Is your estate plan shortsighted because it plans for only one generation at a time? In order to answer this question correctly, take this quick test:
1. Does your will or trust provide that your assets are distributed outright to your children?
2. Does your will or trust provide that your assets are distributed to your children in trust, but your children get the assets outright at some age or upon the fulfillment of some contingency?
If you answered yes to either or both of the above questions, then your estate plan is designed for only one generation. This means that your estate plan is shortsighted because it is not designed to protect subsequent generations at all. By not protecting subsequent generations, you assets could be lost to your child's ex-spouse, your child's creditors and to Uncle Sam.
This article will inform you as to how an estate plan can be designed for more than one generation at a time, thereby saving a large amount of taxes and protecting assets from creditors for generations. It also will inform you of federal and state laws that are designed to protect assets and that can be applied to save both income and estate taxes.
Non-Tax Reasons for a Dynasty Trust
Non-tax reasons exist for leaving assets in a Dynasty Trust for a child. First, if assets are distributed outright to your child, the assets become subject to the claims of your child's creditors. This means that should your child develop creditor problems, the assets you worked so hard to save could be lost in the blink of an eye. Second, if assets are distributed outright to your child, you assets, like it or not, could be lost to an ex-spouse of your child in the event of a divorce. With the divorce rate exceeding one out of every two marriages, using a Dynasty Trust has become a necessity.
If you do not want your assets lost to a creditor or an ex-spouse of your child, then a Dynasty Trust is the solution. State and federal laws recognize that a trust is a separate legal entity from you or your child. In fact, many states give special protection to trusts that have "spendthrift" clauses in them and federal statutes give special protection to trusts that have "anti-alienation" clauses in them.
This means that if the trust provides that the trust assets are protected from the claims of your child's creditors, they will be protected under federal and/or state law. However, if you do not leave assets in a property drafted trust, these laws will not help you.
Estate Tax Savings With a Dynasty Trust
Estate (formerly known as inheritance) taxes must be paid on the fair market value of the assets that comprise your estate at the time of your death. After calculating your estate taxes, federal and state laws generally provide a credit against estate taxes. Under federal law, the credit amounts to $192,800. This credit against gift and estate taxes gives every individual the ability to transfer assets equal to $600,000 during lifetime or at death without paying estate or gift taxes.
The amount of estate taxes that exceeds your credit must be paid within nine months following your date of death. No matter what assets comprise the estate, the taxes must be paid in cash. The taxes range from 37 percent to 60 percent of your assets plus extra taxes (called excise taxes) if you die with an excess accumulation in your individual or business retirement accounts.
If your estate plan distributes assets to your child outright instead of in trust, your net assets become a part of your child=s taxable estate for estate tax purposes. Since your child becomes the owner of these assets, at the death of your child, estate taxes will again be paid on your assets. This is a form of double taxation that most people are unaware of because parents usually predecease their children by many years. However, the effect of this tax (no matter how many years apart) is devastating. This dumping of tax problems onto subsequent generations can be prevented with proper estate planning.
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Most people are aware that each person can pass $600,000 without paying estate and gift taxes. However, most people are not aware that each person can pass $1,000,000 without paying generation-skipping transfer taxes. When the federal government observed that wealthy families were avoiding estate taxes by leaving assets to beneficiaries who were one generation or more below them, it was decided to tax the transfer of this wealth.
Before this tax was implemented, assets would be left for grandchildren or even great-grandchildren (usually in trust so that the child could use and have access to the assets during his or her lifetime) so that estate taxes could be avoided on the same assets for at least one generation.
When the government began taxing the transfer of assets that skipped a generation for estate tax purposes, it provided (probably for these same wealthy families) a credit against this form of tax. With this tax credit, you can transfer assets equal to $1,000,000 during your life or at death, and skip at least one generation for estate tax purposes.
Failing to use any of this credit is like not taking a deduction on your income tax return simply because you did not know it was available. However, this type of error costs you much more in taxes.
By leaving assets in a Dynasty Trust, the assets in the trust are not included in your child's estate for estate tax purposes, despite the child having access to both income and principal during his or her lifetime. For the child, the Dynasty Trust is almost indistinguishable from outright ownership. However, taxes are saved and the assets are protected.
In order to illustrate the tax savings, assume that $1,000,000 is left in trust for your child and that your child survives you by 42 years. Assuming that the trust assets grow at a net rate of just 5 percent per year, the $1,000,000 would grow to almost $8,000,000 at your child's death. By leaving your assets in a Dynasty Trust, for this child, the estate tax savings would amount to $4,400,000 or more, using the estate tax rates now in effect. The table herein illustrates this fact.
Although the above example assumes that your estate is large, it does not have to be for the Dynasty Trust to become an absolute necessity in your estate plan. Many clients with very modest estates have one or more children who already have or will have large estates. If your child's profession allows the child to earn a great deal of money, your child will have a tax problem even though you may not.
So, does is make sense to leave assets to this child outright to simply add to his or her estate tax problem? Of course not. Therefore, the Dynasty Trust is the perfect solution to this double estate tax problem.
In conclusion, transferring wealth to future generations without the assets becoming subject to the claims of an ex-spouse, creditor or the Internal Revenue Service is the way that dynasties have traditionally been created in the past and the way in which dynasties can be created in the future. Are you prepared to take the necessary steps to begin creating a dynasty for your family? If so, your estate plan must be designed for more than one generation at a time using a Dynasty Trust.
Failing to use any of this credit is like not taking ja deduction on your income tax return simply because you did not know is was available.
Scott D. Fletcher is the President of and a Principal in Fletcher Law Firm, P.A., in Little Rock, Arkansas. Fletcher Law Firm is a tax law firm that provides full service plan administration services to employers and plan sponsors and provides outsourced plan administration to third-party administrators, financial institutions, accountants and other professionals. [scott@fletcherlawfirm.net]
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