Strategic Advisory Letter: The Advantages of Transferring Wealth Using Delaware-Administered Irrevocable Trusts

August 1, 2012

With favorable tax laws in place and talk of a possible higher tax regime ahead, many families are revisiting their plans for transferring to and protecting wealth for future generations. Although the future of tax law remains uncertain, current law and recent legislative proposals all suggest that transfer-tax exemptions could become more restrictive and tax rates could rise in the near term. Whether that happens in 2013 or sooner, no one knows for certain. These factors are further motivation for families to now craft and execute thoughtful plans for their long-term legacy if there is no compelling reason to wait until 2013. One key estate-planning tool is an irrevocable trust, in which a grantor cedes control over assets and gifts them to a beneficiary in a tax-efficient way. However, irrevocable trusts can be complex and the state laws that govern them limiting. Delaware trust law, on the other hand, provides several unique benefits to creators of trusts, trustees and beneficiaries that wealthy families should consider.

Potential to Avoid State Income Taxes

Trusts administered in Delaware may offer meaningful tax savings to beneficiaries. In many states, most irrevocable trusts are subject to state taxation on realized capital gains earned by the trust and on income (interest, dividends, rents, etc.) that is not distributed to current beneficiaries. If all of the beneficiaries of qualifying Delaware trusts live outside the state of Delaware and none of them is identified by virtue of their relationship with a Delaware resident, no Delaware state tax is imposed on the income or capital gains earned and retained by the trust. Obviously, if it is possible to avoid state income tax, the trust assets have the potential to grow faster, as the tax burden eroding returns is lower. For example, if a trust currently pays 1% of its overall value each year to satisfy federal and state taxes and those liabilities can be reduced to 0.80% a year by eliminating state taxes, the savings would be left to accumulate and compound each year. A $10 million trust growing at a modest 6% annual rate would be more than $3.5 million larger at the end of 30 years with the lower tax burden.

In addition, Delaware will not impose estate or personal property taxes on assets held in a Delaware trust solely by reason of administering the trust in the state of Delaware.

Greater Flexibility in Administering Trusts

Trustees are bound to exercise fiduciary duties for the benefit of all trust beneficiaries, current and future. This duty can pose a conflict for the trustee because current beneficiaries generally benefit from high-yield investments and larger present distributions, while future beneficiaries generally benefit from long-term growth and principal preservation. These goals are frequently at odds when investing trust portfolios.

Delaware law allows a trust to be converted to what’s called a total-return unitrust, in which a trustee can distribute to the current income beneficiaries a fixed percentage each year, between 3% and 5% of all trust assets, as opposed to the current income only. In doing so, the trustee has better aligned the interests of current and future beneficiaries, mitigating the inherent conflict. In this respect, all beneficiaries share the risk and reap the benefits of a particular portfolio allocation.

Unless a trust instrument provides otherwise, the law also allows a trustee to “decant” or pour trust assets into new trusts for the same beneficiaries, which may include new, more efficient provisions for governance and administration—all without court action, as long as the original trust document permits the trustee to make discretionary principal distributions. Such better provisions can include a beneficiary’s right to remove a trustee, appoint a new trustee or allow a trustee to resign. Other modifications also may include guidance on the distribution policies within the trust document if there is already discretionary access to the trust principal. This kind of action needs careful review by tax and legal counsel, as one would not want to sacrifice long-term tax advantages for the benefit of a desired form of administration.

The Delaware laws provide a statutory roadmap so that these types of changes to existing trusts can generally occur without a court proceeding. There are, however, times when the trust itself will not provide the appropriate remedy, and a court proceeding is required. In Delaware, trust administration and interpretation falls under the jurisdiction of the Delaware Court of Chancery. The Court of Chancery historically has provided an efficient method of resolving fiduciary and commercial issues in a timely manner. Moreover, trust information contained in court filings is limited, and the file can often be sealed for purposes of confidentiality.

Avoidance of Estate Tax Across Generations


Traditionally, trusts are prohibited from existing indefinitely. Delaware and a handful of other states no longer require a trust to terminate after a period of years, leaving open the possibility for a single “dynasty” trust to continue into perpetuity and free from transfer tax at each generation.

Ability to Include Trusted Advisor

Often, clients are intrigued by the benefits of Delaware law but are happy with their individual trustee’s oversight of closely-held business interests or other special assets. Delaware law permits the creation of a “directed trust” whereby an advisor is appointed to direct the trustee as to the exercise of certain powers and duties. This allows trusted advisors to retain authority over certain investment and/or distribution decisions without losing the advantages afforded a trust by Delaware law. For owners of operating businesses that are held in trust (in whole or in part), this is a useful tool so that a trusted business advisor retains discretionary authority over that particular asset.

Credit Protection

Delaware earned its trust-friendly reputation with the development of its legislation on Delaware Asset Protection Trusts. These trusts may provide creditor protection while at the same time allow an individual to retain some control over trust assets. Delaware Asset Protection Trusts have served as an alternative for those clients who prefer not to use an offshore trust vehicle. However, these trusts are relatively new and remain largely untested. We recommend consulting your team of advisors before pursuing this strategy.

Like many jurisdictions, Delaware also has spendthrift laws for legacy trust vehicles specifically intended to protect trust assets from the claims of creditors in third-party trust scenarios. Administered properly, the assets in a Delaware spendthrift trust are generally protected against the claims of creditors.

Conclusion

Delaware law provides valuable benefits to clients establishing Delaware trusts today and in the future. Clients with existing trusts created in another state may also be able to take advantage of Delaware’s benefits, depending on the flexibility of the trust document or the courts that currently preside over them, by moving situs of their trusts to Delaware when the need arises.

To learn more about the advantages of Delaware law and how it can help meet your trust needs, please contact your Strategic Advisory team or the Brown Advisory Trust Company of Delaware.

Alice S. Paik, Strategic Advisor
K. Brigid Peterson, Strategic Advisor

 

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