Volume IX, Number 1 – June 2000
© Donlevy-Rosen & Rosen, P.A.
INTRODUCTION. Most issues of the APN dealing with offshore trusts have focused on the use of such trusts for asset protection. Another, very important, use of a certain type of offshore trust is to effect an estate tax savings. This is accomplished by “freezing” the value of trust assets vis-a-vis the settlor’s estate at current values. Result? Future growth in asset values escape federal estate taxation, thus increasing the amounts received by children and other beneficiaries. A variation of this technique can also be used for nonresident aliens owning U.S. real estate or wishing to immigrate to the United States – to practically eliminate any U.S. estate tax on death.
COMMON METHODS. Examples of common estate freeze techniques are:
Outright Gift – an outright gift is the simplest and least desirable method of implementing of an estate freeze; the transferor loses all property interests in the transferred asset. If properly structured, any post-transfer appreciation will be excluded from federal estate taxation.
Gifts In Trust – General – the same as an outright gift where the transferor is not also a beneficiary of the trust.
Sale Of Appreciating Assets – the sale (usually to a family member or to a trust) of assets which are likely to appreciate in exchange for a promissory note (issued at the date of sale for fair market value) will also effect an estate freeze, because the value of the promissory note held by the transferor will usually be subject to federal estate tax at a value equal to its unpaid balance (although “self-cancelling” notes “disappear” at death). However, the transferor will lose all property interests in and any potential benefits from the asset(s) sold.
Impediments: the major impediments to the implementation of a typical estate freeze are that it may constitute a taxable gift, and, more importantly, it will result in a loss by the transferor of all interest in the property given away. People want to “have their cake and eat it too”; that is, they want to retain some type of interest in the transferred property and obtain the estate tax benefit. In the usual case, if they retain any type of interest in the transferred property, the transfer will not be complete for federal transfer tax purposes, thereby not effecting an estate freeze (see below).
BACKGROUND. A little technical background is necessary here. In order to effect an estate freeze, we need a “completed transfer” for federal transfer (estate & gift) tax purposes. Under the trust law in most jurisdictions, property transferred to a trust in which the transferor is also a beneficiary can be reached by the transferor’s creditors to the extent the transferor could possibly receive benefits from the trust. The IRS says, because of that, the transfer is incomplete for transfer tax purposes. Thus, in the usual case, a trust of which the transferor is a beneficiary will be included in the transferor’s estate for federal estate tax purposes (no freeze).
SOLUTION. Ok, we want to have an interest in the transferred property AND obtain an estate tax benefit. How can we accomplish that? The IRS, in several well-reasoned public and private rulings, has held that if a transferor establishes his/her trust in a jurisdiction whose laws will not permit the transferor’s creditors to reach trust assets (as they would be able to in most places as a result of the transferor being a discretionary beneficiary of the trust), that the transfer will be complete, and will be excluded from the transferor’s estate for estate tax purposes.
WHY OFFSHORE? Although the laws of a few states allegedly restrict a creditor’s access to trusts under the circumstances described above, there are numerous uncertainties in that regard (See, APN, Vol. VII, No. 1). However, we know that certain offshore jurisdictions will be effective to that end. To summarize: You can set up a trust in certain jurisdictions and be a discretionary beneficiary of your trust, and it will be excluded from estate taxation in your estate. Do your assets have to be offshore? The answer is: No. Can they stay at your favorite broker? YES.
Note that we have not mentioned anything about U.S. income tax. That’s because, even though the trust described above will not be subject to U.S. estate tax in the transferor’s estate, it will still be a “grantor trust” for U.S. income tax purposes, requiring the transferor to report all trust income personally (See, APN, Vol. VI, No. 4 for a discussion of these tax laws). Variations of the technique discussed in this issue can be effectively implemented for nonresident aliens owning U.S. real estate or for those wishing to immigrate into the United States. Properly implemented, such planning can result in the elimination of our estate tax.
CONCLUSION & CAVEAT: The structure discussed in this issue will only be effective if certain rules are carefully followed in the planning and operation of the trust (beyond the scope of this issue).