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USING LIVING TRUSTS AS AN
ESTATE PLANNING TOOL
I. COMMON ELEMENTS IN TRUST AGREEMENTS A. Parties to Trust Agreement Grantor. B. Definition of A Living (Inter-Vivos) Trust. "An express trust, including all amendments thereto, created during the grantor's lifetime other than..." certain trusts listed in Surrogate's Court Procedure Act ("SPCA") §103.31. 1. C. (See also SCPA §103.52.)
II. TYPICAL PROVISIONS IN TRUST DOCUMENTS A. Provisions Common to Revocable and Irrevocable Trusts Preamble a. Effective date of Trust Agreement. Dispositive Provisions During Grantor's Lifetime a. Discretionary or mandatory payment of trust income
and/or principal, with appropriate standards/limits upon Trustee's
discretion. Dispositive Provisions Upon Grantor's Death a. Disposition of accumulated income and corpus. The Trust documents will likely provide for a range of alternate distributions, depending on which beneficiaries then survive, their ages, etc.). b. A revocable trust which acts as a "Will substitute" may allow "pour-overs" into it and have provisions similar to testamentary trusts which are intended to minimize and defer imposition of estate taxes. Thus, there may be a disposition to fund a "credit shelter" bequest, a disposition outright or in trust which qualifies for the estate tax marital deduction, etc. (See the sample Revocable Trust document for a married person, which is kindly provided by Mr. Paul Callaway at the end of this outline). c. After both parents/grantors have passed, the principal may pass to a family trust for children until the youngest child attains a certain age and/or thereafter a separate trust for each child which has staggered distributions upon the child's attainment of certain ages. Powers Over Principal a. Granting certain powers to distribute or withdraw principal (and income) may have unintended adverse income, gift or estate tax effects. Consult the "taxable string" sections of the IRC and the "Basic Tax Considerations" section of this manual as good starting points. b. A power of invasion which is limited to an ascertainable standard related to the health, education, support or maintenance of the beneficiary ("HEMS") is generally advisable. Extra precaution is needed when a trustee is also a beneficiary or is related to a beneficiary or grantor, or if the beneficiary has a power of invasion. c. A "5 and 5" power may minimize adverse transfer tax consequences when a beneficiary must have maximum control over principal while avoiding inclusion of it in the beneficiary's taxable estate. Minor Beneficiaries Alternative ways to address the problems presented by minority beneficiaries include: a. Separate trusts for minors which extend beyond age 21. b. Power in trust until age 21. c. Power on the part of the Trustee to distribute to a custodian under the Uniform Gift to Minors Act, to a parent of a minor or to a legal guardian. Rule Against Perpetuities a. A perpetuities savings provision generally provides that any portion of a trust which would fail because of a violation of the rule against perpetuities shall terminate before the violation takes effect, and the Trustee shall distribute all of the trust property to then identifiable income beneficiaries. b. An irrevocable lifetime trust may exacerbate perpetuities problems since generally measuring lives must be in existence on the date the trust becomes irrevocable. Generally see EPTL Article 9 for statement of the rule and operative provisions. c. Powers of appointment should be drafted in such a manner that they cannot be exercised in a manner which violates the rule. Trust Additions a. The trust document may state who may transfer what types of property to the trust. b. Typically, the document provides that a grantor and perhaps his/her spouse can freely add additional property to the trust (other than certain charitable trusts), and that other persons can add property with consent of the trustees. c. Trustees often desire the power to reject property which is environmentally contaminated. Administrative Provisions a. See generally Article 11 of EPTL. b. Statutory powers may need to be limited, or other powers added, depending on the purpose of the trust and the desired income and transfer tax results. Revocability a. A grantor or related person may reserve a right to revoke or amend the trust agreement, if the primary purpose is to have the trust act as a Will substitute. (See III infra. for further discussion). b. An irrevocable trust is typically used to avoid income or transfer taxes, for asset protection purposes or as part of a plan to prevent dissipation of a grantor's or spouse's estate because of long-term care costs. (See IV infra. for further discussion). Trustee Power to Terminate a. Independent trustees are often given power to terminate a trust when its corpus is so small that trust administration charges become unreasonable or when the purpose of the trust is no longer applicable because of law changes, unanticipated changes in beneficiaries' financial status or unusual mortality experience. Trustee Changes a. Favorable characteristics which trustees should possess include: experience as a fiduciary and financial manager; knowledge of beneficiaries' needs and grantor's intent; legal and effective independence from beneficiaries; reasonable level of compensation; proximity to location of grantor, beneficiaries and trust corpus. b. It is often advisable to have two co-trustees serve: an independent professional co-trustee who can maintain emotional distance and provide professional money management, and an individual who is familiar with the family needs and problems. c. Successor trustees should be nominated should a trustee fail to qualify or cease to act. d. Tax considerations will limit the ability of interested persons to appoint, as successor fiduciaries, family members or subservient persons. See Revenue Ruling 95-58, 1995-36 I.R.B. 16 for permissible powers relating to removal and replacement of trustees. Trustee Compensation a. A professional "corporate" trustee usually requires compensation which is not less than that set forth in its fee schedules as published from time to time. b. If a family member is expected to act as trustee without compensation or is to receive a full commission in addition to a commission payable to the professional trustee, the document should so specify, if for no other reason than to forestall criticism from other family members. c. Generally see SCPA Article 23 for rules governing commissions and costs. Trustee Accountings a. Generally, grantors will waive statutory requirements for court supervised formal accountings. It is not uncommon to allow informal accountings upon termination of a trust which only need approval of a majority of adult beneficiaries. Disabled Persons a. The extra cost of having guardians or other representatives appointed to represent disabled persons may be avoided if a person who is not disabled has a similar property interest. See SCPA Sec. 315(5) for "virtual representation". Definitional Section a. In appropriate circumstances, it may be important to define such terms as "children" and "issue" so as to include adopted persons, non-marital children, stepchildren, etc. b. References to terms in the Internal Revenue Code and other laws may need further explanation. Choice of Law a. Typically there is an affirmative statement that New York law is applicable. b. There may be tax or other reasons why another state's or country's laws are preferable. For example, some states have statutorily revoked the rule against perpetuities. Other states and countries have tailored their laws to offer greater protection of trust assets from the grantor's creditors. Such factors as the situs of the trustee and corpus, and the domicile of the grantor and beneficiary, will determine whether New York will respect the choice of law. Transactions with Grantor and his/her Estate a. Whether the trustees can pay any debts, expenses or taxes of the deceased Grantor will largely be driven by tax and liquidity considerations. b. A revocable trust will likely be included in the grantor's estate for estate tax purposes so that liberal provisions allowing payment of grantor's debts, expenses and transfer taxes are not unusual. c. An irrevocable trust which was intended to avoid inclusion in grantor's estate cannot directly pay or discharge the estate's obligations. The trust may be able to loan money and buy assets from the estate on arms-length terms so as to provide liquidity to the estate. Simultaneous Death a. In the event that the grantor and spouse die simultaneously and the order of death cannot be determined, or if the spouses die within six months of each other, there may be important estate and probate reasons to specify which spouse is deemed to have survived. (See EPTL §2-1.6(b)). In order to avoid estate taxation in multiple estates, higher marginal tax rates, and redundant administrative costs, it is common to require other beneficiaries to survive a certain number of days beyond a certain event in order to claim benefits under the trust. Binding Effect/Acceptance a. A trust agreement is typically stated to be binding upon executors, administrators, successors and assigns. b. There is typically an explicit acceptance of the trust by the trustees. Testimonium a. A typical "In Witness Whereof" clause is included immediately before the parties' signatures. b. Acknowledgement of signatures may offer additional evidence of the effective date and provide some comfort to real estate title examiners and over-zealous IRS agents who question whether the trust was in fact in existence on the effective date. Attachments to Trust Agreement a. It is not uncommon to append to the back of the trust agreement a list of assets which are transferred to the trust at inception. b. It is good practice to then obtain a federal identification number for the trust and to register title of the assets in the name of the trust. B. Other Trust Provisions Procedure to Amend Otherwise Irrevocable Trust Agreement a. Power to amend the agreement should be limited in scope and exercisable only by persons for whom the power will not cause adverse income or transfer tax consequences. Special Powers a. Consider whether certain acts of trustees, such as sale of a closely-held business, should need the consent of certain interested beneficiaries. Special Powers of Appointment a. A testamentary special power of appointment may allow a beneficiary to direct disposition of trust property upon death without having it included in the beneficiary's estate. b. A special power of appointment may prevent a deemed "gift-over" to other beneficiaries of a trust, when a beneficiary fails to exercise a right of withdrawal. (See insurance trust discussion below). General Power of Appointment a. Granting of a general power of appointment is sometimes useful to obtain a marital deduction or to prevent imposition of generation-skipping tax. Spendthrift Provisions. a. Protects beneficiaries against their imprudent spending. b. Explicit statement which prevents the application of EPTL §7-1.6 makes court intervention to make principal distributions to beneficiaries less likely. III. G) Revocable Living Trusts Acting as a Charitable Unitrust or an Annuity Trust. 1. Private Foundation Rules. A charitable remainder trust can be structured to be revocable during the grantor's lifetime. Upon the grantor's death, the trust becomes irrevocable. However, it may not be considered a charitable split interest trust treated as a private foundation under IRC §4947-a(2) until a "reasonable period of settlement" has expired. In effect, the trustee has a reasonable period of time after the grantor's death to settle the trust, such as paying debts, taxes and non-charitable distributions. Nonetheless, IRC §4941 may still present "self-dealing" problems on and after date of death. [Regs. §53.4947-1(c), (d).] 2. Importance of Date of Creation of Charitable Remainder Trust. If the terms of a trust agreement fulfill the requirements of a qualified charitable remainder trust but for its revocability by the grantor, then the charitable trust will not be treated as being created until no person (including the grantor) is considered to be the owner of the entire trust corpus pursuant to the grantor trust rules of IRC §§671 to 678. If the grantor was treated as the owner of the entire corpus, the qualified charitable remainder trust would be treated as being created on the date of the grantor's death. However, if the grantor only retained a partial power to revoke a percentage of the trust, he would be treated under IRC §676(a) as the owner for income tax purposes of that percentage of the trust. Under IRC §664, since the grantor was not the owner of the entire trust, the trust would be treated as being created on the date it was executed. Therefore, such a trust would not qualify as a charitable remainder trust since on the date of its creation for tax purposes, the grantor had the power to revoke only part of it. [Reg. §1.664-1(a)(6).] 3. Need for New Charitable Remainder Trust. The revocable trust instrument should create a new trust to serve as the charitable remainder trust. [Regs. §1.664-1(a)(4), (6).]
IV. IRREVOCABLE LIVING TRUSTS - SELECTED USES A. Transfer Tax Planning Trusts for Minors a. IRC §2503(c) provides that gifts to a qualifying trust will be treated as present interests eligible for the gift tax annual exclusion. b. The trust must have a minor as its beneficiary and principal and income can be used only for the benefit of the minor until age 21, at which time the trust will terminate and distribute all its assets to the beneficiary. If the beneficiary dies before attaining age 21, the income and principal must be transferred to the beneficiary's estate or pursuant to the beneficiary's exercise of a general power of appointment. The trust may be continued beyond the beneficiary's 21st birthday only if the beneficiary is given the right to terminate the trust at that time. (See Revenue Ruling 74-43, 1974-1 C.B. 285). Irrevocable Life Insurance Trust a. Proceeds of life insurance insuring a grantor's life may be excluded from estate taxation if the grantor did not have any incidents of ownership in the policy within three years of death. It is common for a grantor to form an irrevocable life insurance trust ("ILIT") which either applies for a new life insurance policy on the life of the grantor and/or accepts irrevocable assignment of existing policies to the trust. In the case of an assignment, the grantor/policyowner needs to live more than three years beyond the date of assignment to the trust. The ILIT in effect leverages the $600,000 unified credit exemption in that the death benefit of a policy is removed from the taxable estate by treating the smaller cash value (interpolated terminal reserve) and perhaps subsequent insurance premiums as gifts. b. ILIT's are often unfunded so there is a need to annually transfer property to the trust to enable the trustee to (coincidentally) pay the life insurance premiums. In order that the transfer to the trust be treated as a present interest eligible for the annual gift tax exclusion, beneficiaries are often given a power of withdrawal (a "Crummey power") exercisable for a limited time after the trustee receives the contribution. [See Crummey v. Commissioner, 397 F2d 82 (9th Circuit 1968)]. c. Depending on the anticipated annual level of contributions that must be made to the trust, the trust may also contain "5 or 5" limitations on the amount that can be withdrawn by a beneficiary so that there is no deemed gift upon non-exercise of the power. Other techniques to avoid the gifts include trust provisions which provide the beneficiary with a special testamentary power of appointment so that a lapse of the withdrawal power does not result in a completed gift, "hanging powers", etc. d. An ILIT can serve double duty as a pour-over receptacle for other assets in appropriate circumstances. Qualified Personal Residence Trusts a. IRC §2702 allows a homeowner to make a gift of a personal residence at a discounted value by transferring it to a qualified personal residence trust ("QPRT"). The homeowner reserves use of the residence for a term of years, after which time the home is typically transferred by the trustee to the children. So long as the homeowner outlives the term of the trust, the home is ultimately transferred to intended beneficiaries at a substantial discount from its fair market value. In effect, the value of the retained possessory interest is subtracted from the fair market value of the fee. The actual discount depends on the age of the grantor/homeowner, the length of time during which use is reserved to the homeowner and the prevailing level of interest rates. 4. Dynasty Trusts a. So-called "dynasty" trusts, formed under the laws of a state or country which does not have a rule against perpetuities, may maintain asset control among family members in perpetuity and minimize transfer taxes in appropriate cases. B. Trusts for Elderly and Disabled 1. Supplemental Needs Trusts a. These trusts are authorized under EPTL §7-1.12. See also Matter of Escher, 52 NY 2d 1006, MHL §43.03(d) and SSL §104(3). Typically the trust is "established" by the disabled person's parent, grandparent, legal guardian or a court. Spendthrift, anti-alienation and other trust provisions are usually drafted in such a manner so as not to reduce public assistance. The document also prohibits a court from exercising power to invade principal otherwise granted to the court under EPTL §7-1.6. If the trust is funded with the assets of the disabled Medicaid applicant or applicant's spouse, then the trust must have a "pay-back" provision to reimburse the state after the death of the beneficiary. 2. Retained Income Trust a. An "income only" trust, in which a grantor transfers assets, retaining only the right to income from the trust, may be a useful tool in appropriate circumstances since the principal is not considered an available resource for Medicaid budgeting purposes. However, property transfers to the trust will be subject to sanctions if a Medicaid application is filed within a certain time period of the transfer. The New York Department of Social Services' expansive interpretation of federal enabling legislation may result in a 60 month (rather than a 36 month) look-back period for transfers "to" the trust, in addition to a 60 month look back for transfers to third parties from the trust. These "income only" trusts usually do not permit principal distributions to anyone while the grantor is alive. C. Asset Protection Trusts 1. General spendthrift provisions coupled with trusts of long duration (such as so-called "dynasty" trusts) can protect assets from creditors, estranged spouses, beneficiaries' financial inexperience or imprudence, etc. 2. At the other end of the asset protection spectrum, a person with high net worth who can negotiate the various "transfer in fraud of creditors" rules, can transfer assets to a family limited partnership. This partnership can be controlled by an offshore irrevocable trust formed by the same grantor and which is sited in a country whose laws offer liberal protection from creditors and procedural roadblocks to collection efforts. D. Charitable Trusts 1. Charitable Remainder Trusts a. A charitable remainder trust allows a grantor/donor to obtain current income and gift tax deductions for contributions to the trust, allows the trustee to sell the contributed property free of capital gains tax (in most cases), allows the grantor/donor to retain a qualified annual income interest and removes the remainder from the grantor/donor's estate. There are 3 basic categories of qualifying trusts: i. Charitable remainder annuity trust ii. Charitable remainder unitrust iii. Pooled income fund 2. Charitable Lead Trusts a. Under this structure, the charity receives a qualifying income interest for a term of years or other measurable period, with remainder passing to the grantor/donor or other beneficiaries. i. Annuity trust ii. Unitrust 3. Charitable Trust as Independent Tax Exempt Entity a. Under this approach, the donor retains no beneficial interest in the property or trust. The trustees of this trust apply for tax qualification under IRC §501(c)(3) so that transfers to the trust are deductible for income, gift and estate tax purposes. i. Private foundation considerations ii. Self-dealing prohibitions under IRC §4941(d) iii. Retention of excess business holdings under IRC §4943(c). iv. Penalty tax under IRC §4943 and under IRC §4944. v. Taxable expenditures under IRC §4945(d). vi. Distribution timing so as to avoid tax under IRC §4942. V. WITH AN IRREVOCABLE LIVING TRUST, ARE YOU HEADING DOWN A DEAD END STREET WITH NO WAY OUT? A. Anticipate Future Events and Provide for Same in the Trust Document 1. If the trust purpose is not served after certain beneficiaries have prematurely died, provide for an alternate disposition. 2. Irrevocable lifetime trusts should address the effect of divorce from the present spouse and remarriage to a different spouse. Rather than triggering the wrath of the spouse by making explicit references to divorce from a named person, consider defining "spouse" as the person (if any) to whom the grantor is married on the date a certain event occurs which may affect a spouse's rights under the trust. 3. Hedge against unlikely but expensive tax disasters by providing alternative bequests when an unlikely event in fact occurs. A common example involves a grantor/insured who forms an irrevocable life insurance trust and transfers existing life insurance policies to the trust. If grantor survives more than three years beyond the transfer date, the insurance trust should work as intended and the insurance death benefits should not be included in the grantor/insured's estate. If a grantor fails to survive for three years after the transfer, the trust can have contingent provisions (such as a distribution of the insurance proceeds to the surviving spouse) so as to offset the inclusion of the insurance proceeds in the taxable estate. 4. Independent trustees can be given broader powers and more flexibility to adjust to subsequent changes in tax law or later events. For example, a trustee of an irrevocable life insurance trust may be given the power to suspend the Crummey withdrawal right of selected beneficiaries who in fact have a history of exercising their right of withdrawal. Trustees are sometimes given power to change the Crummey withdrawal rights to account for later increases in the annual exemption amount, increases in value of the trust corpus for purposes of the "5 and 5" rule, etc. With respect to the generation-skipping tax, the trustees sometimes are given the power to grant general powers of appointment to second generation trust beneficiaries so that a transfer to a third generation beneficiary is treated as a transfer to the second generation subject only to the estate tax and not GST. 5. Appropriately limited powers on the part of an independent trustee to terminate the trust in the event it is not economic, to merge the trust with a similar trust for the same beneficiary, to sell trust assets (such as life insurance policies on the life of the grantor who has had an adverse change in health) can effectively respond to changed circumstances. 6. EPTL §7-1.13 now allows a single trust to be split by the trustee (and sometimes the executor/administrator) for various tax purposes without prior court approval or the consent of the beneficiaries This power to split may salvage a marital or charitable deduction, avoid GST, etc. See the above-cited statute for a list of reasons a trust may be split. 7. EPTL §7-1.9 allows amendment of an otherwise irrevocable trust with beneficiaries' and grantor's consent. Relief under the statute is problematic if the grantor has died or if a beneficiary is incompetent or a minor. B. Petition to Court for Reformation 1. This is all too commonly done when a grantor evidences a clear intent to make deductible charitable or marital bequests but the provisions of the trust contain technical errors which prevent claim of the deduction. C. Post-Mortem Planning Techniques 1. Post-mortem planning techniques, such as making of qualified disclaimer/renunciations, can often salvage a reasonable result from what is otherwise a tax disaster. Various tax elections are available, such as the allocation of generation skipping tax exemption coupled with a split of a trust into 2 separate trusts. For an excellent list of such tax elections, see Blattmacher and Slade, "More Than One Hundred Post-Mortem Estate Planning Elections", July/August 1994 New York State Bar Journal, 26.
by Frank Dec |
