The-Trust-Course-Slides.pdf

WESTERN CPE THE TRUST COURSE Presented By: Steven Siegel J.D., LLM (Taxation) 1 Basic Characteristics and Elements of Trusts 2 Grantor A person who creates a trust (aka settlor, trustor) 3 Trustee • Any legal person (individual or corporation) • May be more than one trustee • Powers of the...

WESTERN CPE THE TRUST COURSE Presented By: Steven Siegel J.D., LLM (Taxation) 1 Basic Characteristics and Elements of Trusts 2 Grantor A person who creates a trust (aka settlor, trustor) 3 Trustee • Any legal person (individual or corporation) • May be more than one trustee • Powers of the trustee are defined by the law and the trust instrument • Selecting the trustee should consider honesty and competence-understanding the needs of the beneficiaries, experience, the absence of any conflicts, and the duration of the trust • For complex situations, consider multiple trustees 4 Beneficiary • Trust may have a single beneficiary or there may be multiple beneficiaries • May have identical or different interests in the trust property • Beneficial interests are typically divided between “income” and “principal” • Principal is what is paid into the trust when it is created and funded • Income is what is earned by the principal 5 Beneficiary • Alternative concept known as a “total return trust” • A trust that pays an annual amount to a beneficiary (called a unitrust amount) • Distinction between “income” and “principal” is less strict 6 Beneficiary • A beneficiary does not have to be in existence at the time the trust is created • Distinctions are made between beneficiaries • “Life tenants” and “remaindermen” 7 Beneficiary • An interest of a beneficiary in a trust may be mandatory or discretionary • Discretion can be broad—allowing the trustee to act with no guidelines • Alternatively, may express an “ascertainable standard” for the trustee’s discretion • Another distinction is “current interests” and “future interests” 8 Beneficiary • Future interests may be either “vested” or “contingent” • Any individual can be a beneficiary • Beneficiaries do not have to be related to the grantor of the trust • Organizations (charities and others)may be named beneficiaries of trusts 9 Beneficiary • As a general concern, all the beneficial interests in the trust must vest not later than 21 years after the death of any person who is alive when the trust becomes effective (rule against perpetuities) • A number of states have abolished the vesting requirements contained in the rule against perpetuities for some or all property transfers • Trusts can be divided into separate and distinct shares for each beneficiary 10 Property • Any type of property may be placed in a trust • Property may be transferred to the trust during the lifetime of the grantor (an inter vivos trust) or under the will of the grantor (a testamentary trust) 11 Funding • Trust may be • Fully funded during the grantor’s lifetime • Partially funded • Nominally funded or unfunded • Testamentary trusts are funded after the death of the grantor • Inter vivos trusts may be revocable or irrevocable 12 Tax Characteristics • Simple trust — required to distribute all of its income currently to its beneficiaries; no principal distributions; no transfers to charities allowed • Complex trust — authorizes the trustee to either distribute or accumulate the trust’s income; principal may be distributed; transfers to charities are allowed • Grantor trust — remains in the control of the grantor while the grantor is alive. The “alter ego” of the grantor. • Most trusts (except grantor trusts) are separate taxpayers 13 Tax Characteristics • Gifts made to a trust are treated as gifts made to the trust beneficiaries • The $16,000 (for 2022) annual exclusion from gift tax is available for gifts of present interests in property made to an unlimited number of U.S. citizen donees • Gifts to U.S. citizen spouse: Unlimited marital deduction • Annual exclusion for gifts to a non-citizen spouse: 2022: $164,000 • Married persons (if U.S. citizens) may split gifts (IRC 2513) 14 Tax Characteristics • When property is transferred to a trust by a lifetime gift, the income tax basis and the holding period of the donor carries over to the trust • Death results in an automatic long-term holding period for most property acquired from a decedent (but not IRD property). • Planning: Careful of low basis lifetime gifts • A beneficiary may have the right to replace one trustee with another trustee. Careful if one can name oneself as the trustee. That may cause estate inclusion. 15 Situs of the Trust • Situs of a trust is its legal home • Flexible planning and drafting allows the trustee to change the situs of the trust • Consider when addressing the situs of a trust • Local income taxes • Creditor protection • Privacy protection • Opportunity to continue the trust in perpetuity • Convenience and expense 16 Trustee Rules, Requirements and Guidelines • Duties of a trustee • Identify and assemble the trust assets • Protect the trust assets • Invest the trust assets • Determine who the trust beneficiaries are • Comply with all recordkeeping requirements • File all necessary income and other tax returns • Prepare a final accounting Caution: Personal liability for taxes if trustee distributes assets before taxes are addressed. 17 Trustee Rules, Requirements and Guidelines • Observe the “prudent man rule” (Conservative view) • Observe the “prudent investor rule” (Invest for both income and principal beneficiaries). 18 Why Are Trusts Useful and Necessary? 19 Why Are Trusts Useful and Necessary? • Allow the persons who create them to exercise control (The “Dead Hand”) • Address a number of issues and problems • Make certain that a person’s assets pass to the desired persons • Professional management investment • Asset protection • Protect children and grandchildren until they have reached maturity (or beyond) • Address disability and old age • Avoid or reduce income, estate, and inheritance taxes 20 The Client’s Wish List • 1. Control: Managerial and investment control. • 2. Use and Enjoyment: Use of gifted and inherited wealth, including income generated by trust assets until death, consistent with family goals and values. • 3. Flexibility: The ability to revise a plan if laws or family dynamics change, or for any other reason. • 4. Creditor Protection: Shelter from creditors, including financial, judgment and matrimonial. • 5. Tax Savings: Income, gift, estate and GST • 6. Simplicity: Avoid complexity. 21 Trusts Are Used in a Number of Planning Situations • Achieve significant estate tax savings through the use of sophisticated estate planning techniques • Allow a person to realize charitable goals • Providing protection from creditors • Domestic asset protection trusts(DAPTs) 22 Living Trusts 23 Definition and Structure • Created by the grantor during life by a transfer of property to a trustee • Grantor generally retains the power to revoke the trust • When the grantor dies, the trust becomes irrevocable. Code Section 645 election allows a Qualified Revocable Trust to be taxed as an estate for at least 2 years after the grantor’s death. 24 Advantages and Uses • A management vehicle • Protection against incapacity and disability • Avoids probate costs and delays • Avoid the need for ancillary probate proceedings • Easy succession of trustees • Immediate access to income and principal by trust beneficiaries • Privacy advantage 25 Limitations of a Living Trust • Titling of property • Generally, the living trust does not provide for protection from claims of the grantor’s creditors • No income, estate, or gift tax savings arise from living trusts 26 Testamentary Trusts Generally • Trusts created by the will of a decedent • Become effective subsequent to death when the decedent’s will is admitted to probate • Contain most of the dispositive provisions of the decedent’s estate plan. 27 Unified Credit Shelter Bypass Trust 28 The Available Unified Credit Exemption from Transfer Tax • For 2022, the basic applicable exclusion shelters $12.06 million from transfer taxation • With planning, a married couple can exclude $24.12 million from transfer taxes. • To benefit from this credit, it must be used and using it requires some affirmative planning 29 Use the Exemption at the First Death 30 Title to Property Is Important Individual must generally have property equal to the annual exclusion amount ($12.06 million in 2022) titled in his or her own name. Difficult to accomplish this even where assets are highly valuable. There may be issues of family business control, professional licenses, etc. 31 Two Steps—Title to Property and Properly Dispose of It • First, title property in the separate names of the spouses • Second, create an arrangement as part of the estate plan that deals with the unified credit portion of the decedent’s property 32 Typical Bypass Trust Disposition • One Alternative: • All income from the trust will be paid to the surviving spouse, along with such principal as the trustee may determine • At the surviving spouse’s death, the trust property is typically either paid to the children of the couple or held in further trust for the children 33 Alternative Trust Dispositions • Another Alternative: • A “sprinkling” trust could be used, where the spouse along with other beneficiaries could all be named as permissible beneficiaries • Another alternative could exclude the spouse as a beneficiary of a trust completely, and leave the trust property available only for children or others 34 Caution if Formulas Are Used in the Trust • Plans created before 2018 may have “awkward” formulas • How is the applicable exclusion referenced? For spouse? For children? Minimum marital deduction formula? • Maximum exclusion amount to non-spouse beneficiaries; balance to spouse? 35 Advantages and Disadvantages of the Bypass Trust • • • • • • Protection from Creditors and Remarriage Elder Abuse Protection Not Taxed at Second Death – Appreciated Property Protected Limited Power of Appointment Can Be Used Here BUT: No Basis Adjustment at Second Death What Assets Will Fund it? 36 Disclaimer Trusts and the Bypass Opportunity • Flexible planning in light of uncertainty about federal exclusion amounts and possible state law estate taxes and the exclusions allowed by states suggests the use of a “Disclaimer Trust” • This planning would leave all of the decedent’s property outright to the surviving spouse, with the spouse given the opportunity to disclaim some or all of the bequest to fund one or more trusts – typically a bypass trust (to use the federal and/or state available exclusions) with the balance passing into a marital deduction trust or being left as an outright inheritance. • Caution: A disclaimer must be accomplished in 9 months from the deceased spouse’s date of death. Will the surviving spouse follow though with the planning? 37 The “Clayton Election” to Address Bypass Trust and Marital Deduction Trust Planning • In Clayton v. Commissioner, 976 F. 2d 1486 (5th Cir. 1992) the Court approved a trust that gave the executor discretion to elect to fund some of the decedent’s property into a bypass trust and some into a marital deduction trust. • This planning preserves and encourages the flexibility of addressing uncertainty of federal and state exclusion amounts, and removes the concern about a surviving spouse acting to disclaim. • Since the decision to make a marital deduction election should be made on a timely filed federal estate tax return, using the Clayton planning gives the executor 15 months from the decedent’s date of death to make a decision (9 month due date + 6 month extension) 38 Using Trusts to Secure the Benefit of the Marital Deduction 39 The Estate Trust • Income distributions to the surviving spouse are at the discretion of the trustee • At the death of the surviving spouse, the entire trust principal, including all of the accumulated income, must be paid to the estate of the surviving spouse • Estate trust may hold assets that are unproductive or non-income producing • Spouse will be able to control the ultimate disposition of the property by his or her will 40 Power of Appointment Trust • Trust provides life income for the surviving spouse and gives the spouse a general power to appoint the trust property • Surviving spouse’s general power of appointment gives the survivor control over the ultimate disposition of the first decedent’s property 41 Power of Appointment Trust • Power of appointment trust requirements • Surviving spouse must be entitled for life to all of the income at least annually from the trust property • Surviving spouse must have a general power to appoint the trust property • No other person may have a power of appointment over the trust property 42 ‘QTIP’ Trust Provisions Qualified Terminable Interest Property • If the QTIP requirements are satisfied, a transfer in trust will obtain the marital deduction and allow the first decedent (and not the surviving spouse) to control the ultimate disposition of the transferred property • Surviving spouse is entitled to all the income from the trust property for life, payable at least annually, and no person may appoint any part of the trust property to anyone other than the surviving spouse while such spouse is alive 43 ‘QTIP’ Trust Provisions Qualified Terminable Interest Property • An election is made to qualify the trust for QTIP status • Mechanics of the election are quite simple—just list the property to be qualified for QTIP treatment on the appropriate area of Form 706, Schedule M • Surviving spouse becomes obligated to include any remaining balance of the property to which the QTIP election applied in the estate of the surviving spouse at such spouse’s death. IRC 2044 • The “Portability QTIP”: The IRS will ignore an unnecessary QTIP election, or recognize it if it is chosen. Rev. Proc. 2016-49. 44 Marital Deduction Trust for a Non-Citizen Spouse (Qualified Domestic Trust – “QDOT”) • The unlimited marital deduction is disallowed for distributions to noncitizen spouses IRC 2056(d)(1). • Exception: the QDOT postpones estate tax when assets pass from the estate of the first spouse to die to the QDOT established for the noncitizen spouse. Tax is imposed either on principal distributions from the QDOT or at the death of the noncitizen spouse. (IRC 2056A) Income distributions are required much the same as the QTIP, and are taxable to the recipient spouse. • Requirements: • At least one trustee must be a US citizen (individual or bank, trust company) • The US trustee must have power to withhold estate tax on QDOT distributions of principal. A “hardship” exemption for some distributions may mitigate this rule. 45 Trust Planning for Children 46 Uniform Gift to Minors Act and Uniform Transfer to Minors Act Transfers • Since the property vests in the minor at age 21 or 18, careful with large funding gifts. • The minor is the “taxpayer” on the income – likely at the parents’ rate due to the kiddie tax. • Caution: If the parent is transferor and custodian – and dies while the UGMA or UTMA account is still open – the account balance is taxed in the parent’s estate. 47 Section 2503(c) Trust • Transfers to trust will qualify for the present interest gift tax annual exclusion, notwithstanding the fact that property is transferred to the trust and held until the trust beneficiary attains age 21 • Property can be distributed to the beneficiary prior to age 21 • If the beneficiary dies, the trust property must be included in the beneficiary’s estate. 48 Crummey Trusts Present interest for gift tax purposes in this trust exists by virtue of the annual right of withdrawal given to one or more beneficiaries, not a required distribution at any particular age 49 Generation-Skipping Trusts for Grandchildren For annual exclusion gifts in trust to be exempt from the GST tax, the GST trust must be created for the benefit of a single skip person and must be vested in that single beneficiary for estate tax purposes. No multi-beneficiary trusts will be granted a GST annual exclusion. 50 Using Trusts to Hold Life Insurance Proceeds • Consider an irrevocable life insurance trust (ILIT) • Life insurance policies will be completely removed from a client’s taxable estate • Clients generally cooperate. The insurance policy is an easy asset to get them to transfer • A client owning a valuable life insurance policy should consider transferring it to an irrevocable life insurance trust • This trust, the ILIT, will be both the owner and the beneficiary of the policy • The life insurance policy will be excluded from the insured’s estate, so long as he or she lives 3 years from the date of the transfer of the life insurance policy • Avoid the 3 year rule if the trust owns the policy from the policy’s inception. 51 Using Trusts to Hold Life Insurance Proceeds • Terms to consider for an ILIT • Give the trustee discretion to pay income and principal for the health, support, and maintenance of the surviving spouse in accordance with an ascertainable standard • In addition, the spouse could, if desired, be given a “5 and 5 power” • The trust should further provide for the disposition of the trust property at the spouse’s death • Or at the insured’s death if the spouse predeceases the insured • The ILIT will not be included in the surviving spouse’s estate 52 Using Trusts to Hold Life Insurance Proceeds • Address gifting issues • The transfer of a life insurance policy to an irrevocable trust is a taxable transfer for gift tax purposes • If the life insurance policy has value (whole life vs. term) • The grantor/transferor may borrow the cash value of the policy before transferring it to the trust 53 Using Trusts to Hold Life Insurance Proceeds • Address premium payment issues • Assuming that the insured is making these premium payments, they are deemed to be gifts by the insured to the trust beneficiaries • The premium payments are gifts of future interests, ineligible for the gift tax annual exclusion that is available only for gifts of present interests 54 Using Trusts to Hold Life Insurance Proceeds • Crummey powers • The solution to this concern is the use of the Crummey power to create the present interest in the trust • The Crummey power refers to a currently available right of withdrawal that is included in a trust • This right of withdrawal creates the required present interest in a trust 55 Using Trusts to Hold Life Insurance Proceeds • It is suggested that the amount of the annual Crummey withdrawal power be limited to $5,000 per beneficiary • If this is done, it avoids a problem for the trust beneficiary that would arise if a power of withdrawal in a larger amount than $5,000 is authorized • When a larger power lapses or is released, it is a gift by the power holder to the other trust beneficiaries • Add additional “Crummey beneficiaries” (Mikel Case – 60 related beneficiaries) 56 Using Trusts to Hold Life Insurance Proceeds • Hanging powers • The concept of the “hanging power” is to provide that there is no lapse of an unused portion of a Crummey power to the extent a power greater than $5,000 or 5% is not exercised. • The power “hangs around” until it can lapse under the 5 and 5 rule, or until the insured dies. • The hanging power should not be contingent. It should operate automatically whenever a “lapse” is possible. • TAM 8901004 suggests that a hanging power contingent on a court finding a “lapse” could be disregarded. 57 Using Trusts to Hold Life Insurance Proceeds • Access the cash value in the trust by spousal access provisions • If the cash value is made available to the insured while living, this would be a retained interest or an incident of ownership in the policy that would result in inclusion of the policy in the insured’s estate • Consider drafting language in the trust that would allow the trustee (preferably an independent trustee) the discretion to make payments to the non-insured spouse during his or her lifetime, even if the insured spouse remains alive • It should not cause an estate tax issue for either the estate of the insured spouse or the non-insured spouse 58 Using Trusts to Hold Life Insurance Proceeds • The policy as a source of future liquidity • Consider second to die coverage • A policy that insures the lives of both spouses, but pays off only at the second death • It is designed to provide liquidity to pay estate taxes or other taxes and/or expenses at the second death (The estate of a decedent may sell assets to an ILIT for cash to gain liquidity). • It should be purchased either by the children and held by them outside of a trust, or purchased by an irrevocable trust for the children’s benefit 59 Using Trusts for Gifts to Charity 60 Assess and Address the Client’s Interest in Charities • The estate tax is a “voluntary” tax • Consider outright transfers to charity – Will they be transfer tax effective? • Will they be made during lifetime or at death? • If the outright transfer is made during lifetime, the charitable gift enjoys an unlimited gift tax deduction • Avoid realizing taxable gain on the transferred property if it were sold as an alternative • If the transfer is made at death, the charitable gift enjoys an unlimited estate tax deduction – will the decedent’s estate be taxable? 61 CHARITABLE REMAINDER TRUSTS 62 Charitable Remainder Trusts • Consider a Charitable Remainder Trust • Generally: • A gift of a remainder interest to charity will entitle the donor to an income tax charitable deduction if the trust is a CRT described in §664 • Allows “bunching” of charitable gifts to protect itemizing. Consider a Donor Advised Fund as the charitable donee. • A CRT is an irrevocable trust that either pays a fixed dollar amount or fixed percentage of its initial value—a charitable remainder annuity trust (CRAT) or a fixed percentage of its annually determined value—a charitable remainder unitrust (CRUT) - to a noncharitable beneficiary for life or for a term of up to 20 years • The trust terminates in favor of charity. 63 Charitable Remainder Trusts • Characteristics of a CRT • The donor is entitled to a charitable deduction for income, gift and estate tax purposes for the present value of the remainder interest given to charity • The CRT as an entity is exempt from federal income taxes. No capital gain is realized by the trust on the sale of the contributed assets. • Exception • A 100% excise tax is imposed if the CRT has unrelated trade or business income (UBTI) 64 Charitable Remainder Trusts • Common elements of a CRAT and CRUT • The annual payout must be a minimum of 5% • The annual payout may not exceed a maximum of 50% • The duration of the non-charitable interest in the trust may not exceed either the life of the non-charitable beneficiary or 20 years • Other than the annuity or unitrust payment, a CRT can make no payment to or for the use of any person other than the charitable organization. 65 Charitable Remainder Trusts • There must be a remainder interest in the trust for the benefit of charity equal to at least 10% of the initial trust value. • There is a 5% exhaustion requiring that the annuity payable to the noncharitable beneficiary cannot be so great that there is a more than 5% chance that the corpus will be exhausted before the charity receives its interest. Rev. Rul. 70-452. • However, Rev. Proc. 2016-42 provides relief from the 5% test. The Rev. Proc. provides for early termination of the trust (and thus the end of the ability to make any more annuity payments) on the date immediately before the date on which any annuity payment would be made, if the payment of that annuity amount would result in the value of the trust corpus, when multiplied by a specified discount factor, being less than 10 percent of the value of the initial trust corpus. 66 Charitable Remainder Trusts • May not hold S Corporation stock; • May participate in LLCs; May be funded with retirement plan benefits • How to calculate the income tax charitable deduction • Value the asset(s) being transferred to the trust • Value the non-charitable income interest actuarially • Reduce the value of the asset by the value of the income interest to determine what is passing to charity 67 Charitable Remainder Trusts • The donor’s federal income tax deduction • The value of the donor’s federal income tax deduction is a function of: (IRC Section 170 Rules apply) • The type of charitable remainderman (Public charity? Private Foundation?) • The kind of property contributed to the CRT (Cash?, Appreciated property?, Long or short-term gain property?, Ordinary income property?) • The donor’s charitable income tax deduction for gifts to a CRT is subject to the same percentage of AGI limitations and 5 year carryforward rules that apply to outright charitable gifts 68 Charitable Remainder Trusts • Gift tax consequences • A transfer to a CRT qualifies for the unlimited gift tax charitable deduction to the extent of the present value of the remainder interest • There is no gift tax consequence if the donor or the donor’s U.S. citizen spouse are the only non-charitable beneficiaries of the trust • There are gift tax consequences where the noncharitable beneficiary is not the donor or donor’s spouse 69 Charitable Remainder Trusts • Estate tax consequences • The decedent’s estate receives an estate tax charitable deduction for the present value of remainder interest that passes to charity • If an interest in the trust is given to a spouse, the marital deduction applies. §2056(b)(8) 70 Charitable Remainder Trusts • Generation-skipping tax consequences • A transfer to a CRT is not a direct skip for GST purposes • The donor/must actually allocate GSTT exemption if skip persons are among the non-charitable beneficiaries. A CRT is not deemed a GST trust for purposes of the automatic allocation rules • CRTs are subject to the private foundation rules • Trustee issues: • There are no restrictions on who can be a trustee • A trustee may be entitled to reasonable compensation as trustee 71 Charitable Remainder Trusts • Charitable remainder trust—beneficiary issues • The CRT may be paid to one or more persons, at least one of which is not a charitable organization • The named individual beneficiary must be living at the time the trust is created • If payable to a class of individuals, all members of the class must be alive and ascertainable at the time the trust is created • Exception: • If the CRT is for a term of years, the members of a class do not have to be alive and ascertainable when the CRT is created 72 Charitable Remainder Trusts • Permissible Remaindermen: • The remainder must be irrevocably payable to a charity. • The CRT may have a specific charitable remainderman and an alternate. • Alternatively, the donor may retain or give another person (or trustee) to power to substitute the charitable remainderman. 73 Charitable Remainder Trusts Typical CRT scenario 1. Donor establishes the CRT 2. Donor contributes assets 3. Trust sells the contributed assets 4. Trust realizes no capital gain and is not subject to the net investment income tax 5. 100% of the sale proceeds are available for reinvestment 6. Payments are then made to the beneficiary in accordance with the terms of the trust 7. Charity receives the balance at the termination of the trust 8. It cannot be a combination of a CRAT and a CRUT 74 Charitable Remainder Unitrust • Charitable remainder unitrust (CRUT) requirements • The CRUT pays a variable amount • A fraction or percentage of the net fair market value of the CRUT valued annually • If additional contributions are made (the CRUT can accept additional contributions, a CRAT may not), the 10% rule applies as of the date of the additional contribution 75 Charitable Remainder Unitrust • There are several types of CRUTs • The standard CRUT • Provides the fixed percentage annual payout of the unitrust amount • Net income unitrust (NICRUT) • Non-charitable beneficiary is paid the lesser of the trust’s net accounting income or a fixed percentage of the value of the trust without a make-up provision • Net income with make-up (NIMCRUT) • The trust provides that if there is a short-fall of annual income based on the fixed percentage expectation, that is acceptable, and the shortfall is to be made up in the future 76 Assess and Address the Client’s Interest in Charities • The NIMCRUT pays the lower of the unitrust amount or the trust accounting income • The NIMCRUT is used to defer income into future years when income is realized and the makeup payments are made. • The goal is to have little or no income in the initial years of the trust so the unitrust distribution is minimized • If the noncharitable beneficiary dies sooner than expected and before receiving the makeup payments, the makeup payments inure to the benefit of the charitable remainderman 77 Charitable Remainder Unitrust • A NIMCRUT can sometimes be used as a replacement for a retirement plan, without all the normal limitations and restrictions associated with a typical qualified retirement plan • In the early years of the CRT, the assets are invested to generate growth, not income • After retirement, the assets of the CRT are reinvested to generate high income, and the Grantor is able to use the makeup amount from earlier years 78 Charitable Remainder Unitrust • “Flip Unitrust” • Trust begins as a NICRUT or a NIMCRUT but converts to a standard CRUT upon a triggering event. • The unitrust percentage stays the same • The makeup feature also disappears on the conversion to a standard CRUT. • The triggering event is a specific date or a single event. • Typically used to keep distributions level, avoid a large surge in income and avoid having to transfer or liquidate illiquid assets to make required payments. 79 CHARITABLE LEAD TRUSTS 80 Charitable Lead Trust • Consider a charitable lead trust • An irrevocable trust, created during life or at death, which provides for the upfront or lead interest being paid to charity in the form of a guaranteed annuity or unitrust payment and the remainder interest passing to or continuing in trust for non-charitable beneficiaries • Two gifts 1.A gift of the annuity or unitrust interest to charity and 2.A gift of the remainder interest to the non-charitable beneficiaries • Either an annuity (a fixed dollar amount) or a unitrust (a fixed percentage of the fair market value of the trust property, valued annually) • The CLT creates a lead interest which qualifies for a gift or estate tax charitable deduction • The CLT is especially favorable when the IRC 7520 rate is low – the charitable interest receives a high value, and the remainder interest a low value. 81 Charitable Lead Trust • The CLT may be either created during the donor’s lifetime (inter vivos) or under the donor’s will (testamentary) • An inter vivos CLT provides the donor with a gift tax charitable deduction in an amount equal to the present value of the annuity or unitrust interest payable to charity and may provide income tax benefits in certain cases (if a grantor CLT is used). • A testamentary CLT provides only an estate tax charitable deduction • The donor is not entitled to an income tax charitable deduction for transfers made to a CLT unless the CLT is structured as a grantor trust • i.e., a trust in which the grantor receives an income tax deduction upon creating the trust, retains a power under §§673–677 that causes all of the future income of the trust to be taxed to the grantor, even when paid to charity. 82 Charitable Lead Trust • The income taxation of a CLT depends on whether the CLT is treated as a grantor trust or a non-grantor trust • If the CLT is treated as a grantor trust, the donor is taxed on all the trust income during the charitable lead term. The charitable deduction for a cash gift is capped at 30% of AGI; a gift of appreciated property at 20%. • If the CLT is treated as a non-grantor trust, the CLT is taxed under normal rules that apply to a complex trust meaning that the CLT is taxed on all its undistributed income and capital gains • A non-grantor charitable lead trust will receive a fiduciary income tax charitable deduction under §642(c) for distributions made to the charitable lead beneficiary • Unlike a CRT, a CLT is not automatically exempt from income tax 83 Charitable Lead Trusts – CLATs and CLUTs • Types of CLTs • CLAT (charitable lead annuity trust) • Must be a fixed dollar amount based on the initial value of the trust payable at least annually • The annuity can be established as a percentage of the assets initially contributed to the trust or by a formula as long as the amount of the annuity is ascertainable at the date of transfer • It is generally advisable to use a formula or percentage of the initial fair market value • The annuity must be paid annually • The amount of the annuity cannot be tied to the income earned by the CLT • If the income of the CLT is insufficient to pay the annuity, the trustee must invade principal to pay the annuity. 84 Charitable Lead Trusts – CLATs and CLUTs • Zeroing out the remainder interest: • It is possible with a CLAT to cause the present value of the annuity stream (the amount of the charitable deduction) to equal the entire value of the gifted property transferred to the trust. • With the current low IRC Section 7520 rates, the calculation of the present value to pay the annuity to charity is high (Favorable!)…and exceeding the “hurdle rate” to achieve appreciation over the low Section 7520 rate is very attainable. • Result: The appreciation of the trust property during the charity’s term of the trust is shifted to the heirs as remainder beneficiaries. 85 Charitable Lead Trusts – CLATs and CLUTs • CLUT (charitable lead unitrust) • The unitrust amount paid by a CLUT is an amount equal to a fixed percentage of the net fair market value of the trust, determined and payable annually. • The valuation of the CLUT may be on a set date or based on an annual average of several dates or according to any other consistent method • If the income of the CLUT is insufficient to pay the unitrust amount, the trustee must invade the principal • Unlike a charitable remainder unitrust, a CLUT cannot take the form of a net income only CLUT, a net income with make-up CLUT or a flip CLUT 86 Charitable Lead Trusts – CLATs and CLUTs • Using a testamentary CLUT, it is possible to have skip persons as the ultimate beneficiaries of the trust and design the trust to be GST tax free – using the GST exclusion of the decedent. • The CLUT allows the inclusion ratio of the trust to be determined as the inception of the trust, so the remainder interest can be created with an inclusion ratio of zero. • This cannot be accomplished with a testamentary CLAT, since the CLAT rules require waiting to determine the inclusion ratio until the lead interest has been exhausted, so a zero ratio is not assured. • However, the advantage of the CLAT is its fixed payment, so that the appreciation during the charitable term benefits the remainder beneficiaries. 87 Charitable Lead Trusts – CLATs and CLUTs • Payout to the charitable lead beneficiary • Distributions from the CLT must be made annually to the charitable lead beneficiaries • There is no minimum or maximum payout from the CLT as opposed to a CRT which must pay a minimum 5% unitrust or annuity trust interest • Term of the lead interest • Unlike a CRT, the term of a CLT may extend beyond 20 years limited only by the applicable rule against perpetuities 88 Charitable Lead Trusts – CLATs and CLUTs • Gift Tax Consequences of charitable lead trusts to the Donor • A taxable gift in the amount of the present value of the remainder interest in the property transferred to the trust at the time the CLT is created i.e., the taxable gift will be equal to the value of the remainder interest that will pass to the noncharitable beneficiary after the charitable lead interest ends • The gift is a gift of a future interest • The donor is entitled to a gift tax charitable deduction for the actuarial value of the charity’s lead interest assuming the transfer is a completed gift • The lower the §7520 rate, the higher the charitable deduction for the annuity interest In a low interest rate environment, the amount of the annuity payment to charity can be set at a much lower rate than in a high interest rate environment thereby increasing the chance that a greater amount of the trust will pass to the non-charitable remainder beneficiaries 89 Planning with Grantor Retained Interest Trusts Using “Bet to Live” Strategies 90 Code Section 2702 Sets the Ground Rules • If a grantor creates a trust with a retained interest, with the remainder interest payable to family members, and if Section 2702 is found to be applicable to a transfer of the interest, and none of the exceptions to Section 2702 coverage apply (the exceptions are discussed below), then the interest retained by the grantor is valued at zero for gift tax purposes. • This means that the grantor is treated as having made a taxable gift of a future interest of the entire fair market value of the property transferred to the trust. IRC 2702(a)(2)(A) • Conversely, if an exception to Code Section 2702 is applicable, the grantor’s retained interest is recognized as “qualified,” so that the amount of the gift is measured by the fair market value of the transferred property less the value of the interest retained by the grantor. 91 Qualified Annuity and Unitrust Interests— GRATs and GRUTs • The term “qualified interest” means • Any interest consisting of the right to receive fixed amounts payable not less frequently than annually • A qualified annuity interest, a.k.a. a GRAT (grantor retained annuity trust) • Any interest consisting of the right to receive amounts payable not less frequently than annually which are a fixed percentage of the fair market value of the property in the trust (determined annually) • A qualified unitrust interest, a.k.a., a GRUT (grantor retained unitrust) 92 GRATs and GRUTs: The Planning Goals • GRATs (in particular) and GRUTs are used to transfer property for the benefit of family members at a reduced gift tax cost, since the value of the grantor’s retained interest is subtracted from the FMV of the transferred property on the date of the gift. • The GRAT and GRUT are also valuation freezing techniques: If the grantor outlives the term of the trust, the trust property and its appreciation have successfully been removed from the grantor’s estate. 93 GRAT and GRUT Interests— General Rules • Distributions from the trust to or for the benefit of any person other than the holder of the qualified annuity or unitrust interest during the term of the qualified interest must be prohibited by the governing instrument. • The term of the annuity or unitrust interest must be fixed by the governing instrument. • The grantor may act as the trustee of a qualified annuity or unitrust. 94 Special Rules for Qualified Annuity Interests (GRATs) • A qualified annuity interest is an irrevocable right to receive a fixed amount • A stated dollar amount payable periodically • A fixed fraction or percentage of the initial fair market value of the property transferred to the trust. • Caution: A high percentage retained annuity may result in returning trust principal to the grantor. • A right of withdrawal from the GRAT, whether or not cumulative, is not a qualified annuity interest • Additional contributions to the GRAT must be prohibited by the governing instrument 95 Special Rules for Qualified Unitrust Interests (GRUTs) • A qualified unitrust interest is an irrevocable right to receive payment periodically, but not less frequently than annually, of a fixed percentage of the net fair market value of the trust assets, which value is determined annually • There is no minimum fixed percentage payment requirement necessary in order to satisfy the requirements of a qualified unitrust interest • A right of withdrawal from the GRUT, whether or not cumulative, is not a qualified unitrust interest • There is no prohibition on making additional contributions to a GRUT 96 Ultimate Tax Planning The Zeroed-Out GRAT • A zeroed-out GRAT is a GRAT designed in such a way that the present value of the grantor’s retained annuity interest is equal to the fair market value of the property transferred to the trust, resulting in a remainder interest valued at zero, and consequently, no gift for gift tax purposes • Walton v. Commissioner, 115 T.C. 589 (2000); Acq. Notice 2003-72, 2003-44 IRB 97 Ultimate Tax Planning The Zeroed-Out GRAT • Walton allows the creation of GRATs with annuities that equal the value of the transferred property, so that all of the property, the income therefrom and the appreciation thereon at the assumed rate of return (i.e., the Code Section 7520 rate) return to the grantor in the form of an annuity • Accordingly, the value of the gift is zero • Where the grantor may die before the end of the trust term, and be survived by a spouse, steps should be taken to have the GRAT remainder interest as well as the grantor’s right to continuing annuity payments be paid to the surviving spouse or to a marital deduction trust • A single asset GRAT may be a wiser choice 98 Take Advantage of the Low Interest Rate Environment • The performance of a GRAT improves with lower interest rates and declines with higher interest rates. • The IRC Section 7520 rate is used to calculate the present value of the grantor’s retained annuity. The record low 7520 rates of 2021 presented an ideal opportunity to create a GRAT. The 2022 rates are moving upward, but are still advantageous. • As the rate declines, the annuity factor increases, so that a given annuity payment will have a greater present value, thereby increasing the value of the annuity retained by the grantor and reducing the value of the gift of the remainder interest • If a GRAT fails to outperform the Section 7520 “hurdle” rate, it has failed as an appreciation freezing technique. • If there was no gift tax paid, the only real loss is the transaction costs incurred by the grantor 99 Income Taxation of GRATs and GRUTs • The ordinary income and capital gains earned by a GRAT or a GRUT during the retained interest term are taxed to the trust grantor under the grantor trust rules • When the grantor transfers assets to a GRAT or GRUT to fund it, there is no recognition of gain or loss to either the grantor or to the GRAT or GRUT, regardless of the value of the property and its basis to the grantor • The grantor’s individual tax rates, rather than the trust’s, become the measure of tax liability • As a grantor trust, the trust may hold S corporation stock during the grantor’s retained interest term • The idea is to transfer a minority interest in an S corporation to a GRAT, taking advantage of the discounts for minority interest and lack of marketability, followed by the actuarial calculation of the GRAT retained and remainder interests 100 Gift Taxation of GRATs and GRUTs • If the trust meets the requirements of a qualified annuity or unitrust interest as described above, the retained interest is acknowledged and the value of the gift is the fair market value of the property transferred to the trust, less the present value of the qualified interest • The gift of the remainder interest is the gift of a future interest 101 Gift Taxation of GRATs and GRUTs • The value for gift tax purposes of a transfer of property to a GRAT or GRUT will depend on the following factors • The value of the property transferred to the trust • The Code Section 7520 rate for the month in which the property is transferred to the trust • The amount of each annual unitrust or annuity payment • The time period (a term of years) over which the unitrust or annuity trust payment is to be made • The age of the grantor 102 Estate Taxation of GRATs and GRUTs • Death after the retained interest term • If the grantor survives the retained interest term of the trust, the trust principal, including all appreciation in the value of the trust property subsequent to its transfer to the trust, is removed from the grantor’s taxable estate, assuming, of course, that the grantor retains no interest in the trust beyond the retained term • The obvious advantage of outliving the retained interest term suggests that a grantor should be realistic in the selection of a term within his or her reasonably anticipated life expectancy • To the extent of the value of the gift taxable portion of the transfer to the GRAT or GRUT in the year of its creation, such value must be reported in the grantor’s estate upon the grantor’s death as an adjusted taxable gift 103 Estate Taxation of GRATs and GRUTs • Death during the retained interest term • If the grantor does not survive the trust term, the GRAT constitutes a retained interest in the decedent’s estate • The portion of the trust corpus includible in the decedent’s gross estate is that portion of the trust corpus valued at date of death (or alternate valuation date) necessary to yield the required annuity annual payment using the appropriate Section 7520 interest rate in effect on the date of the decedent’s death • Where the grantor’s death prior to the expiration of the trust term forces an estate inclusion, the grantor’s estate is entitled to a credit for any gift tax that was paid at the time the trust was created 104 NOTE on Basis • If the grantor outlives the term of the trust, the remainder beneficiaries take the trust property with the carryover income tax basis from the grantor • If the grantor dies within the term of the trust, the remainder beneficiaries take the property with a basis equal to its value at the grantor’s death 105 Generation-Skipping Transfer Taxation of GRATs and GRUTs • GRATs and GRUTs should not be used as vehicles to attempt to reduce or avoid generation-skipping transfer tax issues • An attempt to allocate generation-skipping transfer tax exemption will not be effective until the end of the estate tax inclusion period (ETIP) • Code Section 2642(f)(3) • For a GRAT or GRUT, this will not occur until the grantor’s retained income interest terminates • The grantor cannot allocate generation-skipping transfer tax exemption in an amount equal to the present value of the remainder interest gift at the time of creation of the trust 106 Planning with Short-Term GRATs and GRUTs • The obvious advantage of the short-term GRAT is its ability to act as a hedge against the mortality risk of the grantor’s death during the retained interest term • The use of short-term GRATs also creates a hedge against a possible bad investment or bad income year • Potential disadvantages • If the Code Section 7520 rate increases • Administrative costs will be higher • A planned series of GRATs opens the grantor to possible changes in the law over time 107 Consider the 99-Year GRAT • The longer the term the lower will be the annuity required to zero-out the GRAT that is to produce no gift • Regulation 20.2036-1(c)(2) provides that where a grantor retained an interest in an annuity the value of the property included in the grantor’s estate will be the amount required to produce the remaining annuity using the Section 7520 rate in effect at the grantor’s death 108 Can a Note be Used to Satisfy the Annuity or Unitrust Payment? • The IRS has prohibited the use of notes to pay the retained interest in a GRAT or GRUT on the theory that the use of notes delays the payment of the grantor’s retained interest and alters its value 109 Use of the Common Law GRIT Section 2702 Does Not Occupy the Entire Field • If an individual does not have children and wishes to benefit relatives who are nieces and nephews, the individual is outside of Code Section 2702 • A trust can be created by the grantor with a retained income interest • The income interest need not be “qualified” within the meaning of Code Section 2702 • The retained income interest is valued by standard actuarial rules, and the remainder interest constitutes a taxable gift. There is no minimum income or term requirement • If the grantor’s retained interest is for a period of years, and the grantor outlives the term, the property is out of the grantor’s estate • If the grantor dies within the term, the full date of death value of the property is in the grantor’s estate 110 Use of the Common Law GRIT Section 2702 Does Not Occupy the Entire Field • Since Code Section 2702 does not apply in this situation, there is no obligation to distribute any principal to the grantor to satisfy an income obligation • While obviously not applicable in a majority of family situations, the common law GRIT should be considered where persons do wish to benefit those relatives (or, of course, non-relatives, such as a domestic partner) who fall outside of the “member of the family” limitations of Code Section 2702 111 Qualified Personal Residence Trusts (QPRTs) 112 QPRTS—Qualified Personal Residence Trusts • The QPRT: transfer a personal residence to a trust; retain the right to use and enjoy the residential property for a fixed number of years, the remainder interest in the trust passes to children when the term expires. • Goals: Reduced gift tax by subtracting the value of the retained interest from the value of the property; Reduced estate tax: outlive the trust term – home appreciation will not be included in the grantor’s estate. • A QPRT is a grantor trust. The grantor retains the right to claim the deductions for interest paid on the home mortgage and for property taxes paid. If a grantor trust holds the principal residence of the grantor, and the residence is sold, the exclusion from capital gains taxation is available assuming all of the requirements of Code Section 121 are satisfied. • The QPRT is LESS favorable in low interest rate environments. 113 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • What are the tax planning advantages of a QPRT? • The grantor of the trust is able to transfer the full value of the residence, valued at the date of transfer, but only bears a transfer tax cost equal to the present value of the remainder interest of the trust • The grantor maintains control over the residence during the retained interest term, and is permitted to use, occupy and enjoy the residence during such time. The grantor may serve as the trustee of the trust. • The QPRT may be written to permit the grantor to rent the residence after the expiration of the retained interest term for a fair market value rental. An option to rent the residence at the end of the retained interest term can be included in the qualified personal residence trust and the option exercised by the grantor without causing the property to be included in the grantor’s gross estate 114 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • How is the QPRT treated for gift tax purposes? • The special gift tax valuation rules of Code Section 2702 do not apply, and the grantor's retained interest is not required to be valued at zero • The personal residence is valued at its FMV on the date of the gift and the actuarially determined value of the grantor's retained interest is subtracted from such FMV to determine the value of the remainder interest, which is the measure of the value of the transfer subject to gift tax • A “successful” QPRT (where the term holder outlives the retained interest term of the trust) results in a gift transfer to the remainder beneficiaries with a carryover basis from the grantor • An “unsuccessful” QPRT, where the term holder dies before the end of the retained interest term, resulting in the inclusion of the QPRT property in the grantor's estate at its date of death or alternate valuation date value, results in a stepped-up (or down) basis 115 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • How is the QPRT treated for estate tax purposes? • There are generally two primary objectives • Making the value of the retained interest as large as possible in order to minimize the taxable gift of the remainder portion, and making the term of the trust one which will end while the grantor is still living • When the grantor of a qualified personal residence trust dies before the expiration of the term for which the grantor retained the right to use the residence, the trust property is included in the grantor’s gross estate for federal estate tax purposes at the FMV of the property as of the grantor's date of death or alternate valuation date • If the trust grantor successfully survives the designated retained interest term of the trust, then at the time of the grantor’s death beyond the expiration of the trust term, the personal residence is not part of the grantor’s estate. At the grantor’s eventual death, the grantor’s estate need only report as an adjusted taxable gift the value of the remainder interest in the QPRT as determined at the time the gift was made • The grantor has achieved an estate tax freeze 116 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • The residence must be used by or available to the grantor at all times • It may be occupied in the grantor's absence by the grantor's spouse or dependents • Limited rental by the grantor to third parties may be permitted, so long as the grantor is not providing substantial services • A dwelling unit is treated as the taxpayer’s personal residence if the taxpayer uses it more than the greater of 14 days or 10 percent of the number of days it was rented during the taxable year • A residence may be used as a home office or as a place of business where customers, patients or clients visit, or as a place where day care services are provided, without losing its qualification as a personal residence • A personal residence may include appurtenant structures used by the term holder for residential purposes as well as adjacent land not in excess of that which is reasonably appropriate for residential purposes, taking into account the size and location of the residence 117 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • A broad variety of living arrangements have been found eligible to be qualified as constituting a personal residence. Shares of stock in a cooperative apartment qualify • A condominium, a mobile home, a houseboat, a house trailer and a yacht with toilet and cooking facilities have all been found to qualify as personal residences • There is a limit of two residences that a person may place into personal residence trusts. • If there is more than one residence being held in a personal residence trust by the grantor, one of the residences must be the principal residence of the grantor 118 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • The term “personal residence” does not include the value of any personal property, such as household furnishings, machinery and equipment, etc. • The fact that a residence is subject to a mortgage or other encumbrance does not affect its status as a personal residence, and does not preclude its transfer to a qualified personal residence trust • However, one of the problems that arises in connection with transferring mortgaged property to a QPRT is that the amount of the outstanding mortgage indebtedness must be subtracted from the fair market value of the property being transferred • Each time a mortgage payment is made, the grantor has made a further gift to the remainder beneficiaries of the trust 119 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • Spouses with an interest in the same residence can fund a QPRT with their interests in that residence. The spouses may transfer their interests in the residence to the same personal residence trust. • Separate personal residence trusts for each spouse funded with undivided interests held as tenants in common in the residence may be the preferred planning technique • Transfers to a trust of undivided partial interests in real property are entitled to discounts (Ludwick v. CIR TC Memo 2010-104 - 17% discount) • Be careful here to avoid creating reciprocal trusts 120 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • The governing instrument of the trust must prohibit the trust from selling or transferring the residence, directly or indirectly, to the grantor, to the grantor's spouse or to an entity controlled by the grantor or the grantor's spouse • The sale of the residence will result in either a required distribution of the trust assets to the grantor or the conversion of the trust to a qualified annuity interest, i.e., a GRAT or a GRUT. This conversion can be drafted as part of the trust, and will “save” the planning in the event of a sale of the home. 121 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • Concerns about life expectancy can be “hedged”: • A grantor may wish to set up two personal residence trusts, each of a different duration • A second type of “hedging” transaction involves the purchase of a life insurance policy on the grantor's life for a term at least equal to the term of the trust 122 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • QPRTs are not generally viewed as good vehicles to promote generation skipping transfers • No generation-skipping exemption can be allocated to any transferred property while it remains possible that the transferred property will be included in the transferor-grantor's estate • This is the operation of the so-called estate tax inclusion period (ETIP) rule 123 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • Must the residence pass outright to the remainder beneficiaries at the end of the retained interest term? • No, the grantor may prefer to keep the residence in trust for the benefit of the grantor's spouse or descendants until both the grantor and the grantor’s spouse are deceased, or until an independent trustee deems it appropriate for an outright distribution to be made to the trust beneficiaries – or to an LLC or other arrangement for their benefit. 124 QPRTS—Using Personal Residence Trusts in Tax and Estate Planning • Are there any state law issues that should be considered when creating a QPRT? • Only one state has its own gift tax requirements • i.e., Connecticut • Some states have real estate transfer taxes or similar levies • State law must be consulted to determine if homestead exemptions are affected 125 QPRTS—Us