It's a Matter of "Trusts"

Paula Ellenberg, CPA, CVA, MST and Joe Matthews, MBA (Aug, 2014)

The creation of a trust can be very beneficial, yet very complex.  Often utilized for gift and estate tax planning, trusts are created for a variety of reasons.  Among these are privacy concerns, asset protection, compensation planning, charitable giving, Medicaid eligibility, and financial and/or elder care planning.  This article will discuss some trusts commonly used for estate and gift tax planning in which the donor retains some economic interest during their lifetime.

Grantor Trusts

Simply put, a “grantor” type trust is a legal entity under state law, but it is not recognized as a separate taxable entity for income tax purposes.  This is because the grantor has retained sufficient control over the income and/or principal to cause the grantor to be treated as the trust’s owner for income tax purposes.

Why Use a Grantor Trust?

A key reason why some trusts are intentionally designed to be “grantor trusts” are the trust income tax rates versus individual income tax rates.  The highest marginal rate for both trusts and individuals is 39.6%.  However, it only takes $12,150 of income to reach the 39.6% tax bracket for a trust, while it takes $457,600 of income to reach the 39.6% tax bracket for a married filing joint individual.  In addition, the payment of the income tax on the trust income by the grantor for a grantor trust does not constitute an additional gift to the trust.

Grantor trusts are among the most common types of trusts and can be either “revocable” or “irrevocable.”

Revocable Trust

A revocable trust is created by a grantor during their lifetime (an inter vivos trust).  During his/her lifetime, the grantor has the ability to amend or revoke the trust at any time.   Since this type of trust can literally be “undone” during the grantor’s lifetime, the transfer of assets to the trust is not considered a “completed gift” for gift and estate tax purposes at the time the trust is created.  Therefore, no gift tax return would be required and all income is taxed to the grantor. 

Revocable trusts are not used for estate tax planning purposes, but for other non-tax reasons such as convenience, probate avoidance, or to protect the grantor’s privacy.  This type of trust becomes “irrevocable” only upon the grantor’s death, at which time the trust’s assets are included in the grantor’s taxable estate, however, not included in their “probate” estate.

Irrevocable Trust

An irrevocable trust is created by a grantor during their lifetime.  These trusts cannot be amended or revoked.  Unlike revocable trusts, irrevocable trusts are commonly used for estate and gift tax planning purposes.  The inter vivos transfer of assets to an irrevocable trust is considered a taxable event, with the grantor making a completed gift, and possibly triggering gift tax.  Two of the most commonly used trusts for estate tax planning purposes are the Intentionally Defective Grantor Trust and the Irrevocable Life Insurance Trust.

Intentionally Defective Grantor Trust (IDGT)

The IDGT is an irrevocable inter vivos trust.  This type of trust is useful for both estate tax planning and income tax planning.  These otherwise irrevocable trusts are made intentionally defective by giving the grantor certain powers, such as the power to acquire trust property by substituting other property of equivalent value.  The IDGT is considered a grantor type trust for income tax purposes.  As previously mentioned, this can result in overall tax savings since the income tax the trust may pay could be considerably higher than the grantor might pay on the same income.

This planning technique is ultimately intended to reduce estate taxes by removing appreciated assets from the donor’s estate.  The transfer of assets to an IDGT is considered a completed gift.  Great care must be taken in the creation of IDGT to avoid giving the donor a retained interest sufficient enough to cause the inclusion in his or her estate.

Irrevocable Life Insurance Trust (ILIT)

Life insurance proceeds, while not subject to income tax, are considered part of your taxable estate.  ILITs are used in estate tax planning in order to exclude any life insurance policy proceeds from a decedent's gross estate as well as provide for the decedent’s beneficiaries.  ILITs provide for this gross estate tax exclusion when the proceeds of a life insurance policy are made payable to a beneficiary outside of the decedent's gross estate and the grantor, or individual that is insured, does not retain any incidents of ownership in the policy.

Once the initial gift is made to the trust, often cash to buy the policy or pay premiums, the trust may generate little or no income until funded upon the grantor’s death at which time the trust becomes a separate taxable entity.   Because the trust income may be applied to pay premiums on life insurance on the grantor’s life, taxable income would be taxed to the grantor under the grantor trust rules.  Many trust creators deem it wise to include provisions in the trust instrument to assure grantor trust.

Split Interest Trusts

Split-interest trusts are all based on the same concept:  the donor gives away an asset while retaining some economic interest in the asset.  These trusts are all irrevocable and they are referred to as split-interest gift trusts.  Some of the more common split interest trusts are:  Grantor Retained Annuity Trusts (GRAT), Qualified Personal Residence Trusts (QPRT) and Charitable Remainder Trusts (CRTs).

Why Use Split-Interest Trusts?

Split-interest trusts are designed to take advantage of and leverage a donor’s lifetime gift tax exclusion, currently at $5,340,000. 

Grantor Retained Annuity Trust (GRAT)

A GRAT is an irrevocable trust created by the grantor during his lifetime.  The grantor retains a right to receive a fixed amount payable at least annually for life or a term of years.  In essence, the GRAT is a fixed annuity.  At the end of the term, the trust principal is distributed to the beneficiaries.  The fixed amount is based on the amount of the initial contribution to the GRAT.  This is usually a percentage of the value of the asset being contributed.  The value of the gift would be the value of the residuary interest.  After the initial gift there can be no more transfers to the trust.

The GRAT is generally treated as a grantor type trust for income tax purposes.  In most cases, this is a desired result because the trust assets are not reduced by tax at the trust level.

Qualified Personal Residence Trust (QPRT)

The QPRT is an irrevocable inter vivos trust to which a grantor transfers a personal residence for the benefit of the remainder beneficiaries.  The grantor retains the right to any income from the trust and to use the premises for a term of years.  QPRTS are used for estate and gift tax planning purposes because the value of the gift is “locked in” at the value of the remainder interest.  The property transfer is a completed gift and the property will be excluded from the grantor’s estate if he/she survives the term of the trust.   A word of caution, for a trust to qualify as a “qualified personal residence trust” the trust instrument must provide for all of the requirements of the applicable IRS regulations (Reg. 25.2702-5(c).

Because the grantor retains the right to receive the income of the trust and to use the premises, QPRTS are treated as grantor trusts for income tax purposes.  This grantor trust status allows the donor to claim the interest expense and real estate tax expense deductions. 

Charitable Remainder Trust (CRT)

The Charitable Remainder Trust (CRT) is an irrevocable trust designed to convert highly appreciated assets into a lifetime income stream.   The donor, trustee and income beneficiary can be the same person.  The ultimate remainder beneficiaries of a CRT must be qualified charitable organizations.  There must be at least one non-charitable income beneficiary.  When the non-charitable interest expires, the irrevocable remainder interest in the trust passes to charity.  Since CRTs are exempt from income tax under IRC Sec. 664, if the CRT sells assets with a low carryover basis no income tax is due on the capital gains. 

The grantor of an inter vivos charitable remainder trust receives an income (and gift) tax charitable deduction in the year the property is contributed to the trust.  The deduction equals the actuarial present value of the remainder interest that is ultimately intended to pass to charity. 

The foregoing are a few of the trusts commonly used for income and estate tax planning.  While the creation of a trust can be a complicated and time consuming event, the income and estate tax planning benefits are easily recognizable.  As Billy Joel once said, "…it's a matter of trust".  Clearly, he was not talking about tax planning.  Trust your Dermody, Burke and Brown tax professional to help you navigate through this complex topic.

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