a.Charitable Gifts: Gifts to qualified charities are income tax deductible. In addition, the charitable component of a split interest trust (one where a portion of the trust has a charitable beneficiary, and another portion has a non-charitable beneficiary) is a reduction of total taxable gifts made during the year. The deduction is unlimited as long as the gift is made without restrictions on the use of the property donated. Qualified charities include any corporation organized for religious, charitable, scientific, literary or educational purposes. In addition, a charitable gift to the donor’s own private foundation qualifies for the deduction.
b. Charitable Remainder Trust: A charitable remainder trust (CRT) is an irrevocable trust (an example of a split interest trust) to which the grantor contributes assets retaining a stream of income for either a term of years or for life, with the remainder passing to charity at the end of the term. The grantor is allowed an income tax deduction for the present value of the remainder interest that passes to charity, and the property contributed is permanently removed from his gross estate. The IRS requires the grantor to take an annual distribution of not less than 5% of the trust’s value. The present value of the charity's remainder interest must be at least 10% of the trust's original value in order to ensure that the charity will receive some benefit at the end of the term. The duration of the trust may be a term of years not to exceed twenty (20), for the life of the donor, or the life of the donor and his survivor.
A CRT allows an individual to convert highly appreciated non-income producing or low income producing assets, such as appreciated securities into high income generating investments, without the burden of a capital gains tax, while retaining an income stream and ultimately providing a benefit to charity. Since there is no capital gains tax on the sale of securities inside the CRT, I suggest funding this trust with low basis securities. After the securities are sold, the proceeds would be invested in income producing assets, such as bonds. This would ensure adequate income to meet the annual payment requirement to you. Further, you could maintain control of the trust by acting as trustee.
The CRT can be designed as either a charitable remainder unitrust, "CRUT," or a charitable remainder annuity trust, "CRAT". A CRUT allows the donor to receive an annual payment expressed as a percentage, at least 5% of the trust's fair market value, computed each year. This will provide an increasing cash flow in a climate of rising asset values, which would serve as a hedge against inflation. In a declining market, the decreasing values will reduce the unitrust payment. The CRAT provides an annuity payment which is fixed at the creation of the trust and is unaffected by changes in the value of the trust assets.
Assume your client contributed $1 million of highly appreciated stock to a CRUT for his lifetime and retained an income stream of 7% of the trust’s value payable every year. The charitable remainder could be for the benefit of your client's private foundation (discussed below). Your client would receive a current income tax deduction equal to the present value of the remainder interest, which is about $260,000, representing an income tax savings of approximately $103,000. The trust could then sell the stock without paying any taxes on the capital gains. The entire $1 million proceeds could then be reinvested in fixed income securities and the trust could pay out income an annuity of 7% or approximately $70,000 to your client for the rest of his lifetime. Upon his death, the remainder would pass to your client's foundation.
d. Private Foundations: A private foundation can be established to act as the recipient of charitable interests that might be created as part of an estate plan. Establishing a foundation allows flexibility with regard to the timing of when charitable gifts may be disbursed to the ultimate charitable recipient because the foundation is only required to make annual contributions to qualified charities equal to 5% of its annual value. Therefore, if the foundation’s assets’ growth rate is in excess of 5%, the value of the foundation will appreciate over time. A private family foundation could bear your client's name and your client could be actively involved in its management.
Drafting Tip: Follow IRS regulations explicitly when drafting CRT. They actually provide CRT language.
II.QUALIFIED DOMESTIC TRUSTS
Any property that passes to a surviving spouse who is a U.S. citizen is automatically excluded from tax as a result of the unlimited marital deduction. However, in order for property passing to a surviving spouse who is not a U.S. citizen to qualify for the unlimited marital deduction, the property must pass to a qualified domestic trust (“QDOT”). The regulations impose restrictive requirements on a QDOT that are described below. If all of your property is left outright to a surviving spouse, the credit for the applicable exclusion amount is not utilized. This is because any property that passes to a surviving spouse who is a U.S. citizen (or to a QDOT) is automatically excluded from tax as a result of the unlimited marital deduction. This marital deduction provides estate tax relief on the death of the first spouse, but all of the property is later included and fully taxable in the estate of the second spouse.
A QDOT must meet the following requirements:
- Must be a traditional marital deduction trust or an estate marital deduction trust;
- Must have at least one US trustee that is either an individual US citizen or a domestic corporate trustee (Non-US spouse can serve as Co-Trustee);
- Must be an ordinary trust (inter-vivos or testamentary; not a business trust, investment trust, etc.)
- Trustee must have right to withhold QDOT tax;
- Must meet tax collection requirements; and
- Executor must elect QDOT treatment for trust
Additionally, if the QDOT contains assets in excess of two million dollars ($2,000,000) or if more than thirty-five (35%) of the assets of the QDOT are real property located outside of the U.S. the QDOT must either (1) have a U.S. bank as a trustee, (2) furnish a bond or (3) furnish an irrevocable letter of credit. All income is available but any distributions of trust principal will be subject to taxation unless a formal request is made to the IRS for a tax exempt hardship withdrawal.
Drafting Tip: Include both QTIP and QDOT language as part of a marital husband and wife trust under Wills in case the non-citizen spouse obtains citizenship and name a corporate trustee.
III. QUALIFIED PERSONAL RESIDENCE TRUSTS (QPRTS)
A qualified personal residence trust ("QPRT") is a technique for gifting residential property at discounted values. The QPRT is an irrevocable trust, which becomes the legal owner of the home during the trust term. The grantor would continue to live in the home during the term of the trust, and continue to pay the real estate taxes, mortgage and maintenance expenses; the taxes and interest can be deducted on the grantor's personal income tax return, as it was before. The grantor must remain personally and contractually bound to the trustee to pay off the mortgage indebtedness in order for the amount of the mortgage to be disregarded for valuation purposes. At the end of the term, the beneficiaries would legally own the home but the grantor's spouse may have the right to live in the house for his/her lifetime. At that point, the grantor may also remain living there due to spouse’s life estate. Should the grantor's spouse predecease, the grantor could remain living in the house as long as fair market rent is paid. The term of the trust is a period of years, selected by the grantor. The longer the term, the greater the tax benefits. However, if the grantor does not outlive the term, any tax benefit of this strategy is lost.
An example is helpful to illustrate how effective the QPRT can be as an estate tax savings vehicle. The sixty-five (65) year old grantor's home has an appraised value of $650,000 today. If the grantor selected a 5-year QPRT term, the amount of the actual gift for tax purposes is not $650,000; it would be reduced to about $530,309. This is because the subject of the gift is the present value of the remainder interest at the end of the QPRT term; the discount takes into account the fact that the children must wait until the trust term ends to receive anything. The potential value of the home after 5 years, assuming an annual growth rate of 4%, would be approximately $800,000. Therefore, you could remove an asset, having a future value of $800,000, from the grantor's estate today, where the measure of the gift for tax purposes would be only $530,309. There may not be any gift taxes due on the transfer since such gift would qualify for the $5,340,000 unified credit exemption equivalent.
The advantages of the QPRT are as follows:
- The computation of the gift of the remainder interest does not contemplate future growth in the value of the property. Therefore, any post-transfer appreciation inures to the beneficiaries free of gift or estate tax. In the above scenario, almost $130,500 escapes taxation in the grantor's estate.
- The trust is a grantor type trust which permits you to retain possession and enjoy the tax-favorable attributes of owning the residence.
- At the end of the term, the grantor may continue to live in the house as long as the grantor's spouse is also living there or, if he/she is not, the grantor must pay fair market value rent to the beneficiaries. This “rent” is another way to transfer wealth out of the grantor's estate free of gift taxes. The rental income would be taxable to the beneficiaries but because income tax rates are lower than estate tax rates, this is an economically efficient way to transfer additional wealth to your family.
The disadvantages of a QPRT are as follows:
- The gift is considered a gift of a future interest and the $14,000 annual exclusion is not available for this transfer.
- If the grantor does not survive the term of the trust, the house would be included in the grantor's estate at its fair market value as of the date of death, as if the trust were never created. The term selected for the trust should, therefore, be one that you can reasonably expect to survive. The trust document will still legally control the ownership and disposition of the house regardless of whether or not you survive the term for tax purposes.
- The original tax cost in the residence is carried over to the ultimate beneficiaries. It will not be stepped up to market value at your death since it would not be part of your estate. As stated above, the income tax (capital gains) rate is lower than the estate tax rate, so the tax on the appreciation is less onerous than if the grantor's estate were taxed on the eventual appreciated market value of the home at the grantor's death.
Drafting Tip: Always consider having a grantor trust continue as the owner of the home after the term expires up until the grantor or the grantor's spouse death.
IV. DEFECTIVE TRUSTS
Sale of Stock to an Intentionally Defective Grantor Trust for a Note: This estate planning method allows for the “freezing” of the future appreciation of assets for tax purposes. The grantor would sell assets to a trust for a Promissory Note (the “Note”). The Note would pay the interest at the prevailing applicable federal rate. At the end of the term of the Notes, the principal amount would be paid to the grantor in cash or in-kind (interests in your limited liability companies), or restructured. Most importantly, the portion of assets sold to the trust will be “frozen” in value on the date of the sale. Accordingly, all future growth and appreciation over the grantor’s lifetime would occur outside of his/her estate. Thus, for every dollar of growth, $.55 of tax should be saved and passed on to the children. The estate tax consequences with respect to the Note in the transaction will depend on whether the grantor survives the term of the Note. If the grantor does not survive the term of the Note, the value of the Note should be included in the grantor’s estate. Since the Note never appreciates like the real estate, the “freeze” has been accomplished.
The intentionally defective grantor trust purposely created as a Grantor Trust for income tax purposes. Grantor Trust under IRC §675 (also see Rev. Rul 2004-64, 2004-2; and Rev. Rul 2008-16). A TIN and Form 1041 are always required under general method.
Beneficiary Defective Grantor Trust: A beneficiary of the trust is treated as the Grantor for income tax purposes. Grantor Trust to beneficiary under IRC §678(a). A TIN and Form 1041 are always required under general method.
Drafting Tip: Be sure to use a grantor trust trigger that does not also cause inclusion in grantor's estate. Typically the power to substitute based on Revenue Ruling 2008-22 to be safe.
V. EDUCATION TRUSTS FOR CHILDREN AND GRANDCHILDREN
Education/2503(c) Minor Trust: A trust that receives gifts equal to the annual exclusion amount by the Grantor for the benefit of a beneficiary under age of 21. Trust property may be expended for the benefit of the minor; any remaining balance must be distributed to minor at age 21 or paid to the estate of minor if they die prior to attaining the age of twenty-one (21). Grantor utilizes annual exclusion under IRC §2503(b) for gifts to trust. No Crummey notice is needed to satisfy present interest requirement. Trust is not treated as a Grantor Trust.
Drafting Tip: Avoid IRC §2503(c) trust and instead use Crummey Trusts. Also note most Grandchild Trust's don't satisfy the §503(b) Crummey exemption for GST.
VI. GENERATION SKIPPING TRUSTS
At one time, taxpayers could significantly reduce estate taxes by skipping over a generation when making gifts. Specifically, a taxpayer could avoid the imposition of estate taxes on his assets in his children’s generation by creating a trust for the benefit of his grandchildren. In 1986, Congress enacted the present structure of an additional tax on these transfers called the generation skipping transfer tax (GST). The tax is assessed a flat forty percent (40%) rate on any transfers over $5,430,000 of property that “skip” one or more generations and is in addition to the forty percent (40%) estate and gift tax. Every person may gift up to $5,430,000 to grandchildren, or trusts for their benefit, without the imposition of the GST.
The $5,430,000 GST exemption may be particularly useful in an irrevocable trust with grandchildren or other "skipped" persons as beneficiaries. The GST trust is usually a Complex Trust.
Drafting Tip: Always consider adding trust language to be able to "cure" an improperly allocated GST exemption. Use language to allow the Trustee to split the trust into GST exempt and non-exempt sub trusts to avoid having to take out GST taxable distributions.
VII. FUNDING THE TRUST
Funding of a trust is as important as drafting the trust. It is imperative to have a firm policy regarding funding of the trusts once a client executes it. If the firm is responsible for funding, you should ensure that each asset was properly transferred to the trust.
If the client is responsible for funding his/her trust, you should follow up with the client to ensure the trust was properly funded and request written confirmations of the same.
Typical issues that arise in funding of trusts include the following:
- Deeds are not recorded in County Clerk’s office;
- Brokerage accounts are not properly transferred to the trust – I recommend all correspondence sent to financial institutions are sent via certified mail return receipt;
- Beneficiaries on insurance policies, annuities, retirement accounts, etc. are never changed to correspond to the client’s estate plan; and
- Trust accounts are created with the wrong signature authorities.
 http://files.ali-aba.org/thumbs/datastorage/skoob/articles/CH05%20MDTrusts_2006Supp-6_thumb.pdf; IRC §2056A; Treas. Reg. §20.2056A-2
*** The Treasury Department has newly promulgated Regulations effective June 20, 2005, that applies to those attorneys and accountants (and others) practicing before the IRS that require such individuals to provide extensive disclosure in certain written communications to clients. In order to comply with our obligations under these Regulations, we want to inform you that since this communication is not intended to and does not contain such disclosure, you may not rely on any tax advice contained in this document to avoid tax penalties.