October 28, 2020
By: Bridget A. Alzheimer, Esq. & Ryan A. Brown, Esq.
Background
Revocable vs. Irrevocable Trusts
Estate planning generally centers on limiting administrative and financial burdens on an individual and her family during the individual's lifetime and after her death. For many individuals a reasonable estate plan can be achieved by the combination of a Will and a Revocable Trust. Generally, the Will is constructed as a "Pour-Over Will," meaning it funnels any assets held in the decedent's sole name at the time of death into the Revocable Trust. Since the Trust is revocable during the individual's lifetime, she can change the terms of the Revocable Trust, shift assets in and out of the Revocable Trust, and generally treat any Trust assets as if she still owns them directly.
In this case, the Revocable Trust becomes irrevocable on the death of the individual who formed the Trust (referred to as the Settlor or Grantor of the Trust) and this is usually when the Trust's primary benefits kick in. Anything owned by or payable-on-death to a Revocable Trust during the Settlor's lifetime passes according to the terms of the Trust and bypasses the court probate process, reducing the administrative burden on the Settlor's survivors. Further, the Trust structure allows a Settlor to influence the investment and disposition of her wealth for a period (sometimes generations) beyond her death, and the Trust can be written to provide creditor protection to the Settlor's beneficiaries after her death.
However, Revocable Trusts can provide only limited benefits when it comes to tax-advantaged planning, which is why most practitioners may also recommend establishing one or more Irrevocable Trusts in conjunction with a Pour-Over Will and Revocable Trust. An Irrevocable Trust cannot be cancelled, modified or amended solely by the Settlor. The Settlor relinquishes the power to change trust terms or shift assets in and out of the Trust at will, and the Settlor and the Irrevocable Trust's beneficiaries may have only limited access to the use and enjoyment of the Irrevocable Trust assets and income.
Tax-advantaged planning refers to operating within the current income, gift, estate, and generation skipping transfer tax regimes to preserve and increase wealth for one's self, one's descendants, and one's other intended beneficiaries. A general overview of the estate and gift tax regime can be helpful in understanding how the rules of these regimes can be used to one's advantage.
Gift Tax
Generally speaking, the Federal Government imposes a tax on a taxpayer when she transfers an asset during her lifetime or upon her death. Most taxpayers will never actually pay a tax for one of two reasons: (1) each taxpayer may make tax-free gifts up to a certain amount per recipient each year under the annual gift exclusion (currently $15,000.00); and (2) each taxpayer has a lifetime credit against estate and gift taxes referred to as the Unified Credit (currently $11.58 million per person). Additionally, transfers to charities are not taxable, and in the case of lifetime gifts may also qualify the donor for an income tax deduction.
Generation Skipping Transfer Tax (GSTT)
The Federal Government also imposes a tax on transfers that skip a generation, such as a gift from a grandparent to a grandchild. This tax is known as the generation skipping transfer tax (GSTT). The GSTT can become an issue when a trust is meant to continue for several generations, as a distribution from or termination of such a trust to a skip person may trigger tax consequences. Luckily, similar to the Unified Credit, each taxpayer has a GSTT exemption that may be allocated to a transfer. Currently the GSTTE is set at $11.58 million, matching the Unified Credit, but that is subject to change. The GSTTE is allocated at the time of the transfer. Neither the portion of the transferred asset that is covered by the GSTTE nor the growth in asset value attributable to the covered portion will be subject to the GSTT. Thus, if the GSTTE is properly allocated upon an asset transfer to a multi-generational trust, that asset can grow and fund multiple generations free of the GSTT as well as estate and gift taxes.
Grantor vs. Non-Grantor Trusts
Often, irrevocable trusts are designed to be non-grantor trusts, meaning that income earned by the trust will not be imputed to the Settlor for income tax purposes and the assets in the trust will not be included in the Settlor's estate. However, because the income tax regime and the estate and gift tax regimes don't fully align there are opportunities to switch "grantor status" on and off for income tax purposes only. This can be beneficial, as the trust income tax brackets are much narrower than those for an individual taxpayer (the current top marginal income tax rate of 37% applies when trust income exceeds $12,950 compared to $518,400 for individuals).
Irrevocable Trusts for Tax Advantaged Planning
Many types of irrevocable trusts exist for tax planning purposes. In this summary, we discuss a few of the most common types of irrevocable trusts.
Irrevocable Life Insurance Trust (ILITs)
Irrevocable Life Insurance Trusts (ILITs) are exactly what they sound like. They are Irrevocable Trusts (meaning once settled they can't generally be changed or revoked solely by the Settlor) and they hold one or more life insurance policies for one or more beneficiaries.
Example: Susan creates the Susan Life Trust, for the benefit of her children and further descendants. Each year, Susan makes a gift to the Susan Life Trust which is treated for tax purposes as a gift to the beneficiaries of the Trust. The Trustee of the Susan Life Trust, an independent professional or institution, uses the gifts to pay the premiums on a whole life or universal life policy on Susan's life that is owned by the Trust and which pays to the Trust on Susan's death. Upon Susan's death, since Susan has had no ownership or control over the life insurance policy in the three years preceding her death, the life insurance death benefit is exempt from estate taxes and not part of the calculation for Susan's taxable estate. The independent trustee collects the life insurance death benefit, reinvests it, and continues to manage it for the benefit of Susan's children and their descendants, according to the rules that Susan established.
When drafted and administered correctly, an ILIT can: (1) provide a vehicle to permanently remove assets from the Settlor's estate with little or no reduction of the Unified Credit against gift or estate taxes; (2) provide for estate-tax-free wealth transfer to multiple generations; (3) provide a certain degree of creditor protection to multiple generations; and (4) provide an asset that can be leveraged for various financial purposes. However, an ILIT's income and assets are generally inaccessible to the Settlor and possibly the beneficiaries during the lifetime of the insured (who is often but not always the Settlor) and there may be ongoing administrative expenses in the form of an independent trustee, notices to beneficiaries, and (if generation skipping transfer tax is a concern) the preparation of annual gift tax returns.
Intentionally Defective Grantor Trusts (IDGTs)
Intentionally Defective Grantor Trusts (IDGTs) are so called because typically the goal of planning is to remove assets from a Settlor's ownership for both income and gift and estate purposes. However, there are certain limited powers that may be retained which will cause the trust to be treated as a "grantor trust" for income tax purposes only while skirting all of the "Grantor Trust Rules" that would cause the trust assets to be included in the Settlor's taxable estate. The IDGT aims for this result. By retaining the income tax burden, the Settlor has the opportunity to move additional assets out of his taxable estate without further reducing his available Unified Credit. Additionally, the assets in the trust are able to grow without reduction for income taxes. One retained power that achieves this result is the power to swap trust assets out for assets of the same fair market value. This has the potential to be a very powerful tool in the hands of a Settlor as it can allow flexibility as financial needs or the tax landscape changes.
Example: Arnold creates the Arnold Family Trust for the benefit of his children and their descendants. Arnold appoints an independent trustee for the trust and relinquishes all power over the trust assets except for a power to swap trust assets with other assets of equal fair market value. Because of this retained power, the Arnold Family Trust is considered a grantor trust for income tax purposes. Arnold transfers a few assets to the Trust, using some of his Unified Credit. Then Arnold sells a low-basis income-producing asset to Trust in exchange for a promissory note (taking advantage of current low IRS minimum interest rates). The sale to the Trust is a non-taxable event because it is a transaction between a grantor and grantor trust (and for income tax purposes they are considered the same person) and the Trust takes the asset with a carryover basis. The Trust makes payments on the promissory note with some Trust income, while accumulating and investing the rest. Arnold pays the income tax on all trust income, further reducing the assets he holds in his own name. As Arnold nears the end of his life, it appears the step-up in basis at death rules will not be altered, so he swaps out the low-basis asset with another asset of similar value. When Arnold dies, the low basis asset is included in his taxable estate and its basis is increased to its fair market value. The assets Arnold initially placed in the trust, the asset he swapped in, and the income that accumulated in the Trust during his lifetime are not included in his taxable estate.
The IDGT does have its limitations and primary among those is that the Settlor should have almost no access to the transferred assets or the income they produce. Additionally, other beneficiaries' interests in the IDGT should be carefully crafted so distributions to those beneficiaries during the Settlor's lifetime do not indirectly benefit the Settlor (such as by covering a cost which could be considered the settlor's legal obligation). For best results, an independent trustee should be appointed.
Spousal Lifetime Access Trusts (SLATs)
Spousal Lifetime Access Trusts (SLATs) are typically used to remove assets from a Settlor's estate while still retaining indirect enjoyment of those assets through the beneficiary spouse. Further, SLATs often provide better protection from creditors than a self-settled trust and the beneficiary Spouse can be a co-trustee along with an independent trustee. To avoid triggering inclusion in the Spouse's estate or weakening the credit shelter provided by the SLAT, the Spouse's powers to direct distributions should be very limited.
Example: Harry creates the Sally Lifetime Trust (the SLT) for the benefit of his wife, Sally, and their children, and transfers his separately held property to the SLT, using some of his Unified Credit and allocating Generation Skipping Transfer Tax Exemption (GSTTE) to cover the lifetime transfer. Harry appoints Sally and an independent trustee to serve as co-trustees of the SLT. Sally has the right to receive income from the SLT for her Health, Education, Maintenance, and Support (what the IRS terms an "Ascertainable Standard") and the power to approve similar distributions to the other beneficiaries. The independent trustee has the power to invest and manage trust assets and discretion to make distributions not subject to an Ascertainable Standard to Sally or to the other beneficiaries from principal or income. Because Sally's ability to access income is limited to either an Ascertainable Standard or to her co-trustee's discretion, her interest in the SLT is somewhat protected from creditors. Harry has no retained interest in the SLT assets, so he has removed them from the reach of his creditors as well. When Harry dies, the SLT is not included in his taxable estate. Sally continues to receive distributions from the SLT for the remainder of her life. When Sally subsequently dies, the SLT continues for the benefit of her children and their descendants and is not included in Sally's estate. Because Harry allocated GSTTE to the assets upon transfer to the SLT, no Generation Skipping Transfer Tax (GSTT) will be triggered by distributions from or the termination of the SLT in later generations.
Often each spouse will settle a SLAT for the benefit of the other spouse. The primary risk with dual SLATs is that the IRS or other authorities will deem them to be "reciprocal" trusts and unwind them, bringing the trust assets back into the Settlors' estates and removing the creditor protections. To avoid this treatment, dual SLATs should have as many dissimilarities as possible: they should be funded with individually held assets; trustees, trust provisions, and perhaps residuary beneficiaries should not mirror each other; and distributions received from the trust should not be mingled with marital assets. As with IDGTs, care must be taken so distributions are not deemed to cover a legal obligation of the Settlor. Because SLATs are typically designed to avoid inclusion in both spouses' estates, transfers to a SLAT will reduce the settlor's Unified Credit amount, and therefore should be used in cases where the Settlor expects an asset to appreciate significantly, or in cases where the Settlor wants to hedge against a reduction in the Unified Credit in the future.
Charitable Remainder Trusts (CRTs)
Charitable Remainder Trusts (CRTs) are trusts that establish a gift for a charity, to be distributed after the trust term. During the trust term (which can be a set number of years or a lifetime measure) the Settlor receives an income stream derived from trust assets. The Settlor also receives an immediate charitable deduction for income tax purposes equal to the present value of the amount the charity is likely to receive at the end of the trust term, which is calculated based upon the trust term or the Settlor's life expectancy. The Settlor's retained interest can take the form of a fixed dollar annuity, in which case the CRT is referred to as a Charitable Remainder Annuity Trust (or CRAT), or a percentage of the trust value, in which case the CRT is referred to as a Charitable Remainder Unitrust (or CRUT).
Example: Charles creates the Charles Charitable Remainder Unitrust (CCRUT), naming himself trustee and retaining an annuity interest equal to 7% of the Trust value for his life with the remainder interest going to the local Animal Welfare Society. Charles transfers low basis publicly traded stocks to the CCRUT. Charles takes an immediate income tax deduction for the remainder value of the stocks, calculated based on Internal Revenue Code actuarial tables and based upon Charles' remaining life expectancy. Charles liquidates some of the transferred stock in order to diversify into other income producing assets. The stock sale causes the CCRUT to realize capital gains, but no tax is recognized at that time. Each year, the assets in the CCRUT are valued to determine the amount of the distribution to Charles. Tax is triggered only to the extent of a distribution when that distribution is made. Thus, the capital gains on the sale of the stock are taxed incrementally over the course of multiple distributions. When Charles dies, the CCRUT is not included in his taxable estate. The Animal Welfare Society becomes the sole beneficiary of the CCRUT.
The income tax treatment of CRTs makes them good candidates to receive highly appreciated assets. The Trust itself pays no tax on the liquidation of those assets and a tax is triggered only when income or proceeds are distributed to the non-charitable beneficiary. Consequently, the CRT can accomplish a liquidation that would result in immediate and large capital gains taxes in the hands of the Settlor with the resulting tax directed and deferred over the course of years. However, CRTs are not generally good candidates to receive interests in pass-through entities (due to certain income tax rules) or in closely held businesses (due to trust valuation requirements).
Distributions from a CRT are typically mandatory, with no (or very limited) discretion on the part of a trustee to defer a distribution. Consequently, the CRT can provide only limited creditor protection. Administration costs of a CRT can be high, particularly in CRUTs that can require annual trust valuation. A CRT can be deemed to fail even if the charitable beneficiary does not suffer, such as when distributions are not made according to the trust terms. A failed CRT means all the CRT assets are pulled back into the Settlor's estate. Consequently, CRTs must be administered carefully and in faithful accordance with the trust provisions.
Conclusion
The current uncertainty in financial markets and the tax code warrants a careful evaluation of estate planning techniques for any clients who may potentially expect to have taxable estate. Each client's situation is unique, so the analysis involves a review of the client's financial assets, basis and title on those assets, and some forecasting as to how assets may appreciate in the future. These discussions often involve the work of, and coordination amongst, the client's estate planning attorney, financial planner, and accountant.
Arlington Law Group regularly assists clients to make decisions on the estate planning techniques that best fit their needs, based upon each client's risk tolerance, family situation, and future plans. Please contact us to arrange a consultation to discuss your specific situation.
