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As 2010 came to a close, one of our family clients wanted to gift $30 million to his two children. He had read that the gift tax, normally at 50%, was temporarily at 35%. He announced his intention to make the gift promptly, arguing that such a low gift tax rate was significantly less than the future likely estate tax rate of 50% and the normal 50% gift tax rate.

We were alarmed, not only because we are unequivocally biased against paying taxes whenever possible, but also because we never like to act precipitously, and felt it was important to consider all the options. A $30 million gift would trigger more than $10.5 million in tax, a sum that deserved immediate research of every alternative.

From prior experience, we realized there were a host of alternative strategies, including a Grantor Retained Annuity Trust (GRAT), charitable lead trusts, and various defective trusts that might accomplish the client’s goals, add other benefits, and result in lower taxes being paid. In our years of working with many families, we have seen a wide variety of wealth transfers that included strategies developed by some of the best estate planning attorneys in the country.

In this case, we enlisted the help of a nationally recognized estate attorney who helped us review structures that might work better. The first step was identifying the client’s goals in order of priority: 1) endow each child with a nest egg to provide for his or her needs; 2) execute the transaction within the few weeks left in the calendar year given potential changes in the tax code; and 3) provide some education and guidance to the children in order to assist them in stewarding their wealth for the future.

Our client had charitable endeavors already under way that made the immediate creation of a charitable structure unnecessary. GRAT trusts, although effective in transferring security appreciation, have less flexibility than the final solution—a limited liability company (LLC), the shares of which would be owned by two intentionally defective trusts, one for each child.

Our client funded the limited liability company with $30 million. As manager of the LLC, he retained control of the assets and could take advantage of the size of the pool of assets to invest with managers who had high minimum investment limits or who would otherwise have been unavailable to the individual children’s trusts.

Our client then created two trusts, one for each child, and funded those trusts with an amount of cash below his and his wife’s lifetime gift exemption so that no gift tax was incurred. Our client was the grantor of these defective trusts and could continue, for as long as he wanted, to pay any taxes generated by the trusts himself, thereby passing additional wealth on to his children.

Furthermore, the trusts were established in Delaware, where they enjoy favorable state tax treatment and significant asset protection against civil complaints, such as those that might occur from a divorce. A brother-in-law was made the trustee of the trusts with discretion to disburse funds to the children as necessary. This also created the opportunity to guide the heirs in order to help the assets last their lifetime. Additional provisions were included to allow the trusts to pass to grandchildren or other progeny in the future.

The final step involved having the trusts purchase interests in the LLC via promissory notes, taking advantage of the low intra-family interest rates allowed on such notes. The value of each note was discounted by 37% because the LLC interests were illiquid and had restrictions on several of the investments and their sale and transferability.

The net result of these efforts: our client avoided a $10.5 million payment to the IRS. Each child has a beneficial interest in his or her one-quarter share of the $30 million of assets under the guidance of a close family member. Our client receives annual interest and principal payments on the notes so that over the next 15 years or so, he will actually receive back the entire $30 million initial contribution to the LLC. Both our client and his family enjoy the ancillary benefits of reduced state taxes on the funds and asset protection and are invested with resources normally not available to the younger generation.

Everyone won but the IRS.

The case studies described herein are intended to illustrate Manchester Capital Management’s approach to developing personalized solutions to our clients’ unique investment management problems. These examples should not be considered to be recommendations for any particular client and are not intended to demonstrate a pattern of success or guarantee positive performance. Because our recommendations are individually tailored based on each client’s individual needs, there is no guarantee that our approach to managing any client’s account will share some or all of the characteristics as the situations depicted.

Nothing contained on this website constitutes investment, legal, tax or other advice and is not to be relied on in making an investment or other decision.