“After much observation of super-wealthy families, here’s my recommendation: Leave the children enough so that they can do anything, but not enough that they can do nothing.” – Warren Buffet

At R360, we talk about wealth as a holistic concept that’s far more than just dollars and cents. However, there are certainly instances where inadequate attention to financial wealth can imperil other forms of capital, like social capital (one’s relationships outside the family) and human capital (the overall strength and wellbeing of one’s family). A good case in point is an estate plan.

A thoughtful estate plan is a highly effective tool for cementing your legacy, furthering your charitable work, and ensuring the wellbeing of your children. However, in its absence, many families of means enrich their least-favorite heir: Uncle Sam. Here’s how successful families can take control of their wealth legacy to ensure their hard-earned resources support the causes and people they cherish.

The Zero Estate Tax Plan

The “Zero Estate Tax Plan” premise is simple: create a plan that leaves a predetermined amount to your heirs and the balance to charity while retaining the flexibility to alter it and, if desired, engage in future planning. The planner, of course, can get quite involved in the design and execution.

How much wealth to leave to children and charity is a profoundly personal decision (and not the subject of this article). It is an art as much as a science, and, over time, a family’s values will change. It is therefore essential to have tremendous flexibility built into the various trust vehicles that transfer the wealth and into the overall plan and the estate assets. Let's look at a case study focusing on a few available planning strategies to move wealth efficiently and responsibly. For the sake of simplicity, we’ll assume that the challenging decisions around “how much?” have already been made.

Case Study

Meet Sarah, a 65-year-old widow with four adult children and two grandchildren. Three of her children have followed in her footsteps and are successful entrepreneurs, while the fourth has a fulfilling career as a social worker. Having just sold her successful business for cash, Sarah has a net worth of $100M (net of income taxes), the lion’s share of which is liquid.

With over $10M of ordinary income and $25M of capital gain, primarily from the sale of the business in 2021, Sarah is facing $9M of taxes ($4M of ordinary income taxes at 40% and $5M of long term capital gains at 20%). Recognizing how fortunate she has been and with the added benefit of reducing taxes, Sarah is a firm believer in giving back to society. She has decided to make a $10M donation to her alma mater (a tax-exempt 501(c)(3) ivy league university) to support a building campaign. Although Sarah has discussed it with her legal and tax advisors, she is hesitant to form a private foundation as she has been simplifying her life. She has not used any of her $11.7M lifetime gift exemption (indexed for inflation to $12M in 2022).

Sarah would like to set up a trust funded with approximately one-half her estate in today’s dollars, or $50 million for her children and grandchildren ($12.5M per child), and engage in thoughtful charitable planning. She wants some of the transferred assets to be earmarked responsibly for her social worker son. One of her children has just gone through a messy divorce, and a key concern is to place assets beyond the reach of her children’s spouses or, more importantly, ex-spouses. (Sarah wants her children to engage in their own planning for their spouses.)

2021 Plan

With no planning, Sarah’s federal estate tax liability would be $35.2M, and the lion’s share of the net after taxes could become taxable in her children’s estates. In late 2021, Sarah completed the implementation of her zero estate tax plan consisting of the following wealth transfer strategies for her children, grandchildren, and charity:

Let's examine more closely the three strategies comprising Sarah’s zero estate tax plan:

1. $12M gift of her lifetime gift and GST exemption to a dynasty trust for the benefit of her children, grandchildren, and future generations. These funds will be invested in a combination of marketable securities, private equities, and hedge funds. The earnings and growth can be reinvested as a hedge against inflation or can be used to provide for children and grandchildren. Homes can be purchased (and even businesses started) in the trust. Once gifted funds are sheltered from the gift and generation-skipping transfer taxes (GST), they avoid repeat estate taxation at each generation. The trust may run for hundreds of years or more depending upon the state in which the trust is sited. Trust assets are beyond the reach of children’s creditors, including ex-spouses, in the event of divorce.
2. $35M of permanent life insurance funded with a $10M loan plus annual gifts in the dynasty trust. Current favorable loan rates and terms make this an attractive strategy. The $12M loan will accrue interest at a fixed 1.9% and be repayable to Sarah’s estate upon her death. If the trust investments perform well, the loan could be repaid sooner. The difference between the assumed trust investment returns of 6.75% and the 1.90% loan interest rate funds the life insurance. Provided the trustee approves, the loan can be repaid at any time.
3. $10M contribution to a Charitable Lead Annuity Trust (CLAT). Before the sale of her business, Sarah considered three charitable planning strategies (discussed in greater detail in Sarah’s Charitable Planning Considerations below): i) a direct gift of $10M to her alma mater, ii) funding a charitable remainder unitrust with $10M, and iii) a $10M contribution to a charitable lead annuity trust (CLAT). Sarah chose the CLAT, which:
   ‍
   - Pays $1M per year to her alma mater for ten years;
   - Generates a $10M current income tax deduction (generating $4M income tax savings based on a 40% income tax rate); and
   - Passes $4.5M at the end of the ten-year term to a trust for the benefit of her children, gift tax-free (based on a total return of 6.75%).
   
   Note: Each year during the term of the CLAT, Sarah will report CLAT income on her personal tax return. CLAT investments can be “tax managed” (along with her other personal investments) to minimize taxable gain.

To summarize, Sarah re-positions $22M to fund $50M in trust for the benefit of her family ($10M of which is a loan that can be repaid at any time) plus $10M for charitable planning. Having deployed $32M to fund $50M for children and grandchildren and provide for her alma mater, her remaining estate is comprised of $68M of primarily liquid assets (plus the $10M loan to fund the life insurance).

What can she do with the $68M liquid assets she controls directly? Whatever she wants! The $68M will first and foremost provide for her lifestyle needs. Sarah wants to begin a major home renovation and purchase a larger lakefront home where her family can gather. In the future, Sarah can engage in additional estate and charitable planning, including simply changing her will and revocable living trust at any time to reallocate her wealth among her family and charity. Upon her death, having provided for family members, Sarah is free to leave the balance of her estate to charity. Alternatively, the $35M of life insurance proceeds in the dynasty trust would be available to pay estate taxes, enabling her to pass substantial additional assets to her children at death.

Sarah’s 2021 Charitable Planning Considerations

Prior to closing on the sale of her business, Sarah had indicated a strong interest in a $10M charitable donation to her alma mater. Her tax advisors introduced three planning strategies: a direct gift to the university, the charitable remainder unitrust (CRUT), and the charitable lead annuity trust (CLAT). An advantage of the direct gift to charity option is that it creates a current $10M deduction. It reduces her ordinary income dollar for dollar, putting $4M more in her pocket (based on a 40% income tax rate) and providing the university with the immediate use and control of the gifted funds.

Next, she considered the charitable remainder unitrust (CRUT). A CRUT pays a percentage (for example, 5% of trust assets valued annually) to Sarah for a term of years (or for her lifetime). At the end of the term, the balance passes to the university. The deduction, however, is a fraction of the $10M million contribution. Based on a 5% annual payout to Sarah for her lifetime, her income tax deduction would equal $4.5M, putting $1.8M more in her pocket (based on a 40% income tax rate). Meanwhile, the university would have to wait until the end of the CRUT term to receive its share.

For those selling a business but who have not yet signed a binding contract or letter of intent, a significant benefit of the CRUT is that they can contribute all (or a portion) of appreciated stock. Because the CRUT is a tax-exempt entity, it can sell the stock and reinvest the full proceeds unburdened by taxes. Sarah and her advisors decide that the CRUT does not fit her planning goals because i) she wants to benefit her alma mater sooner, rather than at the end of the CRUT term (i.e., upon her death); ii) her advisors feel that since she’d already signed a letter-of-intent with the buyer, it was too late to avoid recognition of gain on the contribution of the stock to a CRUT; and iii) Sarah’s business was organized as an ’S’ corporation, and the CRUT is not a permissible ‘S’ shareholder.

The charitable lead annuity trust (CLAT), the opposite of the CRUT, provides the same $10M upfront income tax deduction as the direct gift with the added benefit of the remainder interest passing to a trust for the benefit of children. Sarah is comfortable that the university, receiving $1M per year for ten years, will have to wait ten years to receive the entire $10M.

The Benefits of Life Insurance

Unlike assets comprising the estate, assets in the dynasty trust do not receive a stepped-up cost basis at death. In contrast, life insurance death benefits are paid income tax-free to the trust and provide an immediate source of cash to support family members or pay estate taxes or debt.

Life insurance cash values provide significant lifetime benefits as well. First, policy values grow income tax-free. This characteristic will be extremely important in the future as income taxes and taxes on trust investment returns rise. As of this writing, the House of Representatives has passed legislation (that now awaits the Senate’s response) that increases taxes on trust income in excess of $500,000 by 8%. In addition, as long as the dynasty trust is a defective grantor trust, the grantor pays trust taxes. This structure provides a compound wealth transfer benefit by reducing the taxable estate and acting as a free gift and GST transfer to the trust. After defective grantor trust status is turned off, either during the grantor’s lifetime or upon the grantor’s death, the trust will pay its own taxes, again, potentially at a much higher rate than the grantor was paying. Following the grantor’s death, cash values continue to grow tax-free as long as the life insurance remains in force (for example, with survivorship life where the spouse survives or if the policy insures someone other than the grantor). Notably, the policy can be designed to minimize death benefits and maximize cash value growth.

In addition, policy cash values can be accessed tax-free by withdrawing cash up to cost basis (premiums paid), then through borrowing at very low net loan rates. In other words, the benefits of the tax-free growth of cash values are not locked up in the policy but may be accessed during the insured’s lifetime to provide for trust beneficiaries.

Conclusion

The Zero Estate Tax Plan allows wealth innovators to take control of their wealth by implementing a flexible plan that:

1. Carefully manages wealth for the benefit of children, grandchildren, and future generations;
2. Avoids spoiling heirs with too much too soon;
3. Protects wealth from the creditors of children and grandchildren, including ex-spouses in the event of divorce; and
4. Engages family members in collective and individual charitable pursuits, including (potentially) establishing a private family foundation.

The plan provides tremendous flexibility so that Sarah can make alterations as her and her family’s needs and charitable goals evolve.