September 1998 Issue

Using trusts in wealth accumulation and preservation--musts for the high-net-worth individual

Answers to 20 Questions on the Use of Trusts

In Brief

The Answers Are What Count

The author has prepared 20 questions and answers on the use of trusts covering the following:

* Their formation

* Benefits and tax considerations of living trusts

* Re-titling of property to name of irrevocable trust

* Grantor trusts

* Filing requirements

* Defective trusts

* Simple and complex trusts

* Children and grandchildren as beneficiaries

* Estate taxation of living trusts

* The three testamentary trust arrangement

* B-type testamentary trusts

* Five and five power

* Life insurance trusts

* Splitting of interests

* Charitable trust options

* Wealth replacement trusts

* Out-of-state realty

By Peter A. Karl III

1. How are trusts formed?

An inter vivos or living trust is established upon the execution of a trust document. In essence, it is a contract among the following three parties:

* The creator(s) of the trust, known as the settlor(s) or grantor(s),

* An artificial entity, the trust, which is represented by a trustee (most often a natural person, though a corporation such as a bank or even a closely held corporation may also serve in this fiduciary role), and

* The beneficiary(ies), who, while not receiving legal title to the trust property, obtains an equitable interest to the assets (i.e., the right to enforce the trust in court if the trustee is in violation of the agreement). The beneficiaries can either be the present or future recipients of benefits under the contract. In many living trusts, one spouse (or both) can be the grantor(s), trustee(s), and present beneficiary(ies).

The benefits of the trust will be underutilized if a concurrent or subsequent re-titling of assets in the name of the living trust is not made. As a result, a pour-over will in conjunction with the living trust is recommended. This will directs that the decedent's assets that remain in individual name at death be transferred to the trust, which then acts as the controlling document of the testamentary plan. In addition, the will can address such areas as the designation of a guardian for minor children and the disposition of personal effects (the latter as a means of formally allocating the decedent's heirlooms not otherwise covered by a revocable trust since any anticipated dispute among beneficiaries can be resolved through probate, if necessary).

With respect to such nonprobate assets as life insurance, IRAs, and qualified plan death benefits, consideration should be given to naming the living trust as the contingent beneficiary (in conjunction with a total or partial benefit disclaimer by the surviving spouse) in order to achieve additional flexibility in post mortem trust funding (though life insurance can best be addressed through the use of an irrevocable trust--see question 14).

In comparison, a testamentary trust, using the language in a decedent's will, is initiated at death. By law, the assets vest in the trust as of the date of death. The executor of the estate is responsible for accomplishing the formality of the re-titling of assets to the name of the trustee.

2. What are the benefits of living trusts?

There are as many advantages in creating trusts as there are different types of trusts. As indicated in Exhibit 1, the primary distinguishing feature among living trusts (and corresponding benefits) is whether the document provides for the trust's revocation by the settlor/grantor.

3. What are the tax considerations in the formation of living trusts?

As illustrated in Exhibit 2, the tax consequences are also determined by whether the living trust is revocable or irrevocable. This exhibit highlights the importance of treating any transfers to an irrevocable trust as an event that has tax implications (as contrasted with transfers to a revocable trust).

4. What tax traps exist when re-titling property to the name of an irrevocable trust?

From a transfer tax perspective, the contribution of property to an irrevocable trust is considered to be a gift of a future interest ineligible for the gift tax annual exclusion (resulting in the use of the unified credit or gift tax liability) unless--

* the trust beneficiary's income interest is paid at least annually (i.e., no accumulation of income is permitted). The annual exclusion is allowed for the present actuarial value of the beneficiary's right to receive income.

* the trust is a Crummey trust, creating a present noncumulative right of withdrawal by the beneficiary for a limited period of time after the assets are contributed. This feature should be incorporated into the trust documentation along with a separate Crummey notice and waiver signed by the beneficiaries or their guardians upon each contribution to the trust. A 1991 Tax Court case, Cristofani vs. Commissioner, expanded the availability of the Crummey annual exclusions to contingent beneficiaries who would receive benefits under a trust in the event of death of the primary beneficiaries.

Elderly individuals are sometimes unaware of the income tax implications of transferring their personal residence to their children or, alternatively, to an irrevocable trust. Such individuals face the potential loss of the benefit of the IRC section 121 $500,000 gain exclusion for joint taxpayers resulting from such transfer. Similarly, the establishment of an irrevocable trust paying income only to the grantor(s) to accomplish asset protection stemming from nursing home concerns has transfer tax implications upon funding (along with the trust being subject to a 60-month look-back period under Medicaid).

5. What is a grantor trust?

A grantor trust is a trust under applicable state law that is not recognized as a separate taxable entity for income tax purposes because the grantor has not relinquished complete dominion and control over the trust. A living trust would be a grantor trust if any of its provisions include the power to revoke, and if the same individual is both grantor and trustee or co-trustee (i.e., most revocable trusts). Certain irrevocable trusts are also grantor trusts, provided that--

* the grantor or spouse can benefit from the trust income,

* the grantor or spouse has a reversionary interest worth more than five percent of the value of the trust upon its creation,

* the grantor or spouse controls when others may receive trust income and principal (unless that control is limited by ascertainable standards),

* the grantor or spouse possesses certain administrative powers that might benefit them.

At the death of the grantor, a grantor trust becomes a nongrantor trust.

6. When is a trust not required to file Form 1041 or apply for an employer identification number?

There are simplified filing requirements for revocable grantor trusts. This special rule applies to certain revocable trusts that have all assets located in the United States if--

* the same individual is both grantor and trustee (or co-trustee) of the trust and

* the individual is treated as owner of all trust assets under the grantor trust rules.

This filing exemption is available to the common living revocable trust in which one spouse (or both) act as the grantor(s) and trustee(s). The income earned by the trust is merely reported on the individual tax return of the grantor(s).

7. What is a "defective trust" and how can it be used?

An irrevocable trust can be drafted that is a grantor trust for income tax purposes (taxing the trust creator as the owner of the income) while not being taxed in the owner's estate. This "defective trust" can be the purchaser on an installment basis of a business interest or real estate from the older generation owner in order to freeze its value. This also avoids the nontax risks of a direct sale to the younger generation, such as divorce or failure to meet the grantor's personal prerequisites of ownership. In addition, current estate reduction techniques such as a family limited partnership (resulting in a valuation discount from the fractionalizing of ownership) or a self-canceling installment note (SCIN) may be used in conjunction with this type of trust to enhance its benefits.

8. What is the difference between a simple trust and a complex trust?

A simple trust, entitled to a $300 exemption on Form 1041, is one that--

* requires that all income be distributed currently and

* does not allow amounts to be paid, permanently set aside, or used in the tax year for charitable purposes.

A trust that makes a principal distribution in a given taxable year cannot be a simple trust for that year. (A trust may be labeled as a simple trust in one year, but not necessarily in the next.)

A complex trust, eligible for a $100 exemption, is one that does not meet the definition of a simple trust. An example of such a trust (in which income and principal may be distributed or accumulated at the discretion of the trustee) is a sprinkling trust. If irrevocable, this type of trust can protect beneficiaries from garnishment or attachment of their trust interests while shifting the income and estate tax burden to family members in lower marginal tax brackets. Under the 1997 tax legislation, the throw-back rules (applicable to certain distributions of income that had been accumulated in the trust) are not applicable to distributions from domestic trusts in the tax years beginning after August 5, 1997.

A simple trust becomes a complex trust in its final year when assets are distributed to the beneficiaries and no exemptions are permitted.

9. What are the considerations in establishing an irrevocable trust for the benefit of one's children or grandchildren?

An individual may be interested in creating an irrevocable trust for the benefit of minors. As an alternative to a Crummey trust, the two trusts specifically designed for minors under the Internal Revenue Code and their features are shown in Exhibit 3.

The following income tax rules apply to these trusts in 1998:

* For income retained by and taxed to the trust, the following rates apply:

$0-$1,700 15%

$1,701-$4,000 28%

$4,001-$6,100 31%

$6,101-$8,350 36%

Over $8,351 39.6%

Because of these brackets, accumulating income in trusts [such as in the 2503(c) trust] is no longer recommended.

* To the extent income is taxable to the child based upon distributions received pursuant to the terms of the trust, the rules for unearned income of a child under age 14 are applicable.

* Assets sold by the trust within two years of receipt will have their gain taxed to the donor of the property.

Business owners may want to consider funding these trusts for minors with assets to be used in the business (e.g., equipment and/or realty that can then be leased from the irrevocable trust) or loaned to the business (i.e., from cash previously gifted to the trust).

10. When will a living trust be reportable for estate tax purposes?

While a living trust will not be in the probate estate of a decedent, it will be reportable for estate tax purposes if--

* it is a revocable trust, or

* it is an irrevocable trust where the grantor retains certain rights in the trust (such as retention of life income/benefit, disposition rights of income or principal, or trustee appointment).

11. What is a three testamentary trust arrangement (A-B-Q)?

The A share would be the portion qualifying for the marital deduction. This share (which alternatively may be in the form of an outright distribution to the surviving spouse) can provide for income to be distributed to the spouse along with an unlimited power of invasion over the principal.

The B share, (generically referred to as the unified credit bypass shelter trust), is funded to the amount of the exemption equivalent of the Federal unified credit ($625,000 in 1998). This trust can provide for mandatory or discretionary income distributions to the surviving spouse or any other beneficiary(ies); limited distributions of principal to the surviving spouse are available. In effect, this B trust is an "artificial nonspouse," ineligible for the marital deduction while forcing qualification for the Unified Credit. A popular version of the B trust is the sprinkling (life benefit) trust. The latter may be particularly useful when one spouse has a large estate and does not want any assets from the first spouse's estate. Alternatively, there may be a desire to insulate the assets of the first spouse to die from creditors of the surviving spouse (e.g., nursing homes, Medicaid). This concern will dictate the need for a revision in current plans involving smaller estates, particularly when wills exist that merely direct the assets of one spouse to the other.

The Q portion is the amount set aside for the QTIP Trust (qualifying terminable interest trust). The advantage of this type of optional testamentary trust is the availability of the marital deduction for assets placed in the trust even though the surviving spouse (who must receive all the income from the trust) may not currently or ever receive any principal distributions. This vehicle is particularly appropriate in instances of second marriages to preserve the principal upon the death of the surviving spouse for the benefit of children from the first marriage.

12. What language is needed in the "B-type" testamentary trust to prevent it from being included in the taxable estate of the surviving spouse?

Under regulations to IRC section 2041, the language of the trust regarding the availability of principal invasion for the benefit of the surviving spouse must be limited to an ascertainable standard. To meet this standard, the four key words under the regulations are "health," "education," "support," and "maintenance." More liberal wording (such as "comfort," "welfare," and "happiness") could result in the trust being challenged by the IRS.

13. What is meant by a five-and-five power in a testamentary trust?

A five-and-five power is used in a B-type trust to allow the surviving spouse additional flexibility to have an absolute right to demand a limited amount of principal from the trust without taxation in the second estate. The maximum amount that can be demanded in any year under this provision is the greater of $5,000 or five percent of the value of the trust principal.

14. What are the benefits of establishing a life insurance trust?

The use of a life insurance trust is a common technique to reduce the estate of an individual purchasing life insurance when the estate of the insured is not named as beneficiary. Alternatively, an existing policy may be transferred through the use of an irrevocable policy assignment (subject to the three-year-in-contemplation-of-death rules still applicable to insurance policy transfers).

Preferably, an irrevocable living trust is established naming the trust as the applicant/owner, premium payor, and beneficiary of the new policy. The terms of this trust are normally patterned after the B-type trust (i.e., allowing the surviving spouse income and limited principal invasion with remainder to the children). Too often, individuals retain ownership of an insurance policy payable to a beneficiary other than the estate, causing unneeded inclusion of the life insurance proceeds in the estate (consuming all or a portion of the unified credit). In other situations, the insurance is payable to the surviving spouse, compounding the tax liability in the second estate. The life insurance trust, if properly structured, will avoid Federal taxation of the insurance proceeds in the estates of both spouses. In addition, through the use of a Crummey feature, the premiums can be paid by annual gifts to the trust with nominal gift tax consequences.

15. How can a life insurance trust be used in the transfer of an interest in a closely held corporation to family members?

Upon the death of the stockholder, the trust, as beneficiary of the proceeds, would purchase the stock from the estate, providing liquidity to the surviving family. The stock would then be held pursuant to the terms of the trust until such time as various prerequisites for the outright distribution of the stock were satisfied (e.g., age or years of service of certain family members). The existence of a buy/sell agreement and restricted stock should also be incorporated into the plan.

16. How can the concept of splitting the interest of an asset be incorporated into trusts?

Using the theory that an asset can be separated into two components, a life (or term certain period) interest and a death (or other remainder) interest, noncharitable and charitable split interest trusts are current tax planning tools with their distinguishing features and benefits outlined in Exhibit 4.

17. What charitable trust option exists when income is not currently needed?

A third type of charitable trust not described in Exhibit 4, the Charitable Lead Trust (CLT), is the opposite of the two charitable remainder trusts (the CRAT and CRUT). With a CLT, the charity is the income beneficiary of either a fixed payment or fixed percentage of the value of the trust's assets with the creator or other noncharitable beneficiary as the recipient of the trust assets upon the expiration of the trust term. The value of the income tax deduction is based on the income interest being donated to charity. The CLT might be used when the settlor/grantor wishes to obtain a partial tax deduction for the managed growth of the trust property during a period of time prior to the need for such assets (e.g., before retirement or a child/grandchild entering college).

18. How may a charitable remainder trust be used as an alternative to an IRC section 1031 exchange?

Prior to the execution of a contract to sell highly appreciated realty that has been held for investment or business purposes or an operating business, an individual may want to consider donating this property to a newly created charitable remainder trust (CRAT or CRUT) that will then become the seller of the property, avoiding the capital gains being taxed to the individual. The trust will subsequently pay an income for the life of the original owner (and/or spouse) based upon the pre-tax value of the donated property. This income stream is usually higher than would be obtained by the client re-investing the after tax sale proceeds in a certificate of deposit.

19. What is meant by a wealth replacement trust?

A wealth replacement trust is used in conjunction with a charitable remainder trust, since the latter does not provide any benefit of the trust principal to family members (i.e., the remainder is directed to charity). As a result, the life insurance industry developed the concept of having a portion of the income tax savings obtained from the charitable remainder trust applied toward the purchase of life insurance held by a separate trust as owner and beneficiary of a policy insuring the grantor. This entity is patterned after the life insurance trust described earlier. Upon death of the insured, the insurance proceeds held by the trust are used to replace the wealth to the family that has been lost to charity. Alternatively, a second-to-die life policy could be utilized if there are co-grantors.

20. Why is an individual who owns out-of-state realty a prime candidate for the use of a living trust?

From a legal perspective, the expense and delay involved in an out-of-state ancillary probate proceeding can be avoided with a living trust. From a tax perspective, there may be a conversion of the real property interest into intangible personal property (i.e., the trust's beneficial interest), depending on state law. The latter could have state income and estate tax benefits for a nonresident taxpayer.

There is an additional benefit in some states to funding a separate trust solely with realty. In certain states, such as Illinois, the concept of a land trust has been created by statute. This trust is one in which the beneficiary is able to transfer the beneficial ownership of the trust by the mere assignment of a certificate of beneficial interest. While other states rely on judicial doctrine for the land trust theory, many do not permit the transfer of the beneficiary's interest by this certificate assignment method. *

Peter A. Karl III, JD, CPA, is with the law firm of Paravati, Karl, Green & DeBella in Utica, N.Y., and an associate professor with the State University of New York-Institute of Technology (Utica-Rome).

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