The voluminous discussions during the conferences at the 46th Annual Heckerling Institute on Estate Planning held in January 2012 in Orlando, Fla. are a lot to digest. To make it easier, we’ve summarized in a series of articles some of the ideas culled from the many programs and organized them topically. Part III of this series (the final part) focuses on general trust drafting, qualified personal residence trusts, grantor trusts, valuations and probate planning considerations.
General Trust Drafting and Planning
1. Trusts and the reciprocal trust doctrine. Often, you can transform a trust under the terms in the trust document. If a client and his spouse set up trusts for each other that were similar, the Internal Revenue Service might argue trusts should be unraveled and treated as if each spouse had set up his own trust. The theory the IRS would advance to attack a two trust plan is the reciprocal trust doctrine. If both spouses were trustees of the other’s trust, they might each resign and, if both live three years, that might solve part of the problem. In some states, like New York and New Jersey, state law permits the amendment of an irrevocable trust. If the grantor is alive and all the parties to the trust contract agree, they can change the terms. For example, they can add a special or limited power of appointment to one of the trusts and not the other. That addition may prevent the two trusts from being deemed reciprocal.
2. Irrevocable trust can be flexible. Consider the following example. Husband, to use up part of his $5.12 million exclusion, transfers 45 percent of a family business into a trust for the benefit of Wife and their descendants. This could be the same receptacle as used for life insurance on Husband’s life. The distributions from the business held in the trust could fund insurance premiums without the need for Crummey powers (which so often aren’t properly issued). This approach could retain much of the wealth in a manner that’s reachable by the family. If one or both spouses work in the closely held business, they can each still earn reasonable compensation. If only Husband is working in the business, and the couple is living on his salary, at his death his salary stops. Wife’s cash flow needs might adequately be addressed after Husband's death from S corporation distributions. There’s often more flexibility possible with irrevocable trusts than many skittish taxpayers realize.
3. BDITs and Crummey powers. If the client is an entrepreneur, recommend that she not own her next start-up entity. Why have a start up that will be subject to taxation if it’s successful? Some clients might transfer a newfound business to a trust for their children (grandchildren). But, they can do better. If the client, as the parent of the entrepreneurial child, set up an irrevocable trust with $5,000, giving the child a Crummey power (the right to withdraw to qualify for the annual exclusion and grantor trust status), the trust could be grantor as to the child. The child could then sell equity interests in the start up to this trust. This is a beneficiary defective trust (BDIT) as to the child, and the child is the grantor of the trust for income tax purposes. When structuring the trust, the parent should have an attorney arrange to maintain assets in this trust for the duration of the child’s life, to avoid estate tax and minimize any marital issues.
4. Special needs beneficiary and Crummey powers. If a client has a disabled grandchild with special needs, it’s a common recommendation to set up a third party special needs trust (SNT) under the grandparent’s will to help care for the grandchild. Instead, advise the grandparent/client to establish the SNT while the client is alive (an inter vivos trust), so it’s something that’s more tangible for clients and their families to understand. This isn’t only about the legal benefits of the trust, but the emotional impact that having the trust in force provides. An inter vivos trust will help the family better understand what was done. Also, an inter vivos trust could serve as a receptacle for any family member that wants to help the special grandchild by providing a safe receptacle for financial gifts. Practitioners should caution well-meaning family members not to give funds outright to the special needs grandchild, as that might undermine qualification for important aid or programs. Practitioners should also be careful not to casually include a Crummey power in the trust, since it could affect the special beneficiary’s qualification for government programs.
5. Trust termination costs. Negotiate termination fees with an institutional trustee when you’re assisting a client in setting up the trust. Be sure the exit strategy and cost is clear. Some institutions charge costly back end fees to terminate a trust. That may be avoidable by negotiating before the institution begins to serve.
6. GST sunset and trust planning. When planning a dynastic trust, consider one trust for $1.39 million, the $1 million inflation adjusted generation-skipping transfer (GST) amount, and a second trust for the excess of the current 2012 $5,12 million GST tax exemption amount over $1.39 million. If the GST rules sunset in 2013, this might provide greater GST certainty. Don’t create the trusts simultaneously, in case there’s an ordering rule. The client could contribute the balance of his GST exemption to a direct skip trust (no non-skip beneficiaries, like the children, are included as beneficiaries). This could be consummated in 2012, while there’s no issue. Then, the so-called “move down rule” should lock in the client’s GST exemption.1 Even if the GST rules sunset after 2012, the GST event happened in the year before sunset. Importantly, if sunset happens, the grandchildren beneficiaries of that trust aren’t skip people for future years, because of application of the move down rule.
7. Protecting trust protectors and other fiduciaries. The common way to designate a trust protector or certain other advisors is to name an individual to serve in that capacity. There may be a better approach. Consider forming a special purpose entity, like a limited liability company (LLC), which will provide all directions to the trustee (for example, the institutional trustee of a directed dynasty trust). The trust protector, investment advisor and distribution committee can all be part of the LLC. This may create a barrier to provide some protection for these people. Since the people assuming these roles are often friends or family, clients may wish to provide whatever protection they can afford them.
8. State taxation of trusts. If a client intends to name a trustee or trust protectors, he should consider where that trustee or trust protector resides first. The laws of that fiduciary’s state of residence might create the risk that the service of the trustee or trust protector, in what might be a fiduciary capacity, in that state could taint your trust as taxable in that state.
9. Trust protector duties. When you use a trust protector, consider that they may have fiduciary duties. There’s significant disagreement as to whether, absent an express provision in state law or the governing document, protectors are fiduciaries. Can they be blindsided for not reviewing the acts of the trustee? Can they collect fees for their services?
1. Skip the qualified personal residence trust– go directly to the grantor trust. With interest rates at an all-time low, the discount with respect to the retained interest is less substantial than ever on the gift of a house to a QPRT. Consider the direct transfer of the residence or, preferably, fractional interests in the residence, directly to a grantor trust for the benefit of the beneficiary instead of establishing a QPRT. The requirement to survive the term of the QPRT disappears; the client still obtains the benefit of freezing low values for gift purposes and securing fractional interest discounts. Rent payments can be made immediately, thereby further decreasing the value of the estate. All this can be accomplished without income taxes when paid to a grantor trust.
2. Defective QPRT survives IRS challenge. In a recent bad fact QPRT case, the taxpayer won a surprising victory. The facts, greatly simplified, are as follows: Mom set up a three year QPRT. At end of the QPRT term, Mom should have moved out or paid rent to her children, who were owners of remainder interest. The children said Mom intended to pay rent, but just hadn’t gotten around to signing a lease or actually paying rent. Mom died before year-end. Mom had even paid house expenses post QPRT termination. Somehow, the court upheld the QPRT.2 This result was fortunate for the taxpayer, but others shouldn’t rely on this type of luck when planning how to handle a QPRT or any other transaction.
3. Fractionalize the QPRT. Fractional interests in real estate are entitled to discounts. A husband and wife can each transfer an interest, for example 50 percent each, in a residence to a QPRT. The fractional interest will apply to each interest, further lowering the value of the gift. Unmarried individuals can transfer fractional interests by creating two QPRTs, perhaps each one for the benefit of a different child or QPRTs with different year terms for the benefit of the same child.
4. QPRT with a grantor trust as a remainder. With real estate values at an all-time low, the funding of a QPRT affords terrific estate-planning opportunities, despite the low interest rates that are ordinarily a disincentive to QPRT planning. Clients can benefit from a discounted transfer and the right to remain in the residence for a period of years, until the term expires. They then have to pay fair market value rent to the remainder beneficiaries to remain in the house. Practitioners might wish to memorialize that requirement in a letter to the client now to avoid a complaint later that no one was advised of this requirement. The payment of rent can be another benefit for estate-planning purposes, since the grantor depletes his estate by the rent amount. The income tax consequences could be hazardous. While rent on a personal residence isn’t tax deductible by the tenant, rental income to the beneficiaries is taxable income, a disadvantageous imbalance. The solution, as noted above, is to consider structuring the remainder beneficiary as a grantor trust. The rental income shouldn’t have to be recognized, as it’s deemed payable to the grantor under Revenue Ruling 85-13, and the transaction is disregarded.
1. Tax reimbursement clauses might be dangerous. Some grantor trusts (income taxed to the grantor) include a provision that permits the trustee to reimburse the grantor for taxes the grantor paid on trust income. If reimbursement is mandatory, this will cause inclusion in the grantor’s estate. So, does that mean a discretionary reimbursement is guaranteed not to cause inclusion of trust assets in the grantor’s estate? Not necessarily. If the grantor’s creditors can’t reach the trust assets under state law, the trust assets shouldn’t be included in the grantor’s estate. But, if the IRS can demonstrate that there was an implied understanding between the grantor and the trustee, estate inclusion may remain a risk. An actual pattern of distributions (for example, taking all income and having all taxes reimbursed over a number of years) could raise the specter of an estate tax inclusion challenge. But, what if the grantor and the trust sell stock in a closely held business that the grantor had used to fund the trust, and the grantor immediately receives a tax reimbursement? Was there an understanding from the inception that the grantor would receive a reimbursement for the tax paid by the trust on the sale of the business? Many taxpayers might wish to avoid these clauses, since the tax payments reduce their estate (tax burn). There are other options. Consider not having the trust reimburse the grantor, thereby giving the IRS the right to raise the “implied understanding argument.” Instead, the trustee can loan money to the grantor to pay the tax if there’s a real cash flow need.3
2. Draft grantor trusts carefully. A number of provisions can be used to create a grantor trust. An estate-planning favorite is the “substitution power” pursuant to IRC Section 675 (4) (C) – the right of the grantor to substitute property of equal value between the grantor and the trust. This provision renders the trust a wholly grantor trust – for both income and principal purposes. Rev. Rul. 2011-28 reiterates the terms stated in Rev. Rul. 2008-22, which creates a road map to ensure that such power doesn’t cause inclusion under IRC Sections 2036, 2038 or 2042. Here are the ground rules: (1) The grantor’s substitution power has to be in a non-fiduciary capacity; (2) The trustee, either under state law or in the document, must have a fiduciary obligation to ensure the substituted property is of equal value; (3) The power can’t be exercised to reduce the value of the trust or increase the net worth of the grantor; and (4) There can be no shifting of benefits among beneficiaries of the trust that could otherwise result from the substitution of property. Consider drafting the document with these provisions to ensure that Sections 2036, 2038 and 20421 won’t be applicable to the trust.
3. Power to substitute and life insurance. The power to acquire a life insurance policy in non-fiduciary capacity from a trust, so long as the trustee can require the determination of an appropriate value, won’t cause estate inclusion under IRC Section 2042.
1. Creative reduction of estate values. Advise your clients to buy costly assets now, rather than after death (for example, furniture or cars). The value of these types of assets immediately after purchase is dramatically less than what the cost was. This can be a creative pre-mortem planning technique.
2. Revised anti-Kohler regulations. The IRS has sought to prevent taxpayers from restructuring a business post-death, using the alternate valuation date (valuing assets six months after death instead of at death) and then gaming the estate tax system. The prior proposed regulations described events that would be ignored for estate valuation purposes. New regulations identify events that would cause an acceleration of the date at which the asset has to be valued, prior to what would otherwise be the six-month alternate valuation date. There are exceptions for transactions that occur in the ordinary course of business that don’t change the ownership structure of the business.
Probate Planning Considerations
1. Contractual issues impact planning. Math will limit the percentage of interests a client can gift, bequeath or sell to an obvious 100 percent. Too often, even the smartest client’s estate plan seemingly misses this logic. Estate contests often involve conflicting agreements. Contracts often trump trusts or wills. The most common problem comes from the title to assets. Suppose a client’s will created a trust for a child, but the specific assets the client intended to bequeath to the trust were owned jointly by the client and another heir. The heir’s rights would supersede those of the child’s under the will. But, this can be even more fun. Perhaps the client’s separation agreement with a former spouse obligated the client to bequeath that particular asset to the ex-spouse or a different child. What if there was a buy sell agreement that obligated the client’s estate to sell the business interests involved to a partner for a set price? Could the client have inadvertently contracted twice for the same asset? Practitioners should carefully review these ancillary documents and give them as much respect as a will. Too often, testators simply forget about prior commitments or endeavor to retain a practitioner in a limited capacity, which may not permit the appropriate identification of these issues.
2. Settle estate conflicts by using tax savings as a tool. Estate litigation can be costly and emotional issues can make settlement elusive. But in some cases, tax savings may help resolve the dispute. Property received by gift or bequest isn’t subject to income tax. But if the estate is in a high income tax bracket, and the beneficiary is in a low bracket, playing the spreads can add dollars to the pot used to settle estate challenges. What if you can structure the settlement as damages or payment for services? The estate may obtain a deduction at a relatively high tax bracket, and the beneficiary may receive the payment and report it as income at a much lower bracket.
1. Internal Revenue Code Section 2653.
2. Estate of Riese, T.C. Memo. 2011-60 (March 15, 2011).
3. See Private Letter Ruling 200944002 (July 15, 2009); Revenue Ruling 2004-64.