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    • Kathleen Reynolds
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      This calculation illustrates the wealth transfer power of combining several tax techniques into a single trust, here called a “defective dynasty trust.”

      The tax techniques that are combined and illustrated include:

      • The sale to a “defective” trust (a trust of which the grantor is treated as the “owner” for income tax purposes, but not for estate, gift, or generation-skipping transfer tax purposes), so that no gain or loss is recognized on the sale, but the future appreciation of the asset sold is excluded from the seller/grantor’s estate.
      • The sale of a minority interest in a family limited partnership or other entity, so that the purchase price can be discounted below the proportionate fair market value of the partnership assets, even though the beneficiaries of the trust should ultimately realize that full market value when the partnership is liquidated.
      • Generation-skipping, and avoiding death taxes in future generations, by creating a trust which lasts the period allowed by the rule against perpetuities.
      • Leveraging the accumulated trust income through the purchase of life insurance by the trust.

      Dynasty Inputs Screenshot1
      Dynasty Inputs Screenshots2

      Entering Data

      1. FMV of Gift to Dynasty Trust: Enter the amount of the initial “seed money” gift to the trust. (Many practitioners believe that this gift should be at least 10% of the value of the interests to be sold to the trust.)
      2. Years Between Generations: Enter the number of years each generation can be expected to benefit from the trust, representing the average period between the deaths of the members of each generation. (Twenty-five years is the length of generations assumed by the Internal Revenue Code.)
      3. Pre-Discount Value of Limited Partnership Interests Sold to Dynasty Trust: Enter the pre-discount value of the limited partnership (or other entity) interests to be sold to the trust
      4. Discount Applied to Limited Partnership Interests: Enter the total percentage discounts (minority, marketability, or otherwise) that will be applied in valuing the interests in the partnership or other entity to be sold to the trust. (The face value of the installment note is the pre-discount value of the limited partnership interest, reduced by the discount entered.)
      5. Term of Note: Enter the term of the installment sale note, in years. (The term should not be longer than the life expectancy of the grantor.)
      6. Applicable Federal Rate: Enter a rate to override the stored §7520 rate. The applicable federal rate is the market rate of interest that will be applied to the note. The short-term rate is for notes of not more than three years, the mid-term rate is for notes of more than three years but not more than nine years, and the long-term rate is for notes of more than nine years. These rates are published monthly by the Internal Revenue Service and can be found in the Internal Revenue Bulletin. The AFR Manager included with this program tracks and downloads the monthly updates to the federal midterm rates.
      7. Down Payment on the Promissory Note: Enter the amount of any down payment to be made in the first year of the trust.
      8. Estate and Gift Tax Rate: Enter the average rate for all the death taxes that would otherwise apply at the grantor’s death. (The same rate will also be applied to the estates of future generations.)
      9. Net Growth During Grantor’s Lifetime: Enter an assumed annual rate of income or long-term capital growth to be used to calculate the increases in the value of the trust during the grantor’s lifetime. Many practitioner’s believe that the grantor can pay the federal income tax for a “defective” grantor trust without payment of any gift taxes, in which case the rate of income or growth should be a before-tax rate.)
      10. Net Growth After Grantor’s Death: Enter an assumed annual rate of income or capital growth, after taxes, to be used to calculate future values of both the dynasty trust and family wealth outside of a dynasty trust. Following the grantor’s death, the trust will not be a grantor trust, and will be required to pay federal income tax on it’s accumulated income and gains, so this rate should be an after-tax rate. (Although it is possible to accumulate income in a dynasty trust, it is unrealistic to assume that a trust will be created and administered without ever providing any benefits to future generations, so the growth of assets should be net of a reasonable income for beneficiaries.)
      11. Premium Per $1,000,000 of Death Benefit (if any): Enter the annual premium that would be paid for $1,000,000 of insurance on the grantor’s life. (Enter zero to skip the life insurance calculation.)

      Summary The Summary shows the net amount in the trust after the end of the term of the note, based on the discount, income, interest rates, and other information entered. The program computes the amount that can be removed from the grantor’s estate by leveraging a gift to a defective trust using an installment sale of an asset subject to a valuation discount.

      Dynasty Summary Screenshot

      Payment Schedule This is a year-by-year calculation of the note payments and resulting amount removed from the grantor’s estate.

      Dynasty Payment Screenshot

      Insurance Schedule This shows the initial net income remaining in the trust after the payment of the interest on the note and the amount of life insurance that could be purchased with that annual income as a premium payment.

      Dynasty Insurance Screenshot

      Perpetual Dynasty Trust The calculations are displayed in four columns and six rows. The six rows show the trust fund (or inheritance) remaining after taxes (if any) at the death of the grantor and at the end of each of the five generations after the grantor. The four columns compare the results of a one generation trust (ending at the grantor’s death), a two generation trust (ending after the death of the grantor’s children), a three generation trust (ending after the death of the grantor’s grandchildren), and a perpetual trust (never ending, and so continuing through all five generations).

      Dynasty Perpetual Screenshot

      The value of the dynasty trust at the grantor’s death is the same value shown in the summary of results. The value at the end of the first generation is the initial value of the trust multiplied by the assumed growth rate, compounded annually for the assumed number of years for the generation. The value of the dynasty trust for the second (and succeeding) generations is the value of the trust at the end of the preceding generation multiplied by the same growth rate compounded for the same number of years assumed for each generation.

      The calculation of the value of assets after the end of the trust is similar to the growth calculations for the dynasty trust. The difference is that the inheritance of each generation is assumed to be reduced by the death taxes calculated in accordance with the rate of tax entered as an input. The net amount passing to the next generation is then assumed to grow in value, and be subject to tax again at the end of that next generation.

      The potential benefit of a multi-generational dynasty trust can be seen by comparing the values (and taxes) in the different columns.


      Additional Information

      Defective Trust As explained above, a “defective” trust is a trust in which the grantor (or in certain cases, the beneficiary) is treated as the “owner” of the trust for income tax purposes, but not for estate, gift, or generation-skipping transfer tax purposes. This means that the grantor is taxed on the trust income and gets the benefit of all the deductions and credits attributable to the trust. IRC Section 671. any practitioners believe that one of the benefits of a trust in which the grantor pays the income tax is that the payment of the tax is the equivalent of a tax-free gift to the trust to the extent no reimbursement is made (unless the trust instrument or state law requires reimbursement to the grantor from the trust). This benefit is important if the trust is purchasing life insurance because the trust can grow free of income tax and be able to pay larger premiums.

      The Leverage of Market Discounts Another technique used by many practitioners is the intra-family transfer of closely held business interests, family limited partnerships, and other types of fractional or minority interests for which the fair market value (determined by reference to a hypothetical willing buyer and willing seller in accordance with Treasury regulations and court rulings) will be less than the proportionate value of the underlying assets owned by the corporation or partnership, due to discounts for lack of control and lack of marketability. By selling a discounted minority interest to a defective trust, the grantor can increase the “leverage” of the sale, providing additional value to the beneficiaries without gift tax.

      Sale to a Defective Trust – How this technique works The first step is for the grantor to make a gift to the trust as initial “seed money” or equity so that the trust is not under-capitalized and the transaction is a real sale and not a “sham.” (If the sale is too highly leveraged, the seller is totally dependent on the asset itself for the payment of the purchase price, would could lead the IRS and the courts to conclude that the transaction was not really a sale at all.) The grantor subsequently sells interests in a limited partnership (or other entity) to the trust in exchange for an interest-only promissory note with a balloon payment at the end of the term. The sale is income tax free because the trust is “defective” for income tax purposes. (See Rev. Rul. 85-13.) The interest rate for the sale is a market rate of interest determined under IRC Section 1274(d). Because the minority interest transferred represents a discounted value from the proportionate share of the business or assets owned by the partnership or other entity, the income from the minority interests should be higher than the income from other assets with the same fair market value. If the trust is “defective” and does not pay income tax, the income will be able to accumulate more rapidly. The difference between the trust income and the interest on the promissory note may therefore accumulate tax-free for the beneficiaries of the “defective” trust.

      Why use a Dynasty Trust A dynasty trust is an irrevocable trust drafted to last for multiple generations without any estate, gift or generation-skipping transfer taxes at the death of the grantor’s children and in some cases without any such taxes at the death of lower generations as well. Unlike most trusts which require distributions to be made to the children at certain ages, the dynasty trust instead gives the children and other descendants the use and control over the trust property as trustee upon reaching the age at which most standard trusts would otherwise distribute the trust property to the beneficiaries free of trust. This gives the beneficiaries control over and enjoyment from the trust assets as if they owned the property outright, but without causing inclusion in their taxable estates and without subjecting their property to their personal creditors, including ex-spouses.

      The federal estate tax applies to the net estate of a decedent at death, and federal estate tax rates have been as high as 55% for estates of $3,000,000 or more, with an additional 5% payable (or a total of 60%) for estates between $10,000,000 and $17,184,000. In order to prevent the avoidance of the estate tax through long-term trusts, Congress also imposed a generation-skipping transfer tax equal to the maximum federal estate tax rate on each generation-skipping transfer, payable from a generation-skipping trust at the death of each generation. However, there is a generation-skipping tax for each person, and it is possible to “leverage” that exemption through life insurance, so that a multi-generation dynasty trust can be created that can benefit each generation free of federal estate tax and generation-skipping tax.

      A major limitation on multi-generational dynasty trusts is the traditional “rule against perpetuities,” which states that each trust must “vest” (or terminate for tax purposes) twenty-one years after the deaths of all lives in being when the trust was created. That means that a trust can always last at least until all of the grandchildren are twenty-one, and careful drafting can usually allow a trust to last 100 years or more without violating the rule against perpetuities.

      Perpetual Trusts The choice of state law to apply to the dynasty trust is a decision which can affect the wealth of the grantor’s descendants for many generations. Several states (twelve as of 6/1/00) have repealed or modified the common law “rule against perpetuities” to allow trusts to continue forever without any additional gift, estate or generation-skipping transfer taxes. (In the states which still apply the rule against perpetuities, the trust must usually terminate and distribute the trust assets twenty-one years after the grantor and others living when the trust was created have died. Once the trust has terminated, the assets become subject to estate and gifts taxes again.) By extending the term of the trust, the grantor can delay (or avoid altogether) the imposition of any estate tax on the principal and accumulated income of the trust.

      Choosing a State Situs In order to get the benefit of the favorable trust and tax laws of South Dakota, Delaware, or other states, it is usually necessary to have at least one trustee residing in that state. To provide continuity of management, and insure that the resident trust will not die or move, it may advisable to use a bank or trust company as a trustee. (One or more beneficiaries may also be co-trustees and may be given the power to remove and replace the corporate trustee without adverse income, estate, or gift tax consequences. It is also possible for the grantor to retain this power under the holding of Rev. Rul. 95-58.)

      Why this technique is invaluable as a Life Insurance ToolEstate taxes are due within nine months of the death of a single individual or the second to die of a married couple. In almost all cases, life insurance is used to provide the liquidity to pay the taxes without having to sell the estate assets at low values. Life insurance proceeds are income tax free (subject to exceptions), but not estate tax free. In order to make it estate tax free, the life insurance should be purchased by an irrevocable life insurance trust. Most life insurance trusts are structured as Crummey trusts (named after the case by that name) so that transfers to the trust qualify for the gift tax annual exclusion. For larger estates, however, there often aren’t enough Crummey beneficiaries to pay the premiums without making taxable gifts. This often results in the client not purchasing enough insurance to fund the estate tax (or other obligation). Since the sale to a “defective” trust can create such a large cash flow, significant insurance premiums can be supported by the trust assets. In addition, the “defective” trust can also be used to purchase an existing policy from either the insured or an existing life insurance trust without violating the transfer for value rules (IRC Section 101(a)(2)) and without causing estate inclusion under the three-year rule (IRC Section 2035).

      In almost all but the largest estates, the installment sale technique will provide sufficient cash flow to purchase more insurance than the client needs. This is because the technique leverages the estate, gift and generation-skipping transfer taxes so much. If this result is higher than necessary, then the options are to either gift and sell less to the dynasty trust or to use part of the trust income for life insurance and part for other investments.

      These dynasty trust calculations and explanations are based on concepts and illustrations created by attorney Steven J. Oshins, Las Vegas, Nevada, and are reproduced here with his permission.

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