UNLIMITED DURATION TRUSTS

Transcription

1 MINNESOTA CLE S 39 TH ANNUAL PROBATE & TRUST LAW CONFERENCE JUNE 10-11, 2013: UNLIMITED DURATION TRUSTS WHY, WHEN, WHERE AND HOW? Your Clients Will Not Live Forever, But Their Family Values Will Al W. King III, J.D., LL.M., AEP (Distinguished) Co-Chairman & Co-Chief Executive Officer SOUTH DAKOTA TRUST COMPANY LLC 201 S. Phillips Avenue Suite 200 Sioux Falls, SD (605) St. Joseph Street Suite 900 Rapid City, SD (605) East 42 nd Street Suite 701 New York, NY (212) (South Dakota Planning Company) / /

2 Who is a Candidate for a Dynasty Trust? Person looking to take advantage of the $5.25 million gift and GST tax exemptions in 2013; Person buying $500,000 or more of Life Insurance Death Benefit to provide for family intergenerationally; Survivor income and support (versus payment of estate taxes); Person looking to leave $500,000 or more of financial assets to family intergenerationally; Person looking to asset protect and to shield his/her business from estate and GST taxes; Doctor looking to asset protect and estate plan his/her medical practice; Person looking to keep family residence and/or vacation home in the family forever; Wealthy person looking to promote family values (social and fiscal) in perpetuity; Wealthy family looking to structure their estate plan with the Dynasty Trust as the foundation; Combination of above. 2

3 Why Establish a Family Bank Dynasty Trust: Estate & Generation Skipping Transfer (GST) tax savings; Possibly state income and capital gains tax savings; Asset protect family assets; Provides control & flexibility and family involvement regarding the trust investment management and distribution decisions; Also involves trusted family advisors: To make tax sensitive distribution decisions; To assist with unique assets held by trust (i.e., businesses, antiques, real estate, etc.); Incentive provisions to promote family values; Promote social and fiscal responsibility; Family bank The Foundation of the family estate plan coordinating with most all other family trusts. 3

4 What is a Dynasty Trust? Definition: A Dynasty Trust is a generation skipping trust to benefit one s family intergenerationally (spouse, children, grandchildren and possibly great grandchildren and unborns) lasting as long as state law will allow. 4

5 Modern No [or] Long Term Rule Against Perpetuity" States: Common Law Rule Against Perpetuities States ( years) Uniform Statutory Rule Against Perpetuities (USRAP) States (90 years) Term States** Unlimited Duration States (Listed Chronologically by Year of Statute Enactment) Iowa Arkansas Delaware*** (Real Estate 110 years) Idaho* (1959, Pre-1986) Mississippi California Alaska (1000 years) w/ LPofA Wisconsin* (1967, Pre-1986) New York Connecticut Colorado (1000 years) South Dakota* (1983, Pre-1986) Oklahoma Georgia Florida (360 years) Delaware* (1995) Texas Indiana Washington (150 years) Alaska* (1997, 2000) Vermont Kansas Wyoming (1000 years) Arizona (1998) Massachusetts Utah (1000 years) Illinois (1998) Minnesota Nevada (365 years) Maryland (1998) Montana Tennessee (360 years) Maine (1999) New Mexico Alabama (360 years) New Jersey* (1999) North Dakota Ohio (1999) Oregon Rhode Island (1999) *** Generally place real estate in South Carolina LLC, hence subject to unlimited Virginia (2000) West Virginia duration Missouri (2001) Nebraska (2002) Washington D.C. (2001) New Hampshire* (2006) North Carolina* (2007) Pennsylvania (2006) Michigan (2008) Hawaii (2010) Kentucky (2010) * Eight states follow the Murphy case in whole or in part re the method for abolishing their RAP by dealing with both the required vesting and timing issues associated with the RAP. The IRS acquiesced in the Murphy case, which allows for an unlimited trust duration. ** Please note the term states do not address both the required vesting and timing issues associated with the RAP and the IRS may only recognize 90 years. No authority for the term states to arbitrarily choose a term extending the 90 year statute. 5

6 Estate of Murphy v. Commissioner 71 T.C. 671 (1979) (Wisconsin): IRS acquiesced in Murphy 1979 Only reported case involving IRC 2041(a)(3) Tax court held: the exercised LPofA to create another LPofA did not spring Delaware Tax Trap because: Under applicable Wisconsin law, the exercise of a LPofA did not commence a new perpetuities period. Delaware Tax Trap was not violated in Wisconsin, Wisconsin has/had a perpetuities statute expressed in terms of a rule against suspension of power of alienation [rather than] based upon the remoteness of vesting States that follow the Murphy Case: Pre 1986: Idaho, South Dakota and Wisconsin relied on Murphy case Post 1986: Alaska (partial), Delaware (possible issue with LPA), Kentucky, Missouri, New Hampshire, New Jersey and North Carolina all relied upon Murphy. 6

7 Possible Future Transfer Tax Legislation The Obama Budget Proposal Federal RAP (Limit GST Exclusion)- 90 Years Proposal would only apply to trusts created after enactment (grandfather existing trusts) Previously proposed, but died Non-tax reasons for Dynasty Trusts (promotion of fiscal & social responsibility) 7

8 When to Fund the Dynasty Trust Testamentary (Fund at Death) and Inter-vivos (Fund during Lifetime): Scenario #1- Testamentary GST Trust Minnesota Will Scenario #2- Minnesota Will pours over at death to revocable trust with dynasty trust in favorable dynasty trust jurisdiction: MN Will: Marital + Non-marital Trust Combine with pour over to a revocable living trust with dynasty trust provisions and situs in Alaska, Delaware or South Dakota Dynasty trust awaiting pour over from MN Will at death. (1) Marital Trust Testamentary Dynasty Trust Estate Tax Exemption Trust (3) (2) Scenario #3- Inter-vivos (Lifetime) Dynasty Trust Minnesota Will Marital Trust Alaska, Delaware or South Dakota Inter-vivos Dynasty Trust Utilizing $5.25 MM Gift Exemption ($10.50 MM per married couple) $5.25 MM of GST Exemption per spouse Estate Tax Exemption Trust 8

9 The Advantages of the Inter-vivos (Lifetime) Dynasty Trust Vs. the Testamentary (Death) Trust or Doing No Planning: No GST Planning Testamentary GST Planning Lifetime Planning (i.e. Dynasty Trust) Initial Amount $1,550,000 $1,550,000 $1,550,000 Taxable Gift $0 $0 $1,000,000 Gift Tax $0 $0 $550,000 Net $1,550,000 $1,550,000 $0 Net to Great- Great Grandchildren $19,067,472 $42,554,950 $134,446,927 Increase $0 $23,491,997 $115,929,455 * Please note: The Above analysis is based upon 7% growth rate. 9

10 Transfer Tax Consequences of a Lifetime (Inter-Vivos) Dynasty Trust: Transfer Tax Consequences: In order to properly establish an Inter-vivos (lifetime) Dynasty Trust one must utilize both their gift tax and GST tax exemptions: Gift Tax Exemption: $5,250,000 (2013) $1,000,000 (2018 Obama budget proposal) Generation Skipping Transfer (GST) Tax Exemption: $5,250,000 (2013) $3,500,000 (2018 Obama budget proposal) Estate and GST Taxes: Avoided until the trust ends (some states perpetual) If established and funded before Obama budget proposals are enacted (if enacted) Please Note: A Dynasty Trust can also be funded at death (i.e., testamentary) but this is much less advantageous than when funded during one s lifetime; plus the $5.25 million exemptions may not be around unless one dies with current law in place. 10

11 Current Status of Transfer Taxes and Proposed Obama Budget Gift Tax Exemption Maximum Gift Tax Rate Estate Tax Exemption Maximum Estate Tax Rate Exemption from GST Tax GST Tax Rate (Repeal) (Obama Budget Proposal) $ 1,000,000 $ 1,000,000 $ 5,000,000 $5,120,000 $5,250,000 $ 1,000,000 45% 35% 35% 35% 40% 45% $ 3,500,000 Unlimited $5,000,000 $5,120,000 $5,250,000 $ 3,500,000 45% N/A 35% 35% 40% 45% $ 3,500,000 Unlimited $5,000,000 $5,120,000 $5,250,000 $ 3,500,000 45% None 35% 35% 40% 45% 11

12 Tax Revenue over 10 Years under three difference Estate Tax Sceneries: 12

13 How the Lifetime (Inter-Vivos) Dynasty Trust Fits into the Overall Estate Plan: Will and/or Revocable Living Trust: Marital Trust Funded at Death Minnesota Non-Marital Trust Funded at Death Trusts Often Used to Supplement the Above: Grantor Retained Annuity Trust (GRAT) Domestic Asset Protection Trust (DAPT): Self Settled Tax neutral Purposefully Included in Estate >Incomplete Gift Grantor Trust for Income Tax Purposes, i.e., Taxed to Grantor Funded Lifetime Grantor Remains Permissible Discretionary Beneficiary > Generally 10-40% of Assets Situs in Self Settled Trust State (i.e., Alaska, Delaware, Nevada or South Dakota) Charitable Trusts: Charitable Remainder Trust Charitable Lead Trust Private Foundation Family Bank Dynasty Trust: Third Party/Self-Settled* Excluded from Estate Generally Grantor Trust (Initially) Funded Lifetime, death, or both Situs either in Grantor s resident state (i.e., Minnesota) [or] in another Dynasty State (i.e., Alaska, Delaware or South Dakota) Multigenerational * Please Note: Dynasty Trust can also be Self Settled. Please be cautious of Private Letter Ruling and IRC 2036, if Self-Settled, or combination of Third Party/Self-Settled Pets Purpose Trusts: Key Family Assets Private Family Trust Company (Delaware & South Dakota) 13

14 How to Structure the Dynasty Trust: Third party versus self-settled Grantor versus non-grantor Promissory Note Sales Opportunity Directed trust administration (versus delegated) resulting in flexibility and control for the family Asset Protection (discretionary distribution standards and state law) Preserving family values in perpetuity: Promotion of social & fiscal responsibility (family bank) 14

15 Two Major Types of Irrevocable Inter- Vivos Dynasty Trusts: Self Settled: Grantor is permissible beneficiary along with family and/or others; Only available in 14 states with statutes: Third Party: Grantor is not a permissible beneficiary. The only beneficiaries are family and others; Available in all 50 states. Please Note: Alaska Delaware Hawaii Missouri Nevada New Hampshire Ohio Oklahoma Rhode Island South Dakota Tennessee Utah Virginia Wyoming Domestic Asset Protection Trusts (DAPTs)- Self Settled Dynasty Trusts, GST, ILITs - Either Self Settled or Third Party or both GRAT, QPRT, HEET: Third Party 15

16 Four Major Types of Self-Settled Trusts (DAPT): Main Purpose Self-Settled (Grantor Permissible Discretionary Beneficiary) Complete or Incomplete Gift? Estate Tax Generation- Skipping Transfer (GST) Tax Self-Settled Dynasty Trust Estate planning; Asset protection Yes Completed gift using gift tax exemption (PLR ) Excluded from estate? (PLR & IRC Section 2036) GST exempt? (PLR & IRC Section 2036) Third Party/Self- Settled Dynasty Trust Estate Planning; Asset protection Grantor not initially a beneficiary (Trust protector can add and remove grantor as beneficiary) Completed gift using gift tax exemption (PLR ) Excluded from estate? (Generally excluded) GST exempt? (Generally exempt) Tax Neutral Self-Settled Trust (Not a Dynasty Trust) Asset protection Incomplete Gift Non- Grantor Trust (Not a Dynasty Trust) State income tax savings (depends upon state) Grantor or Grantor or Please Income note: Taxes Trust protector non-grantor power add trust grantor as a beneficiary Grantor trust Non-grantor trust non-grantor may trust toggle on and off grantor trust status. Please note: Trust protector power to remove grantor as a beneficiary prior to three years of death may avoid any possible IRC Section 2035 issues. * PLR deals with both inter-vivos and testamentary powers Yes Incomplete gift Grantor holds power of appointment Included in estate N/A Yes Incomplete gift see PLR 2013 Grantor holds powers of appointment (among other powers)* Included in estate Asset Protection Yes Yes Yes Maybe/maybe not? N/A 16

17 Possible Self-Settled Dynasty Trust Estate & GST Tax Issues: Estate Taxes GST Taxes Grantor Does Not Receive Distributions Not included in the estate GST exempt Grantor Receives Periodic Hardship Distributions May not be included in the estate Usually no GST issues* Grantor Receives Frequent Distributions to Live Likely estate tax problem Included in the estate (PLR & IRC 2036) Likely GST problem* (PLR & IRC 2036) * If estate tax uncertainty, possible ETIP issues regarding GST and allocation of GST exemption? 17

18 IRS PLR We are specifically not ruling on whether Trustee s discretion to distribute income and principal of Trust to Grantor combined with other facts (such as, but not limited to, an understanding or preexisting arrangement between Grantor and trustee regarding the exercise of this discretion) may cause inclusion of Trust s assets in Grantor s gross estate for federal estate tax purposes under

19 Possible Answers for Both Estate and Asset Protection Issues - Adding the Grantor as a Future Beneficiary of Self-Settled Dynasty Trust?: Key trust protector power for third party and/or self-settled trusts: Power to add and remove beneficiaries Grantor? Grantor s spouse? Class of grandparent s descendents - Example: This class may be defined: x s [grantor s grandparent s] descendants. Caution: Toggling grantor trust status on or off IRC Section 2035 Coordinates with 2036(a)(1) so, if trust protector can remove grantor as beneficiary within three years of death Consider only adding grantor as a beneficiary based upon status of the spouse: Spouse named as initial beneficiary: Utilize floating spouse: My spouse means the person, if any, who is married to and not living separate and apart from that person (other than for medical reasons), or who satisfied these requirements at that person s death and has not remarried. Grantor later added as a beneficiary upon spouse s death or upon divorce Grantor becomes beneficiary after term of years: 10 years Avoids 10 year clawback if grantor goes through bankruptcy 5 years Grantor sells assets to self-settled trust for a promissory note. 19

20 Ideal Estate and Asset Protection Plan?: When the check to the funeral parlor bounces - Anonymous CAUTION: May not work!!! If gift too much to a self-settled trust? Possible asset protection issues Possible estate tax issues: Implied agreement can be inferred from circumstances IRC section 2036 Risk of transferring too large of a percentage of a client s assets to the trust (generally 10-40% is OK) 20

21 Summary: Self Settled Dynasty Trusts Possible Negative Estate, GST and Gift Tax Consequences? Gift Taxes PLR (Completed Gift) IRS Refused to rule whether excluded from estate. Estate Taxes PRL (Estate Tax Certainty?) Possible Issues - Two prong test: 2036(a) retain possession or enjoyment of property right to income 2038 Revocable transfers right to designate who shall possess on enjoy property Three Main Possibilities Re Grantor Trust Distributions and IRC 2036 (Self-Settled Trust): No withdrawals Not included in estate Periodic hardship withdrawals Maybe not included in estate Live off trust Included in estate PLR Does not address IRC 2036 Issues 2036: Implied agreement can be inferred from circumstances Generation Skipping Taxes ETIP issue as a result of uncertainty regarding estate tax inclusion? 21

22 Two Types of Dynasty Trusts For Income Tax Purposes - Grantor and Non-Grantor: Non-Grantor Trust Trust is a separate taxpayer responsible for paying federal and state income and capital gains taxes: Usually funded with growth assets so income taxes are minimized (also no tax with insurance if purchased by the Trust); Quarterly estimated payments due to federal and possibly the state; Distributions to beneficiaries are taxed in beneficiary s resident state in year received; Generally a non-grantor trust is desired when large capital gains or sale of assets are anticipated (i.e., business, stock, etc.); If non-grantor trust is sitused (i.e., administered) in a no income tax trust state, then the state income tax and capital gains taxes will be saved. These states are:» Alaska» Nevada» Washington» Delaware» New Hampshire» Wisconsin» Florida» South Dakota» Wyoming Grantor Trust Usually the choice for a Dynasty Trust initially to grow and leverage; Then shift to non-grantor trust status when the assets are sold. 22

23 Two Types of Dynasty Trust For Income Tax Purposes - Grantor and Non-Grantor (Cont d): Grantor Trust: Grantor treated as owner of Trust property for income tax purposes, but not for transfer tax purposes: Grantor trust is not taxed for estate tax purposes and/or GST tax purposes; Grantor pays income tax on Trust; Tax free gift to beneficiaries Trust grows faster; Draft Trust to intentionally violate grantor Trust provisions IRC Sections ; Grantor can be reimbursed for income taxes paid on a discretionary basis (revenue ruling ); Asset Protection Trust Protector can switch off grantor Trust status as well as turn it on; Allows for powerful Promissory Note Sale strategy: Funding Trust with $5 million justifies $45 million Promissory Note Sale. Interest on Note paid to grantor tax free (revenue ruling 85-13). 23

24 Possible Future Transfer Tax Legislation The Obama Budget Proposals (cont d) Grantor Trusts/ Promissory Note Sales: Trusts established before enactment date are grandfathered (no additions to these trusts) Coordinate income and transfer tax rules All future appreciation in the assets that are sold to the trust via promissory note sale, etc. Subject to estate tax Despite how long grantor lives Whether or not note paid off IDIT included in estate at grantor s death All distributions from a grantor trust to one or more beneficiaries during grantor lifetime Gift taxed If terminate grantor trust status during grantor s life Gift taxed ETIP issue Cannot allocate GST exemption Exception Life insurance trusts 24

25 Popular No Income Tax Trust States: Alaska Delaware (Exception: Tax on residents) Nevada New Hampshire (Exception: Dividends & Interest Tax on Residents) South Dakota Wyoming 25

26 Alaska and South Dakota have the Lowest State Premium Tax Rates: Alaska Arizona California Connecticut Delaware Florida Georgia Hawaii Illinois Massachusetts Minnesota Nevada New Hampshire New Jersey New York North Dakota Ohio Pennsylvania South Dakota Washington Wyoming 10 bpts. 200 bpts. 235 bpts. 175 bpts. 200 bpts. 175 bpts. 225 bpts. 275 bpts. 50 bpts. 200 bpts. 200 bpts. 350 bpts. 125 bpts. 210 bpts. 200 bpts. 200 bpts. 140 bpts. 200 bpts. 8 bpts. (Lowest) 200 bpts. 75 bpts. Ways to take advantage of Alaska or South Dakota s lowest premium tax: 1. Establish AK/SD trust with AK/SD trustee Purchase policy [or] 2. Establish an AK/SD LLC with AK/SD LLC agent Purchase policy What if existing trust with situs outside of Alaska or South Dakota?: 1. Set up a AK/SD LLC with AK/SD LLC agent to purchase the policy [and] 2. Allocate AK/SD LLC units to trust with situs outside of AK/SD 26

27 Typical Choices for Dynasty Trust Trustee: Trust administration needs to take place in Dynasty trust jurisdiction: Commercial Bank: One stop shopping (i.e., administration, investment management, custody, tax filing, distributions, etc ); Family (Personal Liability); Friends (Personal Liability); Employee and/or Business Colleagues; Possible conflict Private Family Trust Company (i.e., centa-millionaire & billionaire families) Directed Administrative Trustee: Great combination of independent administrative trustee, family, friends and family advisors; Provides flexibility and control regarding investments and distributions; Liability Protection: Gross negligence/willful misconduct standard for liability of family members serving as co-fiduciaries. 27

28 Distribution Committee (Fiduciary, Not Trustee) Directs Administrative Trustee Re Distributions Independent Committee (Tax sensitive distributions) *Combine all functions Full Trustee Example: Typical South Dakota Dynasty Directed Trust Structure with a Trust Protector Promoting Flexibility and Control: Trust Protector Family Committee (Non-tax sensitive distributions) (Family, Friends or Advisors) (Fiduciary, Not Trustee) Powers include: Terminate the trust; Modify or reform the trust; Veto or direct trust distributions; Add or remove beneficiaries; Change situs and/or governing law of the trust; Appoints successor trustees & fiduciaries; Replaces trustees and fiduciaries. Investment Committee (Family & Family Advisors) (Fiduciary, Not Trustee) Directs Administrative Trustee Re Investments Stocks & bonds Insurance Art FLPs LLCs Real estate Private equity Closely-held stock Administrative Trustee (i.e., Sitused in South Dakota) Ownership of assets Establish & maintain trust bank account Prepare & sign trust tax return Trust statements Make distributions Receive contributions Take direction from: Investment Committee Distribution Committee 28

29 Types of Trust Administration Directed Trustee Trifurcates the traditional trustee role to investment & distribution committees and an administrative trustee: Section nd Restatement of Trusts the administrative trustee is generally not liable for following the instructions of an empowered person (i.e., investment and/or distribution committees) within the trust instrument State Statutes. The administrative trustee has no discretionary investment (3 rd party) duties regarding the trust. The selection of investment managers is generally the responsibility of the investment committee run by the family. The administrative trustee takes direction from either a co-trustee, trust advisor, investment committee, or LLC regarding both investments and distributions. State statutes and the trust document exonerate the administrative trustee from taking direction for investments and/or distributions. Typically gross negligence and willful misconduct statutes. Please Note: Some advisors utilize directed trust language without state directed trust statutes (not as powerful). State Statutes Not all states have directed trust statutes. for a Dynasty Trust: Delegated Trustee Trustee delegates to outside investment advisors following the procedures below: Due Diligence on Selection of Investment managers for the trust (i.e., those being delegated to) Experience, track record, ADV, Compensation, Duration Monitoring of trust investment managers being delegated to Asset allocation, FMV Drop, Large Concentration, Investment Trust Investment Policy Statement Drafted by both trustee and investment advisors & managers, and updated and reviewed at least annually. Exoneration for testamentary trusts not allowed in many jurisdictions (Example: NYEPTL ) State Statutes Delegated Trust statutes available in all 50 states. 29

30 Selected Directed Trust States: Alaska * North Carolina Arizona Ohio Colorado South Dakota * Delaware * Tennessee Florida ** Virginia Maine Washington ** Nebraska Washington D.C. Nevada ** Wyoming New Hampshire *Murphy Case Dynasty Statutes and no state income tax state (Best) **No state income tax, but not Murphy case Dynasty Statute state Murphy Case/Suspension of the Power to Alienate (Best Dynasty Trust States): The Murphy case approach, which the IRS acquiesced in 1979, to abrogating or abolishing the RAP is key according to most GST and RAP experts. This approach shifts the perpetuities inquiry from remoteness of vesting to suspension of the power to alienate. For example, if the trustee has an explicit or implied power to sell, the trust jumps outside the rule of suspension of alienation, which limits the duration of the trust. Generally, these states have also abrogated their RAP, which addresses the timing issue. As a result, these states address both the timing and the vesting issues associated with doing away with their RAP as required by the Murphy case. 30

31 Advantages of a Directed Trust: No requirement to diversify trust investments/assets Can hold large concentration in one stock (public or closely-held) Ability to provide broad asset allocation models for trust assets, for example: Harvard University Endowment: Yale University Endowment: Foreign Bonds 2% Domestic Bonds 5% Publicly Traded Commodities 2% High Yield 2% Inflation- Indexed Bonds 4% Domestic Equities 13% Foreign Equities 13% Domestic Equity Natural 6% Resources 7% Foreign Equity 8% Bonds and Cash 4% Private Equity 35% Natural Resources 15% Emerging Marketings 13% Real Estate 12% Private Equities 19% Source: Harvard University Endowment, Harvard Management Company, 2012 Investment committee responsible for initial due diligence and quarterly monitoring of investment assets Absolute Return 18% Directed administrative trustee does not have to interfere Excellent control and flexibility in both up and down economic cycles Source: Yale University Endowment, Yale University Investments Office, 2012 Real Estate 22% 31

32 Comparison of a Directed & Delegated Dynasty Trust: Individual Delegated Trustee Corporate Delegated Trustee Directed Trust Structure with Administrative Trustee Family & Friends Can Control Investments Yes Not Usually Yes Trustee Initial Due Diligence and Quarterly Monitoring of Trust Assets Family & Friends Can Control Distributions Personal Liability (For Investment & Distribution Decisions) High Level (Need to document file) Yes (Need Independent Trustee for tax sensitive) Yes, as a Individual Trustee or Co-Trustee (High) High Level (Need to document file) Not Usually, Unless Co-Trustee Yes, as a Individual Co- Trustee with Corporate Trustee (High) Low Level (Left to Trust Family Investment Committee) Yes as Distribution Committee Fiduciaries (Need Independent distribution committee member(s) for tax sensitive) Yes, but very limited and only as a fiduciary (not trustee) running the investment and/or distribution committees with gross negligence or willful misconduct standard Trust Protector Not Usually Not Usually Yes Power to Remove Trustee and/or Fiduciary Yes Yes Yes State Income Tax Yes Yes Generally, No Asset Diversification Requirements Broad Based Investments Allowed in the Trust (Investment Flexibility) Yes Yes No No No Yes 32

33 Typical Trust Protector Powers (Vary by State Statute): Flexibility Future Circumstances Drafting Personal vs. fiduciary powers No personal gain, duty of loyalty & impartiality, actions for good of trust & beneficiaries Power to remove or to replace trustees Power to veto or direct trust distributions Power to add or remove beneficiaries Power to change situs and the governing law of the trust Power to veto or direct investment decisions Consent to exercise power of appointment Amend the trust as to the administrative and dispositive provisions Approve trustee accounts Terminate the Trust 33

34 Selected States with Trust Protector Statutes:» Alaska» Hawaii» New Hampshire» Arizona» Idaho (1999)» South Dakota (First State Statute 1997)» Delaware» Nevada» Wyoming 34

35 Special Purpose Entity or Trust Protector Company (i.e., Delaware, Nevada, South Dakota & Wyoming): Example of South Dakota Special Purpose Entity: Special Purpose Entity (LLC) Trust Protector Investment Committee Distribution Committee Directs South Dakota Trust Company, LLC Directed Trust Administrative Trustee Not a trust company D&O, E&O Insurance Trust assets South Dakota Investment LLC (SDTC Member) Trust Protector, Investment Committee and Distribution Committee are housed in an LLC acting as agents or employees of the LLC to further tie the trust to the favorable situs state and reduce their liability by purchasing insurance (D&O) as well as provide continuity. 35

36 Special Purpose Entity or Trust Protector Company (i.e., Delaware, Nevada, South Dakota & Wyoming): Unregulated Special Purpose Entities or Trust Protector Companies: The unregulated special purpose entity or trust protector company alternative is generally used in combination with the "directed trust" structure. A recent trend is to establish unregulated entities such as a limited liability company to place a liability umbrella over the heads of the individuals filling the roles of Trust Protector, Investment Committee and/or Distribution Committee. Unregulated Special Purpose South Dakota LLC Serves the role of: Trust Protector; Investment and/or Distribution Committees [And] Provides liability protection through D&O/E&O to independent advisors serving the family in these roles. It is very difficult, if not impossible, to acquire individual liability insurance coverage to serve as committee members and/or trust protector. However, some insurance companies will provide coverage to an entity established specifically for these purposes, thus protecting the trust protector and committee members. Such an entity would also provide legal continuity of its corporate existence by continuing without regard to any single individual s death, disability or resignation. The entity typically has by-laws that allow for additional members to be added or removed so that the entity can continue along with the trust. These entities have to be properly structured so as to avoid estate tax inclusion issues. South Dakota is the only state with a specific state statute for these special purpose unregulated entities. Delaware, Nevada, and Wyoming also allow on a case by case basis and may refer to them as trust protector companies. These entities are generally exempt from regulated Private Trust Company status and are typically special purpose type entities with limited defined duties. 36

37 Grantor as Investment Co-Trustee/Fiduciary: References: Jennings v. Smith, 161 F. 2d 74 (2 nd Cir. 1947) IRC 2036(a)(2) Right to designate who will enjoy the trust property IRC 2038 Power to alter a beneficiary s interest Alternatives: LLC Manager Directed trust investment committee: Grantor and/or family Possible Issues: State income tax? Asset protection? 37

38 Levels of Protection: Dynasty Trust Asset Protection: Discretionary Distribution Standards* Spendthrift Clause Placing Trust assets in a LLC Sole remedy charging order as exclusive remedy * Types of Distribution Standards: Mandatory Income and/or Principle (Not Recommended) Support (Health, Education, Maintenance & Support/HEMS) O.K. Discretionary (Best) Incentive Trust (also Discretionary) 38

39 Discretionary Trusts: Both Self-Settled and Third Party trusts; Asset Protection Following Restatement Second and Common Law: Discretionary Interest in trust is not: Rather a mere expectancy Enforceable Right Same with limited power of appointment and remainder interest Statutes South Dakota (4 Levels), Nevada (2 Levels), and Delaware (1 Level). Case Law: Limited + Few States Restatement Third Most Other States Property Interest [Please see SB 98 Classification of Trusts Merric Law Firm (Denver, CO) for more information 39

40 Dynasty Trust Spendthrift Clause (Asset Protection Cont d): Most all states have spendthrift clause protection for all types of Trust including Dynasty Trusts: Alaska Delaware Nevada South Dakota Please Note: Possible Exception Creditors 40

41 Asset Protection: LLC s and LP s One may want to hold Dynasty Trust assets within an LLC or LP for asset protection purposes as well as ease of administration Best LLC Statute: Sole Remedy Charging Order [versus] Judicial Foreclosure Sale Sole remedy charging order statute states for both LLC s and LP s: Alaska* Arizona Delaware * Florida Nevada Minnesota (LLC Only) New Jersey (LLC only) Oklahoma South Dakota * Texas Virginia Wyoming (LLC only) Please See: *Also Murphy Case, Dynasty Trust and No State Income Tax on Trust State Mark Merric Updated LLC Asset Protection Planning Table Steve Leimberg s Asset Protection Newsletter, January 23, Mark Merric Charging Order: What Does Sole or Exclusive Remedy Mean? Trusts & Estates Magazine, April Mark Merric Forum Shopping for Favorable FLP and LLC Legislation Steve Leimberg s Asset Protection Planning Newsletter, August 8,

42 What is a LLC Sole Remedy Charging Order? (Asset Protection Cont d): Only right to distribution (when and if made) Rather than allowing creditor to attach all rights of an LLC or LP Interest No method to force a distribution No voting rights Waiting game Sole and exclusive remedy No other legal or equitable remedies Use two LLCs Rainy Day Expenses, if needed 42

43 Miscellaneous Asset Protection Considerations: Reimbursement of Attorney Fees: DE & SD: any prevailing party If Trust is sued and lawsuit unsuccessful, the trust is reimbursed for legal fees AK: only if trust is void or set aside MN: Silent, No trust statute NV: only to prevailing petitioner (petitioner must be beneficiary or trustee) Privacy National trend is public regarding any court matters involving Trusts including reformations/modifications, lawsuits, etc : AK: Up to a court DE: Up to a court (limited 3 years) MN: Up to a court NV: Up to a court (not perpetual) SD: Automatic seal in perpetuity 43

44 Keeping Dynasty Trust a Quiet to Beneficiaries Selected Beneficiary Notice Statutes (Notice of Trust/Trust Assets): South Dakota: Ability to waive beneficiary notice of trusts assets. Trust document provides: The settlor, trust protector and/or advisor; The ability to expand, restrict, eliminate, or modify The rights of beneficiaries to receive trust information; Sample Trust Provision Notice: I hereby direct that the Trustee is not required to provide the notice set forth in SDCL to qualified beneficiaries. Alaska allows for beneficiary waiver of notice but limits settlor to exempt the trustee from the notice requirements during the life of the settlor or until the settlor s incapacity, whichever is shorter; Delaware does allow for the waiver of beneficiary notice but does not expressly allow for the trust advisor or protector to modify notice to beneficiaries. Minnesota & Nevada is silent on waiver of notice to beneficiaries. 44

45 Leveraging the Dynasty Trust Promissory Note Sale to a Defective Grantor Dynasty Trust: Sale to a defective grantor Dynasty Trust In Exchange for the trust s Promissory Note with periodic interest payments (at least annual) for a period of years with single balloon payment of principal at end of period Promissory Note is secured by trust assets sold to the trust and authorizes repayment of principal without penalty Trust excluded for estate tax purposes, so income and principal are taxed to grantor (Revenue Ruling 85-13): No gain or loss on sale to trust Grantor not taxed separately on interest payments of the Note Estate tax savings if trust has a total net return in excess of note interest rate Self Canceling Installment Note (SCIN) 45

46 Dynasty Trust Enormous Size Potential without Leveraging: Assumptions - $5 million Gift to Trust; Trust lasts 150 years and earns 3% after- tax; 46% transfer tax every 30 years Three Generation GST Trust - $68,323,832 Dynastic trust - $433,901,284 Number of Years Value of Perpetual Dynasty Trust After # Years Three Generation Dynasty Trust (i.e., Common Law or USRAP State) 31 Years $12,500,402 $12,500, Years $30,341,756 $30,341, Years $73,647,406 $73,647,406 ($33,877,807) Taxes $39,769, Years $178,761,584 $52, 126, Years $433,901,284 $68,323,823 46

47 Dynasty Trust Enormous Size Potential with Leveraging via the Promissory Note Sale to Defective Grantor Dynasty Trust: Assumptions: $5.25 Million Gift to Trust- 150 Years $47.25 Million Promissory Note- Post Discount ($67,500,000) (30% Discount) 9 YR Note- 1.00% Mid Term Rate (May 2013) 46% Estate Tax Rate (30 Years Per Generation) 3% After Tax Return Number of Years Value of Perpetual Dynasty Trust After # Years Three Generation Dynasty Trust (i.e., Common Law or USRAP State) 9 Years $42,872,071 $42,872,071* 39 Years $104,061,770 $104,061, Years $252,585,229 $252,585, Years $613,090,648 $613,090,648 ($282,021,698) Taxes $331,068, Years $1,488,131,922 $433,939, Years $3,612,086,765 $568,773,630 *Does Not Include State Income Taxes 47

48 Promissory Note Sale Dynasty Trust Leveraging Strategy: Grantor Gifts $5MM Allocates $5.25MM of Gift Exemption Allocates $5.25MM of GST Exemption (2012) Promissory Note Sale of Assets to Trust Up to 9 times $5.25MM funding amount (or $47.25MM) Note Term: 3-20 years (Generally 9 years) Interest Only Balloon Note Back to Grantor Interest for 9 Years (Not Taxed) Interest based upon IRS 1274 Rates (1.00% May 2013) Balloon Principal Payment in Year 9 of $47.25MM Initial Gift and Growth remain in trust after balloon note payment, for beneficiaries; possibly fund another Promissory Note Sale Dynasty Trust $5MM Initial Gift Growth on Initial $5MM Gift Growth on $47.25MM Promissory Note in excess of 1274 rate for 9 years Please Note: If married, it is possible to make an initial gift of $10.50MM and therefore a $94.50MM Promissory Note or if maximize current Gift and GST Exemptions up to $5.25MM per spouse resulting in a $47.25MM Note for one spouse or a $94.50MM Note for both spouses. Beneficiaries 48

49 Larger Gift Tax Exemptions ($5MM) Larger Gifts & Installment Sales More Appraisal Risk Defined Value Transfers Regarding Promissory Note Sales Protect Against Appraisal Risk: Example: $5MM: Gift to Dynasty Trust $45MM: Promissory Note Sale with Discounted Asset $50MM: IRS Determined Value of Discounted Asset Problem? Solution: Defined Value Transfer Defined Value Transfer: Expresses transferred asset as dollar value [vs.] percentage interest [or] number of units Wandry v. Commissioner, T.C. Memo, , Mar. 26, 2012 Example: $X to Dynasty Trust as Promissory Note Sale [and] Balance to GRAT as a gift 49

50 Applicable Federal Rates (AFR) as of May 2013: Year/Term May Rate April Rate 0-3 Years, Short Term 0.20% 0.22% 3-9 Years, Mid-Term 1.00% 1.09% 9+ Years, Long Term 2.60% 2.70% Please Note: Section 7520 Rate: 1.2% (April - 1.4%) 50

51 Arbitrage Over Note Interest of 1.00% (as of May 2013): $5.25MM Gift Down Payment Up to $47.25MM- Promissory Note (S) Typically 3-20 Year Note (Usually 9YR Note) 1.00% Interest on $47.25MM 9YR Note- $472,500 Interest tax free to Grantor (revenue ruling 85-13) If asset returning more than 1.00% the Arbitrage remains in the trust for heirs: Can be used by trustee to buy real estate for beneficiaries, buy life insurance, invest, etc. Examples of Possible Assets to Create the Arbitrage: Closely-Held Stock Investments Rent from Residential or Vacation Homes 51

52 Fund trust with $5.25 million (use Gift & GST tax exemptions) Justifies PNS of $47.25 million post discount (All PNS combined cannot exceed) 1.00% Interest rate for May 2013 on $47.25MM 9YR Note- $472,500 annual interest payment Annual Interest payment tax free to Grantor (revenue ruling 85-13) Interest payment can be paid in-kind Promissory Note Sale (PNS) to Grantor Defective Dynasty Trust: Dynasty Trust (Cornerstone) If PNS asset returning more than 1.00% the Arbitrage remains in the trust for heirs: Can be used by trustee to buy real estate for beneficiaries, buy life insurance, invest, etc. PNS PNS PNS PNS Sale of Remainder Sale of Remainder Sale of Remainder Investment Assets Residence/ Vacation Home Closely - Held Stock FLP Walton GRAT* QPRT** CLAT*** *Please See: The GRAT Remainder Sale by David A. Handler & Steve J. Oshins, Trusts & Estates: December ** Structure QPRT so remainder passes to grantor GST trust: Grantor s spouse is beneficiary; Spouse lives in residence tax free; Grantor can reside tax free; Grantor pays rent upon spouses death, or if spouse not beneficiary. Also Please see: I.R.S. Priv. Ltr. Rul (May 8, 2009). ***Sale of remainder interest of a CLAT: See Jonathan E. Gopman, Todd I. Steinberg, and Steven J. Oshins, Ruling on Assignment of Vested Remainder Interest May Have Reached Wrong Conclusion, available at 52

53 Promissory Note Sale (PNS) - Doctors: P.C. Leases Equipment from LLC Professional Corporation Limited Liability Co. (LLC) (Owns Medical Equipment) P.C. pays Lease Payment to LLC 1) Doctors establish a LLC (with sole remedy charging order protection as the exclusive remedy, i.e. Alaska, Delaware, Nevada or South Dakota) to own the medical equipment 2) Professional corporation leases equipment from LLC for fair market rental value Lease payments over IRS May rate of 1.00% remain in Dynasty Trust. PNS Grantor Defective Dynasty Trust 3) Doctors each setup Dynasty Trust and enter into PNS of the discounted LLC interests to the Dynasty Trust 53

54 Designing the Incentive Family Bank Dynasty Trust: Best: If Directed regarding trust administration and discretionary regarding distributions. Incentive Trust Defined: Trusts with provisions designed to encourage or discourage certain types of behavior. Trying to help beneficiary recognize some aspect of what got grantor to where they got so that some aspect of grantor s heritage can be valued and perpetual (Calibre). Leave kids enough to do anything, but not enough to do nothing - Warren Buffet Remember values and names of great-grandparents Promoting social & fiscal responsibility within the family (family values) External Motivation: (act done for outward reward or fear of failure) [versus] Internal Motivation (act done for its own sake and because they enjoy it, i.e. enthusiasm and passion) Motivation Summary: Want motivation to come from inside not be supplied from outside; Money and material goods are external and happiness is internal; Training process for families; Handing down values can be achieved in a more positive, less threatening manner through charitable endeavors (Calibre); Works best with family distribution committee in a Directed Trust 54

55 Distribution Committee (Fiduciary, Not Trustee) Directs Administrative Trustee Re Distributions Independent Committee (Tax sensitive distributions) *Combine all functions Full Trustee Example: Typical Modern Dynasty Directed Trust Structure with a Trust Protector Promoting Flexibility and Control: Trust Protector Family Committee (Non-tax sensitive distributions) (Family, Friends or Advisors) (Fiduciary, Not Trustee) Powers include: Terminate the trust; Modify or reform the trust; Veto or direct trust distributions; Add or remove beneficiaries; Change situs and/or governing law of the trust; Appoints successor trustees & fiduciaries; Replaces trustees and fiduciaries. Investment Committee (Family & Family Advisors) (Fiduciary, Not Trustee) Directs Administrative Trustee Re Investments Stocks & bonds Insurance Art FLPs LLCs Real estate Private equity Closely-held stock Administrative Trustee (i.e., Sitused in Delaware or South Dakota) Ownership of assets Establish & maintain trust bank account Prepare & sign trust tax return Trust statements Make distributions Receive contributions Take direction from: Investment Committee Distribution Committee 55

56 Promotion of Fiscal Responsibility: Sample Incentive Family Bank Dynasty Trust Provisions: Draft family mission statement [and] videotape family goals (transcribe); Incentive Clauses (i.e. $2 of trust income for each $1 of W-2 income) exceptions, i.e. disability; Distribution audit to determine suitability of future distributions Cap distributions based upon beneficiaries net worth indexed for inflation; Assumption $7.5MM enough to live well, but have to protect it (Financial Counsel). Supplemental income for socially responsible profession, i.e. artist, musician, teacher, etc; Monthly Stipend for stay at home parent, also adult child to care for elderly relative; Education costs for family in perpetuity; Lump sum received at college graduation and/or advanced degree(s) (depending upon quality, academic rigor and college reputation); If stipulate 3.0 GPA, may choose easier courses. Monthly payments for Academic Excellence ; Medical costs for family in perpetuity; Real Estate Use Factor : buy real estate for children, grandchildren within the trust and they use it tax free (operates as Family Time Share); Clause to encourage descendants to stay in marriage while the children are minors vest extra in trust; Clause to encourage descendants to get married (wait until certain age, marry right person, etc.); Divorce protection; Floating Spouse Clause (in-laws): define in-law spouses as spouse I am married to and living with ; Deny trust payments unless beneficiary has a prenuptial agreement; Beneficiary conflict clause if beneficiary sues, they get nothing; Denial of distributions if beneficiary fails a drug test or psychological treatment; Family Bank: Loan to Beneficiary (term insurance purchased to provide repayment); Denial of distributions if beneficiary does not participate in family meetings re charitable giving, family investments, estate planning and 56

57 Sample Incentive Family Bank Dynasty Trust Provisions (cont d): Promotion of Social Responsibility: Prepare written document or transcribed videotape illustrating charitable desires, goals, values and purpose (i.e. mission statement); As part of trust or as letter of wishes; Get buy in from family, advisors and distribution committee; Education develop a family learning plan, family/distribution committee meetings, site visits to charities, advice from other philanthropists. Charitable donations by family in perpetuity once dynasty trust attains a certain FMV: The family distribution committee makes donations from the trust directly to charity, thus actively involving the family with charities and thus promoting the family values and mission statement. If beneficiary fails to meet trust performance standards, then funds divert to charity; Child works for charity, family foundation, or volunteers Supplement Income; Conservation Easement on family residence and/or vacation home; Limited powers of appointment/separate shares (charitable giving option); Cryogenics; Charity gift over; Governance distribution committee (possibly hire outside advisor consultants). 57

58 New Approach to Family Bank Dynasty Trust Incentive Provisions Providing Guidelines for Trustee Discretion: Family distribution committee makes distribution based upon following factors: 1. The ability to live within one s means, i.e., managing spending consistent with one s level of income; 2. The ability to manage spending relative to income in a manner that would be consistent with being able to save a portion of income, as needed; 3. The ability to understand and manage credit and debt processes, leading to avoidance of excessive debt; 4. The ability to maintain reasonable accounting of one s financial resources; 5. The ability to understand and manage one s personal assets, either using basic investment procedures and principles oneself or to delegate these actions responsibly to appropriate advisors; 6. The ability to generate income for spending needs if additional resources are required or desired beyond trust distributions; 7. The ability to use of a portion of one s income and/or financial resources to support charitable activities of one s choosing; and 8. The ability to show initiative, engage in entrepreneurship, and demonstrate purpose in paid or unpaid work. Source: Heckerling Use and Abuse of Incentive Trusts: Improvements and Alternatives Jon & Eileen Gallo and James Grubman Ph.D. 58

59 Summary: How to Structure a Dynasty Trust: 1. Dynasty Trust: Excluded from Estate Utilize $5.25 million Gift and GST Exemptions: 2. Third Party vs. Self-Settled vs. Both Trust Protector has power to add Beneficiaries (Grantor? Grantor Spouse?) Use Class of Grandparents' descendents 3. RAP Statute Preferably Murphy case unlimited duration dynasty state with no income tax (i.e., South Dakota) 4. Directed Trust regarding administration: Fiduciaries Investments Investment LLC Special Purpose Entities 5. Need Trust Protector Preferably Murphy case Dynasty state with Trust Protector statute 6. Income Tax Defective (Grantor Trust) initially (usually) Promissory Note Sale 7. Discretionary Distributions vs. Mandatory "or Support 8. Family Bank/Incentive Trust 59

60 Tax Neutral Included in Estate Asset Protection: Domestic Asset Protection Trust Tax Neutral Included in the Estate Incomplete Gift No $5.25mm Exemption necessary Grantor Trust for Income Tax Purposes Self-Settled Grantor as a Permissible Discretionary Beneficiary with family and/or others Typically Transfer 10-40% of Assets Provides Four Levels of Asset Protection Situs AK, DE, NV or SD Promissory Note Sale - Grantor - Beneficiary - SCIN Summary of 21 st Century Family Estate Plan: Loan Dynasty Trust Defective Minnesota Will/Revocable Living Trust Education Planning and Trusts Irrevocable Insurance Trust Excluded from Estate Shifting Growth on Assets: Sale of Remainder Walton GRAT Sale of Remainder QPRT Private Foundation and Charitable Trusts Advanced Trust Planning See Below: Sale of Remainder CLAT Excluded from Estate Use $5.25mm Gift and GST Exemption Third Party/Self- Settled* Grantor Trust for Income Tax Purposes Initially DAPT Situs AK, DE, or SD *Please Note: Dynasty Trust can also be Self Settled. Please be cautious of Private Letter Ruling and IRC 2036, if Self-Settled initially. PNS- Residency/ Vacation Home 60

61 Four Levels of Protection: 1. Self-Settled Trust Statute: Domestic Asset Protection Trusts (DAPT) (Both Tax Neutral DAPT and Dynasty DAPT): Fraudulent Conveyance Period; Exception Creditors; 2. Discretionary Interest Protection Based Upon Restatement 2nd: SD: 4 levels Powerful; NV:2 levels Limited; DE:1 level Limited; AK: None (Legislation Pending 2013) 3. LLC- Sole Remedy Charging Order Protection as Exclusive Remedy; 4. Spendthrift Protection (weakest level of protection, but available in all DAPT states) Plus Other Unique Advantages: Privacy: Varies by state Trend is public (SD is total seal in perpetuity/de is seal for 3 years) Attorney Fees: Reimburse South Dakota trustee Trust if Company, unsuccessful LLC All Rights (DE Reserved and SD) 61

62 Summary of Key DAPT Considerations (Both Tax Neutral DAPTs and Dynasty DAPT): Exception Creditors DAPT State Fraudulent Conveyance Tort Preexisting Creditor Divorcing Spouse Alimony & Child support Statutory Award Attorney Fees to Trustees Lawsuit Privacy Discretionary Interest Not Property LLC & LP Sole Remedy Charging Order Special Purpose Entity Alaska 4 Years (Legislation Pending) No No Problem, unless DAPT set up within 30 days before marriage or after marriage Silent, but possible issue if transfer occurs after marriage or within 30 days before marriage* No (only if trust voided) No Statute (left to courts) No (Legislation Pending) Yes - Delaware 4 Years Yes, Preexisting Torts (Problem) No Problem, except if DAPT set up after marriage Yes Yes (any prevailing party) Yes Statute but limited & 3 years Yes (Limited - 1 Level) Yes Yes Nevada 2 Years No Silent Silent, but possible issue if transfer violates a contract or a valid court order ** No (only prevailing petitioner) No Statute (left to courts) Yes (Limited - 2 Level) Yes? South Dakota 2 Years No No Problem, except if DAPT set up after marriage No Problem, if not awarded prior to setup of trust (7/2013) Yes (any prevailing party) Yes Statute Automatic Perpetual Total Seal Yes (Powerful 4 Levels) Yes Yes (Statute) *Alaska Stat (l). ** Nev. Rev. Stat (3). 62