How To Distribute Wealth To Your Heirs
--------------------------------------------------------------------------------------------------------------------Most individuals choose to give their children their inheritances directly. Proper
trust planning is a golden opportunity to do more for your families. You can
provide your families with many generations of protection from: Creditors,
Predators, and Estate taxes.
A TALE OF TWO FAMILIES
Consider this tale . . .
The Knight Family: John Knight inherited $1 million from his family directly.
His inheritance was titled in his own name. He owned it.
The Day Family: William Day didn’t inherit anything from his parents. They
did leave him $1 million in trust. He could control and could enjoy the $1
million as co-trustee and beneficiary, but his trust owned it.
You might think that John, who inherited his $1 million directly, would be
happier than William, who inherited his $1 million in trust. But if the Knight
family knew what the Day family knew, he would not be. If John could see the
future, he would rather control and enjoy his wealth than own it. Let's take a
closer look.
THE KNIGHT FAMILY
Estate Taxes: Estate tax rates begin at 37% once estates reach $650,000 and rise
to 55% when estates reach $3 million. Since the government taxes everything
we own at death, John would pay estate taxes on his $1 million because he
owns it outright. If his descendants inherit their wealth outright, too, the
govern-ment will tax their wealth each time they pass it from one generation to
the next because each generation will own what they inherit.
Q: Assuming each generation doubles its inherited wealth, what will happen in
three generations if each generation is in the 55% estate tax bracket?
A: John’s $1 million will grow to $2 mill-ion, shrink to $900K when it passes
to his children, will grow to $1.8 million, shrink to $810K when it passes to his
grandchildren, grow to $1.62 million, shrink to $729K when it passes to his
great-grandchildren.
Creditor Claims: To make matters worse, anything one of the Knight
descendants owns is subject to claims by creditors. Lawsuits can wipe out
inheritances long before estate taxes do.
Predator Claims: Who are Predators? Predators can come from within the
family – particularly the spouse of an unsuccessful marriage. Unless each
family member diligently obtains a prenuptial agreement and diligently keeps
inherited property separate from marital property, a soon-to-be-ex-spouse can
make claim to it in a divorce, adding financial loss to a family member’s
personal one.
THE DAY FAMILY
Control and Enjoyment without Ownership: Unlike John Knight, William
Day’s $1 million is owned by a trust created by his parent’s estate plan, not by
William. Even though William can spend all trust income, can use the
principal, and can control the trust assets as a cotrustee of his trust, he is not
deemed to own the trust’s assets, provided the trust is properly drafted. The
terms of the trust must limit William’s access to trust assets to his health,
education, support and maintenance. Actually these limitations are so slight that
William will regard the trust’s assets as his own, even though he does not
legally own them.
You Cannot Lose What You Do Not Own. Because William and his
descendants do not legally own the trust assets, those assets are not subject to
claims of creditors and spouses of failed marriages.
Estate Taxes: Likewise, since they do not own the trust assets, these assets are
not included in their estate for estate tax purposes, even though they can direct
where they go at death.
Q: Again assuming each generation doubles its inherited wealth, what will
happen in three generations if the prop-erty is kept in a properly drafted trust?
A: William’s $1 million will grow to $2 mill-ion, no shrinkage when it passes
to his children, will grow to $4 million, no shrinkage when it passes to his
grand-children, grow to $8 million, no shrinkage when it passes to his great-
grandchildren. An increase of over 10 times the amount passing to the Knight Family.
THE GENERATION-SKIPPING TAX
There is of course, a catch. The estate-tax-free nature of this type of trust
planning did not go unnoticed by Congress. In 1986, Congress enacted a 55%
generation-skipping transfer tax (GSTT) that applies whenever trust assets pass
to a new generation free of estate taxes.
The GSTT Exemption: Congress did however, provide a $1 million generation-
skipping transfer tax exemption. Individuals can contribute up to $1 million to a
specially drafted trust that is exempt from both estate taxes and generation-
skipping transfer taxes. With proper estate planning a married couple can
transfer up to $2 million to such trusts.
Growing $1 Million Estate Tax Free: As we have already seen, your family can
do a lot with $1 million over time in an estate tax free environment. With a 6%
annual growth rate $1 million dollars left to a child in a GSTT Exempt Trust
could grow to almost $80 million as it passed through three generations of
family members, all without incurring additional estate taxes.*
If the Knight family were to invest the same $1 million, at the same rate of
return, for three generations, they would have approximately $7 million after
paying estate taxes three times.**
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*At a 6% rate of growth, $1 million would grow to almost $80 million in the 75
years it would take to pass through 3 generations. Assuming a 25-year age
difference between generations.
**Using the same assumptions as the preceding footnote, $1 million would
grow to only $7.2 million if 55% is paid as estate taxes when it passes to the
next generation in years 25, 50, and 75.
Thanks to W. Edward Dean, Dean & Associates, Estate and Charitable Tax
Planning, One California Street, 19th Floor, San Francisco, California 94111
(415) 352-1440.
Mr. Dean is a tax attorney in San Francisco. He protects wealth through estate,
income and charitable tax planning. Mr. Dean received a B.A. and M.B.A.,
magna cum laude, Phi Beta Kappa, from Dartmouth College, a J.D. from the
University of Virginia, and an LL.M. in Taxation from New York University.
He is former editor of the Virginia Law Review, the Virginia Journal of
International Law, and the New York University Law Review. Mr. Dean is a
California Bar Association-certified tax specialist. He is a member of the San
Francisco Estate Planning Council and the Northern California Planned Giving
Council. He is a founding member of and instructor for the National Network
of Estate Planning Attorneys. He co-authors and teaches the Network's
Charitable Trust Institute and its Generation-Skipping Trust Institute.
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