Tax Implications of Perpetuities

Understanding the tax implications of perpetuities is necessary, especially for individuals or entities who have invested or are considering investing in perpetuities.

When individuals or corporate entities invest, one of the things they consider is the tax implications of the investment. This is because they want to maximize the benefits they will accrue from the investment while paying the minimum possible taxes.

Similar to other investments, the tax implications of perpetuities range from capital gains taxes to estate and income taxes. Several other types of taxes may also apply and we shall discuss all of them here.

See also: Delayed Perpetuity Examples and Types

Since payments from perpetuities have no termination date, it means investors in perpetuities, whether individuals or corporate entities can earn a guaranteed income forever.

Some examples of perpetuities include charitable remainder trusts (CRT), consols, endowment funds, and stocks. Additional examples include payments from lease of land, offices, or residential property.

See also: Perpetuities and Credit Risk

The rule ensures that property ownership is not tied up indefinitely and can change hands freely over time. It prevents a person from including qualifications and criteria in a deed or a will that would continue to influence the ownership of a property long after they have passed away. This concept is often referred to as control by the dead hand or mortmain.

The rule against perpetuities prohibits a person from creating future interests (a transfer of ownership), which are typically contingent remainders and executory interests, in a property that would vest beyond 21 years after the lifetimes of those who are alive at the time of interest creation. This is often referred to as a life in being plus twenty-one years.

However, certain types of trusts such as charitable trusts are exempt from the perpetuity rules. Additionally, the rule against perpetuities is not applicable in Scotland.

In the United States, each state has its stance on the rule against perpetuities, with several states extending the waiting period for property to vest, and some repealing it completely.

More than half of U.S. states have adopted the Uniform Statutory Rule Against Perpetuities in one form or another. The rule uses a wait-and-see approach where interest on perpetuities has 90 years to vest.

The rule against perpetuities serves 3 major purposes viz:

• Fostering ease in the purchase or sale of property.
• Reduce or eliminate the influence of the dead on their living relatives.
• Limit tax avoidance through the use of perpetuities.

See also: Perpetuities and Derivatives: Differences and Similarities

Tax implications of perpetuities

1. Income tax
2. Gift and estate tax
3. Generation-skipping tax
4. Capital gains tax

Income tax

One of the tax implications of perpetuities is the payment of income tax especially if the perpetuity generates taxable incomes such as rental payments, dividends, or interest income.

For individuals, the amount of income tax they pay varies based on the amount of income they generate. The table below summarizes the income tax rate for singles, married couples, and heads of household in 2024.

Tax Rate	Married filing jointly	Married filing separately	Head of household	Single
10%	$23,200 or less	$11,600 or less	$16,550 or less	$11,600 or less
12%	$23,201 to $94,300	$11,601 to $47,150	$16,551 to $63,100	$11,601 to $47,150
22%	$94,301 to $201,050	$47,151 to $100,525	$63,101 to $100,500	$47,151 to $100,525
24%	$201,051 to $383,900	$100,526 to $191,950	$100,501 to $191,950	$100,526 to $191,950
32%	$383,901 to $487,450	$191,951 to $243,725	$191,951 to $243,700	$191,951 to $243,725
35%	$487,451 to $731,200	$243,726 to $365,600	$234,701 to $609,350	$243,726 to $609,350
37%	Over $731,200	Over $365,600	Over $609,350	Over $609,350

For corporate organizations, the corporate income tax rate in the United States of America is 21% but the Biden Administration has proposed in its 2024 budget to increase the corporate income tax to 28%. Thus, any company that may earn from perpetuities will have to pay tax as it is part of the company’s revenue.

Gift tax and estate tax

Due to the long-term nature of perpetuities, part of their tax implications may include gift and estate tax. These are linked taxes that are often charged in cases of transfer of wealth from one individual or organization to another.

Gift tax is charged when the wealth transfer occurs during the lifetime of the person doing the wealth transfer (inter vivos). Estate tax is charged if the wealth transfer occurs after the death of the person who is transferring the wealth.

It is important to note that both gift and estate tax are paid by the person initiating the wealth transfer. This means that if for instance, Mr. Gregory has a perpetuity that he transfers to Mr. John, Mr. Gregory will be liable to pay either a gift or an estate tax depending on when the transfer occurs.

Gifts are taxed on a tax-exclusive basis, this means that they are taxed based on what beneficiaries receive. Estates on the other hand are taxed on a tax-inclusive basis, this means they are taxed based on what decedents bequeath.

Two factors determine how much a person will pay as gift tax:

1. The annual gift tax limit
2. The lifetime gift tax limit.

Currently, in 2024, the annual limit or annual gift tax exclusion is $18,000 while the lifetime gift tax limit is $13,610,000. For estates, the basic exclusion amount of decedents who die in 2024 is $13,610,000.

Once the annual and lifetime gift tax limits are exceeded, the applicable gift tax rate ranges between 18 to 40% as seen in the table below:

Taxable amount exceeding lifetime exemption limit	Gift tax rate
$0 – $10,000	18%
$10,001 – $20,000	20%
$20,001 – $40,000	22%
$40,001 – $60,000	24%
$60,001 – $80,000	26%
$80,001 – $100,000	28%
$100,001 – $150,000	30%
$150,001 – $250,000	32%
$250,001 – $500,000	34%
$500,001 – $750,000	37%
$750,001 – $1,000,000	39%
$1,000,000+	40%

Generation-skipping tax

An additional tax implication for perpetuities is the generation-skipping tax (GST). In the United States, generation-skipping transfer tax applies
to wealth transfers made directly to a recipient, more than one generation younger than the donor.

This means that if for instance, your grandfather bequeathed perpetuities to you, you may be liable to paying the generation-skipping tax. GST is paid on excess amounts after estate tax has been paid and is usually charged at the same rate as the estate tax.

According to the IRS, Congress enacted the Generation-skipping tax in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren.

The GST tax effectively imposes a second layer of tax (using the exemption and the top tax rate under the estate tax) on wealth transfers to recipients who are two or more generations younger than the donor.

Capital gains tax

An individual becomes liable to pay the capital gains tax when they sell an asset at an amount that is higher than what they paid for the asset. Although perpetuities are investments that supposedly last indefinitely, some investors may choose to sell their perpetuity at some point.

When this happens, if the person selling the perpetuity is an individual, the capital gains tax that would be paid on the profit is 20% whereas entities will pay a tax of 21% on the profit. These rates are applicable for 2024 in the United States.

See also: Present Value of Perpetuity Formula and Calculation

Conclusion

The tax implications for perpetuities are varied and are part of the top considerations of investors. This is because understanding the tax implications makes the investor better informed on what to expect in taxes from their perpetual guaranteed source of income.

Some of the tax implications of perpetuities include capital gains, income, and estate tax. Additional taxes include gift and generation-skipping taxes.

The particular tax that will apply to a person’s perpetuity depends on several factors such as the income generated from the perpetuity, its sale, or transfer to another person.