What is a dynasty trust?

Each time one taxpayer transfers wealth to another, the transfer is potentially subject to federal transfer tax, in the form of gift or estate tax. The federal transfer tax system is designed to impose a tax on each and every generation (e.g., father to son, son to grandson, etc.).

The transfer tax system accounts for the fact that a transfer might “skip” a generation by passing from parent to grandchild, for example. This is accomplished by imposing an additional tax whenever transfers of wealth are made to persons who are more than one generation below the taxpayer (e.g., father to grandson). This additional tax is called the generation-skipping transfer tax (GSTT). GSTT is imposed at the highest estate tax rate in effect at the time of the transfer (45% in 2008).

Additionally, most of the individual states impose their own transfer taxes. Together, these taxes can take an enormous bite whenever wealth is being handed down, and eventually eat away a family’s fortune. This can be troublesome to individuals with substantial wealth who would prefer to have their legacies benefit their own family members. It’s from these circumstances that the dynasty trust evolved.

A dynasty trust is created to provide for future generations while minimizing overall transfer tax. With a dynasty trust, a taxpayer transfers assets to the trust. This transfer, from the taxpayer (the grantor) to the trust, is potentially subject to transfer tax (although the taxpayer may use his or her exemption amounts to shield the transfer from tax). The trust then provides for future generations for as long as it exists. Although the trust assets effectively move from generation to generation, there are no corresponding transfer tax consequences.

For more information on dynasty trusts and other trusts such as family foundation, you can go to http://kenhimmler.com.

Structuring the trust to last for generations

At one time, the laws of all 50 states prohibited a trust from lasting beyond 21 years after the death of the last beneficiary alive at the time the trust was created. This rule against perpetuities has been modified or abolished in some states (i.e., Alaska, Arizona, Delaware, Florida, Georgia, Idaho, Illinois, Iowa, Maine, Maryland, Nevada, New Jersey, Ohio, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin). A trust created in one of these jurisdictions can be structured to last for many generations. Even in states that still maintain the rule, a trust can be created that will last for a substantial period of time.

Leveraging tax advantages

Although assets will be subject to transfer taxes when initially funding the trust, the assets (and subsequent appreciation) will be untouched by transfer taxes for as long as they remain in the trust.

Typically, dynasty trusts are funded with amounts that take full advantage of the grantor’s transfer tax exemptions. In 2008, the federal exemptions are $1 million for gifts, $2 million for estates, and $2 million for generation-skipping transfers. These amounts can be doubled if both spouses are funding the trust.

Though dynasty trusts can be created at death through a will or living trust, it may be more advantageous to create this type of trust during the grantor’s life because, if planned properly, the trust can continue to be funded transfer tax free with annual exclusion gifts ($12,000 per trust beneficiary).

Caution: The grantor’s federal gift and estate tax exemption will be allocated to transfers automatically, but the grantor (or executor) must elect to allocate the federal GSTT exemption to transfers.

Tip: As this type of trust is taxed more heavily on income, it may be more advantageous to fund the trust with non-income-producing property, such as growth stocks, tax-exempt bonds, and cash value life insurance. Other appropriate assets might include real estate, discounted property (e.g., interests in family limited partnerships), and property expected to highly appreciate.

Protecting and preserving principal

To enjoy the tax benefits summarized above, access to trust property by the beneficiaries must be limited. The grantor can decide how narrow or broad the beneficiary’s access will be within those limits. For example, a grantor who wishes to give a beneficiary as much control as possible can name the beneficiary as trustee, and give the beneficiary the right to all income and the right to consume principal limited by the ascertainable standards (i.e., health, education, maintenance and support). The beneficiary can be given even more control by granting a special (or limited) testamentary power of appointment (i.e., the power to name successive beneficiaries, but not to himself/herself, his/her creditors, his/her estate, or the creditors of his/her estate).

On the other hand, a grantor who wants to restrict access to the trust as much as possible can name an independent trustee who has sole discretion over distributions coupled with a spendthrift provision. The trustee will have full authority to distribute or not distribute income or principal to the beneficiary as the trustee deems appropriate. The spendthrift provision will prevent the beneficiary from voluntarily or involuntarily transferring his or her interest to another before actually receiving a distribution.

The greater the restrictions, the less likely creditors or other claimants will be able to reach trust property.

• High net worth individuals
• Individuals with family heirloom assets (e.g., vacation home or jewelry) or who desire to keep assets within the family for more than one generation

John and Mary, a married couple, own property with a net value of $3 million, which they would like to pass on to their children and future generations. John and Mary’s financial planner describes the following three scenarios:

Scenario 1-Mary and John leave $3 million outright to their two children.

Scenario 2-John and Mary leave $3 million to a trust for the benefit of their two children and then distributed to grandchildren.

Scenario 3-John and Mary leave $3 million to a dynasty trust created in a state that has no rule against perpetuities.

Assume that a generation is 26 years, the estate and GSTT exemptions are $1.5 million, the estate tax rate is 45%, the growth rate is 7%, principal is not spent, and state variables and income taxes are ignored.

In scenario 1, $3 million passes to John and Mary’s children free from estate taxes. In 26 years, the money grows to approximately $17 million, but after estate taxes are deducted, John and Mary’s grandchildren receive approximately $11 million.

In scenario 2, $3 million passes to the trust free from estate taxes. In 26 years, the money grows to approximately $17 million. 26 years later, approximately $101 million is distributed to John and Mary’s grandchildren.

In scenario 3, $3 million passes to the dynasty trust free from estate taxes. In 26 years, the money grows to approximately $17 million. 26 years later, money grows to approximately $101 million. And 26 years beyond that, the money grows to approximately $587 million that can provide benefits to John and Mary’s great-grandchildren and beyond.

• Can be structured to preserve family wealth for generations
• Minimizes transfer taxes
• Can be structured to protects assets from spendthrift beneficiaries, spousal divorce claims, and unforeseen creditors and claimants

• Trust is irrevocable
• Leaves future generations with limited flexibility to manage changes in circumstances

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Dynasty Trust

A revocable living trust (also known as an inter vivos trust) is a separate legal entity created to own property, such as a home or investments.

The trust is called a living trust because it’s meant to function while the grantor is alive. The trust can continue after the grantor’s death, but the trust becomes irrevocable the moment the grantor dies.

Revocable living trusts are used to accomplish various purposes:

1. To ensure that property continues to be properly managed in the event the grantor becomes incapacitated
2. To reduce costs and time delays by avoiding probate
3. To lessen potential challenges to or elections against a will
4. To maintain privacy
5. To avoid ancillary administration of out-of-state assets

Establishing the trust

Typically, an individual creates and funds the trust, and names himself or herself as both the trustee and sole beneficiary for his or her lifetime (if married, both spouses are typically named beneficiaries). The grantor also names a successor trustee or co-trustee, as well as the beneficiaries who will receive any assets that remain in the trust at the grantor’s death. Often, a spouse or child is named as the successor or co-trustee and is also named as an ultimate beneficiary.

Caution: In some states, a co-trustee is required.

The grantor continues to manage trust assets during his or her life. Any income earned or expenses incurred by the trust flow through to the grantor on the grantor’s individual income tax return. A separate return for the trust is not necessary.

In the event the grantor becomes incapacitated (e.g., from illness or injury), the successor trustee or co-trustee can immediately step in to take over the management of the trust on the grantor’s behalf, avoiding the need for the grantor’s spouse or other family members to petition the court to appoint a guardian.

Tip: If special knowledge or skill is required to manage property in the trust, the successor or co-trustee should be qualified.

At the grantor’s death, assets remaining in the trust pass directly to the beneficiaries, bypassing the probate process. This can save time and money, and can minimize some of the burden of settling the grantor’s estate.

Funding the trust

To ensure that the trust fulfills its objectives, the trust must be funded after it is created. Funding the trust means transferring legal title from the grantor into the name of the trust. This may entail recording a new deed for real estate; re-titling cars and trucks; renaming checking, savings, and investment portfolio accounts; transferring life insurance policies, stocks, and bonds; executing new beneficiary designation forms; or executing assignments.

Although a revocable living trust can be funded with virtually any kind of property, including personal property, special consideration should be made before transferring certain types of property, including:

• Incentive stock options
• Section 1244 stock
• Professional corporations

Tip: Transfers to the trust are not considered gifts, so the grantor doesn’t need to file a gift tax return.

Caution: Some states will reassess the value of a home for property tax purposes when it is transferred to a trust. Some states will disallow income tax deductions related to the home if it is owned by a trust.

Caution: Some banks will impose a penalty when certificates of deposits (CDs) are transferred to a trust because they consider such transfers to be early withdrawals.

For more information on revocable living trusts or living trusts you can go to http://kenhimmler.com.

A revocable living trust can be appropriate for individuals:

• Owning real estate in more than one state (to avoid ancillary probate)
• With concerns about their health or future ability to manage their own financial affairs
• Who want to keep transfers at death private (to avoid family conflicts, for example)
• Who want someone else to manage and invest assets (e.g., persons with special needs, persons who often travel overseas)
• Who want someone with special knowledge or skill to manage and invest assets (e.g., persons who inherit or win large sums of money)
• Who are single or who care for themselves
• Who are unmarried domestic partners
• Who are elderly or ill
• Who are not concerned about transfer taxes

Harry and Wilma just celebrated their golden wedding anniversary. They have a 49-year-old daughter, Cindy, who is a professor at the community college, and a 47-year-old son, Carl, who is an engineer. Harry’s health is beginning to fail, and lately, he’s had a little trouble remembering things. Harry has always taken care of the family finances, and he’s worried that Wilma might not be able to manage them on her own if something should happen to him. Harry and Wilma own the following assets jointly:

Harry and Wilma aren’t worried about federal transfer taxes because their estates ($1,317,250 each) will be sheltered by their exemptions ($2 million in 2008).

So, Harry and Wilma transfer all of the couple’s assets to a revocable living trust. Harry is named as trustee and his daughter, Cindy, is named as successor trustee. The trust also names Carl as successor trustee if Cindy cannot serve for some reason. The sole beneficiaries of the trust during their lives will be Harry and Wilma, and, upon the death of the last spouse to die, any assets remaining in the trust will pass to Cindy and Carl equally.

Now, Harry can still manage the couple’s property himself, but knows that if he should become incapacitated or die before Wilma, Cindy (and if not Cindy, Carl) will immediately take charge, paying the bills and providing Wilma with income until she dies. Harry also knows that when Wilma dies, Cindy and Carl will receive their inheritances without the delay and costs of probate.

Avoids guardianship

Typically, the grantor names himself or herself as the trustee, and someone the grantor trusts or a professional trustee is named as co-trustee or successor trustee. So, if the grantor should become unable to manage the trust assets for whatever reason, the co-trustee or successor trustee can immediately take over control and continue managing the assets with little or no lapse in between. This can be very important with certain types of assets that require frequent attention to maintain their value, such as rental property or a securities portfolio.

Avoids probate

The grantor and the grantor’s spouse are typically named as the sole beneficiaries of the trust during their lives, and at their deaths, any assets remaining in the trust pass to the grantor’s named beneficiaries, usually children and grandchildren. If the grantor can and does transfer all of his or her assets in this way, having a will becomes unnecessary. Since assets passing by trust are not subject to probate as assets that pass by will are, distributions to beneficiaries can be made more quickly (and they are often needed quickly). Further, bypassing probate will save the grantor’s estate any costs that would have otherwise been incurred, such as filing fees and attorney’s fees. And, finally, the grantor’s family will be spared any burden that would be associated with the probate process, such as petitioning the court and organizing documents for filing.

Caution: Bypassing probate may not be an appropriate goal for some individuals. For example, smaller estates may qualify for an expedited probate process or be exempt from probate altogether. In some cases, the costs associated with a living trust may be greater than the costs associated with probate. And, under certain circumstances, the court’s oversight of the estate settlement during the probate process may be welcome (for example, when family conflict is involved).

Does not save taxes

Though a living trust is a separate legal entity, it is not a separate taxpayer during the grantor’s lifetime. The grantor is considered the owner of the trust assets for tax purposes. All income and expenses generated by trust property flow through to the grantor and must be reported on the grantor’s personal income tax return. However, upon the grantor’s death, the trust becomes a separate taxpayer and different income tax rules apply. Further, assets in the trust will be included in the grantor’s gross estate, generally at their date of death value, for estate tax purposes. Therefore, a revocable living trust cannot be used as a way to minimize taxes.

Does not shelter assets from creditors

Generally, assets in a revocable trust are deemed to be owned by the grantor and are therefore reachable by creditors (although, in some states, the assets may not be reachable by Medicaid recovery after the look-back period expires).

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Revocable Living Trust

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Introduction to Estate Planning

What is a domestic self-settled spendthrift trust?

A self-settled trust is a trust where the grantor (i.e., the creator, settlor, or donor) is one of the beneficiaries, or the sole beneficiary, of the trust. A spendthrift trust is a trust that prevents trust beneficiaries from transferring their interests in the trust to other parties (e.g., creditors). Prior to April of 1997, a self-settled trust could not be a spendthrift trust under the laws in all 50 states, and U.S. citizens were forced to create such trusts in offshore or foreign jurisdictions.

In April of 1997, Alaska passed the first legislative act authorizing the use of self-settled spendthrift trusts (also called domestic asset protection trusts). In the same year, Delaware enacted similar legislation (hence this type of trust is often referred to as an Alaska/Delaware trust). A handful of states have since followed suit.

For more information on domestic Self-Settled Spendthrift Trusts and other trusts such as revocable living trusts, you can go to http://kenhimmler.com.

How does a domestic self-settled spendthrift trust work?

In general

With a spendthrift trust, the trustee is given discretion to make or not make distributions to beneficiaries. Because distributions are discretionary, beneficiaries are prevented from voluntarily or involuntarily transferring current or future rights in the trust. In other words, beneficiaries can’t give away trust income or principal in advance of receiving it. One effect of such alienation language in a trust is that creditors of a trust beneficiary cannot claim that trust assets are assets of the beneficiary. Therefore, creditors cannot stake a claim against trust assets, but can only collect money that is actually distributed to the beneficiary.

Requirements

Though the states allowing this type of trust have their own requirements and exceptions, there are elements that are common to all domestic self-settled spendthrift trusts:

• The trust must be irrevocable
• The trust document must expressly state that the laws of the state in which the trust is located govern the trust
• The trust document must include a spendthrift provision
• Some trust assets must actually be held within the state
• The trustee must be a resident of the state (though the state may allow an out-of-state co-trustee)

Caution:Trustees must be independent–the grantor cannot be a trustee or co-trustee, and must not perform any of the trustee’s duties, such as filing fiduciary tax returns or maintaining trust records. However, the grantor can provide investment advice to the trustee and retain the power to veto trust distributions.

Tip:Grantors can add another layer of independent management by naming a trust protector. The trust protector is given the power to provide investment advice to the trustee and veto trust distributions instead of the grantor.

Retained interests

Typically, grantors retain the following interests, although other rights may be permitted, depending on the state:

• Discretionary distributions of income and/or principal
• Veto power over distributions
• Special (or limited) testamentary power of appointment (i.e., the power to name or change the ultimate beneficiaries, excluding the grantor, grantor’s creditors, grantor’s estate, and creditors of the grantor’s estate)

Limitations on claims

Each state limits the time in which creditors can make claims against the assets in the trust. For example, a state may provide that creditors whose claims arise after the trust has been created (i.e., future creditors) have only 4 years from the date the grantor transfers the assets to the trust to make such claims, and existing creditors have the later of 4 years from the date of transfer or one year after the creditor discovers (or should have discovered) the existence of the trust.

Generally, creditors’ claims are barred after the statute of limitations period expires.

Fraudulent transfers

Creditors who make claims within the allowable time period must prove that transfers to the trust were fraudulent (i.e., made when the creditor’s claims were already foreseen by the grantor). If the creditor is successful, the creditor can recover its debt and any costs allowed by the court.

Caution:Self-settled spendthrift trusts, both domestic and offshore, protect assets from unforeseen creditors and liabilities only. If the court deems a transfer to be fraudulent, the grantor may not only have to make the assets available to the creditor and pay court costs, but may also face civil and criminal charges which may result in incarceration.

Exempt creditors

Generally, spouses, children, and existing tort claimants are exempt from the statute of limitations and fraudulent transfer rules as explained above.

Tax considerations

Income Tax

Generally, domestic self-settled spendthrift trusts are grantor-type trusts–income earned by and expenses incurred by trust assets flow through to the grantor on his or her personal income tax return. However, the trust may be deemed a separate taxpayer if an adverse party must approve distributions to the grantor.

Gift Tax

Generally, transfers to a domestic self-settled spendthrift trust are subject to gift tax unless the grantor retains a power of appointment.

Estate Tax

Whether assets remaining in a domestic self-settled spendthrift trust at the grantor’s death are subject to estate tax depends on the degree of control retained by the grantor. Generally, a discretionary income interest is not considered a retained interest, whereas other retained interests could result in estate taxation.

Suitable clients

• Professionals (e.g., doctors, lawyers, engineers)
• Business owners
• Officers, directors, and fiduciaries
• Real estate owners who may be vulnerable to environmental claims
• Other individuals who are exposed to liability or contractual claims

Example

Larry buys a large tract of land that he plans to develop into an upscale residential community of single-family homes and condominium units, as well as health and recreation facilities, and commercial spaces for conveniences such as a small grocery or dry cleaning business. The project will take several years to complete. Currently, the land is not fenced in and is abutted by other residential neighborhoods. Larry lives with his family in a $1.5 million home that is titled in his wife’s name. Larry and his wife live in a state that protects their retirement plans, life insurance, and annuities from creditor claims. But, Larry is the sole owner of an investment portfolio valued at close to $4 million, and he wants to protect those assets in the event of a large lawsuit in connection with the land.

Larry lives in State A, which is adjacent to State B, which allows self-settled spendthrift trusts. Larry creates such a trust in State B, naming a trust company in State B as trustee, and he and his spouse as sole beneficiaries during their lives, and their children as the ultimate beneficiaries. The trustee is given complete discretion to make or not make distributions to Larry and his spouse. Larry transfers his entire investment portfolio to the trust.

Over the next 2 years, the trust company administers the trust and manages the investment portfolio according to Larry’s advice. One year later, with about two-thirds of the project completed, 2 small children are seriously injured while playing on Larry’s land. The resulting lawsuits produced judgments against Larry far in excess of Larry’s liability insurance limits, but the claimants were unable to reach Larry’s investment portfolio to satisfy the judgments.

Advantages

Permits grantor to be beneficiary of spendthrift trust

Grantors can form a trust for their own benefit that protects them against creditors, something that is expressly prohibited by the majority of states. Generally, the states that allow self-settled spendthrift trusts have laws that shorten the time period for a creditor to challenge transfers, and make it more difficult for creditors to prove transfers were fraudulent.

Familiar jurisdiction to grantors

Some grantors will feel more comfortable with a trust located within the United States as opposed to an offshore jurisdiction.

Simpler and less costly than offshore trust

Generally, creating and maintaining an offshore trust is more complex and more expensive than a domestic trust.

Disadvantages

Fraudulent conveyance issues

Grantors must take care not to trigger fraudulent transfer laws, which might subject them to very severe penalties including hefty fines and jail time. Grantors must NOT:

• Create the trust to avoid known creditor claims, spousal support, or child support
• Make themselves insolvent by transferring too many assets to the trust
• Act as the independent trustee

Full faith and supremacy clause issues

Should a creditor be successful in a non self-settled spendthrift trust state, the state in which the trust is located is obligated to enforce the judgment under the Full Faith and Credit clause of the U.S. Constitution. Similarly, under the supremacy clause of the U.S. Constitution, federal law will preempt state law.

May not offer as much protection as an offshore trust

An offshore trust may be less likely than a domestic trust to be attacked by creditors as they generally present more hurdles that must be overcome by the creditor, including the psychological barrier of dealing with foreign persons and systems.

Untested law

The validity of self-settled spendthrift trusts has yet to be tested in the United States Supreme Court. Until the law is firmly established, care should be taken to create and fund such trusts under appropriate circumstances.

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Domestic Self-Settled Spendthrift Trust (Domestic Asset Protection Trust, Alaska/Delaware Trust)

A credit shelter trust (also called a B trust, family trust, or bypass trust) is an irrevocable trust used by a married couple to minimize federal estate taxes on their combined estates.

For more information on credit shelter trusts and other trusts such as living trusts, you can go to http://kenhimmler.com.

Typically, a credit shelter trust is funded with assets sufficient to fully utilize the federal estate tax exemption (also called the applicable exclusion amount–$2 million in 2008) of the first spouse to die. The trust may be funded during the spouses’ lifetimes or at the death of the first spouse to die.

The surviving spouse can only be given restricted access to and control over the assets in the trust. If the surviving spouse is given unrestricted access to and control over the assets in the trust, the assets will be included in his or her estate when he or she dies, negating the purpose of the trust. The surviving spouse can receive:

• All annual income earned by the trust
• The annual, but non-cumulative right to withdraw the greater of $5,000 or 5% of the trust principal, for any reason
• The right to invade the trust principal if necessary for his or her health, education, support, and maintenance (referred to as the “ascertainable standards”)

The surviving spouse can also be given a power to appoint all or any of the assets in the trust to a limited class of beneficiaries excluding himself or herself, his or her creditors, his or her estate, or the creditors of his or her estate (this is called a “special” or “limited power of appointment”). The surviving spouse can appoint the assets in the trust to the specified beneficiaries in any proportion that he or she desires. This allows the surviving spouse to appoint the assets to the beneficiaries who need the assets the most.Caution: Bypass trusts can be funded using a formula or a disclaimer. If a disclaimer is used, the trust document should not include a special power of appointment provision.

The surviving spouse can also serve as trustee.

Tip: In some cases, it may be better to have other family members or a professional (e.g., a bank) serve as trustee, either alone or with the surviving spouse. A neutral trustee is especially appropriate in second marriages.

When the surviving spouse dies, the remaining assets in the trust pass estate tax free to the beneficiaries as named by the first spouse to die in the trust document, or as appointed by the surviving spouse.

Tip: If the trust will continue after the surviving spouse dies, the trust document may need to name a successor trustee, and the trust terms must comply with the rule against perpetuities.

Tip: An experienced attorney should draft the trust document because if it is not precisely drafted the trust may be deemed invalid.

Tip: The separate wills or living trusts of both spouses should provide that, at the death of the first spouse to die, assets are to pass to an irrevocable credit shelter trust up to an amount equal to the deceased spouse’s available exemption. The couple may have to equalize their estates so that the trust can be fully funded by the first estate.

Caution: Different rules apply to non-U.S. citizens.

Spouses with combined assets that exceed the applicable exclusion amount

John and Mary are a married couple who own a home worth $1.5 million, and have life insurance with death benefits of $1 million, $300,000 in a retirement plan, a business interest valued at $1,200,000, and other investments totaling $500,000.

If John dies leaving everything to Mary, there will be no federal estate taxes due because, generally, the law allows an unlimited amount of property to pass to a spouse free of estate taxes. Now assume that Mary lives off the earnings of her $4.5 million estate for the rest of her life. When Mary dies, her entire estate will pass to their children. If Mary were to die in 2008, $2 million of Mary’s estate would be exempt, but the excess over the exemption, $2.5 million, would be subject to taxes at an effective tax rate of 40%. That means that $1,005,800 would go to the IRS and $1,494,200 would go to John and Mary’s children (assuming no other variables).

Now, let’s say that John executed a will leaving an amount equal to his available exemption to a credit shelter trust, and the rest of his estate to Mary. Say John died in 2007. John’s gross estate was $2.25 million ($4.5 million divided by 2). $2 million passed to the trust tax free under John’s exemption, and $250,000 passed directly to Mary tax free under the marital deduction. Mary can live off the earnings of her $2.5 million estate ($2.25 million plus $250,000), and can also access the income earned by the trust, as well as the principal of the trust to the extent she needs it for her health, education, maintenance, and support.

If Mary were to die in 2008, Mary’s estate would be $2.5 million; the assets in the trust would not be included in her gross estate. John and Mary’s children would receive the entire corpus of the trust. Of Mary’s $2.5 million estate, $2 million would pass to their children tax free under Mary’s exemption, and $500,000 would pass subject to tax at an effective rate of approximately 31 percent. That results in $155,800 going to the IRS and $2,344,200 going to John and Mary’s children.

By using a credit shelter trust, John and Mary’s children receive an additional $850,000 of their parents’ estates that the IRS would have received had the trust not been used.

Tip: If John didn’t want the property to go outright to Mary, John could leave the residuary estate to a marital trust instead, naming Mary as the primary beneficiary. When a credit shelter trust is used in conjunction with a marital trust, the arrangement is usually called an A/B trust arrangement.

Achieves tax goal while giving surviving spouse maximum access to and control over trust assets

With this type of trust, if the children of the marriage are minors or have special needs, or if the surviving spouse were to otherwise need the money, he or she would be able to access the property that passes to the trust under the deceased spouse’s exemption (although access would be limited, see Disadvantages).

Preserves assets for descendants

Because assets that fund the credit shelter trust bypass the surviving spouse’s estate, they are preserved for the ultimate intended beneficiaries. This can be especially attractive when there are children from a previous marriage.

Protects assets from future creditor claims

Because a bypass trust is irrevocable, future creditors of the beneficiaries (the surviving spouse or the children) will be unable to reach the assets while they are in the trust. So, this strategy also works well if the children are adults and the parents don’t want them to own property outright for some reason. If this is the case, a spendthrift provision should be included in the trust agreement.

Surviving spouse’s access to the credit shelter trust must be restricted

The deceased spouse can give the surviving spouse access to all, a portion, or none of the income from the credit shelter trust. If access to principal is allowed, it must be limited to health, education, maintenance, or support only. Health, education, maintenance, and support, or “HEMS”, are four magic words used by the IRS, and there’s some guidance about what they mean, but the surviving spouse will have to be careful when withdrawing principal to make sure the money’s use will fall within these parameters.

Adds complexity to the surviving spouse’s life

If the surviving spouse is trustee, he or she will have to maintain separate records for the trust, and ensure that he or she does not overstep the trustee’s powers. If a neutral trustee is used, the surviving spouse will have to cooperate with the trustee

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Credit Shelter Trust

A charitable lead trust (CLT) is essentially a charitable remainder trust in reverse. First, the charity receives an income stream (the income interest), then, at the end of the specified trust term, which can be for a term of years, for the lifetime of the donor, or for the lifetimes of the donor and the donor’s spouse, any income and principal remaining in the CLT (the remainder interest) can either revert back to the donor or pass to other non-charitable beneficiaries named in the trust.

For more information on charitable lead trust’s and other charitable deductions, you can go to http://kenhimmler.com.

A CLT can be funded in two ways:

• Inter Vivos – An inter vivos CLT is funded during the grantor’s life.
• Testamentary – A testamentary CLT is funded at the donor’s death through the donor’s will. As long as the CLT is included in the donor’s taxable estate, the estate can deduct the net present value of the income stream granted to the charity. Minimizing estate taxes is the primary motive for funding a CLT at death.

Generally, there are two types of CLTs for income tax purposes:

• Grantor Lead Trust – With this type of CLT, the donor is considered the owner of the CLT assets. All trust income and expenses pass through to the donor on the donor’s personal income tax return, and the donor can take an immediate income tax deduction for the value of the income stream that passes to the charity (subject to limitations). Minimizing income taxes is the primary motive for creating a grantor lead trust. A grantor lead trust must be an inter vivos trust.
• Non-Grantor Lead Trust – This type of CLT is treated as a separate tax-paying entity subject to the income tax rules associated with trusts. All income and expenses are reported on a separate, fiduciary income tax return–they do not flow through the donor, and no income tax deduction is allowed to the donor, although the trust itself can deduct its annual payments to the charity. A non-grantor lead trust can be either inter vivos or testamentary.

If a CLT’s remainder interest does not revert to the donor or the donor’s spouse, but passes to other non-charitable beneficiaries, there will be transfer tax consequences.

• Gift tax – If the remainder interest passes to other non-charitable beneficiaries during the donor’s life, the transfer will be subject to gift tax, but the net present value of the gift can be reduced (discounted) by the value of the income stream granted to the charity. Because the transfer is a gift, the non-charitable beneficiaries will receive a carryover basis in the trust assets.
• Estate tax – If the remainder interest passes to the other non-charitable beneficiaries after the donor’s death, the transfer will be subject to estate tax, but at the date of transfer value. Any appreciation in the trust assets value will be entirely estate tax free. And, if there are payments still owed to the charity at the donor’s death, the donor’s estate can deduct the net present value of those payments. Because the transfer is after death, the non-charitable beneficiaries will receive trust assets with a step up in basis.
• Generation-skipping transfer tax (GSTT) – If the remainder beneficiaries is more than one generation below the donor, the transfer will also be subject to generation-skipping transfer tax (which may be offset to the extent of the donor’s available GSTT exemption).

The income stream to the charity can be calculated in one of the following two ways:

• Charitable Lead Annuity Trust (CLAT) — A CLAT pays out a fixed amount each year based on the initial fair market value of the trust assets. Earnings and growth are added to the trust corpus, so each payment represents a smaller percentage of the total trust value.
• Charitable Lead Unitrust (CLUT) — A CLUT revalues trust assets annually and pays out an amount based on a specified percentage of that value. The actual payment from a CLUT varies from year to year.

You may want to consider establishing a charitable lead trust if you:

• Have investable assets of $5,000,000 or more
• Are currently making significant contributions to a favorite charity
• Seek to make future gifts at a significantly discounted gift tax cost
• Own assets you expect to substantially appreciate in value
• Wish to reduce the value of your estate to help minimize future estate tax liabilities faced by your children
• Do not need the income from the assets being donated

John, who often donates to charity, owns substantial property and wants his children, who are now young, to inherit as much of his property as possible when he dies. John creates a non-grantor annuity trust as follows:

Trust’s Term: 20 years
Funding Amount: $2,000,000
Annuity Payout Rate: 5%
Section 7520 Rate: 4.8%
Annual Payment to Charity: $100,000
Value of Charity’s Interest: $1,267,630
Remainder Interest to Beneficiaries: $732,370

This example shows that the charity will receive $100,000 annually for 20 years. Assuming the trust’s assets appreciate more than the Section 7520 rate, John’s children will receive an amount in excess of the present value of remainder interest ($732,370) without any gift or estate tax ramifications.

Tip: When interest rates are low, the lead interest for this type of trust is larger than when interest rates are high, resulting in a larger charitable deduction. Interest rates play a key role when considering this type of trust.

John has recently received a windfall and is very concerned about income taxes. John does not need additional income now, but will need it at retirement. John creates and funds a grantor lead annuity trusts as follows:

Trust’s Term: 20 years
Funding Amount: $2,000,000
Annuity Payout Rate: 5%
Section 7520 Rate: 4.8%
Annual Payment to Charity: $100,000
Charitable Income Tax Deduction: $1,267,630

The charitable income tax deduction is subject to rules that may limit or reduce the amount you can actually claim on your income tax return. This type of trust must be created during your lifetime and include provisions that cause you to be considered its owner for income tax purposes. You will have to report all of the trust’s net taxable income on your personal income tax returns. In addition, any assets reverting back to you become part of your taxable estate, thus potentially increasing future estate tax liabilities.

Tip: The value of the non-charitable beneficiary’s interest is determined by first calculating the value of the charity’s interest. This is done using special IRS tax tables. The charity’s interest is then subtracted from the total trust assets to arrive at the non-charitable beneficiary’s interest. Because the executor of your future estate can deduct the entire present value of the lead interest, this strategy works best in a low interest rate environment.

• Enables you to experience the impact of your giving during your lifetime
• Helps to substantially reduce the value of a taxable gift in that the gift is made for a future interest (known as an “estate freezing” technique)
• Provides a gift and estate tax sanctuary for assets expected to appreciate in value
• Allows you to donate to charity and keep trust assets within the family
• Allows you to postpone the non-charitable beneficiary’s receipt of the trust assets
• Allows you to control the payment method, term of the trust and beneficiaries
• Helps to minimize your taxable estate, thus potentially reducing federal estate tax liabilities

• No income tax deduction unless you are also the “owner” of the charitable lead trust
• Requires an irrevocable commitment
• Requires the charitable payment to be made each year, regardless of whether there is sufficient trust income available

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Charitable Lead Trust

A charitable remainder trust (CRT) is an irrevocable trust used to enable donors (called grantors) to give money or property to charities, while continuing to receive income (fixed or variable) from the property for life or for a period of time up to 20 years. The grantor, and/or other beneficiaries (the income beneficiaries) receive distributions from the trust annually, and the charities (the remainder beneficiaries) receive the assets remaining in the trust when the trust ends. The grantor gets an immediate income tax deduction for the remainder interest (subject to the usual limitations), defers or avoids capital gains tax on the donated assets, and gets gift or estate tax deductions for the remainder interest.

For more information on charitable remainder trusts and other charitable deductions, you can go to http://kenhimmler.com.

A CRT can be created in two ways:

• Inter Vivos – An inter vivos CRT is created and funded during the grantor’s life. An inter vivos CRT is used primarily to provide income security to the grantor and/or the grantor’s spouse.
• Testamentary – A testamentary CRT is funded at the grantor’s death through a will or living trust. A testamentary CRT is used to provide benefits to heirs and reduce the grantor’s taxable estate.

Generally, there are two forms of CRTs:

• Charitable Remainder Annuity Trust (CRAT) – With a CRAT, the annual distributions to the income beneficiaries is a percentage (not less than 5% or more than 50%) of the initial net fair market of the assets used to fund the trust. The payout is fixed and never changes, so if trust earnings are insufficient to meet the required amount, principal must be invaded. Any change in asset value over time accrues to the benefit or detriment of the remainder charitable beneficiaries. This certainty in annual payout makes the CRAT more attractive to older grantors. Additional contributions to a CRAT are not allowed.
• Charitable Remainder Unitrust (CRUT) – With a CRUT, the annual payout is variable, a percentage (not less than 5% or more than 50%) of the current fair market of the assets in the trust. Assets are revalued each year–if principal increases, the payout increases. A CRUT is the preferred form for younger grantors who can risk reductions in payouts in return for the potential to hedge against inflation. Contributions to a CRUT can continue.

Tip: There are three variations of the standard CRUT, which makes payouts even if principal must be invaded: NI-CRUT (payout can be reduced to avoid invading principal), NIM-CRUT (payout can be reduced to avoid invading principal, but is made up in subsequent payouts), and Flip CRUT (starts as NI-CRUT, flips to standard CRUT at specified date).

Funding a CRT

A CRT can be funded with most types of assets, but since minimum distributions to income beneficiaries are required, it may be preferable to use cash and marketable securities, or to structure the trust as a NI-CRUT, NIMCRUT, or Flip CRUT (see above) to buy time to sell unmarketable assets.

Caution: The IRS may require a qualified appraisal for unmarketable assets (e.g., a closely held business or real property).

The present value of the remainder interest to charity must be at least 10% of the fair market value of the trust property as of the date the property is contributed to the trust. For CRUTs, this requirement must be satisfied upon the initial and any subsequent contributions.

Present values are calculated using an IRS formula that includes the following factors:

• The ages of the income beneficiaries, or the fixed term of years
• The annual payout rate
• The IRS discount rate
• The form of CRT

This rule prevents very young income beneficiaries and very high payout rates to older beneficiaries. In such scenarios, it is possible that by the time the income beneficiary died, there would be nothing left for the charity.

Trust is tax-exempt

Generally, both CRATs and CRUTs are wholly tax exempt, even though they are only partially charitable, as long as the trust complies with IRS rules. So, say a grantor transfers highly appreciated non-income-producing property to the trust. The trustee can sell the property and invest the proceeds, un-depleted by capital gains tax, in an investment portfolio that may yield a higher return than the donated property.

Caution: A CRT that has unrelated business taxable income (UBTI) will not lose its tax-exempt status, but may face an excise tax equal to 100% of the UTBI.

Trust distributions are taxable

Generally, distributions from a CRT are taxable to the recipient under a tiered system. If the trust payout is from earned income (e.g., interest dividends, rents), the payout is classified as ordinary income. If the trust payout is from principal, the income is classified as a distribution of long-term capital gain first, then tax-exempt income (e.g., municipal bond interest), then return of principal (tax free, of course).

Income tax deduction

Generally, contributions to qualified charities are tax deductible for taxpayers who itemize. The amount of the tax deduction for a transfer to a CRT is usually the present fair market value of the remainder interest to charity (see above), subject to certain IRS limitations (50% of adjusted gross income for gifts of cash, 30% of adjusted gross income for gifts of appreciated stock or real estate) per year. Deductions are available for the tax years in which contributions are made, and any unused portions can be carried over to the next five tax years.

If contributions are tangible personal property (e.g., works of art, rare books or coins) or would result in short-term gain if sold, deductions may be limited to the property’s cost basis, not fair market value.

Gift and estate taxes

Gift and estate taxes will apply on payouts to income beneficiaries who are not grantors or their spouses.

• Individuals who have no children or ultimate beneficiaries
• Individuals with non-income-producing assets who want lifetime income
• Individuals with highly appreciated assets that earn a low rate of return (e.g., stock) or cost money to maintain (e.g., land)
• Individuals with concentrated portfolios who want to diversify

Grantor is an 80-year-old widow with no heirs who owns property with a net fair market value of $1 million, most of which is real estate with a cost basis of $250,000. Grantor is in relatively good health, and is planning to move to an assisted living facility. If grantor sold her property, income tax would be due on the gain at a 15% tax rate.

Instead, grantor creates CRAT, naming her husband’s alma mater as charitable beneficiary, as follows:

Trust Term: 20 years
Funding Amount: $1 million
Growth of Trust: 5.5%
Annuity Payout Rate: 5%
IRS Discount Rate: 4.8%
Annual Amount to Grantor: $50,000 Paid Quarterly
Gift to Charity: $1,138,384
Income Tax Deduction: $354,903

Grantors are a married couple, both aged 55, with high-paying jobs who are concerned about conservation. Grantors own marketable securities that cost them $50,000 which are currently worth $200,000. They would like to reduce their income taxes and make a gift to a charitable conservation organization. If they sold the securities, income taxes on the gain would be $22,500. They create a CRUT instead, as follows:

Trust Term: 20 years
Funding Amount: $200,000
Growth of Trust: 5.5%
Percentage Payout Rate: 5%
IRS Discount Rate: 4.8%
Annual Amount to Grantors: $10,000 Paid Semi-Annually
Gift to Charity: $212,084
Income Tax Deduction: $72,590

CRTs let grantors:

• Give to charity
• Receive income for life or term of years
• Receive immediate income tax deductions
• Reduce or eliminate capital gains, gift, and estate taxes
• Enjoy freedom from investment management decisions and duties

• Transfers are irrevocable
• Terms of the trust are unchangeable (though assets and charitable beneficiaries may change)
• Assets that pass to charity do not pass to heirs

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Charitable Remainder Trust

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Marriage and the Estate Tax