Sale To A Defective South Dakota Dynasty Trust - Leveraging Your Trust Into Perpetuity

1. Maintaining control in the senior generation and providing similar control at each successive generational level;
2. Minimizing gift, estate and generation-skipping transfer taxes;
3. Leveraging the gift, estate and generation-skipping transfer tax exemptions;
4. Providing creditor protection, especially protection from divorce; and
5. Leveraging these tax and creditor protection benefits into perpetuity.

In the author's opinion, the sale to a defective South Dakota dynasty trust accomplishes these objectives better than any other technique available under the current tax laws. Although this article focuses on accomplishing all of these goals, it is important to note that each client is different. The size of the estate, the asset makeup and the clients' desires should always be paramount. What is considered a nearly perfect estate plan for one client is not necessarily a nearly perfect estate plan for another.

The federal transfer tax system taxes property as it is transferred to each generation. The estate and gift taxes were unified in 1976 so that gifts and bequests are subject to the same tax, although the taxes are calculated differently making gifting a much more effective technique. The Internal Revenue Code allows each individual an exemption against the individual's estate or gift taxes. This cumulative amount can either be used during life, at death or partially during life and partially at death. Under the Taxpayer Relief Act of 1997, the exemption amount is $625,000 in the year 1998, $650,000 in 1999, $675,000 in 2000-2001, $700,000 in 2002-2003, $850,000 in 2004, $950,000 in 2005 and $1,000,000 in 2006. If the transferred property exceeds the exemption amount, the excess is taxed at rates as high as 55%. [For estates between $10,000,000 and $21,040,000, the 5% surtax causes the highest rate to be 60%.]

Prior to the changes in the tax laws in 1986, many well-advised individuals would set up irrevocable trusts that would last for multiple generations. They would allocate their estate and gift tax exemptions to the trusts, thus avoiding the estate tax at each generational level until state law required the trusts to terminate. Not only was the initial gift or bequest exempt from estate and gift taxes, but all of the growth and accumulated income on the property was also exempt.

In 1986, this opportunity was curtailed by the enactment of the generation-skipping transfer tax ("GSTT"). The GSTT is a tax on property that is transferred to or for the benefit of a person who is at least two generations below that of the transferor. For example, a transfer of property in trust for the benefit of the transferor's child which passes to the grandchild upon the child's death is subject to the GSTT. The GSTT is taxed at a flat rate equal to the highest estate and gift tax rate, currently 55%.

The GSTT allows each individual an exemption of $1,000,000. Under the Taxpayer Relief Act of 1997, effective for gifts and bequests made after 1998, the GSTT exemption will increase each year by the cost of living, rounded down to the next lowest multiple of $10,000. The GSTT exemption allows an individual to transfer up to $1,000,000 (or $2,000,000 if the donor's spouse elects to split the gift) to a dynasty trust without triggering the 55% GSTT. Because of the GSTT exemption, individuals can transfer up to $1,000,000 to a trust that can continue forever. This type of trust is commonly referred to as a dynasty trust. Furthermore, the $1,000,000 exemption can be leveraged significantly using installment sales to dynasty trusts that are defective for income tax purposes.

The dynasty trust is structured to last for as long as state law permits. Almost every state limits the duration of its trusts by a rule against perpetuities. The rule against perpetuities generally provides that the trust must vest and therefore be distributed no later than 21 years after the death of the last to die of the lives in being who are identified in the trust document.

South Dakota is one of only six states with no rule against perpetuities. If a dynasty trust is set up in South Dakota, it can theoretically last forever without any estate, gift or generation-skipping transfer taxes! South Dakota has traditionally been the jurisdiction of choice for these trusts, not only because it has no rule against perpetuities, but also because it has no state income tax.

Fortunately, it is not necessary for the grantor to live in South Dakota in order to have the trust domiciled there. Notwithstanding the perpetual estate tax savings and creditor protection benefits, the advantage in domiciling a trust in a state with no income taxes sometimes in and of itself is the primary motive for establishing a dynasty trust in South Dakota.

In order to use the laws of South Dakota, a South Dakota bank should usually be named as a co-trustee. Unlike non-corporate trustees who often move out of state or eventually pass away, a bank, especially a large, well established bank, should last in South Dakota for many years. If the bank ever ceases doing business, it can be replaced at that time with a different bank.

In order to obtain sufficient nexus to South Dakota, the bank will hold most of the trust assets or the certificates representing the trust assets. For example, if the dynasty trust owns an interest in a partnership, a copy of the partnership agreement will be held at the bank along with the partnership certificates showing ownership. The bank will also handle many of the administrative duties including the maintenance of trust accounting records.

The extent of the duties given to the South Dakota bank is determined by the grantor of the trust. The trust can be drafted so that the bank cannot make any investment or distribution decisions, or conversely, the trust can be drafted so that the bank is the sole trustee and therefore makes all of the trustee's decisions. In most cases, in order to satisfy most clients' desires that the beneficiary have all the control upon reaching a specified age, the bank is usually named as an "administrative" trustee to hold the assets and to provide many of the administrative duties. In this case, the bank is not given any investment or distribution authority.

Many individuals are reluctant to use trusts because of their belief that the purpose of a trust is to keep the property away from the beneficiaries. Perhaps this reluctance comes from discussions with advisors who use trusts primarily as a probate avoidance tool as opposed to using trusts as a tax planning and asset protection tool. The advisors typically recommend using a third party as trustee to manage the assets until the beneficiary reaches a specified age such as 25 or 35. Upon reaching the designated age, the trustee is directed to distribute the assets outright to the beneficiary. The age that is chosen is the age at which the grantor believes the beneficiary should be given the assets.

The problems with designing a trust in this manner are two-fold. The first problem is that the property becomes available to the creditors of the beneficiary immediately upon an outright distribution from the trust. Conversely, as long as property is held in an irrevocable trust, it is protected from the creditors of the beneficiary, including spouses in the context of divorce.

The second problem with designing a trust so that a mandatory distribution of the trust assets is made upon the child reaching a specified age is that the distributed property and all of its growth and income needlessly increase the size of the beneficiary's estate. Upon the death of the beneficiary, this may cause an estate tax that otherwise could have been avoided using a dynasty trust.

When the client tells the advisor that he wants the property distributed to the beneficiary upon reaching a specified age, in most instances the client has selected the age based upon his belief that this is the age at which the client believes the beneficiary should have control over the property. If this is the case, then this objective can be accomplished by naming the beneficiary as managing trustee of the trust upon reaching the specified age rather than requiring the property to be distributed.

It is difficult to imagine any rights the beneficiary can have owning the property outright that the beneficiary cannot also have as trustee. Outright ownership gives a person (i) the right to manage and control the property, (ii) the right to use the property, (iii) the right to access the income from the property, (iv) the right to access the principal, and (v) the right to determine who gets the property upon the person's death. These are all rights that can be given to the beneficiary as trustee. However, if the beneficiary is given the right to distribute principal to himself, then such right must be limited by an ascertainable standard. In order to provide a broader distribution standard and more flexibility, an independent co-trustee is often named to make distributions and other tax sensitive decisions. The beneficiary is usually given the power to remove the independent co-trustee, with or without cause, and name a successor independent co-trustee. [See Rev. Rul. 95-58.] This leaves the control in the hands of the beneficiary. Thus, the beneficiary does not lose any of the rights that he would have had with outright ownership of the property. When these obvious benefits are combined with the estate tax savings and the creditor and divorce protection, it is not clear why anyone, when given the option to continue the trust, would decline to do so!

When designing a trust, there are three possible income tax payers: the trust, the grantor or one or more beneficiaries. In the past, attorneys were usually very careful to avoid causing the grantor to pay the income tax on income earned by the trust. If the trust income tax was being paid by the grantor, it was usually due to a drafting error made by the attorney. However, with the compression of the trust income tax brackets and with the newer planning concepts, the shift has been towards intentionally drafting trusts so that either the grantor or the beneficiary are treated as the "owner" for income tax purposes. Since the grantor (or the beneficiary) is the "owner" for income tax purposes, he is responsible for payment of the trust's income tax liability, and he gets the benefit of any deductions and credits attributable to the trust. A trust in which either the grantor or the beneficiary is treated as the "owner" for income tax purposes is commonly known as a defective trust.

The attorney can design the trust so that the grantor is the "owner" of the trust for income tax purposes by violating one or more of IRC 673-677 or 679. Similarly, the attorney can design the trust so that the beneficiary is the "owner" of the trust for income tax purposes by violating IRC 678. In determining which Section(s) to violate, the attorney must be certain not to choose a Section which also makes the trust defective for estate tax purposes. This article focuses on the defective trust in which the grantor is the "owner" for income tax purposes, and in all cases hereafter any reference to a defective trust shall mean a trust which is defective with respect to himself.

There are two primary advantages in using a defective trust. First, the grantor's payment of the income taxes allows the trust to accumulate income tax-free and reduces the grantor's taxable estate by the amount of the tax. The payment of the income tax by the grantor is the functional equivalent of a tax-free gift to the trust.

The other advantage in using a defective trust is that transactions between the grantor and the trust are disregarded for income tax purposes under the holding of Revenue Ruling 85-13. This is because a person cannot cause an income tax by selling an asset to himself. For income tax purposes, a sale to a defective trust by the grantor is a sale from the grantor to the grantor.

A complete understanding of valuation planning is necessary in order to understand the sale to a defective trust technique. For transfer tax purposes, the fair market value of an asset is the price a willing buyer would pay a willing seller for the asset. [Treas. Reg. Sec. 20.2031-1(b); Treas. Reg. Sec. 25.2512-1.] Under the willing buyer-willing seller test, it is often possible to arrange the assets in such a way that their value is significantly reduced. Although there are a number of methods to arrange the assets to reduce their value for transfer tax purposes, the most popular method is to place the assets in a family limited partnership ("FLP").

A FLP is a limited partnership among family members or trusts for their benefit. The general partners have the control and the limited partners have no control. The limited partnership interests can be transferred at a discount since they are non-voting interests in a closely-held entity. There are two principal discounts that apply in valuing a limited partnership interest - a minority interest discount and a lack of marketability discount. The minority interest discount is applied because limited partnership interests have no voting power. The lack of marketability discount is applied because a partnership interest in an entity with few partners does not have a ready market and because of the transferability restrictions in the partnership agreement.

For example, assume a combined $2,000,000 worth of assets is contributed to a family limited partnership by Husband and Wife. In exchange for the $2,000,000 worth of assets, Husband and Wife each become 1% general partners and 49% limited partners. If Husband were to sell a 40% limited partnership interest, without considering the willing buyer-willing seller definition of fair market value one might be tempted to conclude that the fair sales price would be 40% of $2,000,000 (i.e., $800,000). However, due to the minority interest and marketability discounts, an appraisal might show that the fair market value is closer to $400,000. This assumes a 50% discount. Estate planners frequently use this ability to discount to leverage the amount that the client may gift. With a 50% discount, twice as much "pro rata" value can be depleted from the client's estate.

The FLP also provides other benefits in the family estate plan. One benefit is that the senior family members can gift or sell limited partnership interests to the junior family members or to trusts for their benefit without losing control over the partnership assets since the senior family members usually retain the general partnership interests. Another benefit is that the limited partnership statutes provide a degree of asset protection since the statutes provide that the sole remedy of a judgment creditor of a partner is limited to a "charging order" against the partnership interests. The charging order remedy gives the creditor a right to distributions but does not give him the right to become a substituted partner. Care must be taken in relying too heavily on the asset protection aspects of the partnership, as some of the states have begun to allow the courts to authorize a foreclosure sale as an additional remedy.

An asset worth $1,000,000 certainly may be sold by the grantor to a defective trust in exchange for $1,000,000 cash without any income tax ramifications under the holding of Revenue Ruling 85-13. Similarly, assuming a 50% discount, limited partnership interests with a non-discounted pro rata value of $2,000,000 can also be sold to a defective trust for $1,000,000 cash without any income tax ramifications.

The sale of assets at a discount is significantly enhanced by leveraging the sale using a deferred payment. The interest-only installment sale with a balloon payment will be illustrated herein, but a private annuity or a self-cancelling installment note might also be considered if the client's situation makes either of these alternatives more favorable. The general rule of thumb used by estate planners is that the trust must have a fair market value of at least 10% of the fair market value of the assets being sold to the trust. Thus, no more than a 10 to 1 ratio of assets being sold to assets independently owned by the trust should be used.

The technique can best be illustrated by an example. Assume the grantor gifts $100,000 to a defective trust and allocates $100,000 of gift tax exemption and $100,000 of GSTT exemption to the transfer so that the trust is wholly exempt from transfer taxes. The grantor then sells to the trust a limited partnership interest with a pro rata value of $2,000,000 (and a fair market value of $1,000,000 after a 50% discount) in exchange for an interest-only promissory note with a balloon payment of $1,000,000 due after nine years. The sale is for fair market value so that no additional gift tax exemption or GSTT exemption needs to be allocated to the trust.

If the partnership assets and the initial $100,000 gift are both earning income at a rate of 10% each year, then the trust will have an additional $210,000 (i.e., 10% of $2,000,000 plus 10% of $100,000) at the end of the first year. Using the January 1998 IRC 1274(d) federal mid-term rate of 5.93%, the interest payable from the trust to the grantor at the end of the year would be 5.93% of $1,000,000, or $59,300. Each year, the trust continues to accumulate much more income than it must pay back to the grantor since (i) the trust is increasing income tax-free, and (ii) the interest is applied against the discounted fair market value of the limited partnership interest.

If the grantor were to die immediately after entering into the sales agreement, his estate would be reduced by the $2,000,000 pro rata value of the partnership assets and would be increased by the promissory note with a face value of only $1,000,000. This would result in an immediate savings of the estate tax on the difference between the two figures. In addition, the promissory note may be further discounted because of its low interest rate. The fact that there is no requirement that the grantor survive the term of the note along with the ability to immediately apply the GSTT exemption are the two primary reasons that this technique is superior to the grantor retained annuity trust technique. [A grantor retained annuity trust is an irrevocable trust in which the grantor retained an annuity payment for a term of years. A complete explanation of this technique is beyond the scope of this article.]

Without even considering any leveraging enhancements using defective trusts, discount planning or installment sales, $1 million earning 10% per annum before taxes (6% per annum after taxes in the assumed 40% income tax bracket) in a non-defective South Dakota dynasty trust will grow to approximately $6.25 billion (The actual figure is $6,249,996,724. This figure is computed by compounding $1 million at 6% per annum for 150 years.) in 150 years versus only $115 million (The actual figure is $115,330,018. This figure is computed by compounding $1 million by 6% per annum for five 30-year periods and after each period reducing the cumulative total by 55%.) if no generation-skipping is done and the assets are taxed at 55% each 30-year generation. This alone demonstrates why a single generation trust should seldom be used. If the South Dakota dynasty trust was drafted so that it was defective for income tax purposes, and the grantor survived for 30 years after making the gift to the trust (so that the trust would be defective for the initial 30 years and non-defective for the remaining 120 years), this simple enhancement would magnify the results after 150 years to nearly $19 billion (The actual figure is $18,988,225,756. This figure is computed by compounding $1 million by 10% per annum for the initial 30-year period and then compounding that figure by 6% per annum for the remaining 120 years.) remaining in the dynasty trust for the descendants.

Assume that the grantor gifted the $1 million to the defective South Dakota dynasty trust and then sold to the trust $20 million in pro rata value of limited partnership interests (with a fair market value of $10 million after an assumed 50% discount). Assume further that the sale was for an interest-only promissory note at the January 1998 IRC Sec. 1274(d) federal long-term rate of 6.13% with a balloon payment of $10 million due after thirty years. Under this enhanced scenario, after the same 150 years, the South Dakota dynasty trust would have over $306 BILLION (The actual figure is $306,379,122,108) in value! [This computation was done using the South Dakota version of the author's Sale to "Defective" Trust Megaanalyzer(sm) software. Sale to "Defective" Trust Megaanalyzer(sm) is a software program that was designed and developed by Steven J. Oshins. Both the general version and the South Dakota version are service marks of Steven J. Oshins.] This result actually understates the potential leverage that can be achieved using this technique since a grantor with an extremely large estate would most likely make further installment sales to the trust beyond the initial sale thereby causing the dynasty trust to grow exponentially.

It is impossible to create the perfect estate plan. However, as estate planners, we should always try to create estate plans for our clients that are as close to perfection as possible. For many of our clients, the sale to a defective South Dakota dynasty trust technique accomplishes this. For other clients, some but not all of the concepts introduced herein should be used. Even for a client with a small estate, the concept of leaving the property in trust as opposed to drafting the trust to terminate when the beneficiary reaches a specified age should almost always be adhered to. This principal applies to all trusts, whether revocable or irrevocable.

First published in April 1998