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Irrevocable Trusts: When to Use Them, Drafting, and Other Considerations

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Irrevocable Trusts: When to Use Them, Drafting, and Other Considerations

This CLE will provide estate planners with an overview of irrevocable trusts and key considerations and challenges with these instruments. Estate planners use irrevocable trusts to protect assets and provide flexibility to adapt to changes in tax law, fluctuating asset values and other changing circumstances. When considering these types of trusts as part of an estate plan, counsel must grasp income and transfer tax rules, which assets can go into the trust, trustee restrictions, prohibitions on trustee powers, how to make distributions, and many other considerations. Planners can structure trusts to allow clients affected by estate or gift taxes to retain varying levels of control depending on that client’s situation and the applicable laws and regulations.

Transcript

- Hi, welcome to today's program titled "Irrevocable Trusts, When to Use Them, Drafting, and Other Considerations." I'm your presenter, Len Garza. I'm the founder and principal attorney at Garza Businesses and Estate Law. We're located in Princeton, New Jersey, and have clients all over the northeast and nationwide. We represent family businesses, close corporations, business owners, executives, and private companies, and we help them get formed properly, structured properly, and grow in a healthy and sustainable way, and help them plan for exit or the next generation. In this presentation, this is going to be an introductory course on irrevocable trusts. In this course, we'll introduce key irrevocable trust terminology, bring you up to speed on irrevocable trusts, provide an overview of some of the drafting concepts, and give you an overview of some common types of irrevocable trusts. Now, when working with the client to create an estate plan, you as the attorney, may want to consider an inter-vivo living trust for that client, depending on their situation circumstances. There are many situations where trusts are advantageous, but having a trust also comes with administrative responsibilities that may be too rigid and inflexible for that client. So it's always important to know that client's situation, what they wanna accomplish, their family circumstances, and have a firm understanding of their assets, liabilities, and what's important to them. So as the planner, we can work with their other advisors, typically a financial advisor or a wealth manager and/or a CPA, to ensure that we're using the right tools, the right estate planning tools, to accomplish their objectives. There are many reasons to consider creating and funding an inter-vivos trust. The grantor may wish to make a gift to family members or friends. The grantor may not wanna make that gift outright to the individual if he lacks the business or investment experience to handle that gift. Think for example, of leaving a gift to a minor or a young adult. Instead of leaving that gift outright, by leaving the asset in trust, the grantor can free the beneficiary from the responsibility and worry involved with the investment administration of the trust fund. The grantor can entrust this to another more experienced trustee for the benefit of the beneficiaries. Also, putting those assets in trusts may be protected from the creditors of beneficiaries as long as you structure the trust properly. In contrast, outright gifts to beneficiaries are largely exposed and unprotected from these threats. However, in addition to outside threats, sometimes the threat's internal, a grantor may prefer to lead the assets to the beneficiaries in trust, as opposed to giving it to them outright, in order to prevent the beneficiaries from being disincentivized to work, go to school, or become a productive member of society. One of my favorite quotes on this point comes, I believe, from Warren Buffett who said, "You wanna leave your kids enough money where they feel like they can do anything, but not so much where they feel like they can do nothing." I find that many clients have this concern and highly value the ability to pass on gifts and their assets to their children, but do so in a conditional way so their children need to meet certain milestones, for example, certain ages such as the age of majority, age 25, 30, and so on, or specific milestones in life such as going to school, going to get their undergrad degree, professional degree, or getting married, buying a house, starting a business. Using a trust, you can customize distributions based on these events, which is something that clients really value. Inter-vivos trusts are also beneficial for a number of tax saving strategies or to qualify for certain tax statuses. Unlike wills and revocable trusts, irrevocable inter-vivos trusts affect transfers during the grantor's life, which may provide transfer tax savings not available in purely testamentary plans. The reason is that when you establish an irrevocable trust, moving the property to trust will often constitute a taxable transfer. This removes the property from the grantor's estate, it also removes any post transfer appreciation in income from the grantor's estate. Many states still have an estate tax and that's another factor that can make irrevocable trusts attractive. Although at the time of recording of this presentation, the federal estate tax exemption is rather high, approximately 12 million per individual and 24 million per married couple, and that affects less than 1% of the population, that is the federal exclusion amount and that's distinguishable from any state estate tax that could be much lower, or rather, have a much lower exemption amount. But when you're looking at irrevocable trusts as a part of the estate plan, the gift in tax, estate tax advantages that accompany a transfer to an irrevocable trust must be weighed against the potential capital gains and tax basis considerations. Some clients may resist an irrevocable trust transfer out of a desire to avoid incurring tax earlier than necessary, or to retain control over property and to ensure that they have sufficient means to maintain themselves. The concept of grantor trusts is important when we're considering irrevocable trusts as part of our estate planning. Grantor trusts are trusts where the grantor holds sufficient control over the trust, to be deemed the owner of the trust for income tax purposes, this causes the trust income to be taxable to the grantor instead of to the trust. We can establish a grantor trust for a variety of reasons, which we'll discuss in a minute. There are many types of grantor trusts. Revocable living trusts are grantor trusts. Some irrevocable trusts are intentionally drafted as grantor trusts, so that the creator is treated as the owner of the trust property for income tax purposes even though he's not necessarily treated as the owner for gift and estate tax purposes. These irrevocable trusts are sometimes referred to as intentionally defective grantor trusts. The intentionally defective term, they are intentionally ineffective, or intentionally defective rather, regarding the income tax liability and that the income tax liability is on the grantor rather than to the beneficiary. Using I-D-G-Ts, or IDGTs, Intentionally Defective Grantor Trusts, requires an understanding of Internal Revenue Code Section 671-679. These sections and their predecessors are a legislative response to taxpayer attempts to use trusts to shift income to taxpayers in lower income tax brackets. The statutory framework consists of a host of conditions that if triggered in a trust instrument or actual administration, cause the grantor or a third party to be treated as the owner of all or a portion of the trust. The overall intent of the grantor trust legislation is to cause the grantor to be deemed to be an owner for income tax purposes, if enumerated interest and powers are retained either by the grantor or anyone else who may be influenced by the grantor, including a spouse or any person whose interests are not, quote unquote, adverse to those of the trust beneficiaries. Now, it's important to note that code Section 672 , one treats a grantor as holding all powers and interests held by the grantor's spouse at the time of a trust creation. In certain situations, the beneficiary can be treated as the owner of a trust for income tax purposes, under the grantor trust rules as well. A person who's considered an owner is required to include in her own personal income tax computation income, deductions and credits attributable to the trust property considered to be owned by her. So what are the uses of IGTs? Well, we can use grantor trust treatment to create income and transfer tax advantages for clients. We can do this by drafting trusts with technical provisions that mechanically trigger grantor trust treatment under code Section 671-679. Most of the time, when we use these provisions, they'll have little use other than to gain grantor trust status. When drafting, as the drafter, you'll need to be careful, particularly when you seek grantor trust treatment in connection with gift strategies used to remove assets from a grantor's estate. Powers granted to or retained by the grantor to achieve grantor trust status may inadvertently cause inclusion of trust property in the grantor's estate for estate tax purposes, under code Sections 2036 and 2038. How is grantor trust treatment beneficial? Well, for a variety of reasons. For trusts created in connection with completed gifts, the grantor retains the income tax liabilities so that the beneficiaries get the full value of trust assets without having to pay future taxes on ordinary income and realized gain on trust assets during the life of the grantor. Grantor trust status creates the opportunity to shift considerable value from the grantor to the trust beneficiaries. This grantor payment of income tax liability is the economic equivalent of a further gift to the trust. Another benefit is that transactions between a grantor and a grantor trust do not result in income recognition. For example, this includes a fair market value purchase of assets by a grantor from the trust for cash or a combination of cash and promissory notes, distribution of appreciated property and satisfaction of an annuity payment, or installment note payment owned by a grantor trust to the grantor, or the payment of interest on the note. This is particularly useful in the sale to an IDGT planning structure in which a grantor establishes an IDGT and sells assets to the IDGT in exchange for a promissory note from the IDGT to the extent that the growth and the value of the assets contributed to the trust exceeds the interest payable to the grantor under the note, the excess passes to are in trust for the beneficiaries gift tax free. There are also other benefits specifically associated with grantor trust treatment, of life insurance trusts, charitable lead trusts, and trusts creating qualified retained interests under Section 2702 of the code, such as QPRTs, Q-P-R-T, Qualified Personal Residence Trust, and GRATs, Grantor Retained Annuity Trusts. So how do we create grantor trust status? We're gonna go over some of the most common techniques to achieve grantor trust status for irrevocable trusts. It's important to note that revocable living trusts are already grantor trusts for income tax purposes due to grantor's right to revoke, so there's no need to include any of these provisions we're about to go over, in those types of trusts. However, unlike assets held in certain irrevocable trusts, the assets of revocable living trusts are includeable in the grantor's estate for estate tax purposes. While any of the provisions we're about to discuss could create grantor status, many estate planning lawyers use several of these provisions, the sort of belt and suspenders approach, in order to ensure that they trigger grantor trust status. Statement of intent to be treated as a grantor trust. Many estate planning lawyers include a statement of intent that the trust is to be treated as a grantor trust, and for the trust to be construed in line with that intent. Power of disposition by a non-adverse party. Code Section 674 contains broad-reaching grantor trust rules. The section provides that the grantor will be treated as owner of the trust if the beneficial enjoyment of the trust is subject to a power of disposition by the grantor or non-adverse party. A non-adverse party is defined as anyone who doesn't have an interest in the trust that would be adversely affected by the exercise, or non-exercise, of the subject power. A non-adverse party includes a purely independent trustee, so most powers possessed by an independent trustee may potentially trigger grantor trust treatment, unless other exceptions apply. Section 674 of the code defines eight accepted powers that may be held by the grantor or any other person, without causing the grantor to be considered an owner of the trust under this rule. In applying these provisions, you should read these exceptions carefully. Code Section 674 , for example, contains an exception for powers held by an independent trustee to distribute income and principle to a trust beneficiaries, provided that no more than half of the trustees are related or subordinate to the seller's wishes. Generally speaking, a related or subordinate person is a non-adverse person who is either the grantor's spouse, parent, issue, sibling, or employee in certain situations. So a trust that gives related or subordinate parties as trustees broad discretion as to accumulation or payment of income, will be a grantor trust so long as those parties are acting as trustees. Power to add beneficiaries. This is another commonly used technique for making a trust a grantor trust for income tax purposes. Essentially, you grant a non-adverse person the power to add beneficiaries to the trust. This also relies on Section 674 . Code Section 674 expressly provides that the exception for independent trustees who have the power to distribute income and principle does not apply if the trustees have the power to add beneficiaries. To avoid the risk of inclusion of the trust property in the grantor's estate for estate tax purposes, this power should not be given to the grantor's spouse or any other related or subordinate party. Administrative powers, powers to substitute property. Code Section 675 describes certain administrative powers that will cause the trust to be deemed a grantor trust for income tax purposes. This is a commonly invoked power in IDGTs, and it's a power exercisable by anyone in a non-fiduciary capacity, without the approval or consent of anyone in a fiduciary capacity, to reacquire trust corpus by substituting other property of an equivalent value. The grantor's ability to reacquire assets is often an independently desirable feature of a trust. It may allow the grantor to swap high basis assets from his or her portfolio, for low basis trust assets, so that the latter will be stepped up for capital gains purposes at the grantor's subsequent death, without gift or estate tax consequences. Power to lend. Grantor trust status may be triggered by the grantor's power to borrow from the trust without adequate interest or security. Many estate planning attorneys avoid the no interest path because there's a deemed gift component to an interest-free loan pursuant to Section 7872. An alternative is to give the trustee the power to lend an interest-bearing loan without security. Power or interest of the grantor's spouse. Having the grantor's spouse as a permissible beneficiary of the trust is a common way to trigger grantor trust status. This is assuming that distributions could be made to the spouse without consent of an adverse party. Similarly, any power or interest held by the grantor's spouse will be deemed to be held by the grantor for grantor trust purposes. Toggling on and off of grantor trust status. A grantor may want to remove grantor trust status. For example, the tax law could change and treat grantor trust status unfavorably, or the grantor may decide that the financial burden of paying the taxes have become too great. Estate planning attorneys should include language in the irrevocable trust, that provides the ability for the grantor status to be toggled on or off. To toggle off, the grantor must relinquish the powers that give rise to the grantor trust status. You may also want to include additional flexibility in the trust, to modify any other provisions that may result in grantor trust status. These include flexibility to change trustees or cause the grantor's spouse to cease being a beneficiary. Some clients may not want their trustee changed or spouse removed as a beneficiary, regardless of adverse tax consequences, so you should craft these provisions based on the specific needs of that particular client. Beneficiary as owner for grantor trust purposes. Under code Section 678, a beneficiary may also be treated as the owner of a trust for income tax purposes in some instances. Under 678 , a beneficiary may be treated as the income tax owner of any portion of a trust, with respect to which that beneficiary has a power, exercisable solely by herself to vest the corpus or the income of the trust in herself. A beneficiary may also be treated as an owner of any portion of a trust with respect to which that beneficiary's previously partially released or otherwise modified power described in 678 , and after the release or modification, retains control that would be subject to grantor to ownership treatment under Section 671-677. Be aware that you can inadvertently trigger this rule if the trust gives a beneficiary a right to demand a certain portion of the trust. For example, when a trust contains Crummey powers, explained below. However, if a grantor is treated as the owner of a portion, or all of the trust, for income tax purposes, these rules don't apply with respect to that portion of the trust, and the beneficiary isn't also treated as the owner with respect to that portion. This prevents two individuals from being treated as the owner as to the same trust assets at the same time. Similar to an IDGT, some planners have attempted to take advantage of the grantor trust rules that would deem a beneficiary an owner of a trust for income tax purposes. One of these proposed structures is a BDIT, also called a Beneficiary Defective Inheritance Trust. These structures typically involve a client who loans or sells assets to the BDIT. The client is a beneficiary of the trust and is treated as the owner of the trust under the grantor trust rules, but is not the grantor of the trust for gift and estate tax purposes. In addition to the typical benefits of an IDGT, the BDIT allows the client to be a beneficiary of the trust to enjoy spendthrift protection and to minimize gift or estate tax concerns associated with any continued control the client or beneficiary may have over the BDIT. Now, what about a change of grantor trust status? What's the impact of that? Well, generally, when a donor makes a lifetime gift, she doesn't recognize gain on the transfer, and the donee generally takes the donor's basis in the gift of property. Similarly, when a donor transfers property to a grantor trust, there's generally no gain recognized on the transaction and no step-up in basis occurs. This makes sense because as the property and the grantor trust is treated as owned by the grantor for income tax purposes, there's no income tax consequences as a result of the transfer. For the same reason, when a grantor sells assets to a grantor trust, no gain is recognized and no step-up in basis occurs. But what happens when the grantor trust status of a grantor trust terminates, either prior to or as a result of the grantor's death? If a trust ceases to be a grantor trust during the grantor's lifetime, the grantor is treated as having transferred the assets to the trust at the time of the termination of the grantor trust status. At this point, the grantor may have to recognize gain, depending on whether the assets in the trust are subject to an encumbrance or not. If the assets are not subject to any encumbrances, the transfer will be treated for income tax purposes in the same manner as if a gift had been made to the trust. Like with the initial gift to the trust, this will generally have no income tax consequences for the grantor, and the trust would take the grantor's basis in the property. However, if the assets are subject to an encumbrance, the grantor will recognize gain to the extent of the encumbrance exceeds the basis. Because of the possibility of a recognition event, if it can be avoided, it's often not preferable for grantor trust status to cease during the lifetime of the grantor. If a trust ceases to be a grantor trust as a result of the grantor's death, the income tax consequences are much less certain. Now, as of this presentation, the IRS hasn't officially taken a position as to this specific issue. To complicate things even further, in a 2015 revenue procedure by the IRS, the IRS stated it'll no longer rule on whether the assets in the grantor trust will receive a step-up in basis under code Section 1014, if the assets aren't includeable in the grantor's gross estate at death. In light of this, proceed with caution. An estate planning attorney should take special care in discussing these points with your clients, considering using grantor trusts. Crummey power trusts. The annual gift tax exclusion is not available for gifts of future interests and property. The annual gift tax exclusion allows individuals to make gifts of up to a certain amount to other individuals, free of federal gift tax. This amount is adjusted annually for inflation. In 2022, the annual exclusion amount is 16,000 per donee, or 32,000 in the case of a married donor who splits gifts with his or her spouse. In general, transfers into trusts are treated as future interests and therefore, do not qualify for the annual exclusion. Enter Crummey power. This is a more flexible technique for making gifts to trusts, so that the gift constitutes a present interest rather than a future interest, which would be excluded and is thus eligible for the annual exclusion. Crummey power is named after the first decided case approving this technique. This is how it works. The grantor makes a gift to the trust. Generally, this gift would constitute a future interest and not be eligible for the annual gift exclusion. However, if the beneficiaries are given the power to withdraw from the trust, some portion or all of the gift, this converts the gift to a present interest and it's now able to use the annual gift exclusion. It's important to note that the existence of this power may have certain income tax consequences, as well as the estate and gift tax ones. For example, the holder of a Crummey power may be deemed to be the owner of the trust for income tax purposes, unless the grantor is also treated as the owner, which will often be the case, especially in the context of insurance trusts. Trusts that utilize these powers are sometimes called Crummey power trusts. These powers are used in many different types of irrevocable trusts, including a life insurance trust. There have been many judicial decisions regarding the scope of planning with Crummey powers. The IRS continues to challenge various aspects of Crummey powers. The IRS has taken a position that if a Crummey power appears to be elusory, it'll oppose the use of the annual exclusion. If an individual's only interest in a trust is the Crummey power, and the power is in fact not exercised, the IRS attempts to draw an inference that there was a prior agreement that the power not be exercised and that the Crummey power was actually elusory. Courts have upheld the availability of the annual exclusion in many cases, but the IRS continues to disagree. The IRS doesn't appear to be as concerned about trusts in which the Crummey power holder is a contingent beneficiary, if the power holder is also within a class of permitted sprinkle beneficiaries who would be entitled to receive discretionary current distributions from the trust. However, if a particular beneficiary is less closely related to a grantor than the other permissible beneficiaries, it's unclear whether this arrangement would withstand IRS scrutiny. In determining who should be given Crummey powers, the facts and circumstances of that particular situation should be considered along with the client's risk tolerance. Crummey powers are typically triggered when a gift has been made to the trust. When drafting the provision granting Crummey powers, you typically state that the Crummey power is to be effective whenever a contribution or addition is made to the trust, constituting a gift within the meaning of Chapter 12 of the Internal Revenue Code. Once the triggering event has been specified, the actual power of withdrawal needs to be set forth. When you give a beneficiary a Crummey power, it's important that the instrument creating the power specify the scope of the power. The scope of the Crummey power should not exceed the amount of the annual gift tax exclusion. In many respects, the power of withdrawal is equivalent to a general power of appointment as described in code Section 2041 and 2514. In those sections, the lapse of such a power is treated as the equivalent of a release or exercise which creates a corresponding taxable gift or estate inclusion, except to the extent that the lapse doesn't exceed the greater of 5,000 or 5% of the value of the property over which the power is exercisable. This is commonly known as the 5 and 5 power. If you as the drafter, are confident that the annual gift to the trust won't exceed the product of multiplying 5,000 times the number of Crummey power holders, the size of the power can be subject to a further limitation, namely that no power holder is given a power that will exceed the 5 and 5 limit. The goal here, is to avoid subjecting the beneficiary to unnecessary gift or estate tax liability. If the powers don't lapse at all upon death or exercise, the property subject to the power would be either included in the beneficiary's gross estate or be subject to the gift tax, even if the power falls within the 5 and 5 limit. This is because the 5 and 5 limit's merely an exception to the rule that the lapse of the power is treated as the equivalent of a taxable exercise or release of the power. To the extent that Crummey powers exceed the 5 and 5 amount, the clause is often drafted so that the power automatically lapses after the beneficiaries had sufficient period of time to exercise it. Now, in the early 1980s, when the annual gift tax exclusion started getting into the 10 and $20,000 range, it got popular to have Crummey power applied to a larger portion of trust assets than could be achieved if the power was limited to the 5 and 5 restriction. At the same time, it was and remains desirable to avoid the tax consequences of lapse of a power in excess of the 5 and 5 amount. This led to the development of the hanging power which lapses over a period of years, to the extent that the lapse is not a taxable event. If the spouse of the creator of the trust is a beneficiary who has a Crummey power, the donor will be prohibited from allocating GST exemption to the trust, for so long as a spouse has an existing power of withdrawal. Accordingly, if GST exemption is intended to be allocated to the trust, you should take care to ensure that the spouse doesn't have a hanging Crummey power. If the spouse has a Crummey power at all, it should be limited to the 5 and 5 amount and expire within 60 days of the gift. In that case, the treasury regulations provide that this will not be considered the sort of power that creates the GST problem. Because of this issue, you may need a tiered approach to the Crummey powers. Specifically, the spouse may have a 5 and 5 Crummey power that lapses 60 days after the gift, while other beneficiaries may have a larger hanging Crummey power that periodically elapses over a longer period of time. Notice of the Crummey power withdrawal right, it's critical that there be a realistic possibility of the exercise of a Crummey power withdrawal, even if that power is never actually exercised. A common way of accomplishing this is ensuring that notice is given to the power holders and informing them of their withdrawal right. If a donor intends to make a number of gifts to the trust, the trustee may consider providing the beneficiary with a waiver of future notices. However, it's generally safer to provide the beneficiary with annual notices, even if the beneficiary has been advised in advance, of a series of intended gifts scheduled to be made over several years. Not doing this and including a waiver to the beneficiary, risk challenge by the IRS, and courts have upheld these types of challenges. In order to better withstand potential challenges by the IRS, the best practice is to maintain a clear record that the beneficiaries were notified of their Crummey withdrawal rights. This will help provide support against potential IRS arguments that the withdrawal right was elusory. Now, what if the Crummey power holder is a minor or an incapacitated person? Well, minors and incapacitated persons, even though they don't have legal capacity, they can still be treated as Crummey power holders as long as the guardian or other fiduciary can be appointed to exercise the power on their behalf. The trust should provide for such a situation by including additional mechanisms for the exercise of a Crummey power held by a minor or an incapacitated person, by someone else on their behalf. Dynasty trusts. Not all irrevocable trusts are designed to last for multiple generations. Trusts that are designed to last multiple generations are sometimes referred to as dynasty trusts. Dynasty trusts are irrevocable trusts that are intended to transfer wealth down more than one generation. Often, these trusts will be established in jurisdictions that have either absolutely abolished or practically abolished the rule against perpetuities, enabling the trust to last indefinitely. These trusts are often estate and generation skipping transfer tax exempt, and thus, any assets remaining in the trust can continue to be held in trust without incurring any transfer tax. Charitable trusts. Many individuals wish to make contributions to charitable organizations, but either want to retain an amount of control over who receives distributions and when, or aren't yet willing to fully part with the assets that they intend to give. There are numerous options for getting the income tax deduction for making a charitable gift currently, while also achieving these objectives. These include the establishment of private charitable foundation, a donor advised fund, or donations to a community foundation. Another option is to gift to a charitable trust. The use of split interest trusts where a charitable organization is either the income beneficiary, these are referred to as charitable lead trusts, or the remainder beneficiary, also referred to as charitable remainder trusts, have become increasingly popular and also can result in transfer tax savings. Self-settled asset protection trusts, or domestic asset protection trusts. Trust laws enacted in several states over recent years offer new possibilities for asset protection planning. These states have enacted statutes that allow for individuals to create irrevocable trusts in which they retain the ability to receive distributions but also have asset protection qualities. These trusts are often referred to as self-settled spendthrift trusts, or self-settled asset protection trusts. They're also sometimes referred to as domestic asset protection trusts. Currently, an example of some of these states that have these type of trusts are Delaware, Nevada, Wyoming, Utah, West Virginia, Alaska, Colorado, and there are others. Generally, self-settled asset protection trust statutes aim to reverse the common law principle that a creditor of a trust creator can reach the trust property to the maximum extent that the trustee can distribute property to the creator. Through these statutes, a growing number of states are expanding creditor protection benefits to grantors, allowing them to create trusts that authorize an independent trustee to make discretionary distributions to the grantor, while the trust assets remain protected from the claims of most of the grantor's creditors. Statutes that permit asset protection trusts generally include the following requirements for the trust. The trust must be irrevocable, the trust must invoke the law of the residence state, you must have a residence state trustee, have at least some of the assets located in that state, and you have to have certain administrative activities with respect to the trust, occur within that state. If you meet these statutory requirements, most actions commenced within the state by the grantor's creditors against a trust property, are prohibited. Exceptions to this protection are for fraudulent conveyances and tort injuries occurring on or before the date of transfer of the trust, and in certain asset protection jurisdictions, claims for marital and child support, depending on the timing of the funding of the trust or the date of the claim. Although more and more states are enacting legislation permitting self-settled spendthrift trusts, the law surrounding such trusts is still uncertain. First, there's a question of whether a court in a jurisdiction that does permit self-settled spendthrift trusts, will give full faith and credit to a judgment from a state that doesn't permit such trusts. Some commenters believe that DAP states would still issue the judgment from a non-DAP state, because spendthrift self-settled trust rules violate the non-DAP state's public policy. Life insurance can be a useful addition to many different types of estate plans. It's common to hold life insurance policies through an insurance trust for estate tax reasons. Under code Section 2042, it's easy for life insurance proceeds to be included in the estate of the insured individual, where they'll be subject to a estate tax either at the death of the individual, or in a case where you employ the marital deduction, at the death of the surviving spouse. Under 2042, the value of the decedent's gross estate includes the value of the proceeds of any life insurance on the life of the decedent that's payable to the decedent's executor. The decedent's gross estate also includes the value of proceeds of any life insurance policies on the life of the decedent, to the extent that the decedent possessed any incidents of ownership, either alone or in conjunction with any other person, and in any capacity, whether individual or fiduciary. The treasury regulations list a number of examples of incidents of ownership. Incidents of ownership is a concept that's broader than most of the estate tax rules that apply to other forms of property. Some of these incidents and the treasury regulations include the ability to deal with the insurance policy, to designate beneficiaries, to borrow against a policy, to select payment options, and others. However, a grantor's retained power exercisable in a non-fiduciary capacity to acquire property held in trust by substituting property of equivalent value, won't in and of itself cause the value of the trust corpus to be includeable in the grantor's gross estate, under Section 2042. There are some situations where an insured may not be concerned with the inclusion of life insurance proceeds in his gross estate for estate tax purposes. For example, if the net wealth of the and his spouse, including insurance proceeds, is below the amount of the estate tax exemption, neither spouse will be subject to estate tax liability. Or the surviving spouse is expected to consume the insurance proceeds during her remaining life, those assets would not be remaining at death of the surviving spouse, and they thus would not be subject to estate tax. We can avoid inclusion of life insurance proceeds in a gross estate for estate tax purposes, by having that policy owned by someone other than the insured, or the insured spouse. For example, this is typically done with a type of irrevocable trust called an ILIT, Irrevocable Life Insurance Trust, which will own the policy on the life of the insured. This type of trust must be irrevocable to avoid inclusion in the grantor's estate under Section 2038 and 2042. Some key considerations when drafting an ILIT are that the insured should not be a trustee unless a trust agreement expressly insulates him from exercising all direct and indirect powers with respect to the life insurance policies held in the trust. But generally, it's much safer and more practical for the insured to simply not be a trustee at all. The insured should not be a beneficiary. The grantor should not hold a power of appointment over the trust property, not even a limited power of appointment. And the insured should not have the power to remove trustees. Although there is some doubt on this last consideration, especially if the grantor can't replace or remove trustee with a related or subordinate person, pursuant to 672. There are also certain powers that may be fined for trust containing assets other than life insurance policies, but that raise risks with respect to life insurance. For example, giving the grantor the ability to borrow from the trust, or against a life insurance policy held in trust, could still result in tax exposure. Also, we should limit the trustee's ability to lend assets without adequate security. Other powers granted to the trustees can create grantor trust status. If the trust isn't intended to be a grantor trust, it's important that the trust income not be used to pay premiums on any life insurance held in the trust. You may also wanna avoid potentially adverse tax consequences to the insurance trust beneficiaries by including various Crummey withdrawal powers. You should give special consideration to giving the grantor's spouse a right of withdrawal. If the GST exemption is intended to be allocated to the ILIT, as the estate planning attorney, you'll want to ensure that the grantor's spouse's withdrawal rights is in compliance with the GST Safe Tax Harbor rules, regarding the estate tax inclusion period. The grantor's spouse should not be given a hanging Crummey power that would, if operated properly, not lapse with the eTip Safe Harbor Rules. Generally, trustees of insurance trusts are subject to the same fiduciary considerations as trustees of any other type of trust. The drafter should coordinate the ILIT with the client's other estate planning documents, ensuring that the burden of paying any death taxes attributable to the insurance trust, is addressed. If the beneficiaries of the ILIT and the grantor's revocable living trusts aren't the same, there could be an unintended disparity in the taxes paid amongst all the beneficiaries. It's advisable to have a separate article for the various fiduciary powers regarding the life insurance policies held in trust. Many times, the insurance company may insist on seeing that a particular power is explicitly set forth in the trust agreement, and not simply an implied power under more general provisions, either within the trust agreement or the governing statute. Now, there's a three year look back that you need to consider whenever you're drafting an ILIT. Code Section 2035 provides that assets that have been transferred by the original owner or over which the original owner has relinquished a power, are includeable in the original owner's gross estate if the transfer took place within three years of her death. So for example, if the insured gifts a life insurance policy to an ILIT on January 1st and dies one year later, the policy proceeds will be includeable in the insured's estate for estate tax purposes. Two of the safest ways to avoid this three year look back are first, the insured grantor lives more than three years after the date of transfer, or have the insured gift the ILIT cash and the ILIT then purchases the life insurance policies on the life of the insured. By doing this, assuming the rest of the trust is structured properly, the insured won't have any ownership over the life insurance policies purchased by the trust and the proceeds of the policies will not be included in the insured's estate at her death, for estate tax purposes, even if she does die within three years of purchase of the policy. Qualified personal residence trust. The code and the treasury regulations specifically provide a means for an interest in trust, all the property in which consists of a residence, to be used as a personal residence by persons holding term interest in such trusts, with the remainder passing to others. This is often referred to as QPRT, or a Qualified Personal Residence Trust. These rules are an exception to the valuation provisions of Chapter 14 of the code, which are currently Sections 2701-2704, which among other provisions, in effect, restrict transfers in which the grantor retains the property for a term of years. When the grantor transfers a residence to a QPRT, she's making a taxable gift of the present value of the remainder as determined under treasury tables. If the grantor survives the QPRT term, the residence will be distributed either to the trust remainder beneficiaries or to a continuing trust that's no longer a QPRT, without further gift or estate tax liability. If the grantor dies prior to the expiration of the QPRT term however, the assets are usually directed to be distributed as part of the grantor's estate, and the tax benefit of the QPRT won't be realized. Under the right circumstances, use of a QPRT can result in a substantial gift or estate tax savings because of the reduced value of the gift as a result of the grantor's retained interest. The key part of this planning is determining the length of the QPRT term. Choosing a lengthy QPRT term will reduce the present gift tax liability, but the trade off is that a lengthier term makes it more unlikely that the grantor will outlive the QPRT term. Remember, if the grantor doesn't outlive the QPRT term, you won't realize the tax benefits. A drawback to the use of a QPRT is that when the residence is eventually sold, the seller, for example, the trust remainder beneficiaries or other successors in interest, will realize capital gain in the amount of the excess of the sale price over the donor's original basis. By contrast, if the residence were to pass through the gross estate of the donor for estate tax purposes, the income tax basis of the legatees, for purposes of future capital gains, would be the date of death value, which presumably, would be much higher than the donor's original basis. Accordingly, use of the QPRT saves gift and estate tax at the cost of a potentially higher capital gains tax. These considerations are similar in many other irrevocable trust structures. There are many other QPRT requirements in the extensive regulations, including the following. The grantor may hold a term interest in no more than two QPRTs. The trust may not hold any assets other than a single residence, or an undivided fractional interest in one. A pertinent structure is used by the holder for residential purposes. Adjacent land reasonably appropriate for residential purposes. And cash for up to six months needs of the residence, or proceeds of damage, destruction, or involuntary conversion, provided that the governing instrument must require that the proceeds be reinvested in a personal residence within two years of receipt. Spouses who own a house jointly, may contribute it to a QPRT if they are joint beneficiaries. The term holder must receive all trust income and the trust must prohibit any distributions to anyone else. No reduction of the term interest is permitted. If the residence is sold, the governing instrument may permit the trust to continue as a QPRT for up to two years after the sale, or the earlier expiration of the trust term. Once the trust ceases to be a QPRT, for example, upon sale or cessation of residential use, either the sale proceeds must be distributed to the term holder or the trust must be converted automatically into a GRAT, effective on the day of the sale or cessation of residential use. Grantor Retained Annuity Trusts, or GRATs. The GRAT is a trust that pays an annuity to the grantor for a specified period of time, and at the end of the period, the trust property is distributed to other designated beneficiaries, typically, the grantor's descendants. The terms of the trust must satisfy very specific requirements of code Section 2702. If you meet these requirements, the grantor will have made a completed gift upon creation of the GRAT, that qualifies for preferred valuation under 2702. You measure the value of the gift by subtracting the value of the grantor's retained annuity stream from the value of the property initially transferred to the trust. To value the annuity stream, you apply the code Section 7520 rate, which is an assumed growth rate to the trust property. The 7520 rate changes monthly and is equal to 120% of the federal midterm applicable rate. Currently in October, 2022, the rate is 4%. So what happens if you don't comply with the statute? Well, failure to comply with Section 2702 when drafting a GRAT, will result in ascribing a zero value to grantor's retained interest, resulting in the gift valued at the entire value of the transferred property. This would not be a good outcome because it would result in your client giving an unintended inflated gift to the beneficiary. The value of the property gifted to the GRAT is measured at the creation of the GRAT. However, since the property in the GRAT will not actually be received by beneficiaries until a date sometimes far in the future, that's where the planning opportunity lies. A planner can capitalize on a potential difference between the assumed growth rate used to measure the value of the gift, the 7520 rate, in effect for that month in which the trust is funded, sometimes called the hurdle rate, and the actual investment performance of the GRAT's assets, which ideally, is higher than the 7520 hurdle rate. All appreciation in excess of the hurdle rate escapes transfer taxes. This can be particularly useful for highly volatile investments. If the assets perform greatly in excess of the hurdle rate, the large growth is sheltered from transfer taxes. If on the other hand, the trust assets perform substantially below the hurdle rate, the gift will have been ineffective since the value assigned to the remainder interest will have been paid back to the grantor in satisfaction of his annuity payment. Because under this scenario, the GRAT assets simply revert to the grantor, the grantor will then be free to try again with no cost other than the transaction cost of creating the GRAT in the first place. By contrast, many other estate planning techniques cause there to be some gift tax or consumption of unified credit associated with the transfer of assets that decrease in value. Accordingly, most GRATs are structured with annuity rates high enough so that the present value of the retained annuity approximates the value of the contributed assets. Use of so-called zeroed-out GRATs minimizes the risk that gift taxes or unified credit will have been wasted on a gift or a remainder interest that will not have materialized due to asset under-performance. Zeroed-out GRATs are also sometimes referred to as Walton GRATs, named after a court case that validates establishing GRATs with a near zero taxable gift. Now, with interest rates rising recently, the advantages of GRATs have somewhat diminished. However, current code Section 7520 rates hover around 3-4%, and can still be outperformed somewhat reliably, and thus, they offer a good opportunity for making use of a GRAT. However, if rates continue to rise, they could surpass the rate of return of some of these GRAT investments, and the use of the GRAT may be less effective. When drafting a GRAT, there are a number of considerations that you and the client should take into account. For how many years should the GRAT last? If the GRAT's too short, the assets may not produce enough total return to pay the annuity and still leave enough growth to pass to the remainder beneficiaries. On the other hand, if the GRAT lasts too long, the grantor may die during the term, in which case, all or most of the assets would be includeable in a grantor's estate for estate tax purposes. Although minimum term limits for GRATs have been proposed for several years, those limitations haven't yet been enacted. Will the annuity be expressed as a dollar term, or as a percentage of the initial value of the GRAT? It's generally preferable to take the latter approach, as any increase in the deemed value of the assets will then not result in an increase in gift tax but instead, will merely result in an increased annuity obligation. Will the annuity be the same each year or will it change from year-to-year? The annuity can increase or decrease each year from the prior amount by up to 20%. This can be a useful way to back load the annuity obligation if the prospects for long-term growth are better than the prospects for short-term liquidity or production of income. Who should be the trustee? You could have the grantor be trustee, as the trust will be ignored for income tax purposes during the grantor's life, and as all or most of the value of the trust assets will be includeable in the grantor's estate if she dies during the term. You can also have a co-trustee, and it's certainly advisable to name a successor trustee, or at least provide a mechanism for the designation of a successor. The instrument should provide that upon expiration of the GRAT term, the grantor automatically ceases to be a trustee and a successor should be named in the trust agreement, or a procedure for designation of a successor trustee should be included. When is the annuity payable? The payment date can either be the anniversary of funding of the trust, or at the end of the calendar year, with the first and the final years being short years. Administratively, the anniversary date may be simpler and the current regulations even permit the payment to be up to 105 days after the anniversary date. There are additional technical requirements with GRATs, including that the GRAT prohibit distributions to anyone other than the annuitant, prohibit use of the note issued by the trust in satisfaction of the annuity, prohibit early termination accompanied by a division of the GRATs assets between the grantor and the remainder beneficiaries on an actuarial basis, and have appropriate provisions for an adjustment of annuity payments if the original value is determined incorrectly. So gifting to minors through a specific type of trust. Many individuals wanna make gifts to provide for minors, but have concerns about making outright gifts to them due to a lack of experience in handling money. As a result, the use of trusts to benefit minors has become increasingly popular. As we talked about previously, generally, transfers into trusts do not qualify for the annual exclusion because the annual exclusion is not available for gifts of future interests and property. One exception is the 2503 trust, which provides that a gift to a beneficiary under the age of 21 years is considered a gift of a present interest for the annual exclusion, if the requirements of that section are met. Central to those requirements is that the income and principle may be expended by or for the benefit of the donee before he has attained the age of 21 years, and that the balance on hand pass outright to the beneficiary at age 21, or if the donee dies before age 21, it's payable to the donee's estate or pursuant to a general power of appointment as defined in Section 2514 . It's important to note that a 2503 trust can have only one beneficiary, the minor. Section 2503 trusts have been reasonably popular because there are no restrictions on the property that may be transferred into, or the investment that be may be held by the trust. Also, even where the age of majority is less than 21, property transferred into a 2503 trust can remain in the trust until the donee is 21 years old. The catch with these trusts is that many clients are not satisfied with the requirement that the trust assets must be turned over to the beneficiary outright when she's only 21 years old. For that reason, trusts designed to qualify under Section 2503 often include a provision to the effect that the beneficiary has a right of withdrawal at age 21, but if a beneficiary doesn't demand distribution of the trust assets within a certain period of time after attaining age 21, the trust will continue until some later age, or for life, with no further opportunity for the beneficiary to demand outright distribution. Granting the beneficiary this termination power is not without its own tax consequences. If the beneficiary can terminate the trust by directing a distribution of the trust assets to herself, code Section 678 will apply and will treat the beneficiary as the grantor of the trust. Additionally, if the beneficiary opts not to terminate the trust and allows the trust to continue, code Section 2514 may apply and deem the lapse to be the release of a general power of appointment. As a result, the assets of the continuing trust may be treated as being owned by the beneficiary for both income and estate tax purposes. This may also influence whether or not the trust will be disregarded for the purposes of determining the rights of creditors of the beneficiary. Additionally, the beneficiary may have a right to revoke the trust even though the instrument says otherwise. Because of these considerations, care should be taken when determining whether to include such a termination provision in a 2503 trust. Thanks for joining us. Here's my contact information. If you have any questions on anything we've gone over, feel free to reach out to me. Mention you saw this program and I'll try to give you guidance any way I can. Thank you.

Presenter(s)

Len Garza
Principal
Garza Law

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