Creating the Dynasty: Tips and Traps for Generation Skipping Transfer Tax Planning January 19, 2016 Jon Grob, McGrath North

• Why “Skip”?

• The Basic Tax Structure and Definitions

• 5 GST Traps

• 5 Tips To Avoid Traps

Topics Considered Today

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Why “Skip”?

• The Power of Compounding (4%):

• Present value of $67mm in 60 years at 4% is $6.4mm.

Dynasty Trust No Dynasty TrustInitial Gift 10,000,000.00$ 10,000,000.00$ Value in 2046 32,433,975.10$ 32,433,975.10$ Estate Tax -$ (12,973,590.04)$ Net Value 32,433,975.10$ 19,460,385.06$ Value in 2076 105,196,274.08$ 63,117,764.45$ Estate Tax -$ (25,247,105.78)$ Net Value 105,196,274.08$ 37,870,658.67$

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Why “Skip”?

• Wealthy children.

– Example: Parents have $5,000,000 and want to leave $2,500,000 equally to children. Child A has a substantial estate and therefore, on Child A’s death, $1,000,000 of the inheritance will be paid to Uncle Sam.

– Alternatively, Parents place $2,500,000 in a generation skipping trust. Child A is the Trustee and may access the $2,500,000 for health, education, support and maintenance. Child A has a testamentary special power of appointment in favor of anyone other than his estate, his creditors, and the creditors of his estate. On Child A’s death, no estate or GST tax is due, saving at least $1,000,000 in tax.

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Why “Skip”?

• Wealthy children.

– This requires open lines of communication between parents and children about their wealth and common objectives.

– This is not always easy or attainable. The fall back is a qualified disclaimer by Child A at parents’ death. The problem is an immediate inheritance received by grandchildren at the terms parents (not Child A) dictate.

– Example: Child A executes a qualified disclaimer on parents’ death. Parents’ estate plan controls and Child A’s 19 year old receives $2,500,000 outright.

– A qualified disclaimer does not avoid a potential GST tax.

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Why “Skip”?

• Non-Tax Benefits

– Lifetime trusts for children have asset protection benefits (creditors, ex-spouses, etc.). This protection can be obtained even if a child is Trustee and has a very broad testamentary special power of appointment.

• This is an attractive feature for many farming families. An LLC wrapper can also provide partition protection.

– For children with poor money management skills, lifetime trusts provide protection from themselves.

– The clients simply wish to disinherit a child.

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Dynasty Trust

Limited Liability

Company

Why “Skip”?

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The Basic Tax Structure and Definitions

• Exemption and Tax Rate

– In 2016 the GST Exemption is $5,450,000.

– The tax rate is 40%.

• Taxable Events – Direct Skips – Taxable Distributions – Taxable Terminations

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The Basic Tax Structure and Definitions

• What is a direct skip?

– A taxable gift occurs and property passes to a skip person.

– Property that is included in a decedent’s estate passes to a skip person.

• Who is a “skip person”?

– A natural person two or more generations below the donor/decedent. Start with donor/decedent’s grandparents, and count generations.

– Spouses are in the same generation as decedent/donor and a spouse’s issue are assigned to generations based on the spouse’s family.

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The Basic Tax Structure and Definitions

• Who is a skip person?

– Example: Donor gives property to spouse’s child. Donor is 62 years older than spouse and 81 years older than spouse’s child. This is not a direct skip because the spouse’s child is assigned to one generation below the spouse and the spouse is in the Donor’s generation.

– For persons who are not issue of the donor/decedent’s (or spouse’s) grandparents, then count years:

• Age separated by 12.5 years or less = same generation.

• Age separated by 12.5 – 37.5 years = one generation below.

• 37.5 years+ = two generations below (and each 25 years thereafter is a new generation).

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The Basic Tax Structure and Definitions

• Who is a skip person?

– A trust if:

• All interests are held by skip persons or

• No person holds an interest and there cannot be a distribution to a non-skip person.

– Example:

• Trust provides for current distributions of income and principal for the benefit of grandchildren and more remote descendants.

• Trust provides no current distributions of income and principal and at

the end of a stated term or measuring life, the property is distributed to grandchildren or more remote descendants.

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The Basic Tax Structure and Definitions

• What is a taxable termination?

– A termination, as a result of death, lapse of time, release of power of an interest in property held in trust IF

• Immediately after the termination, no non-skip person has an interest in the property or

• At least one skip person is or could be a beneficiary of the trust (5% or more probability).

• Example. Trust provides income and principal to child for child’s life. Child dies and the property passes to grandchildren. The property is not included in child’s estate for federal estate tax purposes.

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The Basic Tax Structure and Definitions

• What is a taxable distribution?

– A distribution from a trust to a skip person (other than a taxable termination).

– Example. Trust provides income and principal to child and

grandchildren. Trust makes a distribution to grandchild.

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The Basic Tax Structure and Definitions

• What is an inclusion ratio?

– Every trust (and direct skip) has an inclusion ratio.

– If no amount of GST exemption has been affirmatively or automatically allocated to a trust (or direct skip), its inclusion ratio is 1. This means GST tax applies to all taxable terminations and taxable distributions (or to 100% of the direct skip).

– If GST exemption has been allocated fully to all transfers to the trust (affirmatively or automatically) or to the direct skip, the inclusion ratio is 0. This means the trust (or direct skip) is GST tax exempt.

– Formula: 1 – (GST Exemption Allocated / Property Transferred).

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Automatic Allocation:

• Lifetime direct skips unless opt out by due date for filing 709 (even if no return is filed or is filed late).

– Automatic allocation or opt out (in either event) is irrevocable

after the due date of the 709. – How to opt out?

» Form 709, Schedule A, Part 2, Column C – check the box. » Attach an explanatory statement (note: timely reporting and

paying the tax is sufficient).

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Automatic Allocation:

• Lifetime indirect skips unless opt out by due date for filing 709 (for transfers made after 12/31/00).

– An “indirect skip” is a transfer subject to gift tax that is not a direct skip made to a “GST Trust.”

» The definition of a “GST Trust” is complex and subject to six (6) enumerated exceptions.

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Automatic Allocation for indirect skips continued:

• How to opt out?

– Form 709, Schedule A, Part 3, Column C

– Attach an explanatory statement.

» “election 1” no automatic allocation to current transfer.

» “election 2” no automatic allocation to current and all future transfers.

• GST Election – “election 3” trust is deemed a GST Trust.

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Automatic Allocation

• For transfers at death, any unused GST Exemption is allocated first to direct skips then to trusts of which the decedent is the transferor and from which a taxable distribution or taxable termination might occur at or after death.

• This occurs even if no 706 is filed and is irrevocable after the due date of the 706. Schedule R is the “opt out” method at death.

– Timely Affirmative Allocations

• Usually done via a formula for audit protection

– “Donor hereby allocates to Trust the smallest amount of GST exemption necessary to produce an inclusion ratio that is closest to or, if possible, equal to zero.”

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Late Allocation

• This can be favorable to a taxpayer who wishes to allocate GST exemption to a pre-existing trust.

• Often this also results in dividing a pre-existing trust into an exempt and non-exempt trust.

• The late allocation applies to the value of the trust property on the first day of the month during which the late allocation is made. The allocation is effective when filed.

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The Basic Tax Structure and Definitions

• How is GST Exemption Allocated?

– Retroactive Allocations

• If a non-skip person with an interest in a trust passes away, such person is a lineal descendant of the donor’s grandparent, and is assigned to the generation immediately below the donor (i.e., child), then a retroactive allocation of GST exemption may be made on a 709 that would be timely for a gift made in the year of the person’s death.

• Donor must be alive.

• Example: Donor makes gifts to a trust that provides for children and grandchildren. The trust is not a “GST Trust” because all property passes to children at age 35. Donor’s child unexpectedly predeceases the Donor before age 35 resulting in a taxable termination.

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Trap #1: Reliance on Automatic Allocation Rules

– Example 1: Grantor transfers $1,000,000 to Trust A. Trust A provides that income and principal will be distributed to children for health, education, support and maintenance. On death of a child, property passes to child’s children and in such event, there is no inclusion in the child’s estate (taxable termination). Grantor desires Trust A to have a 0 inclusion ratio. However, Trust A provides that if a child dies without issue, child’s share will pass to child’s estate. On the date of the gift, Child 1 has no issue but Child 1 is eight (8) months pregnant.

– This is not a “GST Trust” so no automatic allocation.

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Trap #1: Reliance on Automatic Allocation Rules

– Example 2: Grantor transfers $1,000,000 to Trust A. Trust A provides that income and principal will be distributed to children for health, education, support and maintenance. At age 50, the trust property is distributed outright to each child. No child has a general power of appointment.

– This is a “GST Trust” so automatic allocation results.

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Tip #1: Make Appropriate Elections.

– Elect out for current years and/or future years if the intent is no GST allocation (election 1 and 2).

– Elect to treat any trust to which exemption allocation is desired as a “GST Trust” (election 3).

– Elect out of automatic allocation rules and affirmatively allocate (with a formula if desired).

• Note: any partial affirmative allocation is a deemed election out of the automatic allocation rules.

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Trap #2: ETIPs

– An allocation of GST exemption to transferred property that would be included in the decedent’s estate or spouse’s estate is not effective until the end of the “ETIP.”

– The “ETIP” or “estate tax inclusion period” is the period during which the value of the transferred property would be included in the estate of the decedent or spouse.

– If any part of a trust is subject to an ETIP, no GST exemption allocation can be made to any part of the trust during the ETIP.

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Trap #2: ETIPs

– Example: Donor establishes an ILIT and gives Crummey powers to wife, children, and grandchildren. The ILIT passes to grandchildren upon the death of donor. As a result of spouse’s withdrawal right (an ETIP), GST exemption cannot and is not allocated to the ILIT. Upon donor’s death, the exemption allocated would be based on the value of the life insurance not premium payments.

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Trap #2: ETIPs

– At the end of the ETIP, an automatic allocation results if there is a taxable termination, distribution or transfer to a “GST Trust” even if not desired.

– Opt out is available before the end of the ETIP.

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Trap #2: ETIPs

– Example: Donor transfers property to a 4 year GRAT. No GST exemption can be effectively allocated because the GRAT term is an ETIP.

– Example cont. At the end of the GRAT term, the ETIP ends. If the GRAT provisions would have resulted in an automatic allocation at the time of the gift (ignoring the ETIP), then GST exemption is automatically allocated at the end of the term, even if not desired.

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Tip #2: Know Thy ETIPs

– Identity ETIPs that may be followed by automatic

allocations.

– Determine whether to opt out of the allocation rules before the end of the ETIP.

– If a spouse is a beneficiary of an ILIT, limit any withdrawal rights to the 5-and-5 power. This does not create an ETIP.

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Trap #3: Crummey Trusts

– Gifts to trusts with Crummey powers, while qualifying for the gift tax annual exclusion, typically do not qualify for the GST tax annual exclusion.

• The GST tax annual exclusion applies to direct skips (and also to direct medical and education expenses).

• This means lifetime GST exemption must be utilized to obtain

a zero (0) inclusion ratio for gifts to trusts with Crummey powers.

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Trap #3: Crummey Trusts

– Most trusts with Crummey powers are hanging powers and grant those powers to non-skip persons (i.e., children). As a result, GST exemption is not automatically allocated as a result of the hanging feature.

– Example. Donor makes a gift of $56,000 in year 1 and again in year 2 to a trust with hanging Crummey powers. Donor has two children and two grandchildren. The Crummey powers lapse to the extent of the greater of $5,000 or 5% of the trust property.

• In year 1, assuming the trust otherwise meets the definition of a GST Trust, $56,000 of exemption will be automatically allocated leaving the trust with a 0 inclusion ratio.

• In year 2, the children (and grandchildren) each have a hanging right to withdraw $9,000 plus an additional $14,000 causing the trust to not qualify as a GST trust and resulting in no automatic allocation.

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Trap #3: Crummey Trusts

– Example: Donor creates a Dynasty Trust. To “super charge” the

Trust, donor also provides hanging Crummey rights to all of donor’s issue, including children. Dynasty Trust purchases a $10,900,000 life insurance policy. Annual premiums are $20,000. No 709s are filed, no GST exemption is allocated. Donor dies 5 years later and GST is allocated (late) to the trust. The Dynasty Trust will have a .5 inclusion ratio and 50% of distributions to grandchildren will be subject to the 40% GST tax.

– Example cont. If Donor had allocated GST exemption on Form 709 each year, Donor would have used $100,000 of exemption and the Dynasty Trust would have a 0 inclusion ratio.

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Tip #3: Allocate Exemption on Annual 709s – For Crummey trusts (particularly ILITs) that have skip

potential, take affirmative steps to either opt out of the automatic allocation rules or opt in and treat the trust as a “GST Trust” (election 3).

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Trap #4: Wasting Exemption and Void Allocations – Waste: Allocations of GST exemption (automatically or

affirmatively) to transfers that have very little skip potential is a waste of a significant tax asset.

– Void: An affirmative allocation is void if no skip can

occur at the time of the allocation. If any skip possibility exists, even if it is so remote to be negligible, the allocation is not void.

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Trap #4: Wasting, Void and Missed Allocations

– Example: Trust provides that three children, ages 19, 22, and 24

may withdraw one-third (1/3) of the initial trust contribution for thirty (30) days upon the first to occur of reaching age 21 or upon the initial contribution. $3,000,000 is transferred to the trust. The Form 709 affirmatively allocates $3,000,000 of GST Exemption to the Trust. Other than the withdrawal power, the trust is otherwise a skip trust.

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Trap #4: Wasting, Void and Missed Allocations

– Result: With respect to the children who are over age 21, their

withdrawal right lapses thirty (30) days after the initial gift and is treated as a release per the 5-and-5 rule resulting in the children being treated as the “transferors” for GST tax purposes. Therefore, 95% of each $1,000,000 allocation (or $950,000 each) is void.

– Result: With respect to the 19 year old, a negligible skip potential

occurs if he passes away before age 21 with surviving children. The allocation is not void. If he survives to age 21, then 95% of the GST exemption allocated for his share ($950,000) will be wasted.

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Tip #4: Try to Fix It

– Consider Judicial Reformation to Fix Void/Wasted Allocations

• Favorable authorities indicate a judicial reformation relates back for all GST and other tax purposes.

– Consider IRS relief avenues (Notice 2001-50).

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Trap #5: Grandfathered GST Trusts

– Trusts that were irrevocable on September 25, 1985 are exempt from the GST Tax.

– If an addition is made, the Trust has a grandfathered and non-grandfathered portion.

– If the Trust is modified in a manner that results in shifts of beneficial interests, the exempt status may be lost.

– A modification may inadvertently result from sophisticated entity arrangement. For example, GST Trust and family members create a business entity that has the effect of shifting beneficial interests.

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Tip #5: Grandfathered GST Trusts

– Be aware of grandfathered trusts and check any planning techniques against IRS rulings and published guidance.

Questions

Jonathan Grob

402.633.9560 jgrob@mcgrathnorth.com

McGrath North Mullin & Kratz, PC LLO First National Tower, Suite 3700 | 1601 Dodge Street | Omaha, NE 68102

www.mcgrathnorth.com

Thank You

Jon Grob Partner - McGrath North Law Firm - Co-chair of the Tax and Estate Planning Practice Group

Member - American, Nebraska and Iowa Bar Associations - Omaha Estate Planning Council - Adjunct Faculty, Creighton University School of Law

Education - University of Colorado, Denver, B.S.B.A. (Cum Laude) - University of Nebraska, J.D. (High Distinction) - New York University, LL.M. (Taxation)

Jon specializes in federal and state taxation, estate, gift and business succession planning, and general corporate law. Jon’s estate planning clients range from young couples just starting out to high net worth clients, including entrepreneurs and executives. Jon has significant experience with sophisticated estate planning techniques, including GRATs, IDGTs, family limited partnerships, and family LLCs. Jon also has significant probate and trust administration experience, and regularly advises clients concerning post-mortem tax planning. Jon has handled numerous estate and gift tax audits before the IRS. Jon currently teaches the estate and gift tax course at Creighton University School of Law.

Contact Info: jgrob@McGrathNorth.com Website: www.McGrathNorth.com (402) 633-9560

Presentation Disclaimer

This presentation should not be considered as legal, tax, business or financial advice. This presentation is intended for educational and informational purposes only. It is provided with the understanding that while the authors are practicing attorneys, neither they nor McGrath North has been engaged by the attendee/reader to render legal advice or other professional service (unless a specific engagement agreement has been executed). If legal advice or other expert assistance is needed by the attendee/reader, the services of a competent professional should be sought.