The
information provided here is for informational purposes only. It is
not,
nor is it intended to be, legal advice.
You should consult an attorney for
individual advice regarding your own situation.
This article describes how an
irrevocable trust can be useful in achieving your estate planning
goals, and the drawbacks of such trusts. Fortunately, or unfortunately,
there are many types of irrevocable trusts and they are used for
many purposes. For ease of discussion, I will group them into two
classes, which I will call "permanent" trusts and "split interest"
trusts.
Permanent trusts are designed
for the prolonged management of permanently and irrevocably transferred
assets. The objectives of this type of trust include:
Immediate removal of
the transferred property from
the settlor's (the person who sets up the trust) estate for
estate tax purposes, often accomplished at the cost of
making a gift for gift tax purposes.
Elimination of income
generated by trust assets from the settlor's income for income
tax purposes. Trusts for minors and life insurance trusts, which
I will discuss further below, are specialized forms of permanent
trusts.
Split
Interest Trusts Split
interest trusts are established to provide income to one set of
beneficiaries for a set time, then pay out to another set of beneficiaries.
For example, charitable remainder trusts are designed to provide
benefits to named individuals, such as the settlor's family, for
a specified period of time, with the remainder interest passing
to charity.
The objectives of this type of trust
include: removing the transferred
assets from the settlor's estate for estate tax purposes, and
receiving a charitable
deduction on the settlor's income tax return.
Another
class of split interest irrevocable trusts, known as grantor retained
income trusts, is designed to minimize taxes by incurring a gift
tax only for the remainder interest which follows a settlor's retained
interest. If this sounds obtuse, you can read more about
GRITs below.
Let
me now describe for you in brief three or four of such techniques
which you may want to consider. Please note that a complete
analysis of each technique is impractical here, but I will be
happy to answer any questions you may have about any of them
that interest you.
The principal advantage of using
an inter vivos (living) irrevocable life insurance trust ("ILIT")
is that it may keep the life insurance policy proceeds from being
taxed as part of the estates of both the insured and the insured's
spouse, while allowing the insured's surviving spouse to enjoy the
benefits of the proceeds as a trust beneficiary. The surviving spouse
may be entitled to all or a portion of the income and/or the insurance
policy proceeds, in the discretion of a trustee other than the spouse,
without causing the proceeds to form part of the surviving spouse's
gross estate. The surviving spouse also may have the right to demand
some of the proceeds for his or her support, maintenance, education,
and health, limited by an ascertainable standard.
Alternatively, the surviving spouse
may be given the power to demand the greater of $5,000 or 5% of
the value of the trust each calendar year, without subjecting any
portion of the insurance proceeds to tax in the survivor's estate,
except for the portion subject to the withdrawal power in the year
of the survivor's death.
Potential advantages include:
Estate tax savings.
The life insurance proceeds
may not be subject to the claims of creditors under applicable
law.
The trust arrangement
may provide significant protection from the claims of the insured's
spouse. For example, having the insurance proceeds payable to
a trust may protect the proceeds from any state law elective
share right of a surviving spouse; such an elective share right,
if exercised, could potentially inflict substantial damage to
the carefully crafted estate plan.
A trust provides a flexible
tool for the management and distribution of assets. It provides
a "ready-made" asset management vehicle which may be crafted
as flexibly as the settlor designs the arrangement.
The goals
for which the insurance was acquired may be advanced by the
ownership and receipt of the insurance proceeds by a trust.
For example, if the insurance proceeds are to provide liquidity
for the insured's estate for the payment of debts, expenses
of administration, and taxes, then this goal generally can be
achieved by authorizing the trustee to purchase assets from
or make loans to the insured's estate or the beneficiaries.
Moreover, this goal may be more easily accomplished by trust
ownership of the policy because the proceeds may not be subject
to estate tax.
Thus, there are circumstances under
which the ownership of a life insurance policy by an irrevocable
trust, instead of individually, is more beneficial. The tax savings
of excluding, for example, $500,000 of life insurance proceeds from
the estate of the second to die could be as much as $245,000. Although
the ILIT provides this significant estate tax savings opportunity,
it presents some distinct drawbacks.
Disadvantages include:
The insured's loss of
control over the policy, including the right to borrow against
or otherwise use the cash value of the policy, to designate
settlement options, and to change beneficiaries of the policy.
This loss of control can be significant, both psychologically
and economically.
The settlor cannot alter
or amend the trust beneficiary designations. However, appropriate
drafting of the trust instrument can reduce the impact of these
drawbacks.
Costs associated with
drafting and funding the ILIT. Besides the legal costs, if a
professional trustee is selected, there will be trustee's fees.
A charitable remainder trust ("CRT") is an irrevocable trust that
pays the settlor, the settlor's spouse or children, an annual income
for a period of years or for life. The annual income can be in the
form of either an annuity, i.e., a fixed sum annually, or a unitrust
amount, which is a fixed percentage of the trust assets valued annually.
Thus, the two flavors of charitable remainder trust are the charitable
remainder annuity trust ("CRAT") and the charitable remainder unitrust
("CRUT"). The remaining property goes to the charity of the settlor's
choice at the end of the trust term and the settlor receives a charitable
deduction.
The advantages of the CRT are
as follows:
Appreciated assets can
be sold by the trust, reinvesting the proceeds, while avoiding
capital gains tax.
The settlor receives
an income stream for a term of years or for life.
The settlor claims a charitable
deduction on his/her income tax return.
The contributed assets
are removed from the settlor's estate, so there is no estate
tax liability on such assets; lifetime unified estate/gift tax
exemption is not reduced.
A CRUT can also be used to provide
for the settlor's retirement needs. Because a CRUT may be structured
to pay the lesser of the fixed percentage of the trust assets valued
annually or the annual income of the trust, a choice of investments
can add to its usefulness. In its initial years - the settlor's
preretirement years - the trust invests in high-growth, low-income
assets. On the settlor's retirement, the trustee can convert the
trust assets to high-income investments to provide the settlor with
income. During the early stage, the trust presumably earns little
or no income and there is little or no required payout. At retirement,
a "make-up" provision in the CRUT allows the trustee to pay out
additional amounts of the trust's income (in years when the income
exceeds the fixed percentage) to "make up" for the early low-income,
pre-retirement years when the fixed percentage was not distributed.
Additionally, a CRT can be combined
with an ILIT to provide estate tax-free wealth replacement. That
is, through a combination of income tax savings and increased cash
flow from the CRT, the settlor can fund an ILIT with additional
premiums. The additional premiums can purchase additional life insurance,
which will partially or possibly even entirely offset the heirs'
loss of the principal given to the charity.
A grantor retained income trust,
or "GRIT," is an irrevocable trust to which the settlor (i.e., "grantor")
transfers assets while retaining an income interest for a term of
years selected by the settlor. Upon expiration of the term, the
trust usually terminates and the remaining balance of the assets
transferred to the trust, including any undistributed income and
appreciation, is distributed to third parties selected by the settlor,
usually his or her children, called remainder beneficiaries.
A GRIT is used to reduce gift taxes
on the transfer of assets to the next generation. It is best used
with highly appreciating assets, including closely-held stock. The
value of the gift is determined when the trust is funded, so any
appreciation of the assets passes gift tax-free to the remainder
beneficiaries. However, the funding of the GRIT is a taxable gift
by the settlor to the remainder beneficiaries; the amount of the
gift is determined by reference to IRS actuarial tables that fluctuate
monthly depending upon the prevailing federal interest rates.
The principal advantages of a GRIT
include:
Appreciation of the assets
is moved out of the estate and avoids gift tax.
Compared with a direct
gift, transfer costs (i.e., gift tax) are greatly reduced, because
a taxable gift is made only to the extent that the value of
the assets at the time of the transfer exceeds the actuarial
value of the retained income interest.
Compared with a direct
gift, the settlor maintains control of the assets for a longer
period.
The settlor retains some
or all of the income from the transferred assets for the term
of the GRIT.
So long as the settlor
survives the term of the GRIT, the assets used to fund the GRIT
are not taxed in the settlor's estate on his/her subsequent
death.
Three cautions
apply to a GRIT, however.
1.
First, if the settlor
dies during the trust term, all or most of the trust assets
would be includable in the settlor's estate, thus failing to
achieve the benefits of the transaction while incurring the
transaction costs. The trust term must be carefully selected
to provide a great likelihood that the settlor will outlive
the term of the trust.
2.
This leads to the second
caution, which is that the settlor will (or should) lose the
economic benefit of the assets during his or her remaining lifetime.
3.
Furthermore, the transaction
will not provide a benefit if the assets do not outperform the
IRS discount rate, currently about 5%.
To comply with IRS valuation
rules, most GRITs are either grantor retained annuity trusts ("GRATs")
or grantor retained unitrusts ("GRUTs"). A GRAT is a GRIT
where the settlor's retained interest takes the form of an annuity;
that is, the settlor retains a fixed right to an annuity payment,
to be made at least annually, based on the value of the trust at
its inception. With a GRUT, the settlor retains a right to a unitrust
payment, to be made at least annually, based on a fixed percentage
of the value of the trust property, revalued annually. As
a result, when the settlor creates a GRAT, the annuity amount will
be ascertainable for the entire term of the trust, while for a GRUT
the unitrust payment will vary based on the fluctuating value of
the trust assets.
A Qualified Personal Residence Trust
("QPRT") is a type of GRIT which provides an opportunity for significant
estate and gift tax savings for taxpayers with substantial equity
in their principal residences and vacation homes. The settlor transfers
his or her personal residence to the QPRT, which is an irrevocable
trust, retaining the exclusive use of the residence for a term of
years selected by the settlor. If the settlor survives the term
of the trust, the QPRT terminates and the residence is either retained
in further trust for, or distributed to, one or more third party
beneficiaries selected by the settlor, such as the settlor's children
or grandchildren.
The QPRT has no income tax consequences
during the term of the trust. The settlor may still use the principal
residence capital gain exclusion and deduct mortgage interest and
property taxes. Transferring the property to the trust will not
trigger a property tax reassessment, although the termination of
the settlor's retained interest would trigger a reassessment unless
the parent-child transfer exclusion applies. During the term of
the trust, the settlor may sell the house and purchase a replacement
residence. If the residence sold is not replaced, the QPRT pays
an annuity to the settlor.
The "catch" is that after the term
of the trust, the settlor will no longer have the right to live
in the residence. At this point, the settlor could lease the residence
for fair rental value from the beneficiaries. However, the IRS will
closely scrutinize such a leaseback transaction. It may contest
the validity of the QPRT if the settlor leases the residence upon
expiration of the term of the trust and pays less than fair rent,
and seek to include the property in the settlor's taxable estate
at his or her subsequent death.
The principal advantages of a QPRT
are as follows:
Appreciation of the residence's
value is moved out of the estate and avoids gift tax.
Compared with a direct
gift, transfer costs (i.e., gift tax) are greatly reduced, because
a taxable gift is made only to the extent that the value of
the residence at the time of the transfer exceeds the actuarial
value of the retained income interest plus the value of the
contingent reversion.
The settlor retains the
right to use the residence for the term of the QPRT.
So long as the settlor
survives the term of the QPRT, the value of the residence is
not taxed in the settlor's estate on his/her subsequent death.
Three cautions apply to a QPRT,
however.
1.
If the settlor dies during
the trust term, the full value of the residence would be includable
in the settlor's estate, thus failing to achieve the benefits
of the transaction while incurring the transaction costs. The
trust term must be carefully selected to provide a great likelihood
that the settlor will outlive the term of the trust.
2.
This leads to the second
caution, which is that the settlor will (or should) lose the
right to use his or her home during his or her remaining lifetime.
3.
Furthermore, any mortgage
principal payments made by the settlor during the term of the
trust, and the value of any improvements made to the residence
during the trust term, would be treated as additional taxable
gifts to the beneficiaries. Therefore, the settlor should pay
off any encumbrances before transferring property to a QPRT,
if feasible.
This article is intended
to give you enough information to decide which of these estate planning
tools might be appropriate, and which are definitely not. We can
then discuss further how the ones in which you remain interested
may be tailored to meet your goals.