As promised, below is a follow-up to my February 29th post. There, I discussed estate tax planning. Below, I want to introduce generation skipping tax planning, using some similar tools.
As of 2016, each person has a $5.45 million exemption from the federal generation skipping transfer (“GST”) tax (separate from the $5.45 million federal estate/gift tax exemption). Although Washington has no GST tax, this is an incredibly valuable federal tax planning asset that every family business owners should consider putting to work.
A “dynasty” trust is one to which assets are typically transferred by gift or sale for the benefit of children, grandchildren and future generations and to which GST exemption has been allocated, making it “exempt” from the GST tax. The assets of a GST exempt dynasty trust are typically not subject to federal or state estate tax or the GST tax during the duration of the trust when a trust beneficiary dies, which allows them to grow in value without depletion for transfer taxes, and enjoy protection against a trust beneficiary’s creditors (including former partners and spouses of your descendants).
In Washington, the longest period of time a trust may be in existence is currently 150 years … some clients feel that’s long enough … others look to establish dynasty trusts in other states that have longer or no durational time limits.
A dynasty trust may be formed such that the grantor (the person(s) creating the trust) pays the income taxes associated with the trust (without such tax payment being a gift to the trust beneficiaries) — such a trust is sometime referred to an “intentionally defective grantor trust” or “IDGT”. A benefit of an IDGT is that, if structured properly, a business owner may sell a portion (or all) of the company to a dynasty IDGT – without the recognition of gain – in exchange for a promissory note from the IDGT. Prior to any such sale, assets with a value of at least 10% of the assets to be sold to the trust must be gifted to the trust, and the assets being sold and gifted to the trust ideally would be income producing (or be sold) in order to make note payments. Consider the following example which results in the transfer of a substantial amount of value to the dynasty trust to a sale to an IDGT.
Married couple who are residents of Washington State create an IDGT, to which their GST exemptions are allocated. As a “seed gift”, the couple transfer stock in their family business to the dynasty IDGT worth $10,900,000 (the combined amount of each of their full current federal gift tax and GST tax exemptions). That seed gift allows the couple to make an installment sale to the IDGT of further stock in their family business, up to $109,000,000. If the sale is of minority interest stock, adiscount of up to 35% may be available, meaning this $109,000,000 can actually represent stock with an undiscounted value of $167,692,308.
In the above sale, the IDGT issues a 9 year promissory note in the amount of $109,000,000 to the couple with an April 2016 applicable federal interest rate of 2.25%, compounded annually. If the stock value grows at 5% per year, it will be worth approximately $260,145,809 at the end of year 9. Also at the end of year 9, the IDGT would owe $133,166,918 on the promissory note. After payment of the note obligation, the IDGT value will be approximately $126,978,891 (increased value of stock gifted and sold less note payments).
Note that if the donors do not survive the 9 year note term, the amount owed under the note (and not any appreciation on the stock sold to the IDGT) is included in their estate for state and federal estate tax. However, in any case, since the IDGT in this example is a dynasty trust, the undistributed $126,978,891 would not be included in the couple’s descendants’ estates for state or federal estate tax purposes.
The foregoing example contemplates a more mature stage company. However, a dynasty trust may receive business interests (and other assets) at any stage of a company’s maturity. The earlier the transfer, the lower the value of the business interest, and the more business interests that may be transferred to the trust (if that’s desired).
There are many ways to effectively utilize the GST exemption. The above example illustrates only one option, and only speaks to one asset of likely many assets owned. It is important to take all moving parts of an estate into consideration when doing this type of planning. Our trust and estates attorneys are available to answer questions, and review existing plans to make sure they still make sense given your circumstances and relatively recent changes in federal tax laws.
* Please note that this article only addresses federal GST, income and estate tax matters specific to the example provided, and does not address any other tax considerations.