On December 17, 2010, Congress and the President gave us the most generous estate and gift tax legislation in the nation’s history, although the generous changes are for a very short duration. Beginning in 2011 and ending at mid-night, December 31, 2012, a taxpayer may gift up to $5M of any asset to their children or an irrevocable trust established for their children and grandchildren.
Generally, the ability to shift appreciating assets from the taxpayer to their descendents and defer the inclusion of the assets and the appreciation from being taxed will create substantial estate and gift tax benefits for the family unit. These benefits can best be illustrated by the following chart:
While the notion of moving substantial sums of wealth from the taxable estate provides significant estate tax savings, the lessons of the recent Great Recession have taught us that no matter how much wealth a person may have, preserving that wealth in case of a future need is paramount. Therefore, for the affluent family making substantial gifts to take advantage of the current but temporary gift tax exclusion is often antithetical to the personal goals of mother or dad.
This is where the HYCET Trust℠ may be of substantial benefit for most affluent taxpayers. If utilizing the current $5M gift tax exclusion is desired, but if a future fiscal emergency should arise, the taxpayer would like to ability to recapture some or all of the prior gift, the HYCET Trust℠ should be considered.
As a general rule, if a taxpayer makes a gift of an asset to an irrevocable trust and retains the right to recapture all of part of the gift for its use and benefit, or to determine who will use and enjoy the gifted asset(s), the entire value of the gifted asset, including the future growth, will be included in the taxpayer’s estate at death. However, under recent IRS rulings, a taxpayer, who sets up a trust in a qualifying jurisdiction (state or country) and follows certain “rules of the road” the taxpayer may retain the right to receive future distributions from the irrevocable trust to which the gifted assets were made.
In PLR 200944002, a taxpayer established a self settled trust in Alaska (an asset protection trust “APT) established for the benefit of his children and grandchildren. The taxpayer inserted himself in the trust as a “discretionary” beneficiary, meaning, the trustee could, in the trustee’s sole and absolute discretion, choose to distribute trust income and corpus to the taxpayer. The trustee was an independent trust company with no prior arrangement to follow the wishes of the taxpayer. The IRS ruled, consistent with its prior rulings, the gift to the trust would be complete, and by inference, removed it from his taxable estate, provided the trustee continued to serve as an independent trustee without undue influence by the taxpayer.
HYCET Trust Platform:
The HYCET Trust℠ name was selected, Have Your Cake And Eat It Too, because of what the trust platform can do for the affluent taxpayer. For those taxpayers who are fortunate enough to be able to avail themselves of the $5M gift tax exclusion, but want to be able to access the income or corpus of the property made the subject of the gift (should their future financial fortunes turn badly), the independent trustee would have the discretion to make distributions to the taxpayer without causing the entire value of the trust’s assets to be included in his or her taxable estate. This will be the result even when the law changes at the end of 2012 and the exclusion is lowered back to $1M.
For the HYCET Trust to deliver these benefits, the grantor/taxpayer of the trust must agree to the following:
- Establish the trust in a “qualifying jurisdiction”
o A qualifying jurisdiction means a state or country whose trust law recognize the creditor protection afforded the creator of a self settled trust. The law must exempt all creditor claims and not carve out certain “special creditors” such as alimony, child support and other such claims which many states’ law exempt from the application of the self settled spendthrift protections.
o The two states that provide this more comprehensive protection from lawsuits are Alaska and Nevada. In point of fact, PLR 200944002, referred to above, was an Alaska self settled trust (APT) that exempted all creditor claims against the creator. Nevada has a similarly designed trust statute that is intended to provide complete lawsuit protection of assets transferred to a self settled trust if the trust creator is subsequently sued.
o Offshore Asset Protection Trusts (APTs) are also self settled spendthrift trusts where the country has adopted trust laws that exempt trust assets from a future lawsuit where the creator of the trust is also included among the class of trust beneficiaries. The Cook Islands, located in the South Pacific, is one such country whose trust laws will constitute a “qualifying jurisdiction” in considering a HYCET Trust℠ .
- Use an Independent Trustee: In all cases, to achieve the benefits of the HYCET Trust℠ , i.e., remove the asset from your taxable estate while retaining a discretionary beneficial interest, the administrative trustee, i.e., the trustee that makes decisions with respect to distributions from the trust to the named trust beneficiaries, must be independent. It must be a resident of the state or country of the laws you are relying on for creditor protection and it must not be a secret arrangement between the trustee and the trust creator to favor the trust creator on requests for future distributions.
- Trust Creator/Taxpayer as Investment Trustee: While this author discourages this trust design to be ultra conservative and avoid giving the IRS any ammunition to invalidate the benefits of the HYCET Trust℠ , a literal reading of the law relating to the taxation of trusts would suggest the trust creator/taxpayer could serve in the limited role of Investment Trustee (IT) and be responsible managing the investments of the trust. The IT would have no powers of deciding the amount and to whom any of the trust distributions are to be made, and would possess no powers to deal with life insurance contracts that might be purchased and owned by the trust.
Using Life Insurance to Enhance the Size of the Tax Free transfer of wealth in the HYCET Trust℠ : A fundamental reason for considering a HYCET Trust℠ is to remove up to $5M per person of assets and the expected appreciation from those assets for the benefit of the taxpayer’s descendents for multiple generations before being subject to estate taxes well into the future (i.e., 300 years or more). Often, the assets that are gifted to the HYCET Trust℠ are income generating assets, like, real estate, dividend paying stocks, or muni bonds. Once inside the HYCET Trust℠ , all future growth remain outside the taxable estate for generations. For example, if Nevada is selected as the qualifying jurisdiction, its laws allow such a trust to remain in existence for up to 360 years. In the Cook Islands, the trust may remain in existence in perpetuity. Let’s examine the wonderful planning opportunities the HYCET Trust℠ presents:
- Life insurance is the most tax efficient asset class in the tax code. Why?
o Death proceeds are received income tax free to the beneficiary
o The cash value growth inside the policy is completely income tax free, whether earned from capital gains, interest, dividends or royalties
o The cash value can be withdrawn from the policy completely income tax free
o At death, the proceeds are free of death taxes
- No other asset recognized by the tax code provides such extraordinary tax benefits – and its all legal. Trust doing this with any other asset class and the government will prosecute you for tax evasion.
Here is the Plan:
- The HYCET Trust℠ is formed and income producing assets are transferred to the trust using the taxpayer’s $5M gift exclusion. If both husband and wife make gifts, they can transfer up to $10M gift tax free.
- If you stopped there, the tax benefits over time would be quite compelling (see the chart above), but you want to make it even better, here is how you do it:
o Trustee purchases a life insurance policy on the trust creator (assuming he or she is insurable)
o The trustee applies to a special lender specializing in life insurance premium financing
o The trustee and the lender enter into a loan agreement where the lender will make loans to the trust each year for the first 10 years of the trust
o The insured is a female, age 50, and the annual premiums borrowed from the lender are $490,000 per year
§ The interest rate is 2.75%
- Annual interest payments are made using the cash flow from the assets that were gifted to the HYCET Trust℠ , not from the taxpayer’s personal funds
§ The loan term if for the life of the insured and the loan is repaid from the death proceeds
§ The death benefit when the insured dies is $14M and the policy will last until the insured is well beyond age 100
§ Beginning in year 6, the policy has a positive cash value account and grows income tax free from then on
§ In year 16, the insured will be age 66 and the cash surrender value will be used to repay the loan in full.
- The life insurance policy will have over $2M in cash surrender value that can be accessed, income tax free, by the trustee for the benefit of the beneficiaries, including the taxpayer
o Bottom Line:
§ The taxpayer, using the assets already in the trust, created several new assets:
- $14M in additional wealth to be available to the trust beneficiaries at the death of the insured, income and estate tax free
- In 20 years, the policy loan is repaid and almost $3M in cash value in the policy that can be accessed tax free
- Each of the spouses can purchase life insurance policies doubling up the amount of tax free additional assets being created through the life insurance asset
§ See the attached life insurance illustration below:
