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Irrevocable Trusts
Generally: There are a number of types of irrevocable trusts that can be
used to make gifts to other persons with the assets under the control
and management of a trustee.
Gifts to an irrevocable trust are sometimes motivated by a desire to
minimize federal transfer taxes or to shelter assets from the claims of
future creditors and other claimants (including spouses in divorce cases
and plaintiffs in civil lawsuits).
To be effective for estate-reduction purposes, the trust must be
irrevocable, and the trust's settlor should not be a beneficiary of the
trust. It is also best if the settlor is not a trustee, either.
In order to qualify for the $10,000 annual exclusion for gift-tax
purposes, irrevocable trusts usually contain a provision giving the
trust's beneficiaries a temporary right to withdraw annual
contributions, at least in part. This withdrawal right is often called a
"Crummey power" in reference to a Ninth Circuit Federal Court
case involving a family with the "Crummey" surname.
Minors' Trusts
A trust can be established for younger beneficiaries to provide for
education and/or other needs of life. Federal tax law has facilitated
the creation of trusts for beneficiaries under the age of 21 years, but
trusts can be designed to continue until any age or during a
beneficiary's entire lifetime.
Bypass and Spendthrift Trusts
A "bypass trust" is a trust that benefits one or more
beneficiaries without being considered assets of those beneficiaries for
estate and gift tax purposes. Under state law, a bypass trust can be
designed to also qualify as a "spendthrift trust", which
cannot be attacked by a beneficiary's creditors. In short, this type of
trust can reduce the beneficiaries' estate taxes and protect trust
assets from creditors' claims at the same time.
Supplemental Needs Trusts
If an intended beneficiary is a recipient of Medicaid, SSI, or other
governmental assistance programs, an outright gift or a gift in trust
may disqualify the beneficiary from continuing to receive such
assistance. Trusts can be designed so that distributions are made only
to "supplement" the benefits already being received. So long
as distributions made by the trustee are discretionary and not
mandatory, the trust assets and trust distributions are not, under most
programs, considered disqualifying resources.
Specialized Trusts
Irrevocable trusts can be designed in an infinite number of ways. There
are some very special types of irrevocable trusts that have evolved over
the years as basic estate planning tools, including life insurance
trusts and charitable trusts. Other irrevocable trusts are relatively
new, having been developed recently to replace types of trusts that are
not longer permitted by law and to maximize the benefits under current
transfer-tax laws.
Insurance and Irrevocable Insurance Trusts
Insurance Generally
The proceeds of life insurance policies are included in the insured's
estate at his or her death if the insured had "an incident of
ownership" in the policy within three years of death. Estate
taxation can be escaped by having someone other than the deceased own
the policy and all of its attendant rights.
Ownership by Spouse
Years ago, when the marital deduction was limited, there was some
advantage in having the spouse own the policy. This does not accomplish
much under current law, and to the extent the spouse is a beneficiary,
taxes will be deferred until the spouse's subsequent death. This defers
but does not eliminate the estate tax problem.
Ownership by Children
Ownership by children or other family members can eliminate the estate
tax, but it may also defeat some non-tax objectives (such as spendthrift
protection) and some tax objectives (such as generation-skipping). The
primary problem is loss of control with respect to the use and
application of the insurance proceeds. Untimely deaths, lawsuits and
other creditors' claims, and even divorces can make the insurance
proceeds unavailable for their intended purposes.
Irrevocable Life Insurance Trusts
An irrevocable trust can be made the owner and beneficiary of all life
insurance, removing the proceeds from the estate of the insured and the
insured's spouse.
The insured's spouse can even be a beneficiary of the trust so long as
contributions to the trust come from the insured's separate property and
other strict formalities are followed.
Gifts of cash sufficient to pay policy premiums will usually be covered
by the $10,000 annual exclusion for gift-tax purposes if the insurance
trust contains the appropriate provision giving the trust's
beneficiaries a "Crummey power", which is a temporary right to
withdraw trust contributions.
Since the policy will mushroom in value at death, the irrevocable
insurance trust will exclude much more value from the taxable estate
than the cumulative value of the annual-exclusion gifts.
Generation-Skipping Trusts
Trusts are created
to provide for the management of trust assets until those assets are
distributed. Trusts inherently involve a deferral of distributions,
usually until the death of the trust's settlor (creator), until a
beneficiary reaches a particular age, or until some other identifiable
event occurs. A "generation-skipping trust" is a trust that
continues more than one generation. It is usually designed as a
"bypass trust" for estate tax purposes so that the taxation of
assets skips a generation.
Generation-Skipping Transfer Tax: Years ago, Congress decided that
generation skipping was reducing the amount of estate tax collected, and
it imposed the federal generation-skipping transfer tax ("GSTT").
Unlike other transfer taxes, for the GSTT, there is not a range of
graduated tax brackets. The GSTT is imposed at 55%.
The GSTT is imposed on transfers to grandchildren and lower generations.
Gifts (other than gifts in trust) that qualify for the $10,000 annual
gift tax exclusion are also excluded for GSTT purposes.
There is a "GST exemption" of $1,000,000 (which is indexed for
inflation so it is currently $1,010,000) that each transferor has. Like
the "unified credit" for gift and estate tax purposes, the GST
exemption can be applied either during life or at death.
Once the exemption has been exhausted, the GSTT applies in addition to
any applicable gift or estate tax.
Bypass Trusts
The GST exemption amount can be placed in a "bypass trust"
that allows beneficiaries from the children's generation to receive the
income from and use of trust assets without having those assets included
in their estates. This is exactly like the "credit-shelter"
trust established for the benefit of a surviving spouse with the assets
of the predeceased spouse. The beneficiaries can have the following
rights and privileges without having the trust's assets included in
their estates:
Income
The beneficiary may receive all trust income.
Principal
The beneficiary may receive trust distributions in the trustee's
discretion.
"5 or 5 Power"
The beneficiary may have the noncumulative right to withdraw up to 5%
(or $5,000, if greater) of the trust each year. This power is not
usually included because if the beneficiary dies holding this power, the
amount over which the power could have been exercised will be included
in the beneficiary's taxable estate.
Power of Appointment
The beneficiary may have the power to direct distributions from the
trust either during life or at death or both so long as the beneficiary
cannot exercise the power in favor of himself/herself, his/her
creditors, his/her estate, or the creditors of his/her estate.
Trustee
The beneficiary can be the trustee so long as the trustee's discretion
to make distribution is limited to amounts appropriate for the
beneficiary's "health, education, support, and maintenance."
Dynasty Trusts
Many generation-skipping trusts are designed to primarily benefit the
settlor's grandchildren, but some generation-skipping trusts are
designed to last for several generations. The laws of most states
require that a trust terminate at the end of 90 years or 21 years after
the death of all those living at the time the trust became irrevocable.
That maximum period is imposed by the "rule against
perpetuities", which is a law that has existed for centuries to
prevent perpetual trusts. Some states have abolished the rule against
perpetuities, and in those states, trusts can theoretically last
forever. It its regulations relating to the GSTT, the IRS has indicated
that it will not be bound by the states' rule-against-perpetuities laws,
and that a transfer after the "perpetuities period" (as
defined by the IRS) will trigger the imposition of the GSTT.
A dynasty trust can allow trust assets to be managed for the benefit of
the settlor's family for approximately three generations. It the trust
is drafted appropriately AND the settlor allocates his or her GST
exemption to transfers to the trust, there can be no estate, gift, or
generation-skipping transfer tax imposed as long as the trust lasts.
A dynasty trust will usually discourge the expenditure of trust
principal, but it will allow beneficiaries to use trust assets. A shared
family mountain cabin or condominium or other vacation property could be
held in this trust for several generations.
Because a dynasty is an irrevocable trust, it also can be a spendthrift
trust that is exempt from the claims of the beneficiaries' creditors.
Grantor Trusts
"Grantor Trusts" are not a type of trust, but rather an income
tax classification. A trust is considered a "grantor trust" if
the settlor (grantor) has certain powers over the trust or if others
have too many powers over the trust that might be exercised in favor of
the settlor. All taxable income that is paid to a grantor trust will be
taxed to the trust's settlor as if the settlor owned the
income-producing assets.
Revocable Trusts
Revocable trusts are always grantor trusts, but irrevocable trusts are
usually designed not to be grantor trusts.
Irrevocable Trusts
Because an irrevocable trust is usually designed not to be a grantor
trust for income tax purposes, an irrevocable trust that is a grantor
trust is sometimes thought to be "defective". Because of the
benefits discussed below, some irrevocable trusts are designed to be
"intentionally defective". Such trusts are designed to be
grantor trusts for income tax purposes but excluded from the grantor's
estate for estate tax purposes.
Paying the Tax
For many irrevocable trusts, the main purpose is to make a gift of
property to the trust's beneficiaries in order to shift the income,
appreciation, and value of the property away from the trust's settlor in
order to reduce the settlor's estate tax liability at his or her death.
A grantor trust requires that the grantor pay all of the trust's tax,
which is yet another way of reducing the settlor's estate. Because the
payment of the tax is required by law, it is not considered a gift.
Thus, some estate planning practioners design their trusts as grantor
trusts to take advantage of this ability to give the trust's
beneficiaries yet another benefit. Most grantor trusts are designed so
that the trustee's powers and the trust's administrative provisions that
cause the trust to be a grantor trust can be cancelled.
Transactions with a Grantor Trust
Any transaction between the grantor trust and the grantor is treated for
income tax purposes as having no tax consequences. One use of that trust
is for business-succession planning, which is discussed in the article
on business entities.
S Corporation
Stock
An irrevocable trust can be designed to hold S corporation* stock in one
of three ways: (a) as a grantor trust; (b) as a qualified subchapter S
trust ("QSST"); or (c) as an electing small business trust
("ESBT"). While the trust's settlor (creator) is alive, the
easiest method is usually to have the trust qualify as a grantor trust.
Even if an irrevocable trust is originally designed to hold assets other
than stock in an S corporation, it is wise to give the trustee authority
(and perhaps the directive) to make the trust qualify as either a QSST
or an ESBT.
*NOTE: An "S corporation"
is a domestic corporation that has filed a special tax election with the
Internal Revenue Service to be tax under "Subchapter S" of the
income tax laws. An S corporation usually pays no tax, and its
shareholders are taxed somewhat like partners. In the absence of an
election to be an S corporation, corporations are taxed under Subchapter
C, so corporations that are not S corporations are sometimes called
"C corporations", although you will not find that term in the
Internal Revenue Code.
Other Irrevocable Trusts
Charitable trusts are discussed in the article entitled (believe it or
not) "Charitable Trusts".
Grantor-retained income trusts (GRITs), such as the grantor-retained
annuity trust (GRAT) and the qualified personal residence trust (QPRT)
are discussed in the article entitled "Estate Freezing
Techniques".
Asset-protection trusts-including offshore trusts
 
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