Recent Estate Planning Developments Fall 2002
The 2001 Tax Act: A Status Report
Great Opportunities for Estate Planning in a Low Interest Rate Environment.
Alaska's Five-Year Experience With Self-Settled Discretionary Spendthrift Trusts.
Your Questions: Comparison of a Private Foundation With a Donor-advised Fund.
David G. Shaftel 2002.
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A Summary Provided by the: Law Offices of David G. Shaftel, PC


As we reported last year, the 2001 Tax Act contained a number of transfer tax benefits which would be phased in over an eight-year period. Ultimate repeal of the Federal Estate and GST taxes is promised in 2010. However, because the Senate was unable to pass the Act with a super-majority of 60 votes, the 2001 Tax Act, with the promised repeal of these taxes, “sunsets” in 2011. That means that the repeal will only last for one year (2010), and then the Federal Estate Tax and GST taxes will come back into effect in 2011.

There have been several attempts to make the above-described repeal of the Federal Estate and GST taxes permanent by bringing these matters before Congress again and attempting to obtain 60 votes in the Senate. Those attempts have failed. The 2001 Tax Act was passed in June 2001 when we had an approximate $100 billion national surplus. Since that time, we have had an economic downturn and presently have an approximately $200 billion deficit. Further, war is on the horizon. Critics of repeal point out that the Federal Estate tax was initially enacted in order to fund the expenses of war.

This year's elections have given the Republicans control of the United States Senate. However, due to the “Byrd Rule” and the filibuster power, sixty Senate votes will still be needed to make the Federal Estate and GST Tax repeal permanent. Many commentators speculate that instead of repeal becoming permanent, an eventual compromise will be reached. They speculate that this will result in a substantially increased estate tax applicable credit exclusion at the level of $2 million or $3.5 million and a significant rate reduction.


We are all aware of the present very low interest rate environment. It is wonderful if we are applying for equity loans or refinancing our mortgage. On the other hand, it is painful for our fixed income accounts such as money markets or new bond purchases. However, these low interest rates present great opportunities for the use of certain estate freeze techniques.

To put this into perspective, in January 1989, the interest rate we used for certain estate freeze techniques was 10%. In November 2002, the interest is 3.6%. Let us look at four of these techniques:

1. “Gift to Charity of a Remainder Interest in a Personal Residence.” Here, the donor deeds his/her personal residence to charity, reserving the right to live in the house for the remainder of the donor's lifetime. An income tax deduction is available for the actuarial value of the remainder. The lower the applicable interest rate at the time of the gift, the greater the income tax deduction.

For example, assume you have a residence with a fair market value of $500,000, one-half of which is attributable to the house and one-half is attributable to the land. You are seventy years old and desire to contribute your house to your favorite charity after you die. If you accomplish this transaction in November 2002 (when the required interest rate is 3.6%), you will obtain an income tax charitable deduction of $350,222 which you can use to offset against your taxable income in 2002 and future years. Compare this to the situation where you made such a gift when the required interest rate was 10%. In that case, your income tax charitable deduction would only have been $205,985.

2. Grantor Retained Annuity Trust. Assume you have $1 million of assets which you anticipate will grow at approximately 10% per year. You contribute these assets to a GRAT. In exchange, the trustee of the GRAT will pay you annuity payments over a ten-year period which will equal $1 million plus interest (3.6% per year if the GRAT is established in November 2002). The recent Sam Walton Tax Court case establishes that no gift occurs when you create such a zeroed-out GRAT. At the end of the ten-year period, due to the 10% per year growth, $457,364 will be left in the GRAT. These assets will then be transferred to your beneficiaries or to an Alaska Self-Settled Discretionary Spendthrift Trust, of which you can be a discretionary beneficiary. (See the discussion of these trusts, below.)

The reason that we have $457,364 left at the end of the ten-year period is that this is the growth amount resulting from the difference of the 10% growth and the low 3.6% required interest rate. You can see that if this interest rate were high (for example, the10% that existed in 1989), then no amount would be left in the trust at the end of the ten-year period. Therefore, low interest rates make GRATs a very valuable technique for estate tax reduction.

The annuity payments can be designed so that they increase by 20% each year. This allows for lower annuity payments in early years and higher ones in late years. As a result, more of the “growth” is kept in the trust at the end of the fixed term.

If the trust does not have cash to make the payments, the trustee can return some of the assets as payment in-kind.

A strong advantage of a GRAT is that it is expressly authorized by the Internal Revenue Code and its regulations. The “zeroed-out” benefit has been provided by the recent Sam Walton Tax Court case.

The disadvantages of a GRAT are that you have to live the fixed term (ten years in the above example) for it to work. If you die during the fixed term, the assets are included in your gross estate and taxed under the Federal Estate tax. Also, you cannot allocate GST exemption to the GRAT until the end of the fixed term.

3. Sale to Grantor Trust. A similar popular technique is an installment sale to a grantor trust. Assume $1 million of assets is sold to the trust in exchange for interest-only payments for nine years, and a balloon payment at the end of the nine-year period. If the trust does not have cash to make the payments, the trustee can return some of the assets as payment in-kind. Since you are selling the assets for their full fair market value, again, no gift occurs. The lower the interest rate, the lower the interest-only payments during the ten-year period. All of the growth of the assets (assumed to be 10% per year) in excess of the interest rate (3.6% if the sale occurs in November 2002) will remain in the trust at the end of the payment period. These assets will be transferred to your beneficiaries or to an Alaska Self-Settled Discretionary Spendthrift Trust, of which you can be a discretionary beneficiary.

The trust is called a “grantor trust” because you have retained certain administrative powers. Because of your retention of these powers, present law provides that all income and deductions of the trust are taxed to you. To state this another way, there can be no taxable events between you and the trust. As a result, no capital gain tax is payable upon the sale of the assets to the trust, and the interest income is not taxed.

If the trust does not have cash to make the payments, The amount left in the grantor trust at the end of the fixed term (nine years, here) will be very similar to the amount left in the GRAT example described above. Again, this amount is so large because of the substantial difference between the assumed growth rate (10%) and the required interest rate (3.6% for a sale to a grantor trust in November 2002).

It is important to recognize that the growth rate may be much larger than what you assume, if the asset value was discounted when it was contributed to the GRAT or sold to the grantor trust. For example, assume that you had first contributed $2 million of assets to a family limited liability company. Your appraiser determined that the value of the limited liability company interests are subject to a fifty percent discount because of minority interest, lack of marketability, and the restrictions of the family limited liability company entity. As a result, the assets in the GRAT or the grantor trust, are really $2 million and would produce “growth” that would be approximately twice the 10% assumed above. This makes the GRAT or grantor trust doubly effective.

The advantages of the sale to grantor trust technique are that the grantor does not have to survive the fixed term for the transaction to work. Also, GST exemption can be allocated to the trust at the time of formation rather than waiting until the end of the fixed term. Further, the interest rate is lower than that used for a GRAT.

The disadvantages of the sale to grantor trust technique are that it is not based on a specific statute and regulations. Rather, it is based upon a series of authorities which tax planners have put together to support the entire approach. Also, either a gift of approximately 10% of the value of the assets sold or a guarantee of that amount needs to be made in order to establish the “validity” of the trust before it purchases the assets.

4. Charitable Lead Trust. This approach allows charitably inclined grantors to provide significant current charitable benefits as well as save substantial estate taxes. A charitable lead trust is similar to a GRAT, with the annuity paid to charity instead of being retained by the grantor. For example, assume that you contribute $1 million of assets to a CLT. Each year, the trustee will pay $120,848 to the charity you have chosen. These annuity payments equal $1 million plus 3.6% per year (the November 2002 interest rate). As a result, there is no taxable gift when this trust is created. Assume that the assets in the trust grow at 10% per year. At the end of the ten-year period, $667,737 will be left in the trust. These assets can be transferred to your beneficiaries or to an Alaska Self-Settled Discretionary Trust, of which you may be a discretionary beneficiary.

Again, these remaining assets are so large because they represent the difference between the assumed 10% growth rate and the required interest rate (3.6% for November 2002). Our planning is designed to take advantage of the great difference between these two rates due to the very low interest environment we are presently experiencing.

A charitable lead trust is very popular in a low interest environment. It provides you with the opportunity to make charitable contributions now to your favorite charities, to your private foundation, or to a donor-advised fund with a public charity such as a community foundation.

A charitable lead trust is not income tax exempt. However, the income earned by the trust each year is offset by the charitable deduction obtained when the income is distributed to charity as the annuity payment.

Charitable lead annuity trusts are reportedly the technique used by Jacqueline Onassis in her estate planning.


Number of Trusts Created. In 1997, Alaska was the first state to enact a usable statute authorizing self-settled discretionary spendthrift trusts (“SSDS Trusts”). In addition, Alaska made its first attempt to abolish the rule against perpetuities, so as to allow for the formation of Alaska perpetual trusts. Five years have elapsed. For the period from 1997 to the present, the following experience has been reported.

Alaska trustees state that approximately 870 trusts have been formed under Alaska law by nonresidents of Alaska. Of these, approximately 310 are SSDS Trusts, and the balance are perpetual trusts. Most of the SSDS Trusts also used a perpetual trust plan. Approximately 110 attorneys provided the legal services for the creation of these trusts.

Alaska estate planning attorneys report that approxi-mately 125 SSDS Trusts have been formed for Alaska residents. In addition, 200 to 300 perpetual trusts have been created for Alaskans. Several lawyers report that their standard “default plan” for medium and large estates now is based upon a perpetual trust dispositive plan. Approximately sixty percent of both the resident and nonresident SSDS Trusts have involved contributions of assets which were completed gifts for federal gift tax purposes.

The following example of a “planning dilemma” illustrates the use of SSDS Trusts for transfer tax reduction planning.

The Planning Dilemma: Early Gift Giving Versus Future Possible Needs. Consider this planning situation: you are a couple in your fifties. One or both of you is a small business owner, executive, or professional. Your net worth is in the range of $3 million to $10 million. Substantial estate taxes could be saved if you made annual exclusion and applicable credit gifts to irrevocable trusts for your children and/or grandchildren. The gifts could be structured so that they qualify for valuation discounts, and the growth of the gift assets would be excluded from your estates. Based on your net worth and your anticipated future earnings, it appears that these gifted amounts would not be needed by you. Nevertheless, you are reluctant to give away significant assets at this point in your life. You might need these assets in the future if you have an unexpected financial reversal.

You ask if you can be added as discretionary beneficiaries of the trust. Then, the trustee can make distributions to you if needed. Before Alaska's law was changed, if you were added as discretionary benefi-ciaries, the IRS could successfully argue that the trust assets should be included in your gross estate at death and be taxed under the Federal Estate Tax.

The reason is that before 1996 all states had a statutory or case law policy that provided that if the settlors are discretionary beneficiaries of the trust, the settlors' creditors can reach the maximum amount that the trustee could distribute to the settlors and, in many instances, this would be all of the assets in the trust. Therefore, the settlors could “run up” debts and the settlors' creditors could reach the trust assets to satisfy these obligations. Another way of looking at the situation is that the settlors, indirectly, have retained ability to reach the trust assets through incurring debts.

This indirect retention of the use of the trust assets prevents the settlors' transfers to the trust from being completed gifts for gift tax purposes. Moreover, such indirect retention would result in the trust assets being included in the settlors' gross estates under Internal.

Alaska's Statutory Change Provides a Solution. In 1997, the Alaska Legislature changed Alaska law to authorize the use of SSDS Trusts. The new legislation provided, in effect, that under Alaska law a settlor may create an irrevocable trust, transfer assets to it, be a discretionary beneficiary of such trust, and yet, the settlor's creditors cannot reach the assets in such a trust.

From a transfer tax standpoint, because the settlor's creditors cannot reach the assets in the trust, the settlor's ability to incur debt does not give the settlor “dominion and control” over the trust assets. Accordingly, the settlor's transfers to a SSDS Trust are completed gifts. The IRS has agreed. In addition, proponents of SSDS Trusts contend that none of the inclusion provisions of the federal estate tax apply to the assets in an Alaska SSDS Trust. The proponents' position is that the settlor has not retained the enjoyment or income from the assets (I.R.C. § 2036), nor does the settlor possess at death the power to alter, amend, revoke, or terminate the transfer (I.R.C. § 2038). Hence, the trust assets should be excluded from the settlor's gross estate.

As a result, you may create an Alaska SSDS Trust, make annual exclusion and applicable exclusion amount gifts to the trust, and be included in the class of discretionary beneficiaries to whom an independent trustee may make distributions. A strong position exists that such assets will not be included in your gross estates at your deaths. In addition, if you need funds in future, due to an unexpected financial downturn, the trust assists are available.

Your Question: A Comparison of a Private Foundation with a Donor-Advised Fund

More and more of our clients have been asking us to provide information about charitable planning techniques and vehicles. We are often asked whether a family should use a private foundation or a commonly used substitute, a donor-advised fund. Here is a summary of the differences between these charitable vehicles.

Private Foundation. Several steps are necessary in order to create a private foundation. First, a non-profit corpora-tion is formed under Alaska law. Then, a thorough and detailed application is prepared and submitted to the IRS requesting tax-exempt status for the foundation. The IRS reviews the application and contacts you several times for clarification and additional materials. Usually, it takes six months or more to obtain the desired tax-exempt status.

You and your family may manage and control your family's private foundation. You can decide upon the charitable recipients of the foundation's annual distribu-tions. Further, you and your family members can be employed by the foundation, pursuant to IRS guidelines. These are significant advantages of a private foundation.

Each year, a private foundation must distribute 5% of its total assets. Careful recordkeeping is necessary, and annual tax reporting is required. The Internal Revenue Code contains a number of “prohibited transactions” which need to be carefully avoided. An annual federal excise tax of up to 2% of the assets of the foundation applies.

You will receive an income tax deduction for assets which you contribute to your private foundation. The amount of the deduction depends upon the type of asset contributed:

• Cash (30% of adjusted gross income);
• Publicly traded securities (20% of AGI);
• Restricted stock and real estate (20% of AGI).

There is a 100% gift and estate tax charitable deduction for assets which you transfer to your foundation.

A private foundation does involve significant startup and maintenance costs. As a result, this approach is not used unless assets of approximately $500,000 are anticipated to be contributed to the foundation.

Donor-Advised Fund. Instead of being a separate entity, a donor-advised fund is a fund that you establish with an already existing public charity. Often the public charities chosen are community foundations because they allow for a broad range of charitable distributions. The donor-advised fund is owned and controlled by the public charity. However, the donor acts in an advisory capacity with regard to investment strategy and grant making. The donor advises the public charity concerning distributions from the fund. While the public charity is not required to follow the donor's advice, generally it does so.

Because the donor-advised fund is set up with an existing public charity, it is much simpler to create and maintain. You do not need to set up a non-profit corporation or apply for tax-exempt status. Recordkeep-ing is done by the public charity, and annual expenses are significantly less. The IRS' prohibited transaction rules do not apply to public charities nor does the 2% excise tax. You are not required to distribute any of the fund's assets on an annual basis.

The disadvantages of the donor-advised fund are that you do not have legal control over investment and distribution decisions. Rather, you give advice to the public charity's board. Second, you and your family members cannot be employed and compensated by the fund.

Since you are contributing assets to a public charity, however, you obtain superior income tax benefits. They are as follows:

• Cash (50% of AGI);
• Publicly traded securities (30% of AGI);
• Restricted stock and real estate (30% of AGI).

The simplicity of a donor-advised fund is very attractive. Such a fund can be created by merely executing an agreement with the public charity. Depending on the public charity, an amount as small as $10,000 to $50,000 may be accepted as contributions to the fund. Usually, an annual fee of 1% to 1.5% of the fund assets is paid to the public charity, which it uses to pay for the expense of maintaining the fund. Any excess of the fee is distributed by the public charity for charitable purposes.

In summary, both private foundations and donor-advised funds are valuable tools for implementing charitable giving. Both approaches allow you to accomplish charitable giving during your lifetime and obtain significant income tax benefits. Each year, you and your family can participate in making the charitable giving decisions. Younger members of your family can participate in and enjoy the satisfaction of the charitable giving process.

The two approaches do differ in regard to the extent to which you and your family will have legal control over operation and distributions. The private foundation provides such control and allows you and your family members to be employed and compensated. However, as described above, there are trade-offs in terms of costs and restrictions which need to be considered. Families desiring to accomplish significant charitable giving need to carefully evaluate each approach and decide which is the most appropriate for them.