IDEAS February Make Big Gifts to a Dynasty ILIT

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1 IDEAS February 2012 Make Big Gifts to a Dynasty ILIT Summary Make big gifts to a dynasty trust and the assets will be out of the transfer tax system forever. Use life insurance for an even more effective transfer. Related Information Potential Clawback Should Not Discourage Gifts, Analysis of Selected Provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Make Big Gifts While the Exemption is $5 Million There s lots of talk about giving assets before 2012 ends, and for good reason. The amount of assets that you can give away during your lifetime without gift tax the gift tax exemption is $5.12 million in Typically, that puts the assets in the hands of the next generation. While that s definitely a step in the right direction, it will one day create an estate tax problem for those in the next generation to the extent they don t consume the assets transferred. What if you could avoid this tax at every future generation? What if you could give $5.12 million to a trust $10.24 million if you re married and the amount of that gift, and whatever amount those trust assets grew to, would never again be subject to gift tax, estate tax, or generation skipping transfer tax? You can, and this trust is called a dynasty trust. Theoretically, it could last forever, never ending and never dumping the assets into the laps of the beneficiaries. Therefore, the assets are never taxed in anyone s estate. ILITs can be dynasty trusts Just to be clear, a dynasty trust isn t that different from a regular trust. Simply put: it s just one that goes on forever or a very, very long time. So, everything you know about giving assets to an irrevocable trust applies here. Can this trust own life insurance? Sure. In fact, dynasty trusts and life insurance work extremely well together. During the insured s life, it s largely treated like any other irrevocable life insurance trust (ILIT). Just as with an ILIT, the insured s death causes income tax-free death benefit to flow into the trust. The difference here is that a good portion of the death benefit can stay in the trust forever, and be reinvested for the 1 The 2010 Tax Relief Act (The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) raised the exemption for gift, estate, and GST tax to $5 million, but also indexed it for inflation, so that it is $5.12 million per person in The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 1 of 6

2 benefit of the trust beneficiaries. In fact, the trustee can use the death benefit from one policy to purchase more life insurance on the lives of the trust beneficiaries. 2 Ultimately, you can set in motion a multi-generation cascade of death benefits, where much of the trust assets can be distributed as they normally would be to help beneficiaries pay tuition or buy first homes as needed but funds that stay in trust can buy policies on children, grandchildren, great grandchildren and so on. 3 Rule against perpetuities Historically, trusts could not go on forever. They had to end after a couple generations due to something called the rule against perpetuities (RAP). 4 More recently, possibly to allow taxpayers to remove assets from the transfer tax system, states have been making it easier for trusts to continue forever (or at least for a very long time). 5 And even for those living in a state that still has a RAP, all is not lost. To set up a dynasty trust it will be necessary to have the trust governed by the laws of a state that does not have a RAP. This might be as simple as picking a trustee located in a state that has no rule against perpetuities (e.g., the Northwestern Mutual Wealth Management Company, located in Wisconsin). 6 GST tax When planning with dynasty trusts, more important than either the gift or estate tax is the generation-skipping transfer (GST) tax. Generally, the GST tax is a separate tax that applies when assets are transferred not to the generation immediately below the transferor, but to any generation beyond ( skip persons ). So, suppose Grandma transfers assets to a trust, to benefit her daughter for life, followed by a distribution to the grandchildren after daughter s death. Those assets will not be in daughter s estate when daughter dies because (in this example) she didn t own the assets, and she didn t have the right to appoint the assets to herself, her creditors, her estate, or her estate s creditors (which would create estate inclusion under 2041). But, 2 Assuming the trust beneficiary has no right to exercise any control over trust property, which would typically be the case, the beneficiary will not have an incident of ownership over a policy on that beneficiary s life, and therefore no estate inclusion under The I.R.S. has said that estate inclusion will exist, however, when the insured/beneficiary is also a trustee. Rev. Rul This is an important reason to consider a corporate trustee. 3 It is important that the trust document provide the ability to purchase insurance on successive generations. 4 The rule has its origin in the Duke of Norfolk s Case of 1682, in which the Duke created a trust purporting to shift beneficial interests based on conditions that might occur generations later. The court held that conditions could not exist indefinitely, believing that tying up property too long beyond the lives of people living at the time was wrong. Black s Law Dictionary describes the rule as follows: no interest is good unless it must vest, if at all, not later than twenty-one years after the death of some life in being at the creation of the interest. 5 The following states have abolished their rule against perpetuities: Alaska, Idaho, New Jersey, Pennsylvania, Rhode Island, South Dakota, and Wisconsin. Several other jurisdictions have provided either a way to opt-out, or permit trusts for a really long time (varies from 150 to 1,000 years): Arizona, Colorado, Washington DC, Illinois, Maine, Maryland, Missouri, Nebraska, New Hampshire, Ohio, Virginia, Florida, Nevada, Tennessee, Utah, Washington, and Wyoming. 6 Consider the effect of state income taxes when choosing a jurisdiction The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 2 of 6

3 because the daughter s interest in the trust terminates in favor grandchildren skip persons the remaining trust assets will be subject to GST tax. 7 Fortunately, everyone has an exemption from this tax, and this year it s $5.12 million. For married donors, that s $10.24 million. The key to preventing the tax is to apply GST tax exemption to all transfers to the trust. Thereafter, it doesn t matter how much the trust assets grow. As long as all assets were covered by the exemption when given to the trust, the GST tax will not apply when the second generation s (daughter s) interest terminates in favor of, or distributions are made to, the later generations. 8 Enter the dynasty trust. The tax advantage of a dynasty trust is that it never makes a final distribution to a beneficiary to be taxed at a death. Instead, the assets can stay in trust forever. 9 GST tax exemption potential sunset ambiguity Some planners might question whether a $5.12 million gift into a generation skipping trust in 2012 sheltered by the current $5.12 million generation skipping transfer (GST) tax exemption 10 will still provide for GST tax-free distributions from the trust to grandchildren after sunset. 11 As stated above, the GST exemption normally helps eliminate all of the GST tax. The formula for getting this result is multilayered, but the short version is this: The GST tax is generally determined when a distribution is made from the trust to a grandchild or later generation, or when the interest of the first generation after the donor terminates. This almost certainly would be after the current 2010 Tax Relief Act sunsets. The GST tax will be zero at that future date (our desired result) so long as the trust s inclusion ratio is zero at that time. If a $5.12 million gift is made to the trust in 2012, a key to having an inclusion ratio of zero depends on the interpretation of this phrase from 2642(a)(2): the amount of GST exemption allocated to the trust Because the daughter s interest terminates at death, the GST taxable event is a taxable termination. If a distribution had been made to grandchildren while daughter was still alive and still had an interest in the trust, it would ve been a GST taxable distribution. See 2612(a) and (b). 8 Of course, if the assets are distributed to a beneficiary, and are not consumed, then they will be in that beneficiary s estate at death. 9 Well, maybe not forever. Machiavelli died 500 years ago in Assume his assets had passed to a dynasty trust. His trust might have survived to 2012, still purporting to be governed by the laws of the Florentine Republic it outlived by 480 years. Given that changes in laws and family circumstances are inevitable, no trust will endure forever. It s just that, to the extent plans can be practically made for future generations, a dynasty trust provides the best option to keep an ample supply of funds in existence for as long as possible, all while avoiding any transfer taxes for multiple generations. 10 For 2012, the $5.12 million GST exemption matches the gift and estate tax exemption. If sunset occurs, the GST exemption will decrease to $1 million, but could be a bit larger, as it was already indexed for inflation. 11 For a detailed discussion, see our earlier article, Potential Clawback Should Not Discourage Gifts, Advanced Planning Bulletin, March (a)(2) The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 3 of 6

4 So long as the amount of GST exemption allocated to the trust is $5.12 million, we are fine; we would have zero GST tax on whatever is in, or is distributed from, the trust thereafter. But if the GST exemption allocated is lower (say, $1 million), we are not fine if the donor has made a $5.12 million gift to the trust; we would have some percentage of GST tax on the assets distributed from the trust. 13 Here s the rub. The calculation of the inclusion ratio will occur in the future, after the 2010 Tax Relief Act will have sunset. And importantly, the sunset provision of this tax act tells us that we are to apply the transfer tax rules to future generation skipping transfers as if the current provisions had never been enacted. 14 If the current law really had never been enacted, the GST exemption back in 2012 when the gift was made to the trust would have been a mere $1 million. So, when calculating a GST tax rate in a future year, are we really supposed to turn back the clock and pretend that the donor never really had a $5.12 million GST exemption back in 2012? And do so even though we know, sitting here today, that the current law in fact does provide that $5.12 million GST exemption? The most reasonable view is no, we won t have to engage in such nonsense. The relevant statutory language in 2642(a)(2) refers to the amount of GST exemption allocated to the trust. Even in the future, it will still be true that the GST exemption that was actually allocated to the trust back in 2012 was the $5.12 million that s permitted today. Moreover, the goal when interpreting any statute is to carry out its intent. The sunset provision was merely meant to re-introduce old rules for future transactions, principally because (let s be honest) it provided a short-term political compromise in light of Congressional failure to come up with permanent provisions. It was not also intended to erase ex-post facto the newly created tax rules for the very few years that they are permitted to exist. Given these considerations, it seems pretty safe to go ahead and make the $5.12 million gift, and take advantage of the current (and temporary) opportunities for passing large amounts of wealth to future generations. 15 Conclusion 13 The GST tax is imposed at the applicable rate, which is found by multiplying the maximum federal estate tax rate by the inclusion ratio with respect to the transfer The goal is for the GST trust to have an inclusion ratio of 0, the result we get when the gift is completely sheltered by GST exemption. If a gift to a GST trust were only partly sheltered by the GST exemption, however, then the inclusion ratio would be between 0 and 1, and the applicable rate would correspondingly be higher than 0%, resulting in GST tax on distributions. 14 The original sunset provision is in 901 of EGTRRA from 2001, P.L It was adopted verbatim by 101(a)(1) of the 2010 Tax Relief Act, P.L , except that the new law changed the former sunset date of December 31, 2010 to the current December 31, If, despite this reasoning, you or your client fear that any gift in excess of $1 million ultimately will not be protected by a GST exemption, you might want to consider creating at least two trusts, one that receives a gift of $1 million, and another to receives gifts in excess of that amount The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 4 of 6

5 Dynasty trusts offer the best plan for keeping assets permanently out of the transfer tax system. They are made possible by using a corporate trustee in a state where a trust is permitted to continue forever, and life insurance on successive generations can be used throughout the trust s nearly immortal life. This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by the Advanced Financial Security Planning Division of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual Financial Network Representatives, their customers, and the legal and tax advisors to those customers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. To comply with Circular The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 5 of 6

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