By Mark Nestmann
If you’re a U.S. person, and you have a net worth over US$1 million, then January 1, 2011 should be a red-letter day.
On that day, the U.S. estate tax exclusion will digress back to its 2002 level of US$1 million. Any estate worth more than US$1 million will be subject to estate tax at a maximum rate of 55%.
Think this doesn’t include you? Consider this: Everything you own, anywhere in the world, counts toward your estate. Your worldwide possessions are also valued at their “highest and best use,” which could bump you up into the “over US$1 million category.”
You can blame Congress for this war on inherited wealth. In 2001, Congress radically retooled federal wealth transfer tax laws. The amendments gradually raised the estate tax exemption amounts, lowered the top estate tax rate and eliminated the estate tax all together for 2010. But in 2011, estate tax rates will return — and they’ll be back to their extremely low US$1 million thresholds.
Congress has been playing a ridiculous game with your heirs’ wealth. It’s absurd, but unfortunately, it’s still the law. The good news is there are ways to reduce your estate tax responsibilities.
One of the most effective ways to deal with this uncertainty is with a dynasty trust. This type of trust is designed to avoid wealth transfer taxes completely, once each generation.
You should know that an irrevocable dynasty trust generally won’t reduce taxes during your lifetime. But your foresight could save your descendents millions of dollars in future taxes.
Three Taxes to Avoid When You Finally “Stick It” to the IRS
To be effective, a dynasty trust must successfully deal with three separate, but related, taxes — estate tax, gift tax and generation skipping transfer tax.
Estate tax: For 2008, your estate must be worth US$2 million to qualify for taxes — at a top rate of 45%. After disappearing in 2010, the estate tax resurfaces in 2011. Only, as I mentioned, your estate only has to be worth US$1 million to be eligible for estate taxes — this time at a higher tax rate of 55%. However, you can double these exclusions if you’re married and you do some basic estate planning (which need not include a dynasty trust).
Gift tax: If it weren’t for gift tax, you could avoid estate tax simply by giving away most of what you own. The gift tax plugs that loophole by requiring that you pay a tax up to 45% on gifts you make while living that exceed US$1 million (US$2 million if you’re married). That exclusion won’t change in 2011, although in 2010, the maximum rate drops to 35%, and rises to 55% in 2011.
Generation Skipping Transfer Tax: The tax targets transfers that skip generations, because the assets won’t be included in the skipped generation’s estate. Essentially, the IRS applies the tax to each generation as if the trust beneficiaries own the assets in the trust outright. Every U.S. taxpayer has a lifetime generation skipping transfer tax exclusion of US$2 million. If you transfer this amount or less into a dynasty trust in 2008, your heirs won’t pay this tax. This particular tax exclusion increases in 2009, will be repealed in 2010, and then brought back in 2011 with an exemption of US$1.06 million. Again, if you’re married, the exclusions double.
And Now, for the REALLY Good News…
A dynasty trust is irrevocable, so its assets are no longer part of your estate. The secret to building a good dynasty trust, then, is making contributions to it that avoid both gift tax and generation skipping transfer taxes. Then you just leverage your contributions value once they’re removed from your estate.
Life insurance is ideal for this purpose. Usually, you pay contributions to a dynasty trust in the form of premiums for a life insurance policy. Neither the death benefit, nor your policy’s cash value, is subject to estate tax.
Let’s say you create a dynasty trust for the benefit of your two children, three grandchildren and their descendents. Under the gift tax rules, you can make a gift up to US$12,000 to anyone you want, once a year, without that gift counting toward the US$1 million limit. You and your spouse could each gift US$60,000/year in your heirs’ names to your dynasty trust (US$120,000/year total) without lowering your remaining gift tax exclusion. Complex requirements apply to ensure that the gift complies with IRS “present interest” rules. To deal with this issue, make sure you hire a competent estate planning attorney to guide you.
Over a seven-year period, your contributions will total US$840,000. And if you’re under 70 years old and healthy when you begin funding the trust, your US$840,000 could purchase a life insurance policy with a death benefit of US$5 million or more. That’s six-to-one leverage. If you’re younger when you create a dynasty trust, the leverage is even greater.
Assuming your dynasty trust would avoid an estate tax of 55% applied to each successive generation, your grandchildren could save nearly US$4 million in estate taxes. And that’s not counting the growth of the trust’s assets!
Taking Your Dynasty Trust Offshore
Most dynasty trusts are settled domestically, in a state that’s abolished the so-called “Rule Against Perpetuities” (RAP). In these states, a trust can literally last forever.
Numerous offshore jurisdictions have also abolished this rule, so your trust can last forever offshore too. While this makes it possible to establish an offshore dynasty trust, if the trust has U.S. beneficiaries, this is usually a bad idea. Among other pitfalls, significant tax penalties apply once you die, unless all income and realized gains are distributed annually as earned to the U.S. beneficiaries.
However, there’s no reason a dynasty trust can’t hold offshore investments. Again, competent tax advice is crucial to avoid numerous booby traps in the tax code. But when set up correctly, you can use this trust to save your heirs thousands in taxes — so it’s well worth the effort.