The Ohio Legacy Trust – a new method of protecting your assets

On March 27, 2013, Ohio became one of the few states where the law allows you to create a trust for your own benefit which is protected from most creditors when the Ohio Legacy Trust Act took effect.

Under this new law, you may create an irrevocable “Legacy Trust” to hold your assets for your benefit or the benefit of members of your family.  You can retain the right to receive income or discretionary distributions, make withdrawals of up to 5% of the trust assets each year, the right to use real property held by the trust such as a house, the power to change trustees, a veto power over distributions, and the right to control the investment of trust assets. 

There are several technical requirements you have to meet when creating a legacy trust.  The trustee must be an individual Ohio resident or a trust company doing business in Ohio, and you cannot be the trustee or a co-trustee—though you can be an advisor to the trustee.  When you create the trust, you must sign an affidavit verifying under oath that:

• ·       the assets being transferred to the trust are not the proceeds of unlawful activity;
• ·       you have the right to transfer these assets;
• ·       by placing them in the trust, you will not become unable to pay your debts as they become due;
• ·       you have no intention of defrauding your creditors; and,
• ·       you do not intend to file bankruptcy.

If there are any lawsuits or administrative actions pending against you at the time you create the trust, you have to disclose these in the affidavit; if there are none, the affidavit has to so state.

If you’ve followed all the rules in creating the Legacy Trust, the assets in the trust will not be subject to most creditor claims.  (The only exceptions are claims for child support, or of a former spouse who was married to you when the trust was created.)  Your creditors have a period of time (usually 18 months from the creation of the trust) to file a lawsuit to undo the transfer of assets the Legacy Trust, and in order to do so they have to be able to prove that you created the Legacy Trust and transferred the assets in question specifically to defraud that creditor.  As a practical matter, that will be a difficult case to make—and any creditor whose claim arises more than 18 months after the trust is created will be unable to attack it at all.

The Legacy Trust will be of particular benefit to clients whose personal assets may otherwise be subject to future business risks, such as doctors practicing in a high-risk specialty or entrepreneurs starting a new business.  They can also be used along with a prenuptial agreement to protect family assets from the risks of a second marriage.

Defined Value Gifts

As we've discussed before, there is a "unified credit" against the gift and estate taxes which cancels out the tax on some wealth transfers--we often call the amount protected from tax the "exemption equivalent."  Right now, that exemption equivalent is $5 million (plus an annual inflation adjustment), though it is scheduled to be reduced to $1 million (plus an inflation adjustment) with the expiration of the 2001 and 2010 tax acts at the end of this year.  (The Obama administration has proposed making the future exemption equivalent $3.5 million in its last budget, but for various political reasons this is unlikely to be enacted before the election.)

If you want to make large transfers of wealth and not pay taxes (who doesn't?), you have to make sure not to give away more than the exemption equivalent.  With cash or easily-valued assets such as marketable securities, this is not difficult to accomplish.  For farmers and other family business owners, the bulk of their wealth is in non-liquid assets like land and closely-held business assets which, if you're not selling them to a buyer at arm's length, must be valued by an appraisal.  An appraisal is a professional opinion as to the "fair market value"--"the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts" as the IRS defines it. It is not unusual for two appraisers to come to different valuations for the same asset in perfect good faith. 

If the taxpayer wants to give the full amount of the exemption equivalent, and the assets available to make the gift are the sort that have to be valued by appraisal, a lot is riding on that appraisal.  Human nature being what it is, the government's expert appraiser usually values gifts or estate assets higher than the taxpayer's expert appraiser, particularly when the government's valuation results in a taxable transfer in excess of the available exemption equivalent and a tax due!  This naturally leads to a lot of IRS audits, administrative appeals, and Tax Court litigation.

One tactic used by taxpayers who wanted to max out their tax-free gifting was to make a combined gift of property to individuals and charities.  The gift instrument would designate that a fixed amount was to go to the individuals and the excess to charity.  This discouraged the government from attacking the taxpayer's valuation because any increase in the value of the gift would pass to a charity--and the IRS still wouldn't collect any tax on it.

In a recent Tax Court case reported on in the Wall Street Journal, the taxpayers made a gift of closely-held business interests under an instrument which limited the gift to $1 million, with no charitable excess gift.  The IRS revalued the assets at something more than $1 million.  The Tax Court ruled that the excess over $1 million was not a gift because the taxpayers expressed an unambiguous intent to give $1 million and no more.

This obviously makes it easier for taxpayers to make controlled tax-free gifts of hard-to-value assets, particularly high net-worth individuals who want to make large lifetime gifts before the exemption equivalent goes down at the end of this year.  As the Journal observes, "The decision is so advantageous for taxpayers that it could inspire a response from Congress or the IRS."

Dynasty Trusts

As I'd mentioned in the discussion of the Rule Against Perpetuities, quite a few states have replaced or supplemented the Rule's complicated and counter-intuitive limit on the duration of a private trust with a fixed term of years. In Florida, for example, a contingent interest is valid if it vests (becomes certain) within 90 years, or within the traditional "life plus 21 years" period of the Rule. In Wyoming, they've replaced the Rule with a rather impressive fixed time limit.  Regardless of when its contingent interests vest, a private trust governed by Wyoming law cannot last more than 1,000 years!

In some other states, of which Ohio is one, a trust can "opt out" of the Rule so long as the trustee has an unrestricted power to sell trust assets.  (The power of sale means you don't have to worry about the problem that inspired the Rule in the first place: unresolved contingent interests interfering with the free transferability of property.)   In other words, an Ohio trust can last, if you so desire, until the Second Coming, or until the sun swells up into a red giant, or until whatever other future event constitutes "the end of the world" in your personal belief system..

This has led to the development of what is commonly called a "dynasty trust."  A dynasty trust is a trust for the benefit of one's descendants which has either a very long period (200 years or more) or no fixed termination date at all.  The trustee has discretion to make distributions to any of the grantor's descendants from time to time in whatever amounts the trustee finds to be appropriate, and the trust may contain language further directing or restricting the trustee's exercise of discretion.

The trust is funded with an amount equal to what can be protected from the federal generation-skipping transfers tax by the use of the grantor's available GST exemption.  It's possible for multiple grantors, such as a husband and wife or a group of siblings, to make contributions to the same trust and thus "pool" their GST exemptions.  The grantor either uses up part of her unified credit, or pays the necessary gift or estate tax.  The effect of the dynasty trust is to place the trust property beyond the reach of the federal wealth transfer tax system for as long as the trust lasts--the transfer subject to gift or estate tax occurs when the trust is created.  Because we've used GST exemption to protect the assets of the trust from GST upon funding, it doesn't matter whether it's a "direct skip" right now or whether there are going to be "taxable distributions" and a "taxable termination" somewhere down the road. 

This makes the dynasty trust a particularly good vehicle for protecting family business assets from future transfer taxes.  Through the end of 2012, every individual has a $5 million GST exemption and a unified credit equal to the tax on $5 million, allowing for some spectacularly large dynasty trusts to be created--provided that you have assets in those amounts and can afford to give away that much.

Drafting a trust like this is an interesting exercise.  The client will often want to give the trustee some guidance on what distributions would or would not be appropriate; my job is to put this down on paper in a way that accurately captures the client's intent while (we hope!) still being understandable to some future bank trust officer 500 years from now and being sufficiently flexible to allow that future trust officer to adapt to several centuries' worth of cultural and tax law changes.

The Rule Against Perpetuities

The Rule Against Perpetuities is an old doctrine from the English common law which limits the duration of a private (noncharitable) trust.  The most widely accepted statement of the Rule comes from Professor John Chipman Gray's classic 1886 treatise on the subject:

No interest is good unless it must vest, if at all, not later than twenty-one years after the death of some life in being at the creation of the interest.

If you're not quite sure what that means, don't feel bad.  It took Professor Gray 496 pages to explain the Rule and its application to lawyers who were already familiar with the subtleties of property law.  The complexities were such that the Supreme Court of California, in a 1961 case, ruled that it was not malpractice if a lawyer drafted a will that violated the Rule because the Rule Against Perpetuities was too difficult to master!

The Rule applies to contingent interests--that is, where the question of whether you get anything from the will or trust depends on some future event. An example would be a trust distribution where Alice receives the trust income for life, and when Alice dies, it goes to the children of Alice who are then living.  We don't know if any particular one of Alice's children will get anything from the trust until either Alice or that child dies.  Alice's children are therefore what we call "contingent beneficiaries."  (Alice is a "vested beneficiary.")

To really, really, really (over)simplify it, the Rule requires that the interests of all contingent beneficiaries be resolved--that is, we know for sure if they'll get anything or not--before the end of a "measuring life"--the life of some person who was living when the trust was created--plus 21 years.  In the example I gave in the previous paragraph, we have no problem.  Alice could be our "measuring life," and when Alice dies we will know which of her children outlived her, and therefore who gets the trust property, well within the Rule's time limit.  A trust with a more complex future distribution involving generations yet unborn could, however, very easily crash into the Rule.  In order to avoid violating the Rule, a trust couldn't attempt to reach too far into the future.

The original purpose of the Rule was to allow for the free transfer of property.  If a piece of land--which was the primary source of wealth back in the 1600s when the Rule got started--had too many contingent interests, it became impossible to transfer it because either you couldn't identify all the dozens of people who might have an interest in the land, or you couldn't find all of them, or you couldn't get them all to agree to sell the land, or you couldn't figure out how to split up the proceeds afterward, or some combination of all that.

In a modern trust with contingent interests, this is not an issue because the trustee, the sole owner of all the trust's assets, will have the power to sell those assets at any time.  Even though the problem the Rule was attempting to solve wasn't a problem any more, the Rule still applied to modern day trusts.  In recent years, however, most state legislatures have overridden the Rule with a statute that either replaces the "life in being plus 21" period with a fixed time limit, or allows a trust to ignore the Rule completely.  We'll talk about some planning arrangements that take advantage of that change in the next post.

If you'd like to learn more about the Rule Against Perpetuities and want to have some fun doing it, I recommend you read three delightful law review articles written by Professor W. Barton Leach (1900-1971): "Perpetuities in a Nutshell" (1938), "Perpetuities in the Atomic Age: The Sperm Bank and the Fertile Decedent" (1962), and "Perpetuities: the Nutshell Revisited" (1965).

Federal Estate and Gift Taxes -- Generation Skipping Taxes and How They Affect Trust Design

In the previous post, we took a quick overview of the generation-skipping transfers tax, "affectionately" known as the "GST."  This is the tax that's imposed, in addition to the federal estate or gift tax, on any "generation-skipping transfer."  A "generation-skipping transfer" (sometimes called a "skip") is any transfer, at death or by gift, to a "skip person."  To illustrate what a "skip person" is, let's use the family tree from the last post, with a slight modification:

Grandma

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Junior

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Skippy

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Skippy II

Grandma is the person who's going to be making the transfer.  Assuming all of these people are living on the date of the transfer, Skippy and Skippy II would be "skip persons" and Junior would be a "non-skip person"--yes, that's the official term from the tax code.  A gift to Skippy or Skippy II would be a "generation-skipping transfer," and will be subject to the GST unless the annual exclusion applies or Grandma has GST exemption she can allocate to the transfer.  A transfer to Junior is not a skip, and will not be subject to the GST.  (If Junior dies, and then Grandma makes a transfer to Skippy, that will not be a skip because there is no living person in the generation between them, and the GST won't apply--but transfers to Skippy II will still be skips subject to GST.)

So far, I've been talking about outright gifts.  If the gifts are made to a trust, the question of whether they're skips or not is determined by looking at the beneficiaries of the trust.  A gift to a trust for the benefit of Skippy will be a skip because Skippy is a skip person.  A trust for the benefit of Skippy and Skippy II--same result, because all of the beneficiaries are skip persons.  All of these transfers are called "direct skips," and if there's any GST to be paid, it's paid when the transfer is made.

Now for the tricky part: what about a trust for the benefit of Junior, Skippy, and Skippy II?  Let's assume for purposes of the example that the trustee can make distributions to any one or more of these three people in its discretion.  A trust like this might be seen where Junior is the "gray sheep" of the family.

In this case, when Grandma puts assets into the trust, we don't know if the transfer is a skip yet because we don't know if any particular property in the trust will be distributed out to a skip person (Skippy and Skippy II) or a non-skip person (Junior).  If the trust makes any distribution to Junior, those are not skips, and there's no GST.  Any distributions to Skippy or Skippy II are "taxable distributions" on which a GST will have to be paid at the time of distribution unless Grandma allocated GST exemption to the trust back when she created it.

What happens when Junior dies?  As of that moment, we know for a certainty that all future distributions will be to the skip persons.  Junior's death is therefore a "taxable termination"--it's called that because the interests of all non-skip persons in the trust have terminated--and is the occasion for assessing the GST against all of the remaining trust property--again, unless Grandma allocated GST exemption to the trust back when she created it.

In other words, a transfer to one of your children which is held in trust for life, with final distribution to your grandchildren, may subject the trust property to the GST.  Therefore, it's necessary to allocate GST exemption to the trust when the trust is created; this is done on the relevant estate tax or gift tax return.  If you don't have enough GST exemption to cover the entire transfer, the trust has to be designed so that the non-exempt part is included in your child's estate so that it's taxed there instead of being hammered by the GST.

Federal Estate and Gift Taxes -- the Generation Skipping Transfers Tax

The generation-skipping transfers tax, or "GST" for short, is perhaps the hardest-hitting element of the federal wealth transfer tax system. For purposes of illustration, let's use a very simple family tree:

Grandma

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Junior

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Skippy

To begin, imagine that it's before 1976, when the first version of the GST was enacted.  (It was replaced in 1986 with the arrangement we have today.)  By virtue of his place in the family business and/or earlier gifts from Grandma, Junior is independently wealthy.  Anything that Grandma leaves to him at death will simply get added to Junior's gross estate and taxed again at Junior's passing.  What people in Grandma's position often did was to create a trust for Skippy and the other grandkids, and perhaps also later generations, and thus "skip" taxation in Junior's generation.  The trust usually could reach no farther than the grandchildren's generation because of something called the Rule Against Perpetuities, which we'll discuss another time.

As we've noted in earlier posts, one of the baseline policies of the gift and estate tax system is to tax accumulated wealth once per generation, and generation skipping transfers like these cut that down to once every other generation.  Because most people would only do this if Junior was well provided-for, these "generation-skipping trusts" were a strategy only a very very high net worth family could make use of--so that the estate and gift taxes actually fell harder on those who were wealthy enough to pay estate taxes, but not wealthy enough to play at generation skipping.

To redress this flaw and discourage generation skipping transfers, Congress enacted the GST.  The GST is imposed, in addition to the estate or gift tax, on any transfer to a "skip person."  There's a complex definition of a "skip person" in the tax code, but what it boils down to is that, in the example above, Skippy is a "skip person" if Junior is living on the date of the transfer.  If Junior dies, and then Grandma makes the transfer to Skippy, it's not a generation skipping transfer and the GST does not apply.

What makes the GST hit so hard is the rate of tax: it's equal to the highest estate tax rate then in effect.  In 1986, when the modern version of the GST entered the tax code, that top rate was 55%--so it was possible for a generation-skipping transfer to be taxed at a combined 110% (up to 55% estate/gift tax + 55% GST).  The purpose of this was not to collect a 110% tax so much as it was to make large generation-skipping transfers so uneconomical that no one would want to do them.

Well, maybe not all generation-skipping transfers.  Not wanting tax policy to interfere too much with the time-honored tradition of doting on grandchildren, Congress also provided that the GST does not apply to most annual exclusion gifts, and gave every person a $1 million GST exemption.  The exemption let each person transfer a total of $1 million to the grandkids (and other skip persons) before the GST kicked in.  (There was also a $2 million-per-grandchild temporary exemption which expired in 1989--named the "Gallo provision" in honor of the high net-worth family which "suggested" it to their Congressional representatives.)

Under the 2001 tax act ("the Bush tax cuts"), the GST exemption increased in parallel with the exemption equivalent provided by the estate and gift tax unified credit, so that it reached $3.5 million in 2009.  During the "estate tax holiday" in 2010, there was (so we thought) no GST at all.  The 2010 tax act reinstated the GST retroactive to January 1, 2010, but at a 0% rate--so if you made a generation-skipping transfer before the tax was retroactively re-imposed, you didn't get hit with a surprise tax assessment.  For 2011 and 2012, the GST exemption is $5 million.  Unless Congress acts before the end of next year, the GST exemption will "snap back" to $1 million on January 1, 2013, as part of what the media calls the "expiration" of the "Bush tax cuts."

You may think that the GST is a problem only for the super wealthy, but it can affect people of relatively modest means.  A trust for your "gray sheep" child which holds the assets for the child's life, then distributes to that child's offspring afterward, is a generation-skipping transfer that is subject to the tax unless there is sufficient GST exemption to cover it.  We'll talk about how the GST affects trust design, and some of the "work-arounds" that have been developed to counter it, in future postings.

E-Mail and Attorney-Client Confidentiality

I plan to do a future post on attorney-client privilege and confidentiality issues in estate planning.  While you're waiting for that, I'll refer you to an interesting article on confidentiality issues with the use of electronic mail published at lawyerist.com.