Estate Analyst: Resurrecting the $20 Million Estate

Two limousines pull up alongside each other. The passengers roll down their windows. A bottle is exchanged. Is it Dom Perignon? Is it Grey Poupon? Or is it...Pepto Bismol?

Worrisome economic times have humbled estates of all sizes. Even a once-mighty estate may now need to be nurtured back to fiscal health.

As the estate tax prepares for a dramatic return in 2011, the challenge of estate taxation has returned as well.

Let's review some of the best planning options for estates of about $20 million. One of those options is the Beneficiary Defective Inheritor's Trust (BDIT).

Meet John Dough

We pick up the discussion of a $20-million John Dough estate where we left off. The Dough estate, with many valuable homes and assets, has nonetheless been hit hard by the recession.

Suddenly, instead of cruising along at $20 million with healthy income and solid equity growth each year, the estate has experienced severe shrinkage, has virtually no income, and jeopardizes its future by continuing to spend money like Nero during the last days of Rome. Making matters worse, any untimely demises of the Dough parents during 2011 under the automatic reversion to former estate tax rules would result in a huge estate tax burden.

The nightmare scenario ends badly. What was $20 million and growing in 2007 has been diminished by several million dollars during the recession, is currently eroding by several million more, and could conceivably get chopped in half with an extremely unfortunate and unfair arrival of an estate tax from 2001 during 2011. The net result could be about $6 million being distributed among the four Dough children in 2011. Yes, things could be worse than leaving each child with $1.5 million. The results in the given hypothetical situation would probably work out better than that, even with poor planning. But for optimal results, the estate must get back on a growth track and have some methods for bypassing transfer taxes.

For example, if the estate can eliminate expenses and generate enough current income to just break even without liquidating significant assets, it will have an opportunity to recover and appreciate in value in the future. Many economic forecasts indicate rough patches in the near term and a longer term with sluggish growth, but, with so much national and international debt, there is a likelihood of heavy inflation in the future.

Why is inflation anticipated? The United States has a national debt of $13.5 trillion at the moment. If the Treasury prints more money, the dollar will go down in value, prices will go up, and the $13.5 trillion will be easier to pay off. The United States will resist simply printing more money, but governments around the world facing the same problems will also be burning off debt with some inflation. Economic cycles come and go; when the next growth cycle arrives, there will be good reason to increase monetary supplies and stoke the fires of growth. Not all assets will benefit equally from inflation, but an estate with a number of valuable and diversified assets will grow significantly.

As a rule of thumb, a 10% growth rate will double an asset's value in about seven years. A 7% growth rate will double an asset's value in about 10 years. So, for argument's sake, if a $20-million estate has shrunk down to $15 million or so currently, a 25-year projection with 8 years of slow growth, 7 years of heavy inflation, and then 10 years of moderate inflation could produce a magnificent estate. Let's say the $15-million estate spends the next eight years recovering and increasing back up to the $20 million it was worth previously. If that estate then has the benefit of heavy and then moderate inflation for periods of 7 and 10 years, respectively, it would then double to $40 million and then $80 million by 2035.

A husband and wife who are age 50 now will turn 75 in 2035. If they have $20 million in assets now, experience growth as described, and simply earn enough other income to break even, they will have very large estates. If they inherit additional wealth or have significant wealth increases from careers or businesses, their estates will be even larger. These are estates that will undoubtedly incur transfer taxation in the future.

By transferring these assets currently, while they are diminished in value and long before the waves of inflation cause their value to recover and then double and redouble, the assets will avoid the heavy transfer taxes that would apply to them in the future.

The BDIT Option

There are a number of estate-planning approaches that freeze the value of assets for estate planning purposes or protect assets from creditors, but let's focus on a relatively new idea that compares well to other techniques.

Inheritors' trusts have been discussed and vetted for the past decade. But it may take a while for novel solutions to filter down into everyday usage--and the BDIT may have become associated with the largest of estates--but even a relatively moderate estate of $8 to $10 million can use a BDIT to great advantage. When scrutinized closely, the BDIT has many elements that are tried-and-true staples of estate planning built right into it, raising the comfort level for employing this approach. And a smaller estate of $10 million that really can't contemplate other alternative estate planning techniques that lose control and benefits of assets can take full advantage of a BDIT. Let's review.

"Intentionally defective" is a misnomer, in that it's an approach taken to direct tax liability to the most strategic person or entity.

The Inheritor's TrustTM concept of transferring assets to a trust established by a parent is not brand-new by any means, and the Beneficiary Defective Inheritor's Trust (BDIT) is simply a variation on that theme. It utilizes the same approach as any Intentionally Defective Grantor Trust (IDGT) that enables income to be taxed to the grantor.

An IDGT is designed to be "intentionally defective," i.e., in violation of grantor trust rules. Trust income can be accumulated or paid to the beneficiaries, but it is taxed to the grantor of the trust, thus further reducing both the size of the remaining estate that the grantor would need to transfer and the applicable transfer taxes.

The same concept applies to a client who sets himself up as a beneficiary of an Inheritor'sTrust. The trust is drafted so as to treat the beneficiary (the client) as the owner of the trust for tax purposes, i.e., defective beneficiary status for income tax purposes but not for estate tax or creditor purposes. This can be accomplished in various ways. One simple approach is by providing the beneficiary with Crummey-style withdrawal powers under IRC §678(a).

The biggest difference between an IDGT and a BDIT is that the BDIT involves an Inheritor's Trust that is created by a third party, so the client becomes a beneficiary and trustee of the trust rather than a grantor. This means greater control and use of the trust assets for the client than with a traditional IDGT, in which the client cannot be the beneficiary.

With that premise, the client (i.e., the beneficiary of the trust), can even have power to modify the trust in the future. The client may not only be the trustee, but he or she can also have broad powers of appointment to rewrite key provisions of the trust to adapt to changed circumstances. An irrevocable grantor trust that provides the grantor with too much power risks having the entire trust invalidated.

Traditional trusts that transfer assets downstream have some disadvantages, in that the grantor can't also be a beneficiary in most jurisdictions. A self-settled trust attracts the scrutiny of creditors and the IRS. By comparison, a trust established by the client's parent does not have this issue.

Unlike traditional downstream trusts, the Inheritor's Trust looks upstream to take better advantage of assets that the client has not yet inherited. A parent of the client sets up the trust as a grantor, and the client can then sell additional assets to that trust.

Intercepting an inheritance and directing it into a separate trust before the assets can be received by the client's estate has impressive advantages. The funds are directed in anticipation of what the client would have done. The client exercises great influence over the funds under the terms of the trust. Yet the assets, having never belonged outright to the client, avoid exposure to debts and liabilities.

An Engine of Wealth

The Inheritor's Trust can take on a life of its own: Once a pool of assets arises, it can be invested in businesses, life insurance, or other assets.

If the client has an existing asset when setting up an Inheritor's Trust, he can sell that asset to the trust now when the value is relatively low and take back an installment note. Another party, such as the client's spouse, can guarantee the note. As an alternative, an irrevocable life insurance trust can be used to guaranty the note. By selling a business or other wealth-earning opportunities to the trust at its inception, future earnings and appreciation of the assets are kept out of the client's estate.

Over time, the growth of the trust creates a separate pool of assets to use as seed money in several contexts. Businesses and investments can take shape within the trust without ever being exposed to the divorces, creditors, and personal liabilities that would otherwise apply.

Life insurance is often suggested as part of several estate planning techniques. Life insurance can provide a source of liquid assets to pay estate taxes or can be an instant asset that is not included in the decedent's taxable estate because it was purchased and owned by a separate irrevocable trust. The Inheritor's Trust is positioned in the same way and can purchase life insurance on the client's life without the proceeds being included in the client's gross estate.

The  Inheritor's Trust can become the 1% general partner of an FLP. A relatively small amount of assets is needed; if the funds are derived from a separate source, i.e., anyone other than the client, the trust will retain the controlling interest. The client could retain control over the FLP in a fiduciary capacity on behalf of the trust, yet his or her estate would only possess noncontrolling interests in the FLP.  

As with any well-designed trust, once an Inheritor's Trust is up an running with a trustee and other professionals administering assets, it can handle any number of arrangements. So an Inheritor's Trust can be coordinated with a generation-skipping GRAT, a buy-sell arrangement for buying out a business, state-income tax strategies, and many other techniques in an array of useful variations. See Oshins, Alexander, and Simmons, The Defective Beneficiary Inheritor's Trust: Finessing the Pipe Dream, CCH (2008).

BDITs for Moderate Estates

We often associate relatively new estate planning techniques with ultra-large estates, but the Inheritor's Trust and the BDIT variation of it make good sense for moderate estates, including the $20-million size we've been discussing, estates in the $8- to $10-million range, or simply the estate of a professional with a high-income career track, such as a physician, attorney, business owner, or executive.
   
As opposed to someone with $50 million or $100 million, who can afford to part with substantial amounts of wealth, someone with $10 million can't really part with wealth. A BDIT provides a "have cake and eat cake" solution, in that the client can move assets into a trust and a) retain control over the assets as trustee, b) retain income from the assets as a beneficiary, and c) do all without being considered the grantor. Moreover, these installment-sale transfers to the BDIT will not use up the client's other lifetime gifting and generation-skipping exemptions.  

Comparing Techniques
   
Richard Oshins, who has worked on the Inheritor's Trust concept for many years, recently compared the BDIT variation of the Inheritor's Trust with a number of other popular approaches with the moderately sized estate in mind.
   
FLP v. BDIT: Family Limited Partnerships provide a freeze of values and discounting of values for assets transferred to the FLP, while maintaining control by the business owner. The same benefits are provided by a transfer of business assets to a BDIT. The difference, however, is that the IRS is constantly trying to treat FLP transfers as running afoul of section 2036 and including the transferred assets in the grantor's estate, whereas a transfer to a BDIT is never treated that way.

IDGT vs. BDIT: A sale of assets to an Intentionally Defective Grantor's Trust (IDGT), in return for a note, is an approach favored by some; however, when business assets are transferred, the grantor has to retain shares of the business to maintain control, which has estate tax implications. By comparison, a note sale to a BDIT can occur without any strings. The client can transfer the asset and let go of it because he or she will then retain control over it as trustee of the BDIT. The client also retains the use and benefit of the transferred assets as a beneficiary of the trust. There are strategic uses for special power of appointment that can be applied with this approach as well.
   
DAPT vs. BDIT: A Domestic Asset Protection Trust (DAPT) is typically designed to take advantage of one of the 13 state jurisdictions within the United States that allow some variation of self-settled trusts. These DAPT jurisdictions have various exceptions and waiting periods. The shortest of the waiting periods is two years for Nevada and Hawaii. By comparison, the BDIT takes effect immediately. It should also be noted that, other than Nevada, most asset protection trust jurisdictions limit the settlor's control and do not automatically provide tax savings. By comparison, the BDIT provides the client with control as the trustee and provides tax savings by removing assets and their future appreciation from the client's estate. Foreign asset protection trusts also have limitations on control and involve continuous expenses.    
   
ILIT vs. BDIT: The Irrevocable Life Insurance Trust is a classic arrangement that keeps assets out of the grantor's estate. An irrevocable trust is set up, and Crummey transfers are made to the trust each year. The trust purchases and owns life insurance on the grantor. The life insurance proceeds are not taxed in the grantor's estate. A BDIT can simply purchase life insurance on the client's life without the proceeds being included in the client's estate. An independent special trustee would be used to own the insurance for this option. The same benefits as an ILIT are obtained but without the Crummey transfers and record keeping.
   
Gifting vs. BDIT: The simplicity and immediate gratification of a gift is attractive, without a doubt. Clients can utilize the annual gift tax exclusion and the lifetime exemption of $1 million to move assets from the client's estate to that of a beneficiary. On the other hand, assets transferred to a BDIT can then be used by the same beneficiaries, with the permission of the client in his or her capacity as trustee. The assets remain in the BDIT and are protected from creditors. None of the clients gifting exemption is exhausted by use of the BDIT.
   
Revocable Trusts vs. BDIT: The revocable living trust provides management control during life and probate avoidance at death. The BDIT provides just as much control and avoids probate just as well. The difference is that the BDIT also provides transfer tax savings and lifetime asset protection. The revocable living trust remains accessible to the grantor's creditors during life and is included in the grantor's taxable estate at death.
   
QRP vs. BDIT: A Qualified Retirement Plan can provide a buildup of tax-deferred assets. By comparison, life insurance inside a BDIT can provide tax-deferred growth without the complexities of retirement plan administration, mandatory employee coverage, required minimum distributions, and income in respect of a decedent. Meanwhile, the cash value of the life insurance is accessible to the insured beneficiary thanks to an independent trustee.

Conclusions
   
For the moderate estate in the $8- to $20-million range, the BDIT approach can provide a combination of control, income, creditor protection, and transfer tax savings that is straightforward and well organized. With the return of the estate tax, there is now more motivation to consider this approach than ever.