Wills, Trusts, and Estates

Week 5-6

Spring 2015

Trusts

• Creator (Grantor/Settlor/Trustor)

• Trustee Legal Title

• Property (Corpus/Res/Principal)

• Beneficiaries Equitable Title

• Provisions/Terms (Trust Instrument/Deed of Trust)

Requirements for a Valid Trust

• Settlor manifests an intention to create a trust

• Trust must be created for a legal purpose and not be against public policy

• Trust must accurately identify beneficiaris EXCEPT charitable trusts

• Trusts SHOULD be in writing

Trust Instruments

• Wills trust is setup via language within the will – Testamentary Trusts

• Trust Agreements a contract entered into between the settlor and the trustee, who are not the same person, to create a trust

• Declaration of Trust a written document creating a trust in which the settlor is also the trustee

General Drafting Guidelines

• Identify the settlor

• Appoint the trustee

• Identify the purpose of the trust

• Identify the property that will be held in trust

• Set out the duties of the trustee

• Grant power to the trustee

• Compensation for trustee

• Name the beneficiaries and successor beneficiaries of the trust

• Provide for the termination of the trust

• Governing law

• Signature, attestation, notarization

Specialized Trust Provisions

• Trustee’s level of discretion (“Sprinkling”)– Trustee decides when to distribute or accumulate the trust

income

• Crummey Clause• Spendthrift Clause

– “The purpose of this trust is to protect Sam Spender from his own financial mismanagement and to provide him with a reasonable means of support, free from the claims or interests of others. Any and all distributions from the trust shall be paid directly to the beneficiary, Sam Spender, and to no other person or entity. The beneficiary shall not have the power to transfer, assign, or pledge his interest in the principal or income of this trust prior to receipt.”

• Savings Clause

Termination of Trusts

• Terms of the trust mandate termination after a specified time or completion of a task

• Trust purpose has been fullfilled

• Precatory trust

• Settlor revokes the trust (Revocable Trust)

• Trustee’s decision, if the trust terms grant him such power

Classification/Characteristics of Trusts

• Inter Vivos Trust or Testamentary Trusts

• Revocable Trusts or Irrevocable Trusts

• Simple or Complex

• Pour-Over Trust

Inter Vivos and Testamentary Trusts

• Inter Vivos (Living Trust) = Trust established during the settlor’s life– Property in an inter vivos trust is NOT subject

to probate

• Testamentary = Trust established at death through one’s will– Property is subject to probate– Estate Taxes are due when the property

passes to a testamentary trust

Revocable Trusts (Living Trusts)

• Revocable Trusts = The trust can be revoked or changed by the grantor at any time.– All revocable trusts are inter vivos trusts

• Not included in Grantor’s probate estate• Spouse can claim an elective share from the assets of

the trust.• Tax consequences:

– Value of the trusts assets are included in the grantor’s gross estate for Federal Estate Tax purposes

– Incomplete gift, therefore no Federal Gift Tax liability– The Grantor is generally responsible for paying the income tax

on all of trust income.– Creditors can generally reach the trust assets during Grantor’s

lifetime and at death.

Irrevocable Trusts

• Irrevocable Trusts = Grantor retains NO right or power to change the trust and gives up control over the trust property permanently.

– Can be testamentary or inter vivos

• Trust assets are NOT included in the Grantor’s probate estate

• Tax consequences:

– Value of the trusts assets are NOT included in the grantor’s gross estate for Estate Tax purposes

– Grantor’s transfer of assets to an irrevocable trust can be a completed gift for Gift Tax purposes.

– Income from the trust assets is generally taxed to the trust or to its beneficiaries.

• Crummey provision allows Grantor to use their gift tax annual exclusion, BUT gives the Beneficiary a general power of appointment that will place the covered property into the Beneficiary’s gross estate – 5/5 Lapse rule for multiple beneficiaries

Transfers to an Irrevocable Trust that will be Included in Grantor’s Gross Estate for

Federal Estate Tax Purposes

• Grantor retains a life income or life estate• Grantor retains a reversionary interest• Grantor has a general power of appointment to direct whom the

assets will pass• Grantor dies within 3 years of transferring life insurance policies to

the trust• Grantor transfers life insurance policies to the irrevocable trust and

retains incidents of ownership - ex. naming himself trustee• Grantor retains an interest in the trust property – ex. right to pledge

it for loans

Simple v. Complex Trusts

• Federal Income Tax laws categorize trusts as:– Simple Trust = requires all income be distributed currently (i.e.,

in the tax year in which it is earned; trust instrument must provide that no amounts are to be paid, permanently set aside, or used for charitable purposes; and, the trust must not distribute any amounts that are allocated to the corpus (principal) of the trust.

• Entitled to a personal exemption of $300

OR– Complex = all trusts that are not considered “Simple Trusts”

• Entitled to a personal exemption of $100

• An estate is entitled to a $600 exemption

Pour-Over Trust

• Assets poured from another source (e.g. will, IRA, insurance contract) into the trust

• Or can pour out of the trust and into the estate

Specific Types of Trusts• Irrevocable Life Insurance Trusts (ILIT’s)• Bypass/Credit Shelter/A-B/Family Trust• Marital Trusts

– Power of Appointment Trusts– Qualified Terminable Interest Property Trusts (QTIP)

• Grantor Retained Interest Trusts (GRIT’s)– Grantor Retained Annuity Trusts (GRAT’s)– Grantor Retained Unitrusts (GRUT’s)– Qualified Personal Residence Trusts (QPRT’s)– Tangible Personal Property Trusts (TPPT’s)

• Dynasty Trusts• Trusts for Minors – Sections: 2503(b) [Mandatory Income Trust] and 2503(c) Trusts• Blind Trusts• Charitable Remainder Trust (CRT)

– Charitable Remainder Annuity Trust (CRAT)– Charitable Remainder Unitrust (CRUT)

• Charitable Lead Trust (CLT)• Pooled Income Funds (PIF)

Irrevocable Life Insurance Trusts (ILIT’s)

• Where the trust owns the life insurance policy, but the Grantor/insured pays the premiums

• Life insurance procedes will be included in an insured’s estate for Estate Tax purposes if:– the insured owns the insurance policy at death, or – if while alive held any ownership in the policy (ie. right to change a

beneficiary or cancel the policy), or– insured’s estate is named as the beneficiary of the policy

• An ILIT removes the life insurance proceeds from the Grantor/insured’s Gross Estate for Estate Tax Purposes UNLESS – trustee is instructed to pay Grantor/insured estate taxes or administrative

expenses of the estate, or – policy is transferred within 3 years of Grantor’s death

• Grantor can make annual gifts to the trust (qualify for the annual gift tax exemption) that will cover policy premiums if a Crummey provision is included

• Purpose of ILIT:– Remove proceeds of life insurance from insured’s estate– Provide liquidity at death– Provide for beneficiaries

Bypass/Credit Shelter/A-B/Family Trust

• Testamentary or Inter vivos trust• Designed to take advantage of the applicable

credit amount of 1st decedent spouse • No marital deduction, assets included in 1st

decedent spouse’s gross estate and taxable estate, but bypasses surviving spouse’s estate

• Often used to provide income to surviving spouse and remainder to children

• Spouse may be income beneficiary• Spouse may hold a limited power of appointment• Marital Trusts: POA trust and QTIP

Power of Appointment Trusts• Testamentary or Inter vivos irrevocable trusts

• Marital trust that qualifies for the unlimited marital deduction and gives a general power to appoint remainderman to surviving spouse– GPOA is needed so the unlimited marital deduction can be

utilized– Surviving spouse is entitled to all trust income and must be paid

at least annually– Trust corpus included in surviving spouse’s taxable estate; if

surviving spouse exercises their power of appointment during their life then the surviving spouse has made taxable gifts

• GSTT can be avoided by granting a non-skip person a GPOA over a trust that will distribute assets to a skip person

Qualified Terminable Interest Property Trusts (QTIP)

• Marital trust that qualifies for the unlimited marital deduction and gives the power to Grantor to name the remainderman

• Grantor (first spouse to die) does not pay any Estate or Gift tax on the transfer of property to the QTIP

• Requirements for a QTIP:– Surviving spouse is entitled to all trust income and must be paid

at least annually– Only spouse can be appointed income– Trust corpus taxed (Estate Tax) at last surviving spouse’s death

• Often used to pay income to spouse with remainder to children• Included in the surviving spouse’s taxable estate• Trust pays its pro rata share of estate tax for surviving spouse

Grantor Retained Interest Trusts (GRIT’s)

• Grantor reserves right to income from a trust or the right to use trust assets

• Value of the taxable gift is FMV minus the grantor’s retained interest this = the remainder interest that is considered a gift

• Give this “temporal discount”

• Types of GRIT’s: GRAT, GRUT, QPRT, TPPT

Grantor Retained Annuity Trusts (GRAT’s)

• Special type of GRIT where Grantor retains a right to receive a fixed percentage of the initial contribution on an annual basis for a specified term (usually 2-5 yrs)

• Income taxed to grantor during lifetime for income tax purposes• Not taxed in grantor’s estate unless grantor dies within time they are

receiving income from the trust (trust term)– If grantor dies within the trust term, the value of the assets required to

produce the annuity is included in the grantor’s gross estate at the FMV at the date of death unless a QPRT, then full FMV of residence is included in gross estate

• Gift is a future interest (no annual exclusion), but can subtract from the applicable exclusion amount

• This is an irrevocable trust• May require extensive valuation at time of the trusts initial creation

GRAT Example

• Jason contributes $1.3M in securities to an irrevocable trust. He retains the right to receive $80,000 per year from the trust for the next 10 years. At the end of 10 years, the trust will terminate and the remainder will be paid in equal shares to his grandchildren. The retained interest is a qualified annuity interest and will be given full actuarial value under Sec. 7520 valuation rules. Thus the value of the gift is equal to $1.3M minus the value of a 10-year $80,000 annual annuity.

Grantor Retained Unitrusts (GRUT’s)

• Grantor receives payments from the trust at least annually of a fixed percentage of the net fair market value of the trust assets as determined annually

• Everything else is identical to GRAT

GRUT Example

• Assume the same facts as the previous GRAT example. However, Jason instead retains the right to receive payments equal to 7% of the trust based on its current value each year. The retained interest is a qualified unitrust interest and will be given full actuarial value under Sec. 7520 valuation rules. Thus, the value of the gift is equal to $1.3M minus the value of a 10-year unitrust interest.

Qualified Personal Residence Trusts (QPRT’s)

• Grantor transfers a personal residence to the trust and the retained interest is the grantor’s right to “use” the residence for the trust term

QPRT Hypothetical

• Virginia, a 70 year old widow, is in the maximum estate tax bracket. She places her $100,000 personal residence into a QPRT that provides for her to live there 10 years, and then the property passes to her children. Virginia will calculate the present value of her right to live in the house and subtract it from the FMV of her house to calculate the remainder gift to her children. If Virginia dies before 10 years, the FMV of the property at her death will be included in her estate. After 10 years, Virginia could be permitted to remain in the residence provided there is an agreement and rent is charged at market value.

Tangible Personal Property Trusts (TPPT’s)

• Similar to QPRT, but personal property (ex. paintings, jewelry, etc.) is transferred that has the potential to appreciate in value

• Hard to place a value on the grantor’s retained interest in their right to use a piece of personal property so watch out for the IRS

Dynasty Trusts

• Designed to last for a very long time

• No set ending date

• Set up in state that does not have the RAP (South Dakota, Idaho, Alaska, and a few others)

Trusts for Minors

• Gifts to minor’s do not qualify for the gift tax annual exclusion since it is a future gift UNLESS it qualifies under §2503(b) and §2503(c)

• §2503(b) = income distributions must be made annually to a child beneficiary or to a custodian account or used for minor’s benefit– Does not end when beneficiary reaches 21

• §2503(c) = accumulates income in the trust, but trust property must be made available to beneficiary once they turn 21 (if minor dies before turning 21 then trust goes to minor’s estate)

Blind Trusts

• Revocable trusts

• Set up where grantor may have a conflict of interest

• Used by political officials while in office

Trusts in the Gross Estate• Mary’s husband died 2 years ago. His will included 3 testamentary trusts: a

trust for the benefit of Mary’s children, but giving Mary a general power of appointment over the trust assets (GPOA), a bypass trust for the benefit of Mary’s children, but giving Mary a power to invade the trust for an ascertainable standard – health, education, maintenance and support - for the remainder of her life (Bypass Trust), and a charitable trust for the benefit of Mary’s alma mater (Charitable Trust). At Mary’s death, which of the trusts assets will be included in her gross estate?

• 1. GPOA Trust• 2. Bypass Trust• 3. Charitable Trust

• A) 1 only• B) 1 and 2• C) 2 and 3• D) None

Answer

• A. Only the GPOA Trust would be included in Mary’s gross estate, because the withdrawal right of the Bypass Trust was limited to an ascertainable standard, its assets are not included in Mary’s gross estate.

Charitable Remainder Trust (CRT)

• Irrevocable trust in which the remainder beneficiary is a qualified charity

• Trust can last for life of the Grantor, or for a term of up to 20 years

• Charity does not have to know it was named as the remainder beneficiary

• 2 types of CRTs: Charitable Remainder Annuity Trust (CRAT) and Charitable Remainder Unitrust (CRUT)

Charitable Remainder Annuity Trust (CRAT)

• Value of charitable gift: Total value of the transferred property minus the present value of the retained interest

• Grantor gets a fixed percentage of the initial FMV of the property transferred to the trust or a fixed dollar amount annually

• When income is insufficient for payout to a Grantor then must invade corpus

• No additional contribution are permitted after trust is set up

• Very inflexible• Good for clients who desire certainty of fixed income

CRAT Example

• Dan Donor transfers property valued at $400,000 to a CRAT that provides for a 5% of the initial value of the principal payout for a 20-year term; consequently $20,000 will be distributed annually to the noncharitable income beneficiary.

Charitable Remainder Unitrust (CRUT)

• Value of charitable gift: Total value of the transferred property minus the present value of the retained interest

• Grantor receives a fixed percentage of the trusts assets, valued annually

• When income is insufficient for payout of the fixed percentage to a Grantor then can pay up to income amount and make up deficiency in a subsequent year

• Annual valuation may be expensive if property in trust is something like a closely held business, real estate etc.

• Additional contributions are allowed after the trust is set up

• Very flexible

Charitable Lead Trust (CLT)

• Income from property transferred to a trust is distributed to the charity. The remainder reverts to a noncharitable beneficiary (ex. family member)

• If a Grantor trust then Grantor is taxed on the income and receives the charitable deduction equal to the amount the trust pays to the charity

• CLAT;CLUT• Keeps property within the family unit while at the

same time conveying a benefit to charity.

Pooled Income Funds (PIF)

• Value of charitable gift: Total value of the transferred property minus the present value of the retained interest

• Grantor makes an irrevocable transfer of property (including all remainder interest) to a public charity

• Property is commingled with the property of other grantors and pays a return on the basis of earnings from the fund

• Grantor retains an income interest for 1 or more beneficiaries for life (no term trusts)

• Preferred by those who want to avoid having to establish and maintain a trust – Often maintained by universities

• Appeals to donors who are not contribute large sums

Test Example

• On January 20, Jason Transfers property to a trust over which he retains a right to revoke ½ of the trust. The trust is to pay Jill 3% of the trust assets valued annually for her life with the remainder to be paid to a qualified charity. On October 9, Jason dies and the trust becomes irrevocable. Which of the following trusts does this qualify as?

• A. CRAT• B. CRUT• C. Pooled Income Fund• D. None of these

Answer

• Answer is D. At the trust’s creation it is revocable; therefore, it does not qualify as a CRAT, CRUT or a Pooled Income Fund.

Income Taxation of Trusts

• Income tax liability can be imposed on:– The trust itself– The beneficiaries– The grantor– A third person– Any combination above

Income Taxation of Grantor Types of Trusts

• Grantor Trusts = construed where the grantor retains so much control (powers or ownership interests) Grantor must include the trust income, deductions, and credits on his own income tax return.

• Part Grantor and part regular trust

A Grantor Trust will be construed if any of the following powers or interests have been retained:

• Reversionary interest in trust income or corpus

• Power to control beneficial enjoyment

• Certain administrative powers

• Power to revoke

• Power to Distribute

Income Taxation of Mallinckrodt Trusts

• Mallinchkrodt (§678 trust) = where a third person is treated as the owner of the trust and they must include those items of income, deductions, and credits attributable to the portion of the trust he owns in his own income tax return.

A Third Person will be treated as the owner of any portion of a trust if he has any of the following rights or powers:

• Power of appointment (GPOA) vest the corpus or income in herself or for her own purposes not specifically designated by the trust.

• Crummey trust the beneficiary who had the right of withdrawal will be taxed on the income attributable to that portion of the trust.

Income Taxation of Taxable Trusts

• Trusts that are not Grantor or Mallinckrodt trusts.• If the trustee makes no distributions from a trust to the

beneficiaries during a tax year, then the trust is taxed on its income for that year.

• If the trustee distributes income or property to beneficiaries, the trust gets a deduction for that distribution and the beneficiaries are required to include the value of the distributions in their gross income.

• Each beneficiary receives a Schedule K-1 from the trustee.