by Layne T. Rushforth
Irrevocable Trusts - Generally: There are a number of types of irrevocable trusts that can be used to make gifts to other persons with the assets under the control and management of a trustee.
Gifts to an irrevocable trust are sometimes motivated by a desire to minimize federal transfer taxes or to shelter assets from the claims of future creditors and other claimants (including spouses in divorce cases and plaintiffs in civil lawsuits).
To be effective for estate-reduction purposes, the trust must be irrevocable, and the trust's settlor should not be a beneficiary of the trust. It is also best if the settlor is not a trustee, either.
In order to qualify for the $14,000 annual exclusion for gift-tax purposes, irrevocable trusts usually contain a provision giving the trust's beneficiaries a temporary right to withdraw annual contributions, at least in part. This withdrawal right is often called a "Crummey power" in reference to a Ninth Circuit Federal Court case involving a family with the "Crummey" surname.
Minors' Trusts: A trust can be established for younger beneficiaries to provide for education and/or other needs of life. Federal tax law has facilitated the creation of trusts for beneficiaries under the age of 21 years, but trusts can be designed to continue until any age or during a beneficiary's entire lifetime.
Bypass and Spendthrift Trusts: A "bypass trust" is a trust that benefits one or more beneficiaries without being considered assets of those beneficiaries for estate and gift tax purposes. Under state law, a bypass trust can be designed to also qualify as a "spendthrift trust", which cannot be attacked by a beneficiary's creditors. In short, this type of trust can reduce the beneficiaries' estate taxes and protect trust assets from creditors' claims at the same time.
Supplemental Needs Trusts: If an intended beneficiary is a recipient of Medicaid, SSI, or other governmental assistance programs, an outright gift or a gift in trust may disqualify the beneficiary from continuing to receive such assistance. Trusts can be designed so that distributions are made only to "supplement" the benefits already being received. So long as distributions made by the trustee are discretionary and not mandatory, the trust assets and trust distributions are not, under most programs, considered disqualifying resources. Supplemental needs trusts are another form of a spendthrift trust specifically designed so that the trust assets are not counted as the beneficiary's assets for purposes of determining eligibility for benefits under assistance programs.
Specialized Trusts: Irrevocable trusts can be designed in an infinite number of ways. There are some very special types of irrevocable trusts that have evolved over the years as basic estate planning tools, including irrevocable life insurance trusts (ILITs) and charitable trusts (CRTs and CLTs). Other irrevocable trusts are relatively new, having been developed recently to replace types of trusts that are not longer permitted by law and to maximize the benefits under current transfer-tax laws.
Insurance and Irrevocable Insurance Trusts
Insurance Generally: The proceeds of life insurance policies are included in the insured's estate at his or her death if the insured had "an incident of ownership" in the policy within three years of death. Estate taxation can be escaped by having someone other than the deceased own the policy and all of its attendant rights.
Ownership by Spouse: Years ago, when the marital deduction was limited, there was some advantage in having the spouse own the policy. This does not accomplish much under current law, and to the extent the spouse is a beneficiary, taxes will be deferred until the spouse's subsequent death. This defers but does not eliminate the estate tax problem.
Ownership by Children: Ownership by children or other family members can eliminate the estate tax, but it may also defeat some nontax objectives (such as spendthrift protection) and some tax objectives (such as generation-skipping). The primary problem is loss of control with respect to the use and application of the insurance proceeds. Untimely deaths, lawsuits and other creditors' claims, and even divorces can make the insurance proceeds unavailable for their intended purposes.
Irrevocable Life Insurance Trust (ILIT): An irrevocable trust can be made the owner and beneficiary of all life insurance, removing the proceeds from the estate of the insured and the insured's spouse.
The insured's spouse can even be a beneficiary of the trust so long as contributions to the trust come from the insured's separate property and other strict formalities are followed.
Gifts of cash sufficient to pay policy premiums will usually be covered by the $11,000 annual exclusion for gift-tax purposes if the insurance trust contains the appropriate provision giving the trust's beneficiaries a "Crummey power", which is a right to withdraw trust contributions for a brief period of time, usually 30 days.
Since the policy will mushroom in value at death, the irrevocable insurance trust will exclude much more value from the taxable estate than the cumulative value of the annual-exclusion gifts.
Trusts are created to provide for the management of trust assets until those assets are distributed. Trusts inherently involve a deferral of distributions, usually until the death of the trust's settlor (creator), until a beneficiary reaches a particular age, or until some other identifiable event occurs. A "generation-skipping trust" is a trust that continues more than one generation. It is usually designed as a "bypass trust" for estate tax purposes so that the taxation of assets skips a generation.
Generation-Skipping Transfer Tax: Years ago, Congress decided that generation skipping was reducing the amount of estate tax collected, and it imposed the federal generation-skipping transfer tax ("GST Tax"). Unlike other transfer taxes, for the GST Tax, there is not a range of graduated tax brackets. The GST Tax is imposed at the highest estate tax bracket (48% in 2004).
The GST Tax is imposed on transfers to grandchildren and lower generations, who are referred to in the law as "skip persons".
Gifts (other than gifts in trust) that qualify for the $14,000 annual gift tax exclusion are also excluded for GST Tax purposes.
In 2013, there is a "GST exemption" of $5,250,000 that each transferor has. Like the "unified credit" for gift and estate tax purposes, the GST exemption can be applied either during life or at death. The "applicable exclusion" for gift tax purposes is fixed at the same amount.
Once the exemption has been exhausted, the GST Tax applies in addition to any applicable gift or estate tax.
Bypass Trusts / "Generation-Skipping" Trusts: The GST exemption amount can be placed in a "bypass trust" that allows beneficiaries from the children's generation to receive the income from and use of trust assets without having those assets included in their estates. This is exactly like the "credit-shelter" trust established for the benefit of a surviving spouse with the assets of the predeceased spouse. The beneficiaries can have the following rights and privileges without having the trust's assets included in their estates:
Income. The beneficiary may receive all trust income.
Principal. The beneficiary may receive trust distributions in the trustee's discretion.
"5 or 5 Power". The beneficiary may have the noncumulative right to withdraw up to 5% (or $5,000, if greater) of the trust each year. This power is not usually included if the beneficiary has a taxable estate because if the beneficiary dies holding this power, the amount over which the power could have been exercised will be included in the beneficiary's taxable estate.
Power of Appointment. The beneficiary may have the power to direct distributions from the trust either during life or at death or both so long as the beneficiary cannot exercise the power in favor of himself/herself, his/her creditors, his/her estate, or the creditors of his/her estate.
Trustee. The beneficiary can be the trustee so long as the trustee's discretion to make distribution is limited to amounts appropriate for the beneficiary's "health, education, support, and maintenance."
Dynasty Trusts: Many generation-skipping trusts are designed to primarily benefit the settlor's grandchildren, but some generation-skipping trusts are designed to last for several generations. The laws of most states require that a trust terminate at the end of 90 years or 21 years after the death of all those living at the time the trust became irrevocable. Under Nevada law, a trust can endure for 365 years. That maximum period is imposed by the "rule against perpetuities", which is a law that has existed for centuries to prevent perpetual trusts. Some states have abolished the rule against perpetuities, and in those states, trusts can theoretically last forever. It its regulations relating to the GST Tax, the IRS has indicated that it will not be bound by the states' rule-against-perpetuities laws, and that a transfer after the "perpetuities period" (as defined by the IRS) will trigger the imposition of the GST Tax.
A dynasty trust can allow trust assets to be managed for the benefit of the settlor's family for approximately three generations. If the trust is drafted appropriately AND the settlor allocates his or her GST exemption to transfers to the trust, there can be no estate, gift, or generation-skipping transfer tax imposed as long as the trust lasts.
A dynasty trust will usually discourage the expenditure of trust principal, but it will allow beneficiaries to use trust assets. For example, a shared family mountain cabin or condominium or other vacation property could be held in this trust for several generations.
Because a dynasty is an irrevocable trust, it also can be a spendthrift trust that is exempt from the claims of the beneficiaries' creditors.
Grantor Trusts"Grantor Trusts" are not so much a type of trust as they are an income tax classification. A trust is considered a "grantor trust" if the settlor (grantor, trustor, trust creator) has certain powers over the trust or if others have too many powers over the trust that might be exercised in favor of the settlor. All taxable income that is paid to a grantor trust will be taxed to the trust's settlor as if the settlor owned the income-producing assets.
Revocable Trusts: Revocable trusts are always grantor trusts, but irrevocable trusts are usually designed not to be grantor trusts.
Irrevocable Trusts: Because an irrevocable trust is usually designed not to be a grantor trust for income tax purposes, an irrevocable trust that is a grantor trust is sometimes thought to be "defective", and so it is sometimes called a "defective grantor trust" ("DGT") or an "intentionally defective grantor trust" ("IDGT"). Because of the benefits discussed below, some irrevocable trusts are designed to be grantor trusts, which makes them "intentionally defective". Such trusts are designed to be grantor trusts for income tax purposes but excluded from the grantor's estate for estate tax purposes.
Paying the Tax: For many irrevocable trusts, the main purpose is to make a gift of property to the trust's beneficiaries in order to shift the income, appreciation, and value of the property away from the trust's settlor in order to reduce the settlor's estate tax liability at his or her death. A grantor trust requires that the grantor pay all of the trust's tax, which is yet another way of reducing the settlor's estate. Because the payment of the tax is required by law, it is not considered a gift. Thus, some estate planning practitioners design their trusts as grantor trusts to take advantage of this ability to give the trust's beneficiaries yet another benefit. Most grantor trusts are designed so that the trustee's powers and the trust's administrative provisions that cause the trust to be a grantor trust can be cancelled.
Transactions with a Grantor Trust: Any transaction between the grantor trust and the grantor is treated for income tax purposes as having no tax consequences. One use of that trust is for business-succession planning, which is discussed in the article on business entities.
S Corporation Stock
An irrevocable trust can be designed to hold S corporation* stock in one of three ways: (a) as a grantor trust; (b) as a qualified subchapter S trust ("QSST"); or (c) as an electing small business trust ("ESBT"). While the trust's settlor (creator) is alive, the easiest method is usually to have the trust qualify as a grantor trust. Even if an irrevocable trust is originally designed to hold assets other than stock in an S corporation, it is wise to give the trustee authority (and perhaps the directive) to make the trust qualify as either a QSST or an ESBT.
*[NOTE: An "S corporation" is a domestic corporation that has filed a special tax election with the Internal Revenue Service to be tax under "Subchapter S" of the income tax laws. An S corporation usually pays no tax, and its shareholders are taxed somewhat like partners. In the absence of an election to be an S corporation, corporations are taxed under Subchapter C, so corporations that are not S corporations are sometimes called "C corporations", although you will not find that term in the Internal Revenue Code.]
Other Irrevocable Trusts
Charitable trusts are discussed in the article entitled (believe it or not) "Charitable Trusts".
Grantor-retained income trusts (GRITs), such as the grantor-retained annuity trust (GRAT) and the qualified personal residence trust (QPRT) are discussed in the article entitled "Estate Freezing Techniques".
Asset-protection trusts--including offshore trusts--are discussed in the article entitled "Asset Protection".
The Nevada Nongrantor Incomplete Gift Trust or "NING" is discussed in a memo entitled "The NING", which is in PDF format. This trust is not designed to save federal transfer taxes, but is used by persons living in a state with high personal income tax rates to eliminate or reduce the that tax.
These materials continue in the article entitled "Charitable Trusts".