If you are a high net worth, very high net worth or ultra high net worth individual or household, you will benefit immensely on proper estate planning, including the use of appropriate trusts, to minimize your taxes and maximize the transfer of your wealth to the next generation.
One strategy of reducing your assets is by establishing trusts. Depending on the type of asset you own, an estate planning attorney will be able to assist you in determining what type of trusts are suitable for your estate. To reduce the valuation of your assets for purposes of estate tax or credit protection, the transfer must be to an irrevocable trust, a trust that you cannot revoke or amend. Otherwise, if the transfer is to a revocable trust, it is still considered your property upon death and subjected to estate taxes.
Generally, there are six trusts that a high net worth individual usually considers in reducing assets:
Intentionally defective grantor trusts (IDGT)
One way to reduce the tax valuation of your estate is to transfer property to an intentionally defective grantor trust (IDGT). An IDGT is a complete transfer to the trust for estate tax purposes, but an incomplete or defective transfer for income tax purposes.
An IDGT is an irrevocable trust because you cannot amend or revoke the trust. However, it is a defective irrevocable trust that is considered a grantor trust for income tax purposes because:
- you retain the power to substitute trust assets, or
- you designated your spouse as trustee and have given your spouse-trustee authority to add beneficiaries, or
- you authorized an independent trustee to make loans to you without security, or
- you authorized the use of trust income to pay life insurance premiums on your or your spouse’s life.
As a complete transfer for estate tax purposes, IDGTs remove the property from your estate for purposes of estate tax but is considered your property for purposes of income tax. Reporting income using your social security number is beneficial because individual income tax rates are lower than trust tax rates. Removing the property from your estate for purposes of estate tax is advisable for high net worth individuals because of the New York estate tax cliff, subjecting a New York resident to estate tax on the entire estate, if the entire estate is valued at 105% of the estate tax exemption amount (which is $6.4155M as of 2022).
Transfer to the IDGT can be made via gift or installment sale. If it is made via gift, it is deducted from an individual’s lifetime gift exemption. If it is made via installment sale secured by promissory note, no gain is recognized because exchanges between a grantor and a grantor trust are not taxable events.
The promissory note is included in your estate but any appreciation is not. For example, if you transferred a house worth $1,000,000 to the IDGT and received a promissory note of 1% per annum for 10 years with a balloon payment of $1,000,000 at the end of 15 years, this promissory note will form part of your estate. The IDGT will pay you $10,000 per annum which may not be considered income because it is lower than APR but is included in your gross estate. After 15 years, if the house is worth $4,000,000, you were able to shield $3,000,000 in appreciation of value from your estate. The IDGT will continue to manage the property for your beneficiaries in accordance with the terms you provided in the IDGT.
Irrevocable life insurance trusts (ILIT)
Another way to reduce the official valuation of your assets is to set up an irrevocable life insurance trust (ILIT).
You transfer property to the ILIT, which then uses the income of such property to purchase insurance over your life. Upon your death, the proceeds of the life insurance policy are transferred to the ILIT, as beneficiary, and the property transferred to the ILIT is not considered as part of your estate for purposes of estate tax.
Your property transfer to the ILIT is usually as a gift, for which a gift tax return is filed and which will be subtracted from your lifetime gift exemption.
To qualify as an ILIT, all premiums paid must come from the ILIT’s own checking account.
For example, you have $10M of assets, and you want your assets to be below $6.4155M due to New York’s estate tax cliff. You transfer two commercial real estate properties worth $2,000,000 each to the ILIT, both of which are earning a combined rental net income of $80,000 annually. Your current estate will now be $6M. Not only is it exempt from paying estate tax in 2022, it is also well below the $6.4155M threshold of the estate tax cliff.
The combined rental net income of the two commercial properties, $80,000, will be used to purchase life insurance premiums on your life. Upon your death, the proceeds of the life insurance policy will be given to the ILIT, as beneficiary, who will then distribute it to your designated beneficiaries, free of probate and estate tax.
Charitable lead trust / Charitable remainder trusts
Charitable trusts allow you to reduce the official valuation of your assets, but still, at the same time, transferring it to a trust where you can designate the beneficiaries who will benefit from the trust assets.
A charitable lead trust allows you to transfer property to the trust, giving a periodic donation (either a specified amount or a specified percentage of trust assets) to a charity or charities for a particular period of time, after which the remainder of the trust assets will be distributed to your designated beneficiary, which could include you.
A charitable remainder trust, on the other hand, will allow you to transfer property to the trust, giving you or your designated beneficiary the right to receive a stream of income for a particular period of time, after which the trust assets will be distributed to your designated charity.
Once the properties are transferred to the trust, they are removed from your estate for purposes of computing estate tax.
The establishment of these types of trusts require specialized knowledge of IRS rules. For this reason, it’s important to go to a trust attorney with expertise in this area to ensure your trust is established as such.
Generation skipping trusts
In a generation skipping trust, assets are transferred to the trust with a designated beneficiary (called skip person) who should be 37.5 years younger than you. During the term of the trust, the appreciation or income of the trust assets can be used by the skipped generation (usually your children). After the term of the trust, the trust assets are distributed to the skip persons (usually your grandchildren).
In order to be feasible, the property transferred to a generation skipping trust must be below the exemption amount. Otherwise, the tax on a transfer to a generation skipping trust is 40%, in addition to the estate or gift tax.
Because the transfer is made from the grantor to the skip person, you are able to avoid the estate taxes twice: on your own estate taxes and your children’s estate taxes, if the property were transferred straight to your children and not to your grandchildren.
Grantor retained trusts
Another way of reducing the valuation of your assets for the purposes of estate tax is the establishment of a grantor retained trust.
There are three types of grantor retained trusts that can help reduce your estate property:
- Grantor retained annuity trusts (GRATs)
- Grantor retained unitrusts (GRUTs)
- Grantor retained income trusts (GRITS)
The GRAT, GRUT, and GRIT are similar, except that a GRAT gives you a fixed annuity payment during the term of the trust, the GRUT gives you a payment equal to a fixed percentage of the trust’s assets, while the GRIT allows you access to the net income of the trust’s assets. At the end of the trust term, the trust assets are distributed to your designated beneficiary free of estate taxes.
The transfer of property to the grantor retained trust is usually via gift where you pay a gift tax in excess of the lifetime gift tax exemption.
For example, you, a founder of a tech-start up with a valuation of $5M, has $1M worth of stocks. The start-up is registering for an IPO, and you transfer the $1M stocks to a grantor retained trust prior to IPO. The trust gives you an annuity payment of $205,000 per year for 5 years, at a total amount of $1,025,000. At the end of the 5 years, the trust can distribute the stocks to your designated beneficiary, free of estate tax. If the value of the $1M stocks is now $3M, $2M appreciation of assets is transferred to the designated beneficiary estate tax-free.
One disadvantage of this trust is that the trust asset is transferred to the designated beneficiary using the basis at the time the trust was created. For this reason, in the example above, when the designated beneficiary receives the $3M worth of stocks, its basis is still $1M. If it sells the $3M stocks, the designated beneficiary will have to pay a capital gain on the $2M appreciation of assets.
Grantor retained trusts are similar to charitable trusts, except that the designated beneficiaries are not charities but non-charitable entities.
Spousal lifetime access trust (SLAT)
A spousal lifetime access trust is a trust that can reduce the valuation of your estate for purposes of estate tax and removes it not only from your estate, but also the beneficiary-spouse’s estate.
In a SLAT, you transfer individually owned assets to the trust, with the other spouse as beneficiary. Because the other spouse is the beneficiary, it is not subject to any gift tax because of the unlimited marital deduction, allowing spouses to transfer properties to each other without incurring taxes.
To ensure that the donor spouse is protected in case of divorce between the spouses, a trusts attorney should draft the SLAT to ensure enough protective mechanisms are in place for unforeseen circumstances, especially since transfers are irrevocable.
Now is the time to start planning your estate
In New York, high net worth individuals, especially those with liquid and illiquid assets of more than $6.4155M (as of 2022), should plan their estates. Otherwise, a majority of their wealth would go to estate tax.
Why? Because New York has an estate tax cliff. This means that your estate is exempt up to a certain amount ($6.11M in 2022). However, if your estate exceeds 105% of the exempt amount ($6.4155M), your estate will be taxed entirely. If your estate is between $6.11M to $6.4155M, your estate is taxed on the amount that exceeds $6.11M on a graduated basis, depending on the amount.
Thus, even if the federal estate tax exemption as of 2022 is $12.06M, it is wise to start reducing the valuation of your estate to below $6.4155M so that your entire estate will not be subjected to New York estate tax.
Parties to a trust
Generally, there are three parties to a trust: the grantor, the trustee, and the beneficiary. But irrevocable trusts in New York may also now include a Trust Protector, another party you give authority to make other decisions and changes to the trust. The Trust Protector can ensure that the trust is administered in accordance with the trust terms. The inclusion of a Trust Protector allows the trust to be flexible and gives you more protection of the trust assets, especially in cases where the trustee proves to be unreliable or untrustworthy.
Who is a high net worth individual?
To compute for net worth, you need to subtract your liabilities from your liquid assets. Liquid assets are assets that are easily convertible to cash, such as bank and brokerage accounts. This usually excludes real estate since it can take months to convert real estate into cash.
As of 2021, Forbes defines high net worth, very high net worth, and ultra high net worth individuals as:
High net worth: Individuals or households holding liquid assets valued between $1M to $5M
Very high net worth: Individuals or households holding liquid assets valued between $5M to $30M
Ultra high net worth: Individuals or households holding liquid assets valued at more than $30M to $5M
High net worth individuals, especially those with assets above the New York estate tax cliff, should properly plan their estate to minimize estate taxes and ensure the greater transfer of wealth to the next generation. An estate planning attorney specializing in high net worth individuals and households can help establish the proper trust, given the type of assets you have. We at the Law Offices of Albert Goodwin are here for you. We have offices in New York, NY, Brooklyn, NY and Queens, NY. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.