Estate Tax Planning

Estate Tax Planning

Below is an initial introduction to the alphabet soup of estate tax planning. These are just quick overviews of different concepts and should only serve to direct you into further research. This is nowhere near a comprehensive overview of this area of law. As you can tell there are a dizzying array of options and each have pros and cons, plus many of these concepts can be used in combination with each other.

A consultation with your attorney would be required to determine what would work well for your family.

Charitable Vehicles

Donor Advised Funds

Great way to capture charitable tax deductions in the year in which you have a significant income tax burden. You can then do your charitable giving from this fund over future years.

CRT – Charitable Remainder Trusts

The present value of the remainder of a charitable remainder trust must equal at least 10 percent of the net fair market value of property transferred in trust on the contribution date. We call this rule the “10 Percent Minimum Remainder Interest (10% MRI) requirement.” I.R.C. § 664(d)(1)(D) and (2)(D).Because the Trustor’s charitable remainder trust agreement commits them to eventually give the assets of the trust to charity, section 664 and related provisions will reward this commitment by granting them three tax benefits. The Internal Revenue Code:

  • forgives the Trustor’s capital gains taxes on the sale of the assets contributed to the trust,
  • grants the Trustor an immediate charitable tax deduction, and,
  • permits the trustee to invest the sales proceeds in a tax-free investment environment similar to an IRA

There are two types of charitable remainder trusts:

  1. the charitable remainder annuity trust and
  2. the charitable remainder Unitrust.

I.R.C. §664(d). The Code distinguishes these trusts from each other by the manner in which the trust determines its distribution

CRAT – Charitable Remainder Annuity Trust.

A Trustor establishes this trust and puts property in, keeping the right to receive an annuity payment from the trust for an initial term – either for a term or years or for the Trustor’s life. After the initial term the amount remaining in the trust (the “remainder”) is distributed to a charity named in the trust.

CRUT – Charitable Remainder Unitrust.

A Trustor establishes this trust and puts property in, keeping the right to receive a percentage, or Unitrust amount, of the trust assets for an initial term – either for a term or years or for the Trustor’s life. After the initial term, the amount remaining in the trust (the “remainder”) is distributed to a charity named in the trust.

NICRUT – A Net Income Charitable Remainder Unitrust Trust:

Used as a type of CRT. This trust annually pays to the Recipient(s) the lesser of the trust’s net income or an annual “Uni Amount”. The Uni Amount is a fixed percentage of the value of the trust assets at the beginning of the trust’s tax year. Because the Recipient(s) receive the lesser of the trust’s net income and the Uni Amount and because the Uni Amount is a percentage of the value of the trust assets at the beginning of the trust’s tax year the annual amount distributed to the Recipient(s) will vary with variations in the trust’s income and the value of the trust. Additional contributions may be made to a net income charitable remainder Unitrust if that option is provided for in the trust document.

NIMCRUT – A Net Income with Makeup Charitable Remainder Unitrust Trust:

Used as a type of CRT. This trust annually pays to the Recipient(s) the lesser of the trust’s net income or an annual “Unitrust Amount” in a manner similar to the NICRUT. However, if the net income of the trust is less than the Unitrust Amount in a given year, the amount by which the Unitrust Amount exceeds the value of the net income is added to a “deficit account.” If the net income of the trust is greater than the Unitrust Amount in a given year that excess amount can be distributed to the Recipient(s) up to the amount of the deficit account. To the extent excess income is distributed to the Recipient(s) the deficit account is reduced. The amount of excess income that can be distributed to the Recipient(s) is limited by the size of the deficit account. Additional contributions may be made to a net income charitable remainder Unitrust if that option is provided for in the trust document.

SCRUT – Standard Charitable Remainder Unitrust

Standard version of a CRUT – see CRUT above.

NIMCRUT TO SCRUT = FLIPCRUT:

Used as a type of CRT. A FLIPCRUT starts out as a NIMCRUT and then converts to a SCRUT upon the happening of a predetermined event. The event that decides when this switch (FLIP) takes place is referred to as the “triggering event.” It may be either a date certain or some other event over which the Grantor has no control.

CLT – Charitable Lead Trusts

Under a CLT, the donor can donate an asset’s income stream for a period of years to a charity instead of the remainder interest. The remainder interest can then pass to a private party under the direction of the grantor (i.e. grandchild, child, etc.)

There are two types of charitable lead trusts:

  1. the charitable lead annuity trust and
  2. the charitable lead Unitrust.

CLAT – Charitable Lead Annuity Trust

A CLAT’s assets are assumed by the IRS to grow at the hurdle rate that is determined when the trust is created. Any appreciation above the hurdle rate passes tax-free to the beneficiaries at the end of the term set forth in the CLAT document. This is basically the opposite of the CRAT. Here the Trustor establishes a trust and names a charity to receive an annuity amount from the trust for a specified amount of time (the “initial term”). At the end of the initial term the remainder pays back to the Trustor or to other noncharitable beneficiaries named in the trust. (See also GRAT, which is similar except that payments in CLAT go to a charity instead of the Grantor).

CLUT – Charitable Lead Unitrust.

This is basically the opposite of the CRUT. Here the Trustor establishes a trust and names a charity to receive a percentage of the trust’s value for a specified amount of time (the “initial term”). At the end of the initial term the remainder pays back to the Trustor or to other noncharitable beneficiaries named in the trust.

MORE COMMON IRREVOCABLE TRUSTS

GST – Generation Skipping Trust

An irrevocable trust that assigns a beneficiary who is younger than the settlor by at least 37 ½ years is called a generation-skipping trust. Generation-skipping trusts allow the settlor to avoid estate taxes that would be applied if the children, i.e., the next generation, took ownership of the assets. The skipped generation has access to the appreciation of the assets.

Dynasty Trust

A dynasty trust is an irrevocable trust that is not subject to estate taxes for as long as state law allows:

  • Alaska – 1,000 years
  • Delaware – 100 years
  • Nevada – 365 years
  • South Dakota – Perpetual
  • California – 99 years

GRAT – Grantor Retained Annuity Trust

A GRAT allows the grantor to transfer property into the trust and receive an annuity payment (calculated as a certain dollar amount based on the value of the assets transferred to the trust and the then current 7520 rate) for a specific length of time. After the annuity period ends or when the grantor passes away, the assets are handed off, tax-free, to the designated beneficiaries.

The Section 7520 interest rate is fixed by the Internal Revenue Code and is set as the “hurdle rate” at the time the GRAT is established. Section 7520 rates are currently low, so any appreciation of the trust’s assets above that hurdle rate gets passed tax-free to the trust beneficiaries at the end of the term specified in the GRAT document. With the interest rates so low, there is greater potential for a tax-free payout down the road. Additionally, because the assets belong to the trust, they will be passed on without triggering gift and estate tax liabilities.

Can be used in combination with SCIN for a SCIN-GRAT.

Rolling GRATs

The risk with a long-term GRAT is if the Grantor dies prior to the expiration of its term. Death of the Grantor would subject the trust assets, including any income and appreciation, to estate tax. To reduce the mortality risk (especially for elderly clients or for those with health concerns), there is an estate planning technique that utilizes shorter-term GRATs.

The “Rolling GRAT” technique involves creating a series of consecutive short-term GRATs (typically 2 to 3 years) with each successive GRAT funded by the previous trust’s annuity payments. Rolling GRATs minimize the risk of mortality during the term and thereby increases the success of transferring wealth. Two years is the shortest amount allowable by the IRS according to recent revenue rulings.

GRIT – Grantor Retained Income Trust.

A GRIT is similar to a GRAT except that the Trustor receives the income stream from the trust assets, rather than a fixed annuity amount from the trust for a specified period of time. After the initial term ends the GRIT pays to other beneficiaries.

GRUT – Grantor Retained Unitrust.

A GRUT is similar to a GRAT but instead of taking out an annuity interest the Trustor receives a percentage of the trust (called a Unitrust amount) for a specific amount of time based on the value of the property in the trust. After the initial term ends the GRUT pays to other beneficiaries

IDGT – Intentionally Defective Grantor Trust

IDGTs are “effective” for estate tax purposes but “defective” for income tax purposes, meaning that the grantor — not the trust — pays tax on income earned in the trust, allowing trust assets to grow. Essentially, each tax payment that the Trustor pays on the assets in the trust is a transfer of funds to the next generation without any impact to their lifetime exemption.

The interest rate that must be charged on the promissory note is the hurdle rate – in this case the applicable federal rate (AFR) as of the month of the sale. With interest rates currently so low, property sold to the trust is more likely to earn a higher rate of return than the interest on the loan. Asset appreciation will accrue to the trust rather than the Trustor. Once sold to the trust, the property is no longer considered to be a part of the grantor’s estate. Assets sold to the IDGT will be excluded from the grantor’s gross estate to the extent the grantor outlives the term of the note.

This is a form of irrevocable trust that gets the value of the trust assets out of the client’s estate but allows the client to continue to be treated as the owner for income tax purposes only. One of the main advantages is that the trustor can add value to the trust by paying the income tax that is due on the income in the trust without those tax payments being treated as additional taxable gifts to the trust. Also, it gets the trust out of the more aggressive income tax rate tables that apply to trusts.

ILIT – Irrevocable Life Insurance Trust

An existing insurance policy can be transferred into an irrevocable life insurance trust (ILIT), or the trustee of the ILIT can purchase an insurance policy in the name of the trust. The donor can make gifts to the ILIT that qualify for the annual gift tax exclusion, and the trustee will use those gifts to pay the policy premiums. Since the insurance policy is held by the ILIT, the premium payments and the full death benefit are not included in the donor’s taxable estate. Furthermore, the insurance proceeds at the donor’s death will be exempt from income taxes.

BRANDED IRREVOCABLE TRUSTS

BDIT – Beneficiary Defective Inheritor’s Trust.

Also known as a BETIRBeneficiary Taxed Irrevocable Trust. High levels of asset protection are gained due to the restrictions to access it by a beneficiary. A parent funds a BDIT with a gift – the beneficiary (the middle generation) cannot make “gifts” to the trust, rather they transfer assets to the BDIT via sales or loans. An independent trustee is used for distributions. You can serve as the Investment Trustee. Can use and enjoy trust assets (i.e. residences) rent-free. Can exercise a lifetime or testamentary power of appointment which gives you flexibility in the distribution of the trust. Good vehicle to consider starting valuable businesses within since they can grow outside of the estate tax system and have creditor protection.

For another twist see: https://gbq.com/the-bdit-a-trust-with-a-twist/

SLAT – Spousal Lifetime Access Trust

With the threat of a lowered estate and gift tax exemption amount, a spousal lifetime access trust (SLAT) allows donors to lock in the current, historic high exemption amounts to avoid adverse estate tax consequences at death. The donor transfers an amount up to the donor’s available gift tax exemption into the SLAT. Because the gift tax exemption is used, the value of the SLAT’s assets is excluded from the gross estates of both the donor and the donor’s spouse. An independent trustee administers the SLAT for the benefit of the donor’s beneficiaries. In addition to the donor’s spouse, the beneficiaries can be any person or entity including children, friends, and charities. The donor’s spouse may also execute a similar but not identical SLAT for the donor’s benefit. The SLAT allows the appreciation of the assets to escape federal estate taxation and, in most cases, the assets in the SLAT are generally protected against credit claims. Because the SLAT provides protection against both federal estate taxation and creditor claims, it is a powerful wealth transfer vehicle that can be used to transfer wealth to multiple generations of beneficiaries

FAPT – Foreign Asset Protection Trust.

This is more advanced form of asset protection trust that is established under the laws of a foreign country that has even more favorable asset protection for clients. Nevis, the Cook Islands, Jersey, Guernsey, and other remote countries are popular choices

OBIT – Optimal Basis Increase and Income Tax Efficiency Trust

OBIT is a form of trust that includes elaborate formula language granting testamentary or lifetime powers of appointment to strategically cause assets to be included in a decedent’s gross estate. The formula language is designed in a way that prioritizes estate inclusion for assets with low basis in order to ensure assets get a step-up, and not a step-down in basis when the power holder dies, and includes protective language to cause inclusion up to the decedent’s AEA. Rather than describe a specific type of trust, OBIT describes the estate tax inclusion nature of a trust designed to cause assets in the trust to receive a step-up in basis when a beneficiary holding a power of appointment dies.

TERMINOLOGY

Applicable Exclusion Amount (AEA)

The basic estate tax exclusion amount (2020 of $11.58 million; 2021 of $11.7 million) plus any deceased spousal unused exclusion (DSUE). DSUE is any remaining estate tax exclusion amount that was ported over from a pre-deceased spouse.

Decanting

This is the process by which a trustee exercises the power to distribute property from one trust (the “originating” trust or the “inception” trust) into a new trust for the benefit of a beneficiary. Decanting is an increasingly popular strategy to allow a trustee to create new, more favorable trust terms for a beneficiary. (Remember that a trustee can only exercise a decanting power consistent with the trustee’s fiduciary duties to the beneficiaries). Often used to move the situs of a trust to a new jurisdiction to extend the length of term or for more favorable creditor protection laws.

Distribution Advisor:

This is a Trust Advisor whose role is limited to advising the trustee on when to make or withhold distributions from the trust.

Hurdle Rate

A hurdle rate is the minimum rate of return on a project or investment required by the IRS.

SCIN – Self-Cancelling Installment Note.

IRS allows you to pay a higher percentage rate on promissory notes to compensate for the feature wherein all remaining principal balance due at the date of death is eliminated. If the payor dies before the end of the term of the note you can pass significant value to the next generation without penalty. However, if they outlive the term of the note then they have paid higher interest over many years for no benefit.

Trust Advisor

Many attorneys use this term interchangeably with Trust Protector. Whether those terms are truly synonymous is open to question and is still an evolving issue under the law.

Investment Advisor

This is a Trust Advisor whose role is limited to advising the trustee on the kinds of assets to invest in.

Trust Protector

This is a special type of power holder who can control certain aspects of irrevocable trusts. There is little consensus among attorneys as to what the protector can and cannot do, whether they serve in a fiduciary or nonfiduciary capacity, who should be the trust protector, etc., but they play an important role and have valuable authority over modifying irrevocable trusts.

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