A. A-B-C Living Trust

An A-B-C Living Trust is simply an A-B Living Trust with a “C” or QTIP Trust added to it. Generally, when the decedent spouse’s interest in the trust estate exceeds the $2 million estate tax exemption, the excess pours into the QTIP Trust. By contrast in an A-B Living Trust the excess pours into the “A” or Survivor’s Trust. The QTIP Trust benefits the surviving spouse in that he or she must receive all the income from the trust. Also, the principal of the QTIP Trust is available for the surviving spouse’s needs. The QTIP Trust also qualifies for the marital deduction, and therefore, no death taxes are due on the death of the first spouse. The QTIP Trust is considered for tax purposes to be part of the surviving spouse’s estate, and therefore, subject to the death tax on the surviving spouse’s death. However, death tax savings can be realized through a proper administration of the A-B-C Living Trust on the death of the first spouse.

A QTIP Trust has several significant benefits. A QTIP Trust enables the decedent spouse to specify the beneficiaries who will receive the assets of the trust on the death of the surviving spouse. For example, the QTIP Trust will ensure that on the surviving spouse’s death, the assets of the trust will be distributed to the decedent spouse’s children instead of to the surviving spouse’s children from a prior marriage. Thus, a QTIP Trust gives the decedent spouse control over the final distribution of the trust’s assets,

ABC Living Trust

B. Use of Generation Skipping Transfer Tax Exemption

Like the Estate Tax Exemption, the Generation Skipping Transfer Tax Exemption for year 2006 is $2 million. In order to make efficient use of your Generation Skipping Transfer Tax Exemptions (one for each spouse), your living trust must be an A-B-C Living Trust that provides for the creation of an irrevocable separate trust for each of your children on the surviving spouse’s death. Each child’s separate trust is then divided into an Exempt and Nonexempt Trust. The Exempt Trust represents that portion of your Generation Skipping Transfer Tax Exemptions allocated to that child’s trust. For example, Husband and Wife with an A-B-C Trust are survived by two children and after all death taxes, debts and expenses have been paid, the children inherit, in trust, $3 million each. Both spouses Generation Skipping Transfer Tax Exemptions are allocated to the children’s Exempt Trusts ($2 million to each Exempt Trust). Thus, of the $3 million inherited by each child, $2 million is in the Exempt Trust and $1 million in the Nonexempt Trust. Although, the child is the primary beneficiary of his or her Exempt and Nonexempt Trusts, both trusts can be used for the benefit of that child’s children and issue. The Nonexempt Trust should be used for the needs of the child and his or her family, while the income of the Exempt Trust should be accumulated and added to its principal so that the assets of the trust are growing over the term of the trust. Generally, the Nonexempt Trust will continue no longer than the child’s retirement age. However, the Exempt Trust can continue for the lifetimes of the child and that child’s children and issue.

There are many significant benefits to an Exempt Trust especially if income is accumulated and added to principal. The assets of the Exempt Trust are protected from any creditors or potential future creditors of the child and that child’s children and issue. Also, the assets of the Exempt Trust retain their separate property character, and therefore, are not subject to division in the event the child’s marriage ends in divorce. However, the most significant benefit of an Exempt Trust is that the assets of the trust will not be subject to death tax on the death of the child. Returning to the previous example, if the $2 million allocated to the child’s Exempt Trust grows to $10 million over the child’s lifetime, on the child’s death the full $10 million passes to that child’s children free of death tax because your Generation Skipping Transfer Tax Exemptions were used. In contrast to an A-B-C Living Trust that uses your Generation Skipping Transfer Tax Exemptions, a living trust that leaves the trust estate outright to the children will be taxed again as the estate passes from the children to the grandchildren and taxed again as it passes from the grandchildren to the great grandchildren.

There are some very attractive ways an Exempt Trust can be used for the benefit of the child and his or her family. For example, the Exempt Trust can purchase a home as a trust asset. The child together with his or her family is able to live in the home and enjoy the benefits of the home without any adverse income tax consequences to the child or his or her Exempt Trust. However, the home will be protected from the claims of any creditors or potential future creditors because the Exempt Trust, not the child, has legal title to the property. The Exempt Trust can purchase a Guaranteed Life Insurance Policy on the child’s life with the trust as the owner and beneficiary of that policy. On the child’s death, the insurance proceeds together with all the assets in the Exempt Trust will pass to that child’s children free of death tax. In this manner a dynasty can be established for each succeeding generation.

C. Wealth Replacement Trust

An A-B-C Living Trust uses both spouses Estate Tax Exemptions in order to save death taxes. However, large estates will still be subject to the death tax on the surviving spouse’s death unless additional estate planning techniques are used. One estate planning technique oftentimes used in conjunction with an A-B-C Living Trust is to create a Wealth Replacement Trust. Although there are many ways to create and fund a Wealth Replacement Trust, usually annual gifts are made to the trust. There are no gift tax consequences in making the gifts as long as the gifts fall under the annual exclusion of up to $12,000 per beneficiary per year. Usually the children and grandchildren are named as the beneficiaries of the Wealth Replacement Trust. For married couples, the gifts are used to pay the premiums on a Guaranteed Life Insurance Policy that pays only on the death of the surviving spouse. The Wealth Replacement Trust is the beneficiary of the Guaranteed Life Insurance Policy. Therefore, on the death of the surviving spouse, the insurance proceeds are paid to the Wealth Replacement Trust. The insurance proceeds are not subject to the death tax on the surviving spouse’s death because the Wealth Replacement Trust is also the owner of the Guaranteed Life Insurance Policy. The Wealth Replacement Trust will receive the insurance proceeds free of income taxes. The Wealth Replacement Trust may use the insurance proceeds to purchase assets from your A-B-C Living Trust, or to make loans to your A-B-C Living Trust to provide the cash to help pay death taxes and expenses. The assets purchased by the Wealth Replacement Trust may then be distributed to the beneficiaries or continue in trust for their benefit.

Individuals with the majority of their net worth invested in real estate, closely held business interests or other illiquid assets will find the Wealth Replacement Trust to be an effective estate planning technique for addressing their exposure to the death tax. The insurance proceeds from a Wealth Replacement Trust will provide the cash to help pay death taxes and expenses, and thereby, avoid a forced sell of the assets in the estate. In effect, the insurance proceeds will replace what will otherwise be lost to the Federal Government in death taxes. Making the annual gifts will reduce the size of the estate that would otherwise be subject to the death tax. Also, making the annual gifts will effectively address the exposure to the death tax, because the gifts are used to pay the premiums on a Guaranteed Life Insurance Policy that will provide tax free insurance proceeds to the beneficiaries of the Wealth Replacement Trust.

1. Guaranteed Life Insurance Policy funded with a Single Premium Immediate Annuity

The purchase of a Single Premium Immediate Annuity (“SPIA”) to fund a Wealth Replacement Trust is a very simple yet extremely effective technique of addressing the exposure to the death tax. A lump sum of money that will otherwise be subject to the death tax is used to purchase a SPIA. The SPIA will pay a fixed dollar amount each year for your lifetime. The annual payments from the SPIA are used to make gifts to a Wealth Replacement Trust. At the time of your death, the SPIA is not subject to the death tax because it has no value at that time for death tax purposes. However, the Wealth Replacement Trust will provide tax free insurance proceeds to the beneficiaries of that trust. In effect, this estate planning technique, converts cash or other liquid assets of the estate that will otherwise be subject to the death tax into lifetime annual payments that are used to make gifts to a Wealth Replacement Trust. For example, take $1 million that will otherwise be subject to the death tax at a rate of 46%. If no planning is done, the children will inherit $540,000 after taxes. In contrast, $1 million used to purchase a SPIA will generate lifetime annual payments that are used to make gifts to a Wealth Replacement Trust. The Wealth Replacement Trust will use the gifts to pay the premiums on a Guaranteed Life Insurance Policy that (depending on your age and insurability) will provide tax free insurance proceeds with a typical range between $1.5 million and $2 million to your children at the time of your death. Clearly there are significant benefits to your family from using this estate planning technique. However, most attorneys are either unaware of this estate planning technique or will not discuss this technique because it involves very little legal work for them to do.

D. Family Limited Partnership

A Family Limited Partnership (“FLP”) can protect the family wealth from future creditors and provide a tool for reducing the size of your estate for gift and death tax purposes. An FLP is made up of general partners who manage the partnership and have unlimited liability and limited partners who are precluded from managing the partnership and are liable only to the extent of their investment in the FLP. Assets are transferred into the FLP in exchange for general partner and limited partner interests. The limited partner interests cannot be freely sold or assigned because of restrictions contained in the partnership agreement. This lack of marketability together with the lack of control limited partners have in the partnership causes the limited partner interests to have a discounted value for gift and death tax purposes.

Gifts of limited partner interests are usually made to children and grandchildren or to irrevocable trusts for their benefit. The discounted value of limited partner interests enables you to leverage these gifts for gift tax purposes. For example, if the discount determined by an independent appraiser is 25%, $2,666,667 of assets in the FLP will have a gift tax value of $2 million. Each spouse’s $1 million gift tax exclusion is used to avoid gift taxes at this time. The tax savings are significant. The initial gift tax savings in our example are 46% of $666,667. Also, only FLP interests owned at your death are included in your estate for death tax purposes. These interests are also discounted for lack of marketability and control. However, based on a recent Tax Court decision, in order to avoid possible inclusion of all the FLP assets in your estate for death tax purposes, you should not acquire a controlling or managing general partner interest in the FLP on formation of the partnership. In other words someone other than yourself should exercise control over the assets of the partnership.

FLP’s also provide many significant income tax benefits to the partners that make them very attractive in planning for income tax responsibilities among the partners. If properly structured, an FLP can alleviate some of the income tax burden on a family.

E. Defective Grantor Dynasty Trust

A Defective Grantor Dynasty Trust (“Dynasty Trust”) is a sophisticated estate planning technique that leverages the accumulation of trust assets in several ways. First, discounted gifts of limited partner interests are made to the Dynasty Trust using your $1 million gift tax exemption. Also, $1 million of your Generation Skipping Transfer Tax Exemption is allocated to the Dynasty Trust at the time the gifts are made. The allocation of your Generation Skipping Transfer Tax Exemption makes the entire trust an Exempt Trust, and therefore, all the trust assets, including any future growth, are protected from the death tax and from the reach of creditors. Second, you are taxed on the trust income because of certain powers that are retained by you. These retained powers cause you to be the owner of the trust assets for income tax purposes, but not for gift or death tax purposes. Consequently, the Dynasty Trust accumulates income tax free. Your payment of taxes on trust income amounts to a gift tax free addition to the trust. Third, limited partner interests are sold to the Dynasty Trust in exchange for an interest only promissory note with a balloon payment. The sale is for fair market value, and therefore, there is no need to allocate additional Generation Skipping Transfer Tax Exemption to the Dynasty Trust. The Federal mid-term rate is used for the interest rate on the note. The Federal mid-term rate has been very low in recent years making this estate planning technique very attractive. The sale will produce additional gift and death tax savings if the income earned on the limited partner interests sold to the Dynasty Trust exceeds the amount of interest paid on the note. Also, more compounding growth of trust assets can take place when the note can be repaid with a balloon payment at the end of the term. There is no gain recognized on the sale of appreciated assets made to the Dynasty Trust, because you are treated as the owner of the trust assets for income tax purposes. Likewise, the repayment of the note has no income tax consequences to you or to the Dynasty Trust.