person (to the extent the transfer would otherwise be taxable). At the time a transfer is made, a taxpayer wishing to preserve his or her available exemption amount for anticipated future transfers may elect to have the exemption not apply to the current transfer.

The mechanics for utilization of the exemption are more complicated with respect to interests given to skip-persons through trusts in which nonskip persons also hold interests. In essence, the allocation of GST exemption is made as to the value of property going into the trust—not to the value of interests eventually received by the skip person upon a subsequent taxable termination or taxable distribution.

Example: G creates a trust in 2001 by transferring $500,000 in marketable securities. The trust provides for the income to be paid to G`s child, C, for life, and upon C`s death, the principal is to be distributed to G`s grandchild, GC. Since an interest is created in a skip-person, a GST tax would be payable when the skip-person, GC, receives the trust property upon C`s death. However, when G makes the initial transfers of securities to the trust, $500,000 of the $1,060,000 GST exemption is allocated to this transfer. Because available exemption has been allocated to 100 percent of the gift into the trust, all future GSTs out of the trust will have a zero inclusion ratio, and thus, the entire trust is, in effect, exempted from GST tax; no portion of any future distribution to a skip-person will be taxed. (As explained earlier, the "inclusion ratio" is equal to 1 minus the "applicable fraction." In this case the applicable fraction is $500,000/$500,000, or 1. Thus, the inclusion ratio is 1 minus 1, or zero.)

Assume that when C dies, 35 years later, the trust property then passing to GC has increased in value to $4 million. This is a "taxable termination," but because the inclusion ratio is zero, no portion of the $4 million will be taxable. If G had elected not to allocate any of the GST exemption to the gift into the trust, the entire $4 million would be taxable. With an applicable tax rate of 45 percent or more, the tax savings from an allocation of GST exemption to achieve a zero inclusion ratio can be very substantial.

An additional example, with detailed comparative computations, is set forth at the end of  this Subdivision.

Importance of Leveraged Use of GST Exemption in Establishing the Insurance- Funded Family Bank

As illustrated by the foregoing example, it is generally advantageous to elect to allocate GST exemption to any transfer to a trust from which a skip person is likely to receive benefits in the future. Substantial appreciation in value over a prolonged time period can be sheltered from GST tax by allocation of GST exemption to 100 percent of the gifts into the trust. One of the most important applications of this principal is the creation of a family bank through leveraged use of GST exemption in a life insurance trust. It is generally desirable to allocate GST exemption to any transfer to a life insurance trust in which a skip-person holds a vested interest. If the interest in the insurance policy proceeds ultimately to be received by the skip-person is expected to be substantially more than the premium payment going into the trust (as is likely to be the case because insurance death benefit proceeds usually greatly exceed premium input), allocation of the exemption to the premium payment gifts will ultimately free the transfer to the skip-person from the tax, while using up an exemption amount which is only a fraction of the otherwise taxable amount. This leveraging of the exemption may be illustrated by the following example:

Example:

G establishes an irrevocable life insurance trust, which acquires a $5 million policy on the life of G. Upon G`s death, the proceeds are to be held by the trustee with the income to be paid to G`s child, C, for life, and on C`s death, the corpus is to be distributed to G`s grandchild, GC. Each year, for 20 years, until G`s death, G contributes $40,000 to the trust for the payment of premiums. Each such year a portion of G’s GST exemption is allocated to the $40,000 gifts. G dies, survived by C and GC, and the $5 million insurance proceeds are paid to the trust. Since a grandchild of G holds an interest in the trust, the GST tax comes into play, and GC, the grandchild, is a skip-person, but the tax is not imposed until C dies. At C`s death a "taxable termination" occurs, and the GST tax would be applied to the value of GC`s interest. Assuming no appreciation or decline in value of the $5 million insurance proceeds during the years that the income was paid to C, the taxable transfer to GC will be $5 million. Because GST exemption was allocated to 100 percent of all gifts into the insurance trust (a total utilization of $800,000 of exemption over the 20 years before G`s death), the inclusion ratio will be zero; thus 100 percent of the transfer out of the trust to the skip-person (the entire $5 million) is effectively exempted. If the trust were to have continued for one or more additional generations, no GST tax would ever be applicable, regardless of how much the assets of the family bank may have eventually grown, because the trust was at all times 100 percent GST tax exempt.

Duration of a Family Bank

The ultimate duration of a family bank may be limited by a “rule against perpetuities” statute in the state whose law governs the trust. The rule against perpetuities, established centuries ago as part of English Common Law, was intended to prevent an owner from effectively tying up real property ownership forever. The rule, as originally adopted in almost all U.S. states, applies to personal property as well as real estate. Although often complicated in its application to specific factual situations, the rule in general invalidates the creation of a trust unless by its terms the trust must terminate no later than 21 years plus a period of gestation (i.e., 9 months) after the death of a designated party who is alive at the time the trust is established. For example, if at the time that G creates a trust in 2001, he has any grandchildren, he could specify that the trust will end 21 years after the death of the youngest of those grandchildren. If his youngest grandchild at the time of establishing the trust was only 1 year old, and that grandchild lives to age 80 or more, the trust could remain in existence for more than 100 years (21 years after the death of the designated grandchild).

In recent years a growing list of states  (including Alaska, Delaware, South Dakota, Wisconsin, Idaho, and Maryland) have effectively eliminated the rule against perpetuities for trusts in those states.  These jurisdictions have apparently made this change in order to encourage trust business in their states.  Thus, it now appears that a family bank/dynasty trust may be established to last in perpetuity for the benefit of infinite future generations, but only if the trust has sufficient nexus with one of these states (as specified in the state`s own statutes) to qualify for governance by that state`s trust law.

Asset Protection Element in Certain States

Of the handful of states that have eliminated the rule against perpetuities, some (egs., Alaska and Delaware) have also adopted legislation enabling the establishment of so-called domestic assets protection trusts. This is a form of irrevocable trust designed to protect assets from potential creditors’ claims, while at the same time allowing the trustee to make discretionary distributions of assets back to the grantor (without triggering inclusion of the trust assets in the grantor’s gross estate under one of the “strings-attached” provisions (i.e., Code §§2036 or 2038)). If the intended federal tax effect of the asset protection element of these state trust laws eventually stands up to potential IRS scrutiny, the combination of asset protection and perpetual existence, make the establishment of a family bank in one of these states potentially very attractive. The grantor of the trust need not be a resident or otherwise connected with the state; however, it is generally required that the designated state have a substantial connection to the trust, such as the location of trust administration, domicile of the trustee, or location of trust assets at the time the trust is established. Domestic asset protection trusts are discussed on detail in Section 4, Subdivision G.

Conclusion

The foregoing examples and the detailed computations in the illustration below demonstrate the astounding tax savings which can be achieved through well planned use of the GST exemption, leveraged to shelter a growing asset pool from transfer taxes over several decades and through several generations.

Through this technique, an individual or couple can establish a "family bank" for the benefit of succeeding generations, potentially as far as great-great-grandchildren--or even in perpetuity in certain states--with potential for long-term compounded growth of the "bank`s" assets, undiminished by estate, gift or generation-skipping transfer taxes, as benefits pass through successive intervening generations.

As discussed above, the irrevocable trust and life insurance have taken on new importance in an environment of an estate tax law that has built-in changes and is likely to be subject to material, but unknown, future revisions. The traditional reluctance of individuals to lose control over their wealth during their lifetime by an irrevocable transfer will, of course, remain. However, techniques are available to provide significant measures of personal financial security and limited continuing control over ultimate disposition, even after an irrevocable transfer. These include naming of a spouse or other family member as a beneficially interested trustee with discretionary authority to distribute funds to him or her self  limited by an ascertainable standard.

Other techniques involve the law of certain states that have adopted trust legislation which permits the establishment of trusts whose assets are protected from the creditors of the grantor, but permit the trustee to make discretionary distributions of assets back to the grantor. Such trusts offer another potential avenue for mitigation of the loss of access to monies placed in an irrevocable trust for estate planning purposes (See Section 4, Subdivision G for a detailed discussion of Domestic Asset Protection Trusts).

If the carryover basis at death approach is ultimately retained in the Code, life insurance takes on considerable new importance as a vehicle for avoidance of income taxes. Thus, life insurance takes on considerable importance: both as a vehicle for passage of wealth free of the burden of a possible future carryover basis regime, and simultaneously as a funding vehicle for an irrevocable trust seeking to leverage the transfer tax exemptions in a way that  “guarantees” success in wealth transfer planning.

THE BENEFITS OF GST TAX PLANNING

Assumptions:

·         Trust earns income at 6.5% annual rate, all of which is reinvested.

·         55% federal estate tax rate in 2011 and thereafter.

·         Each generation dies 28 years after the death of the respective parent.

·         $1 million of the transferor’s exemption amount was allocated to the initial transfer creating the "Family Bank," and thus, the GST-exempt trust has an inclusion ratio of zero.

 

GST Exempt "Family Bank"

No GST Planning

Initial amount funded by grantor

$1,000,000

$1,000,000

Value after children`s generation

5,831,617

5,831,617

Minus:  Federal estate taxes (*55%)                                     

0

(3,207,389)

Net Value

                                                                                    5,831,617

                        2,624,228

Value after grandchildren`s generation

34,007,759                   

15,303,493

Minus:  Federal estate taxes (*55%)

0

(8,416,921)

Net Value

34,007,759

6,886,572

Value after great-grandchildren`s generation

198,320,235

40,159,852

Minus:  Federal estate taxes (*55%)                                     

0

(22,087,918)

NET DISTRIBUTION TO GREAT-GREAT GRANDCHILDREN:

$198,320,235    

$18,071,934

 

Calendar Year

Highest Estate and GST Tax Rates

2001

55%

2002

50%

2003

49%

2004

48%

2005

47%

2006

46%

2007

45%

2008

45%

2009

45%

2010

**One Year Repeal

*2011and thereafter

55%

**A sunset provision in EGTRRA 2001effectively repeals all of the changes as of the end of the year 2010. Unless this sunset provision is changed, the pre-EGTRRA 2001 Code provisions will all be reinstated. Thus, the estate and GST tax would be reinstated in 2011, with an exemption amount of $1,000,000 (the level to which it had been scheduled to climb by the year 2006 (under pre-2001 Act law)) and a maximum rate of 55 percent.

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