Most clients, when asked how they would like to have their estates distributed if there were no such thing as taxes to be considered, tell us they want most everything to go to their spouse, or to be divided among their kids if their spouse is not living. After calculating the potential estate or inheritance taxes, most clients want to create a structure that comes as close as possible to giving their spouse outright ownership of property, yet keeps that property from being part of the spouse’s estate for tax purposes, ultimately minimizing, if not eliminating, estate taxes for their children and grandchildren.
Most of our clients know this involves leaving property in a trust for the benefit of your surviving spouse upon your death. In many estate plans, (1) the surviving spouse is designated as the trustee, (2) the trustee (surviving spouse) can use the assets in the deceased spouse’s trust for health, support, maintenance or education (magic language from the estate tax regulations can exclude the first spouse’s trust assets from the calculation of the second spouse’s estate tax), and (3) the surviving spouse has the power (whether narrowly focused or practically unlimited) to alter how the first spouse’s trust is distributed upon the second spouse’s death.
With this approach, the surviving spouse has practically complete control over the first spouse’s trust assets during the balance of his or her lifetime. Yet the first spouse’s trust assets (including any appreciation in value) are not subject to estate tax when the second spouse dies.
Furthermore, if the surviving spouse later got into financial trouble, such as a huge judgment from a horrific motor vehicle accident that exceeded the surviving spouse’s insurance coverage, the assets in the deceased spouse’s trust should be exempt from the claims of the surviving spouse’s creditors. The surviving spouse’s other assets might be fair game for the judgment creditor and his attorneys, but at least the deceased spouse’s assets should be protected.1
With these benefits of control and protection from estate taxes and potential creditors, does it make sense to terminate the trust and just distribute assets outright to children when the second spouse dies? In an increasing number of cases, we think not.
Instead, let’s keep those benefits for the children and future generations. We’ll still divide up the estate between or among the children, but we’ll maintain each child’s share in a trust. Assuming each child is old enough and able to do so, we name each child as the sole trustee of his or her share. As trustee, each child can use the trust funds as needed for health, support, maintenance or education. The child can have the power to direct how the trust fund is distributed upon his or her death, but if they don’t exercise that power, their share of the trust will be divided among their children, and the pattern will repeat itself generation after generation until someone down the line changes it. The child excludes the trust assets from their own estate tax, and can protect the trust assets from the claims of their own creditors2, including a future ex-spouse. Over the past ten years or so, a combination of law changes and cases have occurred to make this pattern feasible.
First, the generation-skipping transfer (“GST”) tax exemption is currently $5.12 million for amounts transferred to generation-skipping trusts in 2012 and $5.25 million for amounts transferred in 2013. The GST tax is a separate and additional estate tax that applies when a lot of property goes down two or more generation levels below the transferor. But, the GST tax exemption is measured by the value of what initially went into the trust, not by what eventually is distributed from it. So if $5 million is placed in such a trust today, and $70 million is distributed from the trust to great-grandchildren 60 years from now, the whole amount still escapes any additional estate tax or GST tax.
Second, Maryland has joined a number of other states in repealing or limiting the “Rule Against Perpetuities,” a hold over from English common law that said, in effect, that a trust could only last for the lifetime of the current generation plus 21 years.3 Maryland law has allowed trusts created after September 30, 1998 to opt out from the Rule Against Perpetuities.
Third, many states have expanded and strengthened the rules regarding the exemption of trust assets from execution for the liabilities of trust beneficiaries. In Maryland, this principle was upheld in the court case of Duvall v. McGee, where Maryland’s highest court clarified and reiterated the principle that assets of a trust (not created by the beneficiary himself) could not be attached by a beneficiary’s judgment creditors.
We realize that this approach is counter-intuitive, but most of our clients who have heard this recommendation adopt it. Let’s consider some other factors.
Isn’t there a lot to do in maintaining the trust? The trustee needs to keep the trust assets in one or more separate accounts, and file a separate income tax return (federal form 1041 and Maryland form 504) for the trust each year. In general, to the extent that the trust distributes income to a beneficiary in any year, the beneficiary pays the tax on that income. If the trust retains income, it pays the tax on that income itself.
What if my son or daughter needs the money? They can use it, as long as they use it for “health, support, maintenance or education”. If they can’t justify a distribution on one of those four standards, it’s probably not a distribution worth making.
Won’t setting up their inheritance in trust show that I don’t trust my child? No, or we wouldn’t be naming them as their own trustee. They are still in control of their inheritance; you are just affording them the opportunity to protect that inheritance from an ex-spouse, other creditors and additional estate tax.
Are there other advantages to creating such a trust? Although we don’t know of any studies yet showing this to be the case, we believe that putting the inheritance in a segregated trust fund, even one controlled by the beneficiary, will earmark those funds in the beneficiary’s mind and encourage the beneficiary to preserve those funds to be used only when truly needed.
I have a modest estate, isn’t this overkill for me? Albert Einstein once remarked that the most powerful force in the universe was compounding interest. Call us skeptical, but we believe that the long-term trend for taxes is up, both in the form of tax rates and lower exemptions. Even if you don’t have an estate tax problem today, your children or grandchildren may well have significant estate tax problems down the road. Just like you should do what you can to take advantage of the current economic environment, you should do what you can to take advantage of the current legal and tax environment. Assume that you have an estate of $500,000 now that is not subject to estate tax, but will be subject to federal and state estate taxes of 50% for your children and grandchildren. Let’s also assume that the trust grows at the rate of 8% per year, and that each generation is an additional 30 years. Here’s a summary calculation of the difference to your children’s and grandchildren’s estates:
By avoiding a 50% tax every generation, in two generations your family will have four times as much wealth.
If this is such a great tax saving idea, why does the IRS allow it to stay on the books? As a matter of fact, this issue has now attracted the attention of Congress. However, historically Congress has always grandfathered existing irrevocable trusts from later changes in estate tax laws; and any new law would likely limit, but not completely repeal, the benefits of this approach. This is not yet a major issue for Congress, just a blip, and the most likely legislative remedy would be to enact a sort of Rule Against Perpetuities for estate tax purposes. Even so, as the example above shows, keeping your estate free from estate taxes for only two generations can provide significant benefits to your family.
If you are interested in providing “dynasty trust” provisions in your estate plan, please contact our office.
1 Although we believe this analysis to be correct under current law, we cannot guarantee results. At the very least, the surviving spouse should resign as trustee if any event occurs that might create a large potential liability.
2 The same caveats as noted at footnote 1 apply.
3 This is a very shorthand description of the Rule.