John S Budihas, CLU, ChFC

The Ming Dynasty ruled China for 276 years. Its demise in 1644 was due in part to the depletion of the imperial treasure. If the dynasty’s rulers had access to today’s financial planning strategies for preserving wealth, there is no telling how many generations this powerful family could have occupied the throne of the Middle Kingdom.

Perhaps the creation of a dynasty trust could have helped the Ming Dynasty’s rulers pass their riches to future family members and extend its influence over China for many more centuries.

Like the Ming Dynasty, wealthy American families encounter wealth transfer problems of their own in the 21st century. Currently, there are a number of roadblocks for taxpayers who desire to leave a large legacy to their heirs. The “Great Recession of 2008/2009”—the deepest and most severe since the Great Depression—has caused the loss of billions of dollars of asset values in investments, pension/profit sharing funds, IRA accounts and real estate. In addition to devalued asset values, however, there are other roadblocks to passing a family’s treasure ad infinitum to subsequent generations: (1) state anti-perpetuity trust laws, (2) generation skipping tax laws, and (3) the $1 million dollar cap on lifetime gift transfers.

Most states have anti-perpetuity rules that permit a trust to remain in existence for only 21 years plus nine months beyond the lifetime of those trust beneficiaries who were alive when the trust was created. These are called rules against perpetuity or RAP states.

However, there are approximately 16 non-RAP states that allow a trustee to continue managing trust assets ad infinitum, and the assets in the trust need never vest in the trust beneficiaries. Let’s call them the perpetuity states.

A taxpayer, regardless of where domiciled, can create a trust in any perpetuity state and transfer and/or re-title property to an irrevocable trust in that state. The only requirement is that the independent trustee of that irrevocable trust must be a resident of or doing business in that state. This is a requirement by all states whether the state is a perpetuity or a RAP state.

Trust laws are not standard but are state specific and differ with respect to (1) whether trust income is subject to state income taxation, (2) the amount of discretion a trustee has to allocate principal and income to remainder or income beneficiaries, and (3) whether a trust can be reformed or modified.

Creating a perpetual trust is only one part of a multi-generational wealth continuation solution. Perpetuity by itself does not address or solve the problem of the generation-skipping tax (GST) that may be incurred when property is transferred to someone who is more than one generation removed or 37 or more years younger than the donor.

GST can be devastating. The 2003 GST is a flat tax equal to whatever the top marginal estate tax bracket rate is in the year of the gift and the GST exemption is whatever the testamentary federal exemption is. In 2009, the GST exemption was $3.5 million and the tax rate 45 percent.

The GST is paid in addition to the standard gift tax that is incurred by the donor’s gift to the skip beneficiary. That’s a double tax. Second, any GST paid by the donor is considered another gift made by the donor, which is also subject to taxation at the top 45 percent marginal bracket rate. That’s a triple tax!

Be aware, however, that as we write this article, there is no GST, because there is no federal estate tax. Who could have foreseen that Congress would fail to address the expiration of estate taxes in 2010 caused by the Economic Growth and Tax Reform Reconciliation Act (EGTRRA)? Take advantage of this unique window of planning opportunity while it lasts.

Most tax law practitioners expect Con­gress to extend the 2009 estate law into 2010 and beyond. If they do, will the estate and GST laws of 2009 be retroactive to January 2010? Or will they be retrospective only from the signing of the new legislation?

Many do not think the law will be made retroactive because of the constitutional issue. However, if the 2010 changes should be retroactive, the taxpayer would then file a 709 gift tax return before the end of the tax year to allocate whatever the new GST exemption for 2010 would be.

Just as the Ming Dynasty needed a shield to preclude the dissipation of wealth to future generations, today’s estate owners need a plan not only to shield assets from the ravages of taxation, creditors and litigators, but also to replenish assets lost in the global recession. The current uncertain tax environment only intensifies the need to execute a pre-emptive tax planning strategy for all ages. That effective strategy can be the generation-skipping perpetuity trust (GSPT), created in one of the available perpetuity states that can build a permanent protective shield around a taxpayer’s assets to avoid excessive depletion of estate assets.

The EGTRRA of 2001 enhanced the value of GSPT planning by indexing the GST exemption to the very same scheduled increases of the IRC Section 2010 estate exemption equivalent. As the federal estate tax exemption grew from $1.12 million in 2003 to $3.5 million in 2009, so did the GST exemption.

A taxpayer’s exemption amount can be doubled if the spouse elects to split his or her GST exemption; i.e., the non-donor spouse can elect to allow the donor spouse to use his exemption with a properly filed 709 gift tax return. This is called a “split” gift. A non-grantor spouse who elects to do this is not considered a donor for estate tax purposes, but only for gift tax purposes. This is an important distinction that allows the non-grantor spouse to be a beneficiary of the GST trust without concern about trust assets being subject to estate taxation under IRC Section 2036 in the spouse’s estate.

Care must be taken that such a spouse/beneficiary not be given excess Crummey withdrawal powers that exceed $5,000 or 5 percent (5 by 5 power) of the trust assets. Any exercise of this general power that exceeds the “5 by 5” power can cause the spouse to become a trust grantor and cause potential estate tax issues. Crummey powers grant a trust beneficiary the general power to withdraw a gift from a trust within a short period of time so that the donor’s gift can qualify for an annual exclusion present interest gift.

EGTRRA also allowed for automatic allocations of a GST exemption to all generation skipping transfers, whether those transfers are direct gifts to a grandchild or indirect gifts to a trust for a grandchild. Still, to avoid any future conflict, a timely gift tax return (Form 709) with a notice of GST allocation should always be filed with each and every gift to the GSPT. (Annual exclusion gifts are not subject to GST.)

Here is an example of how the GSPT strategy works. Business owner Tom Barry can leverage his lifetime GST exemption into a $50 million legacy GSPT and effectively avoid potential estate, gift and generation-skipping taxes in a most cost- and tax-effective way for all future generations.

Step 1: Tom lives in Connecticut but decides to establish his multi-million dollar GSPT in the perpetuity state of South Dakota with a resident institutional trustee. South Dakota is one of the most favorable perpetuity states because any income generated by the trust is not subject to state income taxation.

Tom may add his spouse as a co-trustee to provide guidance to the institutional trustee regarding the distribution of trust assets; however, if his spouse is also a trust beneficiary, any trust powers that she has should be restricted. Trust beneficiaries may include children, grandchildren, great grandchildren, etc. Tom can even add a “protector” trust provision to his perpetuity trust, giving an independent person the power to alter, amend and/or add beneficiaries to the trust in the future.

Step 2: Tom’s South Dakota trustee applies for a $50 million second-to-die life insurance policy with an increasing death benefit on Tom and his spouse, Marie, who are 55 and 52 years old, respectively. This is referred to as a policy with a return of cash value death benefit provision. Normally Tom would have to make a gift to the trust of the $390,690 to pay the premiums. He would also need to allocate his GST exemption to that premium gift to forever exempt all trust assets from the GST (if there is a GST). Again, there is no GST in 2010 at this time.

Tom and Marie could split their annual trust exclusion gifts—up to $26,000 per trust beneficiary—and also split their $2 million lifetime gift exemption. However, even with split-gifting, they would exhaust their lifetime exemption in the future. Tom and Marie can substantially discount the annual premium for gift and GST purposes from approximately $553,000 to $390,690, if they use a properly designed collateral assignment split dollar plan between the GSPT family trust and Tom’s corporation. The split-dollar strategy described in Step 3 is the answer.

The life insurance policy is designed to have an increasing death benefit so that at the death of the surviving spouse, an enhanced death benefit of $50 million plus the cash surrender value of the policy is paid tax-free to the trust. Not only is Tom able to use the corporate pocketbook to fund his dynasty legacy, but Tom’s corporation experiences an additional tax savings—it has a multi-million dollar accumulated earning account. Earnings retained by a corporation in excess of $250,000 may be subject to a 15 percent federal penalty tax in addition to the corporate graduated tax at the end of the taxable year. However, a non-equity split-dollar plan may be structured to avoid the penalty tax.

Step 3: The split-dollar arrangement between the GSPT and the corporation is a non-equity collateral assignment agreement that should be designed to comply with the new split-dollar regulations issued in September 2003. The split-dollar agreement states how the premiums and policy benefits are to be shared  between Tom and his corporation. The corporation is given an assigned interest in the life insurance policy equal to its split-dollar interest. The agreement attributes ordinary income taxation to Tom equal to the taxable split-dollar benefit for the second-to-die life insurance policy for $50 million—using the appropriate government PS 38 rate table, that would be $553.

This is treated as additional compensation to Tom and is separate from the $2.8 million corporate paid premium. The $553—not the $2.8 million premium—is also the amount of the gift that Tom is considered to have made to the trust under the split-dollar plan. If there were a GST, Tom would need to allocate only $553 of his GST exemption to that gift in order to shelter all future distributions to the grandchildren.

This is leverage par excellence and gift and GST gift valuation discounting at its best—all of which was accomplished using a split-dollar strategy.

The life insurance policy’s increasing death benefit rider can help to ensure that the trust will ultimately be able to retain $50 million for intended legacy planning. The corporation’s interest in the split-dollar plan may be satisfied with the enhanced portion of the death benefit that is equal to the total cash surrender value of the policy.

Key to successful split-dollar applications is how the termination and the payback of the corporate interest under the split-dollar agreement will occur, should termination be prior to death. The reimbursement of the corporate interest can be accomplished in the following ways:

1. The GSPT could be the remainder beneficiary of a grantor retained annuity trust (GRAT) asset that could reimburse the corporation for its interest in the split-dollar plan when the split-dollar agreement is terminated.

Tom could create a GRAT, which is an irrevocable trust that provides him an income for any given number of years. At the end of the GRAT term, Tom can direct the remaining assets to the GRAT remainder beneficiary—Tom’s GSPT—and this is considered a future interest gift. The remainder gift could be discounted by 70 percent or more for gift tax purposes, depending on the terms of the GRAT and the amount of income paid to Tom. Tom cannot apply his GST exemption nor his annual exclusion to the GRAT remainder gift; however, the GST exemption could be allocated at the end of the GRAT term.

2. When the split-dollar plan is terminated, corporate interest could be secured with an interest-only promissory note executed between the trustee and the corporation. Principal on the note could be payable at the death of the surviving spouse. Should the corporation forgive any payment when due, Tom would be charged as receiving compensation and would also be considered to have made a gift to the trust of a like amount.

3. A GSPT can also be included in a family limited partnership (FLP) by making discounted gifts over time of limited partnership interests to the GSPT. Proper allocation of the GST exemption would also be made to these present interest gifts to the GSPT. A sufficient amount of limited partnership income interests could be given to the GSPT so that it could reimburse the corporation for its split-dollar interest.

Family limited partnerships are sometimes used to provide another layer of discounting in transferring assets out of the estate. Limited partnership interests can be discounted up to 40 percent for gift tax purposes because of their lack of marketability and their minority interest status. FLPs are viable estate asset transfer and asset repositioning strategies when structured in accordance with state statutes and tax court case law rulings.

Taxpayers need not suffer the Ming Dynasty depletion syndrome when it comes to wealth creation and wealth transfer to future generations. With proper planning, advisors can help their clients create dynasties of their own by selecting a perpetuity state and by properly allocating the GST exemption.

Life insurance policies contain fees and expenses, including cost of insurance, administrative fees, premium loads, surrender charges and other charges or fees that will impact policy values.
These materials are not intended to provide tax, accounting or legal advice. As with all matters of a tax or legal nature, your clients should consult their own tax or legal counsel for advice.

In the United States, anyone who is not a citizen is considered an “alien” for tax-planning purposes. The federal government classifies aliens as either resident aliens (RA), which means they are non-U.S. citizens domiciled in the United States, or nonresident aliens (NRA), which means they are non-U.S. citizens who are not domiciled in the United States.

Many financial planners have found that the needs of both RAs and NRAs for estate and business planning have increased significantly in the last decade due to international travel, relocations, marriages, foreign investments in the United States and the like.

There are many opportunities to serve the RA and NRA populations, particularly when it comes to how they are impacted by estate, gift and income taxes. However, you must know the rules and guidelines.

As a general rule, U.S. citizens and aliens who choose to be domiciled in the United States are subject to U.S. estate, gift and income taxation on all of their property and income located and earned not only in the United States, but anywhere in the world. NRAs, on the other hand, are subject to gift and estate taxes only on property located within the United States and to income tax on income generated by assets within the United States. NRAs who have U.S.-based assets are considered foreign nationals.

Be aware that citizens and residents of U.S. possessions (Guam, Puerto Rico, Virgin Islands) are considered NRAs for estate- and gift-tax purposes unless they become residents of the United States. They are not subject to the same gift and estate tax laws as U.S. citizens or RAs; therefore, their estate exemption for U.S. situs property is $60,000 and they do not have spousal split gifting privileges. However, U.S.-born citizens who subsequently become residents and citizens of a U.S. possession still continue to be taxed as U.S. citizens (IRC Sections 2208, 2209 and 2501(b)(c)).

An increasing percentage of U.S. citizens are married to Canadian citizens who may qualify for RA status, whether they retain their Canadian citizenship or not. Since Canadian tax law is generally based on residency and not citizenship, once Canadian citizens are no longer residents, they are not subject to Canadian taxation, except on Canadian sources of income (dividends, interest, pension). At death, however, there may be taxation on capital gains property. For those Canadians who decide to move back to Canada after being in the US, and they bring their US spouse with them or move back alone, they may want to look into buying their own property again, which means websites such as K5 Mortgage will be beneficial from a financial perspective.

Though Canada does not have an estate tax, it does have a testamentary capital gains tax on Canadian property that is owned by nonresident citizens. A protocol to the U.S.-Canada income tax treaty provides reciprocal tax credits to reduce any double taxation that might arise from the imposition of a U.S. estate tax and a Canadian income tax due on the death of the nonresident (U.S. Canada Treaty, Art. XXIX B(7)).

The United States currently has approximately 7 gift tax and 15 estate tax treaties with other countries. Treaty provisions may require that the tax laws of the country in which the property is located apply. Other treaties allow taxation by both countries and include tax deductions or credits to offset any double taxation. There is an untapped market for trust and estate planning when one spouse is an RA who maintains citizenship in another country.

Do you even ask the question of spousal citizenship during an estate planning fact-finding process? Overlooking spousal citizenship could create a planning and legal catastrophe.

Since 1988, neither an unlimited marital estate tax deduction nor an unlimited gift tax deduction has existed for any property transferred outright from a citizen spouse to a noncitizen spouse. However, property transferred to an RA spouse can receive the equivalent of an estate tax marital deduction through the use of a qualified domestic trust (QDOT). The marital deduction for gifts and estate transfers is still available for assets passing from an RA to a U.S. citizen spouse.

Specific Gift and Estate Plan Strategies
 • Resident Alien Spouse Planning
 1. Lifetime Gift Tax Exclusion Transfers. An RA spouse can make unlimited tax-free annual property transfers to the U.S. citizen spouse. However, the citizen spouse can make a tax-free annual gift up to only $134,000 in 2010 (adjusted for inflation) to the RA. Both resident spouses have access to the $1 million lifetime gift exemption. As we write this article during the first half of 2010, there is no U.S. federal estate tax, and there may not be unless Congress decides to address the issue and make the estate tax retroactive from the beginning of the year.

Gift taxation on lifetime transfers is still a factor and so the annual exclusions and lifetime gift exemptions remain applicable. State inheritance and estate taxes remain a factor that needs to be addressed in 2010, especially for those in states that have their own exemptions for property transfers. So the legislation enacted by the Economic Growth Reconciliation Act of 2001 has repealed the federal estate and generation skipping taxation for 2010, and it also reinstates both taxes in 2011 with only a $1 million testamentary exemption and a 55 percent top marginal bracket rate.

Jointly owned property with an RA may cause the total value of the property to be included in the first-to-die spouse’s estate unless there is proof that the surviving spouse contributed to the purchase price. Only 50 percent of joint property interest is included in the estate of the first-to-die when both spouses are citizens.
 2. Life Insurance. Creative life insurance planning can be effectively used for risk management, wealth creation and asset protection when one spouse is an RA. Life insurance can be owned by either the RA spouse or a life insurance trust to maximize flexibility and to provide asset protection. The annual $134,000 tax-free exclusion can be made by the citizen spouse to the RA to pay the premiums. Resident alien or trust ownership of a life insurance policy on the citizen spouse can compensate for the loss of the marital deduction and is generally preferable to the restrictive conditions of a qualified domestic trust. QDOT principal distributions to the surviving RA spouse are subject to the marginal estate tax bracket of the decedent so as to limit the RA’s access to only income distributions. Tax-free life insurance death benefits can enhance the marital legacy for the RA.
 3. Eligibility for Marital Deduction. An RA spouse may become a naturalized citizen prior to the filing of the deceased citizen’s estate tax return to become eligible for the unlimited estate tax marital deduction.

 • Nonresident Alien Planning
 What about the planning opportunities that exist for your NRA clients who may own assets, homes, investment property, stocks and real estate in the United States that will ultimately be transferred to family members who are U.S. citizens? Remember, NRAs are subject to estate taxes on U.S.-owned real estate and tangible property, including stock in U.S. corporations. Also included in the estate are an NRA’s interests in partnerships doing business in the United States.

The estate exemption for testamentary transfers of U.S. assets owned by NRAs is only $60,000, or an equivalent credit of $13,000. The typical U.S. treaty generally states that the country where the assets are located collects any estate taxes due, while the country where an NRA is domiciled provides a commensurate credit. This avoids the double taxation of the same asset that otherwise could be taxed in two different countries. Some European nations state that if a deceased citizen owns property in another country, it is the beneficiary who pays any taxes due. Certainly, NRA planning strategies require expert legal counsel. 

• Nonresident Alien Spouse Planning
 Many planning opportunities exist because of those assets that are not subject to estate and/or gift taxes of an NRA under U.S. tax law, but could be subject to estate/gift taxes of an RA.
 1. Life Insurance Owned by an NRA. Life insurance owned by an NRA is not subject to estate taxation regardless of the beneficiary or incidents of ownership that an NRA may have in the life insurance policy. Estate and income tax-free policy proceeds can be used to compensate for the low exemption of $60,000 applicable to other NRA estate assets located in the United States. Since NRA-owned life insurance is considered an intangible asset, there is no gift tax on the transfer of an NRA’s policy to another person or entity during life.
 2. Partnership Planning. An NRA can engage in indirect tax-free transfers of both tangible and intangible U.S. assets to family members who are U.S. residents and citizens or to a U.S. family trust by first converting those assets to partnership interests. Since NRA partnership interests are considered an intangible asset for gift tax purposes (but not for estate tax purposes), subsequent gifts of partnership interests would not generate gift tax consequences and would remove potential estate assets from the taxable estate. Thus, we have executed an indirect tax-free transfer. If a family dynasty trust was the donee of an NRA’s limited partnership interests, the trust would receive its pro rata share of partnership income and be used to pay the premiums on a legacy-building NRA life insurance policy for all family members.
 3. Trust Planning. Since stocks, bonds, life insurance, partnership interests and debt instruments are all considered intangible assets, they too can be transferred to a family trust without gift tax consequences during life. To the extent any of these assets are by nature income producing, they too can be used to fund life insurance premiums on the NRA for leveraged wealth accumulation, asset protection and legacy planning.
 4. Annual Lifetime Gifts from a citizen spouse to an NRA spouse are currently limited to the $134,000 exclusion. Both spouses have the opportunity to make annual exclusion gifts of $13,000 to an unlimited number of people, but spousal gift splitting privileges are not available. Unified credit transfers are not available to the NRA spouse.

The rules governing the tax consequences of transfers by RAs and NRAs are complex, and the treaties that do exist between countries are not uniform. Always defer to those who are skilled in the law that governs these subjects. Nevertheless, the obligation exists to identify the need, so be sure to ask your clients during the fact-finding process whether or not there is an alien in the house. If so, they, too, will need help with estate- and tax-saving strategies to reach their financial security objectives.

This information is written in connection with the promotion or marketing of the matters addressed in this material. The information cannot be used or relied upon for the purpose of avoiding IRS penalties. These materials are not intended to provide tax, accounting or legal advice. As with all matters of a tax or legal nature, your clients should consult their own tax or legal counsel for advice.

The backbone of our country’s financial strength and the cornerstone of its growth and employment is the family-owned business. There are approximately 28 million family-owned or closely held businesses in the United States. These companies employ 53 percent of the private workforce, generate more than $1 trillion in payroll, and produce one-half of the nation’s gross domestic product (GDP), according to a 2007 Small Business Administration (SBA) report.

Despite their critical role in our nation’s commerce, the SBA reported that only one-third of closely held businesses are successfully transferred to the next generation. One reason for this abysmal failure rate is that less than half of family-owned businesses have a documented business continuation agreement. Of those businesses that do have continuation agreements, only 28 percent have adequately funded their succession plans.

What a pity. Closely held businesses are often a great source of pride—not to mention capital and jobs—for family members. With proper planning, families should be able to smoothly pass successful businesses from one generation to another in a cost- and tax-effective manner.

To better understand how this can be accomplished, let’s consider the hypothetical case of a small-business owner, Jack Leonard, who owns a chain of furniture stores, valued in excess of $2 million, which have consistently appreciated in value. Leonard has seven objectives that he would like to accomplish in the most tax- and cost-effective way possible:
 1. Name his son, Jeff, who is active in the business, as the successor owner.
 2. Use corporate dollars to fund any solution that will help solve an ongoing accumulated earnings tax problem.
 3. Treat his spouse, Vicky, and two daughters equitably, even though the business interest constitutes most of Leonard’s taxable estate.
 4. Avoid gift and estate taxation on the transfer of business and personal assets during life and at death. (Jack and Vicky are already using their annual exclusions for gifts to their grandchildren. The Leonards want to retain as much of their available lifetime exemption as possible for other planned transfers.)
 5. Minimize estate transfer taxes to the greatest extent possible.
 6. Protect assets from potential creditors and litigators.
 7. Transfer assets to grandchildren without excessive generation-skipping taxes.

Keeping it simple, Leonard may be able to cost-effectively achieve each of his seven objectives by combining a life insurance trust with a split-dollar funding strategy. Estate, gift, generation-skipping taxes, corporate accumulated earnings taxes and asset protection can be minimized or perhaps avoided and, despite the fact that his business interest constitutes a large percentage of his estate, Leonard can achieve an equitable distribution of estate assets to other family members. The strategy would look like this:
Step 1: Leonard creates a flexible but irrevocable life insurance trust—the Leonard Business Succession and Family Asset Protection Trust. His son, Jeff, and his daughter, Caroline, are named co-trustees. Beneficiaries have separate trust interests. Jeff is the beneficiary of any business interest acquired by the trust, while Vicky, Caroline and the grandchildren have separate trust interests.

Jeff and Caroline, in their fiduciary capacity, apply for a $3 million “return of account value” or “option B” increasing death benefit universal life insurance policy on their father. Just because trusts are irrevocable does not mean that they cannot be quite flexible. Trust provisions can provide for a “trust protector,” an independent non-adverse party, to have powers to add or change beneficiaries, change the trust situs/location, etc. Some states, such as South Dakota and Delaware, provide for much flexibility to meet future family and economic circumstances.

Step 2: The trustees enter into a non-equity collateral assignment split-dollar agreement with the Leonard Corporation. This effectively allows Jeff to use and deplete the corporate accumulated earnings pocketbook to fund the premium payments. A non-equity split-dollar plan will return all of the policy cash values to the corporate sponsor. An increasing death benefit approach can enhance the $3 million death benefit by the accumulated cash value account so that at Leonard’s death, the trust would receive sufficient funds to reimburse the Leonard Corporation its interest in the split-dollar plan, purchase the business interest from Leonard’s estate, and help provide a legacy to the family’s heirs.

The split-dollar approach allows the corporation to use its accumulated earnings before they are subject to an excise tax of 15 percent on top of the corporate 35 percent marginal income tax bracket. Split-dollar gift tax consequences are avoided and split-dollar income tax consequences are minimized since gift and income taxes are leveraged through economic benefit leveraging that is characteristic of split-dollar plans.

The only compensation charged to Leonard with his third party split-dollar plan is the term cost for the net amount at risk value of the life insurance policy and not the premium paid by the corporation. This term cost is referred to as the economic benefit realized by Leonard and is determined by the government table rates listed in Notice 2001-10, referred to as the 2001 Table rates.

IRS Notice 2002-8 also permits Leonard to use the insurance company’s yearly renewable term rates in lieu of the 2001-10 table rates if they are lower. The insurer’s rates must be those that are advertised and available to all consumers. That same reduced amount is also treated as a gift by Leonard to the trust beneficiaries. Final regulations governing the structure and taxation of all split-dollar plans were issued in 2003 and are effective for plans established after September 17, 2003.

Step 3: The provisions of the trust direct the trustee to purchase Leonard’s $2 million stock interest from his estate at his death. The corporate stock is now owned by the trust with a new cost basis and thereafter distributed to Jeff, who is now the sole owner of the Leonard Corporation. The estate realizes no capital gains tax consequence due to the current IRC Section 1014 full step-up in cost basis that Leonard’s estate realizes on his stock interest at his death.

Step-up in cost basis tax rules may be changed to a modified adjusted cost basis income tax regime if Congress does not change the provisions of the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001.

Step 4: Leonard’s last will and testament distributes the $2 million received by the estate for the stock transfer to his surviving spouse, Vicky. She may disclaim her interest and have it transferred by executor directly to the Leonard Asset Protection Trust under the existing estate tax exemption, which is currently $3.5 million. The disclaimer will depend on Vicky’s financial needs at the time of Leonard’s death. Any amount disclaimed by her would be directed by Leonard’s will to the existing Leonard trust.

Step 5: The corporation’s share of the split-dollar death benefit can be used to fund a tax-deductible survivor income benefit to Vicky or be available to purchase any additional stock in the estate that is not purchased by the trust itself. The corporate redemption of any of Leonard’s stock that is not purchased by the trust could qualify for the “partial” stock redemption rules under IRC Section 303 and be eligible for non-dividend tax-free treatment. This kind of redemption is treated as a capital transaction.

As long as the full step-up in basis rules of IRC Section 1014 remain in effect, there would be no capital gains tax liability to the estate. Of course, federal and state estate and inheritance taxes need to be addressed to the extent Leonard’s stock is included in his adjusted gross taxable estate. The corporation could also redistribute its share of the split dollar plan benefits to Vicky under a death-benefit-only spousal fringe benefit plan. These benefits would be taxable to Vicky as ordinary income.

Step 6: Vicky’s estate could subsequently be left directly to any surviving children or be moved into the existing Leonard Asset Protection Trust and be managed for the trust beneficiaries. The trust can have “protector provisions” that permit a non-fiduciary third party to add or change trust beneficiaries to allow for changes in the Leonard family as mentioned in Step 1.

Using comprehensive planning techniques, Leonard can be somewhat assured that:
 • The Leonard Corporation will pass to Jeff.
 • His assets will be equitably transferred to all family heirs.
 • The financial needs of Vicky will be met and trust assets will be insulated from creditor claims against Leonard or the trust beneficiaries.
 • All estate assets will be transferred without any additional generation-skipping tax consequences.

In other words, Leonard can keep all of his assets in the family. All, of course, will depend upon the corporate funding of the split-dollar plan and the continued viability of the family corporation.

Business continuation planning is a market waiting to be tapped. Creative applications are available for a wide range of family and business circumstances. Chances are you know business owners like the Leonards who need help navigating the difficult waters of gift, income and generation-skipping taxes.

This information cannot be used or relied upon for the purpose of avoiding IRS penalties. These materials are not intended to provide tax, accounting or legal advice. As with all matters of a tax or legal nature, your clients should consult their own tax or legal counsel for advice.