HEETing up the Dynasty Trust An effective, albeit complex, way to pass wealth from generation to generation without incurring estate taxes is through the use of a Dynasty Trust. When structured properly, these trusts can last indefinitely while protecting the assets against uncertainty; bankruptcy, lawsuits, and divorce settlements can be prevented from piercing the trusts, keeping the assets within the family. While avoiding estate taxes is great, the far-reaching powers of the generation-skipping transfer (or GST) tax are more difficult to avoid. Additionally, because of the lifetime exemption ($5,120,000 in 2012), the GST tax may still kick in no matter how well-structured the dynasty trust is. Complementing a Dynasty Trust with a Health and Education Exclusion Trust, or HEET, can expand the amount of wealth transferring down generations without triggering the GST tax. Establishing a HEET requires some philanthropic motive along with the GST tax-avoidance motive. Since the point of a HEET is to prevent the GST tax from kicking in, the trust always has to have a current beneficiary that is a non-skip person. Naming a charity a non-skip person by definition as a current beneficiary achieves that. The charitable beneficiary must have a significant interest in the trust, and it should be noted there is some debate on what would constitute a significant interest many practitioners recommend annual unitrust payments to the charity of anywhere from 4% to 10% of the FMV of the trust s assets. Once the charitable hurdle is cleared, distributions to skip persons must be limited to payments for education or medical expenses. This cannot be done, though, by reimbursing the skip person for amounts already expended: payments must be made directly to the education or medical provider. (This is the same basic technique used to provide education and medical expenses currently while avoiding the gift and GST taxes.) For education expenses, only payments for tuition qualify: books, supplies, room and board, and other fees will not be qualified expenditures, but the tuition can be for any level of education pre-school to past-grad. For medical expenses, the standard is service for the diagnosis, cure, mitigation, treatment or prevention of disease or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care : thus, elective surgery would be excluded, while premiums for medical and long-term care insurance are allowable. (Continued on Page 2) Contents Special Interest Articles HEETing up the Dynasty Trust 1 Protecting your Children From Themselves 3 Individual Highlights Charles W. Horn, III, EA 2 James A. Horty, III, CBC 3 Delaware: Trust-Friendly State 4 Upcoming Events 2013 January Orlando, FL Heckerling Institute May New York, NY NYSBA Annual International Estate Planning Institute July Lexington, KY Midwest/Midsouth Estate Planning Institute September Cary, NC ACTEC Southeast Regional October ACTEC Mid-Atlantic Regional New York, NY Southern Federal Tax Institute Atlanta, GA S. California Tax & Estate Planning Forum San Diego, CA DBA Trust Conference Wilmington, DE
Page 2 Annual Newsletter Charles W. Horn, III Charles W. Charlie Horn, III, EA, is the author of the article, HEETing UP the Dynasty Trust. Charlie is the Tax Manager at Commonwealth. He provides advice and direction on the tax implications of complex transactions. He has more than twenty years of accounting experience, all of it in tax. He is a seasoned accounting professional with extensive experience working with ultra high net worth clients for income and gift tax compliance. He has expertise in complex tax issues, including reporting of income/deductions from hedge funds and private equity partnerships, deferred compensation distributions (including stock options), rental properties, and operating businesses. He is also an Enrolled Agent licensed to practice before the Internal Revenue Service. An effective, albeit complex, way to pass wealth from generation to generation without incurring estate taxes is through the use of a Dynasty Trust. Commonwealth Trust Company 29 Bancroft Mills Road, 2nd Floor Wilmington, DE 19806 Phone: 302.658.7214 Fax: 302.658.7219 businessdevelopment@comtrst.com Delaware's independent, privately-held boutique trust Company partnering with your existing Advisers to provide sophisticated, professional trust administration solutions. Find us on the Web: www.comtrst.com HEETing up the Dynasty Trust (Continued) There are two ways to consider establishing an inter vivos HEET: directly funding the trust (perhaps annually) using the annual gift tax exclusion and/or lifetime exemption, or naming the HEET as the remainder beneficiary of a zeroed-out grantor retained annuity trust or zeroed-out charitable lead annuity trust. If one chooses to create the HEET directly, but would prefer not to fund it currently, the trust could be funded with life insurance, thus limiting the assets removed from the overall estate currently. Conversely, the current funding of an inter vivos HEET removes both the after-tax income and the asset appreciation from the settlor s estate. If structured so that the trust is treated as a grantor-type trust for tax purposes for example, by including the power to substitute trust property in a non-fiduciary capacity the charitable distributions made each year will qualify as charitable deductions for the grantor. If the inter vivos trust is not a grantor-type trust for income tax purposes, the trust itself will be allowed a charitable deduction for the amounts paid each year. The HEET can also be established in the settlor s will (or living trust) and then funded at death. The assets would still be includible in the estate, subjecting them to estate tax, but no GST tax would be assessed. No charitable deduction will be allowed to the estate, but the trust will be allowed a charitable deduction each year for the amounts paid to charity. As with any trust, a HEET trust instrument is a legal document that must be carefully drafted by a competent attorney to achieve the intended results. * * * * * * *
Page 3 Annual Newsletter Protecting your Children from Themselves We have all read in newspapers, magazines, and seen on television and in movies; the trials and tribulations of trust fund babies. By definition they are the children, grandchildren and great grandchildren of very wealthy self-made men and women who created trust funds many decades ago with the intention of giving their heirs a better life than they had. Although the intentions of the grantors were good at the time, many of their heirs look at the trust as a free ticket to the good life without any responsibility. For many heirs it has led to a life of excess, court battles with other heirs fighting over money and for the most part, with few exceptions, a downward spiral to rock bottom. Today many wealthy men and women are using trust funds to help and protect future generations by placing rules, conditions and stipulations to the trust funds that they are creating. These rules and conditions act as a handbook for the beneficiaries of these trusts to live by and can allow them the access to or the denial of the income from the trust. These rules have been learned from the past and are benefiting from the precedent set in place by previous litigations by establishing very clear defined terms. Health, Education, Maintenance, and Support. Almost every trust has a section for discretionary standards for distributions of which HEMS (health, education and maintenance standard) is the most common. Now all of these categories are becoming clearly defined due to the lack of clarity leading to the misinterpretation of these definitions in the past by beneficiaries. Education is now defined as primary education, vocational studies, college and post graduate with reasonable time limits established as well as grade point average (GPA) requirements. The narrow definition, time limits and GPA requirements are established to prevent the lifetime student beneficiary as shown in the movie Van Wilder, the story of a career student who spent close to a decade in college without receiving any degree and living the ultimate frat boy life at the expense of his trust. The Maintenance definition has been become very specific and it is often tailored to meet the expectations of the grantor as to what the trust will provide. It clearly defines what type of home and or apartment the trust will allow the beneficiaries to purchase or rent rather than letting the beneficiaries buy whatever they want at the expense of the trust. This has changed considerably over the years due to the fact of many trust fund babies are buying a primary home and a couple of vacation homes, which was not the intent of the grantor when the trust was written. Now the trust documents have a housing definition as well as a clause defining how many and the types of expenses the trust will pay for. Many grantors are using Letters of Wishes (this was previously used only in the international context) which is a non-binding letter of wishes from the grantor which can provide specifics that the trust document cannot as to when a distribution would be appropriate and when it would not. Less is More. The concept of Less is More is one of the easiest ways to control the money that your children and grandchildren will receive (Continued on Page 4) James A. Horty, III James A. Jimmy Horty, III, CBC, is the author of Protecting Your Children from Themselves. Jimmy holds the office of Secretary of Commonwealth, is a member of its Board of Directors, and a Business Development Associate. Jimmy brings with him more than twenty years of experience in working with and advising high net worth individuals, families and foundations. Specializing in the area of succession planning within closely held companies, he is able to bring a global approach to the business of trust administration. In addition to his responsibilities at Commonwealth, Jimmy is deeply involved in Wilmington and Delaware civic organizations such as Sojourners Place, an organization committed to assisting homeless individuals on their journey to self-sufficiency through a case-managed residential program.
Page 4 Annual Newsletter Protecting your Children from Themselves (Continued) from a trust. The grantor can set the distribution payments (with adjustments for inflation) at an amount that will allow each child a modest lifestyle and will give the children the initiative to work harder to achieve a better lifestyle if they want it. Incentives. Some grantors are rewarding their children with incentives that can increase distribution payments for things such as completing law or medical school or becoming gainfully employed. Some trusts will make distributions only up to and not in excess of amounts earned by the beneficiaries to help promote gainful employment. The incentives clause can also control the child with substance abuse problems by providing the child will receive additional payments upon the completion of a drug or alcohol rehabilitation program and remaining sober. Marriage. With the 50% failure rate of marriages worldwide, many grantors are establishing conditions in the trusts regarding the distributions once a child gets married. Some grantors are stipulating the distributions to stop prior to the wedding of a child to prevent the trust corpus and income from becoming a marital asset in the event of a divorce and also make sure that the new spouse is not in the marriage just for the money. Two friends had to sign off on the distributions from their trusts prior to their getting married. For one of them, who was divorced in less than a year, it helped in settling the divorce quickly. With the second friend her distributions started again after she and her husband were married for over ten years and had children. Both of their trusts had clauses that all of the distributions ceased and were held in the trust for a period of 10 years or until they had children. Trusts have changed with the times, they are no longer archaic instruments that let the grantors control their heirs from the grave, they are now instruments used to help the heirs and future generations appreciate what they have many times while the grantor is still alive. Beneficiaries are appreciating what they have while continuing to be motivated into productive, responsible members of society. Rather than living a care-free life, they are able to learn from the benefits that the funds provide. This allows grantors who previously would not have funded trusts for fear that it would make their descendants lazy, to create trusts. * * * * * Delaware: The Trust Friendly State Trust Friendly Structure State Income Tax Directed Trust Protector Asset Protection Dynasty Trust Limited Disclosure to Beneficiaries Decanting Early 20 th century Noncharitable purpose trust statute 2007) Residents only Prudent Investment Modified Prudent Investor Rule (1986) 1986) Diversification of Investments Standard Directions in governing instrument or from IA not to diversified respected. Yes (since 2008) Statutory Insurable Interest in Trustee of an ILIT 1998) 1997) Invasion Standard for Spendthrift Trusts Trust income and principal not subject to voluntary or involuntary transfer 1 1995)* Invasion Standard for Discretionary Trusts No (since 2007) 2003)** No-contest (in terrorem clause) 2003) 2003) State Liability Systems Ranking 2 1 *possible without statute since 1933 **restricted by trust instrument only 1 except that, by case law, income may be reached for separate maintenance of a spouse 2 based upon data from the U.S. Chamber of Commerce survey (June 19, 2012).