We have used in this column the term "investment-driven estate planning" before, and today we explore another facet of the phenomenon, which couples investment advice with the proper estate-planning technique for spectacular client results.
More than one-third of the states have now repealed an ancient law known as the Rule Against Perpetuities (RAP). This rule, which still pretty much exists in the balance of the states, determines when trusts must end, whether the trust was created by your client during life or at death. Even where the RAP still exists, trusts can last close to 100 years, or slightly longer, before they need to terminate and distribute what is in them to the beneficiaries.
An important bit of knowledge is the so-called, situs consideration. If your client is in a state ("situs") where the RAP has not been repealed, your client can create the trust in a situs where the RAP has been repealed. The trust assets should be there, and the governing trust document should indicate that state's law is to govern, along with a couple other maneuvers, none overly complicated. Moving an existing trust from one state to another (without a clause in the trust authorizing such a move) is a much more difficult and sometimes impossible task because court approval is required and rarely forthcoming.
Just so your information is up to snuff, the states (listed alphabetically) that have repealed the RAP are: (1) Alaska, (2) Arizona, (3) Colorado, (4) Delaware, (5) Florida (360 years), (6) Idaho, (7) Illinois, (8) Maine, (9) Maryland, (10) Missouri, (11) New Jersey, (12) Ohio, (13) Rhode Island, (14) South Dakota, (15) Virginia, (16) Washington (150 years-sort of stingy) and (17) Wisconsin. In those states, the trust never has to end, so it is much like a private foundation, but for the benefit of individuals, not charities. You could name charities among the beneficiaries of a private trust, but it is still a private trust and governed by private-trust law, not charitable-trust law.
Why is it important to know all of this? You, better than I, know what earning even an additional 25 basis points over a 50-, 100-, 200- or 300- year period would mean to the growth of investments within a trust that can last for that length of time. The strategy of creating such a trust, assuming it will last 100 years or not end at all and benefit your client's spouse, children and grandchildren initially, but other descendants thereafter, is combining investment performance with the perfect technique to make it work best for the benefit of those to whom your client is most committed.
Now what about federal estate taxes? (state death taxes can be a factor, too, but are outside the scope of this article). There is a federal tax rule that when one generation dies out, there is a 50% tax (beginning in 2002 at the 50% rate) on the entire value of the trust, and every time a generation ends, the tax applies again. For example, if your client established a trust for the benefit of children, grandchildren and great-grandchildren and when the last child died, there was $1 million in the trust, the Generation-Skipping Tax ("GST") of 50%-or $500,000-would be imposed. If when the last grandchild died, there was $700,000 in the trust and the rate remained at 50% (it is scheduled to drop before 2010 to 45%), there would be a tax on the trust of $350,000 (50% of $700,000). This is not good!
Coming to the rescue are devices of law which, if carefully observed, will mean none of the foregoing is applicable to your client's trust. No taxes will be paid as a generation ceases. The law helps in several respects. There are the laws signed into existence by President Bush in 2001. The GST is repealed in 2010, but it could come back in 2011. The rate of the GST tax drops to 45% by 2009, although that is no bargain. There is an exemption of $1.1 million from this tax, if that is all you put into the trust beginning in 2002, or $2.2 million, if your client and his or her spouse are considered the joint contributors.
But, the best is yet to come. If the trust (and these trusts are known most commonly as Dynastic Trusts or GST Exempt Trusts) contains certain provisions, like the ability of the creator to substitute at any time property outside of the trust for property inside of the trust of equal value or the creator gives the trustee the right to add beneficiaries, it falls into a category of trusts known as the Intentionally Defective Grantor Dynastic Trusts. This produces a stunning result during the trust creator's lifetime by letting your client add to the trust property of any amount in addition to the $1.1 million or the $2.2 million figures previously discussed.
How? Your client sells to the trustee securities you are managing for him or her in an investment advisory account in the client's sole name. The aggregate basis in the securities is, say, $100,000, and the fair market value of the securities is $5 million. Because of the peculiarities of federal tax laws (there are two things you do not want to see made, said one famous law professor, sausage and the law), no gain on the sale is recognized. The trustee takes the $100,000 basis, but your client pays not one cent of capital-gains tax.
Your client must, however, receive a note from the trustee with an interest rate set by the Treasury for the full $5 million value of the sale (otherwise there would be a gift, and the gift tax is not repealed in 2010), and that note rate will depend upon the length of the note and interest rate in the month the transaction occurs. Incidentally, if the interest is paid by the trustee to the creator of the trust on the note, it is not income to your client, or the interest can accrue and be paid when the note is paid, or from time to time. This means that your client has put into your hands to manage, because the trustee will engage you as investment advisor to the trust, $2.2 million and $5 million additional for a total of $7.2 million, which is nothing to sneeze at.
There are several important rules applicable here. We have no time to discuss them, but I can say I have very, very few clients of substantial wealth who are not doing exactly what has been described in this column.
One final technical point needs to be made. Your client, if the $5 million of securities sold to the trust grows to $10 million and the trustee sells the securities for $10 million, must pay the capital-gains tax, which would be the difference between the $100,000 (basis) and the $10 million fair market value of the sale. But, the trust could pay off out of the $10 million in proceeds from the sale the $5 million note, owed to the creator of the trust, and still have $5 million in the trust from the sale, and your client could use a portion of the note proceeds to pay the capital-gains tax.
You can immediately see the advantage of all this. What is inside the trust, after being placed there tax-free, remains there tax-free for the duration of the trust or until the creator's death, if earlier. At that time, the trust will begin to pay, or the beneficiary will begin to pay, income tax. I am including in the term tax-free, any gift tax, any estate tax, any GST and any income taxes after the creator dies. Put all this together, and this is a marriage made in heaven between the principles of estate planning and the principles of investing. What a difference a little knowledge makes when you mold together two fields of specialty and build the house that Jack built.
Attorney Roy M. Adams is a partner and worldwide head of the trust and estate practice at Kirkland & Ellis in New York.