We all know the mantra of real estate agents: Location, location, location. A great house next to the freeway isn’t worth nearly as much as the same home in a quiet, tree-lined suburb. The same concept applies in wealth transfer, where a given structure in one location can be dramatically more valuable than in another location. The recent tax reform has created compelling incentives for families with multi-generational wealth to follow the same approach by building a financial “house” for future generations (a Dynasty Trust) in an ideal location (one that minimizes the effect of taxes). For families in highly taxed states like California, there is a compelling reason to move assets to the friendly streets of Delaware.
Several items in the recent Tax Cuts and Jobs Act of 2017 significantly affected wealthy families in highly taxed states. The two most pertinent here are:
- The sharp increase in the effective state tax rate as state taxes are no longer deductible. In California, the effective highest tax rate increased from about 8% to 13.3%.
- The doubling of the lifetime gift and estate tax exemption from about $5.6 million to $11.2 million per person ($11.2 million to $22.4 million for a married couple).
Unfortunately, California-based families have a couple of challenges:
- The higher effective state tax provides a drag on investment returns.
- California’s “rule against perpetuities” limits the lifetime of a Dynasty Trust and thus the time period before estate taxes are assessed upon the Trust.
- No state tax burden. California cannot tax a properly structured DE-based Trust, and Delaware does not tax Trusts whose beneficiaries are not DE residents.
- Delaware allows perpetuities, so Trust assets can grow forever free of State and estate tax burdens.
Using such an approach to minimize taxation is extraordinarily powerful when compounded over a multi-decade period. In a case of couple who wants to use their incremental lifetime exemption to benefit many generations, the difference can be dramatic as illustrated below.
Case 1: Simple Gift. The couple gifts $11.2 million to their California-resident children. Assets grow at 4% net (a conservative assumption), and each generation pays 40% estate tax. After three generations (assuming 20 years per generation), the value of the Trust is $25.5 million. Not bad.
Case 2: Dynasty Trust in CA. The $11.2 million goes into a California-based Dynasty Trust that statutorily terminates after the second generation and is then subject to estate taxes. Asset growth is again 4% net. Value of the Trust after three generations is $42.4 million. Better.
Case 3. Dynasty Trust in DE. The $11.2 million goes into a Delaware-based Dynasty Trust. Free of CA taxes, asset growth is 4.25% net. No estate taxes are ever due. Value of the Trust after three generations is $136 million. WOW!
The choice of location is the dominant factor in the ultimate value of the Trust, far outweighing other factors that typically receive more attention such as the choice of advisor, active versus passive management, etc.
With our own Delaware Trust Company, Tiedemann is well positioned to help clients properly structure and locate their assets to ensure that the most capital possible flows to the purposes that they choose.
Bruce Brugler is a Managing Director of Tiedemann Advisors LLC. Tiedemann Advisors is an investment advisor. Investors should consult with their financial, tax and legal advisors before investing in any investments or trust arrangements. The information is not intended to be, nor should it be construed or used as, investment, tax, accounting, legal or financial advice. Any information that may be considered advice concerning a federal tax issue is not intended to be used, and cannot be used, for the purposes of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter discussed herein. This is for information purposes only and is not a solicitation to buy or sell any specific investment.