Trusts

In various posts we have talked about the use of trusts – revocable trusts to manage assets and avoid probate, generation skipping trusts to benefit descendants of several generations, irrevocable trusts to remove life insurance from your taxable estate, special needs trusts for disabled beneficiaries, to name just a few. As a side benefit most trusts help to protect the assets in the trust from the beneficiary’s creditors.

A trust can be written to hold the assets until a beneficiary reaches a certain age, or to distribute the assets in percentages when the beneficiary reaches specified ages.  The thinking behind this “age based” distribution is that a beneficiary may not be able to handle the principal at a young age, but should be able to as she grows older.  But in almost all cases, I advise my clients to create the trust to last for the lifetime of the beneficiary. The beneficiary may not be more skillful at handling money or become more reliable as she grows older, and creditors may have claims at any time during the beneficiary’s life.

Often clients react: “But I want my son/daughter to be able to use the inheritance.”  I explain that the beneficiary will have access to the funds if the trust has a distribution standard allowing the trustee to distribute principal for health, support or education.  In fact, the beneficiary can act as her own trustee, giving her the right to invest the funds as she wishes, and make distributions for her needs.

Moreover, the beneficiary can be given what is called a “power of appointment” to name in her Will the people who will receive any trust assets remaining at her death.  The power of appointment gives the beneficiary the same power as she would have had, had the inheritance been given to her outright. The power to say who gets the property is just short of ownership.

And you can limit the power of appointment.  Say you don’t want your daughter to give any balance of the trust to her nephew, with whom she is close, because he is estranged from the rest of the family. You can limit the power of appointment to allow her to distribute the trust assets at her death to anyone other than the nephew, or to only your direct descendants, or only among her then surviving siblings. You can make the power broad or narrow, and tailor it to the family situation.

Because trusts can be written with (almost) as much flexibility as you want, I see no reason not to use a trust for the life of the beneficiary. And a broad power of appointment can give your beneficiary the control she would otherwise have to pass the assets on to someone else.

Questions regarding this article may be sent to Publications@Capehart.com.

Gifts, both tax and non-tax, are great to accomplish estate planning goals. A gift to a special type of trust, called a Grantor Trust, can be one of the best types of gifts you can make.

The primary non-tax benefit of a gift is seeing the recipient use the funds for college, drive the car, or benefit from other property during your lifetime, while you are around to enjoy it.

The tax benefit is getting the assets out of your taxable estate so that they won’t be taxed at your death. The gift also gets the appreciation of those assets out of your estate. Whether this growth is dividend income or capital gains, it will be taxed to the recipient of the gift at his/her rates, which are usually lower if the gift is to a child or grandchild. Of course, the recipient must pay the income tax, but he/she at least has the principal of the gift and some of the gain, after tax, to use.

If the gift is made in trust and the funds are to be held in the trust for use in the future, the trust pays the tax, and, because of the way income tax is calculated for a trust, the trust’s income tax rates may be just as high as those of the donor. So if a gift is made in trust with the idea that the funds will grow for the future, the income tax paid by the trust will be a drag on that growth within the trust.

If you can afford it, you could agree to reimburse the recipient, an individual, or the trust for the income tax paid each year to make up for that drag, but this would be another gift. If the original gift were large enough, reimbursing the income tax each year might impact your overall estate plan and might even require you to pay gift tax.

What if you could make the original gift but NOT shift the burden of paying the income tax to the recipient? That would be the best of both worlds: you make a gift to reduce your estate, the funds grow tax free in the hands of the recipient (because you are paying the income tax) and each time you pay the income tax, it would NOT be a further gift (because legally you have the obligation to pay the tax).

Good news! You can do this by making a gift to a Grantor Trust. The IRS will ignore the trust for income tax purposes, and will tax the income and gain to you. But the gift is still made, and for estate tax purposes, the property will be out of your estate. The assets given away to the Grantor Trust will grow tax free as far as the trust is concerned, because you are paying the income tax, and you will not be treated as making further gifts, because you are obligated to pay the tax in the first place.

Even better news: each time you pay the income tax, the funds used to pay the income tax are out of your estate as well. You continue to reduce your estate without any gift or estate tax cost! A gift to a Grantor Trust is truly the gift that keeps giving every year (and gift tax free)!

Questions regarding this article may be sent to Publications@Capehart.com.

Frank Casagrande set up an irrevocable trust in which he was to transfer his life insurance policies.  At the time, he was married to Roberta, who was named as the beneficiary of one of his policies.  The beneficiary designation was never changed. Subsequently, Frank divorced Roberta and married Rosemary.

After Frank died, Rosemary filed an action to have the policy reformed to conform with the property settlement agreement which Frank entered into with Roberta, as well as his Will and his trust.  One of Frank’s children contested this action.  Although the court enforced the agreement, the matter was brought to the Appellate Division before its final resolution, which meant lots of time and legal fees.

This case demonstrates the need we have to stop looking at estate planning as merely documents.  For many, substantial assets pass outside of a will, such as life insurance, annuities, retirement plans, and jointly held accounts.  One can argue that Frankshould have made sure that this beneficiary designation was changed.  However, the Casagrande case is played out far too often in the administration of estates.  Professionals need to insure that plans are properly implemented.  Clients need to insure that they hire the attorneys and advisors to do so.

I can’t tell you how many times I have heard this question, usually years after the irrevocable trust was signed: “You mean I can’t change the trust?” The short answer to the question is “No, an irrevocable trust is, by its terms, irrevocable and cannot be changed”. The long answer is… well, first some basics.

Broken down to its simplest, there are two types of trusts – revocable and irrevocable.  Revocable trusts are often used to avoid probate in many states where the probate process is complex and expensive. New Jersey doesn’t happen to be one of those states, but there are occasions when a revocable trust is appropriate in NJ, such as to enable a bank or trusted advisor to hold and manage the assets of a person who is unable to do it.  Another is when privacy is important and someone doesn’t want to put his distribution scheme in a Will (which becomes a public document upon probate). In both cases, the trust can be changed or revoked at any time by the person who created it.

An irrevocable trust has many uses, but one of the most common types is an irrevocable life insurance trust (ILIT).  An ILIT is used to remove life insurance from a person’s taxable estate while keeping it available to help pay estate taxes and provide for loved ones.  For the assets to escape the taxable estate of its creator, however, an ILIT must be written so it can not be changed in the future – it is irrevocable.  So we explain to our clients that they must be certain of the trust beneficiaries and trustees, and how they want the proceeds of the insurance to be distributed. And we emphasize that once it is signed, it cannot be changed.  Of course there are other types of irrevocable trusts, but they all share this one characteristic – the terms are fixed.

Often there is not a very good reason to want to change an irrevocable trust – the client has had a minor disagreement with the trustee or wants to add or delete a beneficiary.  But sometimes there is a good reason – a beneficiary has become disabled and the trust would disqualify the beneficiary from needs-based public benefits.  Or the beneficiary has developed a substance abuse problem, and without a change the trust proceeds would be squandered.

The long answer to the question about revising an irrevocable trust is: “Well, depending on how important it is, and how much effort you want to expend, it is possible to modify the trust.” And there are two ways to do it.

First, you can apply to a court to approve a reformation of the trust.  You must provide a good reason based upon a change in circumstances and supported by the intent of the creator of the trust.  If the creator of the trust is alive, this is easy. But if the creator has died, you must be able to prove his probable intent. Depending upon the reason and your evidence, the court may or may not grant your request.

The second way is to “decant” the trust.  Like pouring a fine bottle of wine into a different container, decanting a trust “pours” the trust’s assets into a new trust, which is created with the revisions that you want.  New Jersey does not have laws allowing decanting, and the court cases are not clear.  So the best way to decant a trust in New Jersey is to “move” the trust to a state that clearly permits decanting – Delaware, Alaska, Florida, and New York, to name a few. Moving the trust so that it is governed by a different state’s law depends on the wording of the original trust and the law of the state that you are moving it to. The benefit of decanting: it can be done without persuading a court that the reasons justify the change. And the terms of the new trust can usually be changed fairly significantly. But it can be more complicated, because it requires moving the trust to another state and consulting with an attorney in that state.

If you find yourself wanting to change an irrevocable trust, it is not impossible, just complicated. So if the reason for the change is not that important, stick with the short answer.

Questions regarding this article may be sent to Publications@Capehart.com.

For high net-worth individuals and couples, there are a variety of transfer techniques in order to minimize exposure to death taxes. These include, but are not limited to Disclaimer Trusts, Credit Shelter Trusts, Applicable Exemption Trusts (a/k/a Credit Shelter Trusts), and Q-TIP Trusts. These Trusts, effective for use with married couples, can be utilized in Wills and Revocable Living Trusts. To further minimize potential payment of estate and inheritance taxes, a variety of other techniques may be employed. These techniques focus on major lifetime gifting. They include, but are not limited to:

A. Annual exclusion gifts. Each year, an individual may currently give $13,000.00 per donee and, with the consent of a spouse, $26,000.00 per donee;
B. Lifetime exemption gifts. Substantial gifts, over the annual exclusion amount, may be made if a donor pays gift taxes and survives three years although an exclusion of $1,000,000 for aggregate lifetime gifts may be used;
C. Gifts to Remove Appreciation. Gifts may made to remove appreciation from a donor’s estate;
D. Education. Unlimited payments of qualified tuition expenses may be made if paid directly to the educational institution;
E. Medical. Unlimited payments of medical expenses may be made so long as said payments are made directly to the provider and to the extent they are not covered by insurance;
F. Spousal. Inter-spousal gifts using the unlimited marital deduction;
G. Leveraged Gifts. Gifts may be made through Trusts which include, but are not limited to, a Qualified Personal Residence in Trust (QPRT) and Grantor Retained Annuity Trusts (GRAT);
H. Life Insurance to Others. Gifts of existing life insurance outright to owners other than the insured;
I. Life Insurance to Trust. Gifts of life insurance premiums through the use of an Irrevocable Life Insurance Trust; and
J.Charitable gifts.
The focus of this article will be the utilization of charitable giving in estate planning. Charitable planning has a variety of benefits including personal satisfaction, lifetime income tax minimization and post-death estate and inheritance tax minimization. Charitable planning takes a variety of forms ranging from simple lifetime checks to charitable organizations through the utilization of more complex Charitable Lead Trusts or Charitable Remainder Trusts.

Various sections of the Internal Revenue Code apply to transfers to charitable organizations. Unless otherwise indicated, all citations within this article will be to the Internal Revenue Code of 1986 and the regulations issued thereunder. The most notable sections, in understanding and implementing charitable planning, include:

A. Section 170 – Income Tax Deductions for Charitable Transfers;
B. Section 2055 – Charitable Transfers Deductible for Estate Tax Purposes;
C. Section 2522 – Charitable Transfers Deductible for Gift Tax Purposes;
D. Section 501 – Defining Tax Exempt Organizations;

E. Section 509 – Defining and Describing Private Foundations; and
F. Section 664 – Describing CharitableSplit Interest Transfers.

A. OVERVIEW OF THE WEALTH TRANSFER
CHARITABLE TAX DEDUCTION

Transfers that qualify for a charitable deduction can be utilized for income, estate and/or gift tax purposes. Generally, transfers, that qualify for the charitable deduction, are made to a tax exempt organization. These organizations are described in detail in Section 501. The most relevant provision is Section 501(c)(3), which describes what is commonly thought of as a charitable organization: a corporation, community chest, fund or foundation organized and operated for religious, charitable, scientific, testing for public safety, literary or educational purposes or to foster a national or international sports competition or for the prevention of cruelty to animals or children, no part of the net earnings of which inure to the benefit of any private shareholder or individual, or substantial part of which is carried on propaganda or attempting to influence legislation and which does not intervene in or participate in any political campaign. In addition to public charities, the charitable deduction can be employed by entities commonly known as private foundations. These entities, defined in Section 509(a) are those which are not included in the definitions covering public charities. See Section 509(a)(1)-(4).

RevRul59-310, 1959-2 CB 146 sets forth the prevailing definition for charity in determining whether a private or public organization qualifies as an appropriate recipient by which a donor can request or assets a charitable deduction. This ruling states, in relevant part “charity in the legal sense of the term includes benefits which are for an indefinite number of persons and are for the relief of the poor, the advancement of religion, the advancement of education, for erecting or maintaining public buildings or works or otherwise lessening the burdens of government.”

Charitable deductions are allowed for transfers to qualified and identifiable recipient organizations. In general, there are four types of these organizations:

1. Charitable Corporations and Associations – if they are to or for the use of corporations/associations “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes,” See Section 2055(a)(2).
2. Government – if said transfers are to or for the use of the United States, any of its states, the District of Columbia, counties, cities, towns and other political subdivisions so long as the transfers are solely and exclusively for public purposes. See Sections 2055(a)(1), 2522(a)(1) and 178(c)(1).
3. Trusts/Fraternal Organizations – if the transfers are used “exclusively for religious, charitable, scientific, literary, or educational purposes or for the prevention of cruelty to children or animals…” See Section 2055(a)(3). It is important to note that these organizations are disqualified for purposes of charitable deductions if they participate in propaganda, lobbying, or participation in political campaigns. It should also be noted that said organizations may undertake activities above and beyond that for charitable purposes. However, deductible transfers must be exclusively used for charitable purposes.
4.United States Veterans Organizations – if there is no use of the net earnings for the benefit of a private shareholder individual. See Sections 2055(a)(4) and 2522(a)(4).

In order to qualify for a charitable deduction, a charitable interest must meet certain criteria:

1. It must be or an ascertainable interest;
2. It must comply with proper reporting requirements; and
3. There must be substantiation of the transfer.
An interest is certainly ascertainable and simple to recognize of an outright gift or a donor’s or decedent’s interest in property. However, when property is transferred in Trust or for both a private and charitable purpose Reg Sections 20.2055-2(a) and 25.2522(c)-3(a) state that the deduction will only be allowable if the charitable interest is ascertainable at the time of the contribution and can be severed from the private interest. Examples of deductible and ascertainable interests include: undivided portions of a donor or decedent’s entire interest in a type of property, remainder interest in residence and farms, qualified conservation contributions and a remainder interest in a Trust, a charitable lead interest or a charitable gift annuity.

As to reporting, charitable transfers during lifetime must be reported for income tax purposes on an individual’s personal income tax return provided that the individual taxpayer itemizes his or her deductions. Charitable transfers for decedents are reported on Schedule O of the federal estate tax return, known as the Form 706.

Proper reporting entails proper substantiation. Proper substantiation follows the following set of rules:

A. As to charitable contributions of money, a taxpayer is required to maintain a canceled check, receipt or letter acknowledging the contribution from the donee.
B. For contributions of property other than money, a taxpayer must keep a receipt or letter from the donee noting the date of the donation, the location of the donation and a description of the contribution. In the event the donor wishes to claim a deduction greater than $500.00, he or she must also keep written records regarding the acquisition of the property including the date and manner of its acquisition as well as the cost or other basis of property held for less than twelve months before the contribution. If the claim deduction exceeds $5,0000.00, a donor must also obtain a qualified appraisal as well.

B. CHARITABLE LEAD TRUSTS

One of the most popular techniques, for mid-level to high ne-worth clients, is the utilization of Charitable Trusts. There are two general forms for Charitable Trust:

A. Charitable Lead Trusts; and
B. Charitable Remainder Trusts.
Since the Tax Reform Act of 1969, only certain kinds of bequests in Trusts qualify for the estate tax charitable deduction where there is one or more non-charitable beneficiaries in addition to the charitable beneficiary. Both Charitable Lead Trusts and Charitable Remainder Trusts are vehicles by which there are benefits both to donor and/or his or her family as well as charitable organizations.

A Charitable Lead Trust is a Trust, which is established by a donor, with the contribution in trust of investment property in which the income from the Trust is to be paid to one or more qualified charitable organizations at least annually for the term of the Trust. Typically, assets, which are used to fund this Trust, are those which are expected to appreciate over the life of the Trust. Upon the expiration of the term of the Trust, the remainder interest passes to a non-charitable remainderman, specifically the donor’s intended beneficiary.

The use of Charitable Lead Trusts, in general, meet two goals. First, it allows the donor to make significant lifetime donations to charitable organizations. Second, it also ensures that the family members, who will be the ultimate heirs of said Trust, will enjoy the ultimate prosperity of the asset. In establishing these Trusts, the donor, as well as his or her family, forego income for the tradeoff of realizing long-term capital appreciation and at a low gift or estate tax cost.

In order for a Charitable Lead Trust to qualify for the charitable deduction, the income interest, to be received by the qualified charitable organization, must be either in the form of a guaranteed annuity or a unitrust interest. The term of the Trust may be either for finite period of years or can be based upon the life or lives of individuals who are alive at the creation of the Trust.
A Charitable Lead Annuity Trust is one in which a charitable organization receives a fixed amount in the form of a guaranteed annuity for a certain number of years, with the remainder passing to a private individual or individuals. A Charitable Lead Unitrust is one in which a fixed percentage of trust corpus, determined annually, is paid to a charitable beneficiary or beneficiaries, with the remainder passing to one or more non-charitable beneficiaries at its termination.

To properly understand Charitable Lead Trusts, one must recognize that they are split interests where the charitable organization holds the first or lead interest and the non-charitable entity or individual receives the remainder interest. A guaranteed annuity interest is deductible regardless of whether or not it is in Trust. It must consist of the right of a charitable organization to receive a guaranteed annuity. If a Charitable Lead Trust is used, the Trust must be irrevocable. If the interest is not in a Trust, it must be paid by an insurance company or other company that issues annuity contracts.

See Sections 170(f)(2)(B), 2055(e)(2)(B) and 2522(c)(2)(B).

The Unitrust interest is deductible, whether utilized in a Trust or not, if it consists of the right of the charitable organization to receive payment of a fixed percentage of the fair market value of the property if funding the interest so long as the payment is made at least annually. Like the annuity interest, it must be paid by an insurance company or other company in the business of issuing such interests if the Unitrust interest is not in Trust. If it is in Trust, the Trust must be irrevocable. See Sections 170(f)(2)(B), 2055(e)(2)(B) and 2522(c)(2)(B).

Both forms of Lead Trusts can be established as Grantor Lead Trusts, Non-Grantor Lead Trusts and Testamentary Lead Trusts. A Grantor Lead Trust is one which is established by a donor and provides the donor a current income tax charitable deduction for the present value of the charitable distribution over the term of the Trust, but the Trust income is imputed as taxable income to the donor each year. In a Non-Grantor Lead Trust, a gift or estate tax deduction is allowed for the value of the charitable interest, established as the present value of the payments to charity over the term of the Trust. Unlike the Grantor Lead Trust, there is no income tax deduction for the Non-Grantor Lead Trust for the donor. Testamentary Lead Trusts are commonly used when there is no deferral through the use of the marital deduction and the estate can thereby obtain an estate tax charitable deduction for the present value of the charitable lead interest.

C. CHARITABLE REMAINDER TRUSTS

Charitable Remainder Trusts are practically the opposite of Charitable Lead Trusts. Both are split interest vehicles. However, the initial beneficiary of the Trust is the donor and/or his or her family in the Remainder Trust, whereas in the Lead Trust, it is the charity itself. As a result, in the Lead Trust, the family is the remainder beneficiary. In a Remainder Trust, one or more charitable organizations is the remainder beneficiary.

A remainder interest in a Trust is deductible if the Trust takes one of three forms:

Charitable Remainder Annuity Trust, Charitable Remainder Unitrust or a Pooled Income Fund. A Charitable Remainder Annuity Trust is authorized under Section 664(d)(1). It is an Irrevocable Trust in which a fixed amount is paid at least annually to one or more persons for a term of years or for life. The fixed amount must be a sum certain not less than 5% or more than 50% of the initial net fair market value of the Trust. The lead beneficiary (or if there is more than one, at least one of said beneficiaries) must not be a permissible donee of a charitable contribution listed in Section 170(c). If a term of years is utilized, it must not exceed 20.
Individuals, who will receive payments from a Charitable Remainder Annuity Trust must be living at the creation of said Trust. No other payments may be made other than to or for the use of an organization qualified under Section 170(c).

At the termination of the fixed amount payments, the remainder must be distributed to or for the use of a charitable organization or held for the benefit of such an organization. The Trust may have one or more remainder beneficiaries that are charities. All remainder beneficiaries must be charities.

In order to qualify for a charitable deduction, the present value of the remainder interest must be at least 10% of the initial fair market value of the property contributed to the Trust. This requirement applies to all Charitable Remainder Trusts established after July 28, 1997.

A Charitable Remainder Unitrust is an irrevocable Trust from which a fixed percentage is paid at least annually to one or more persons for a term of years or for life. The requirements as to percentage, lead beneficiaries and term are the same as with a Charitable Remainder Annuity Trust. As with a Charitable Remainder Annuity Trust, individuals receiving payments, from a Charitable Remainder Unitrust, must be living at the creation of the Trust. The 10% rule also applies.

The difference of a Charitable Remainder Unitrust is that this type of Trust may pay annually to the income beneficiary income if it is less than the fixed percentage amount rather than the fixed percentage mandated by the Charitable Remainder Annuity Trust. In addition, if income is greater than the fixed percentage amount, that income may also be paid to the income beneficiary to the extent that the aggregate Charitable Remainder Unitrust income in prior years was less than the aggregate fixed percentage amounts (A Charitable Remainder Unitrust with these net income and “makeup” provisions is often referred to as a NIMCRUT.)

An alternative to the Charitable Remainder Trust is a Pooled Income Fund. It is also referred to as a “Poor Man’s Trust” or a “No Trust Trust”. It is an irrevocable Trust in which multiple donors transfers property, retaining an income interest an contributing an irrevocable remainder interest to a charitable organization listed in Section 170(b)(1)(A). Private foundations and public charities, which support other public charities or which receive more than one-third of their support from memberships, admissions fees, grants and gifts and less than one-third from investment income are excepted. The income interest retained by the donors is for the life of one or more income beneficiaries living at the time of the transfer. The income interest is also paid at the rate of return actually earned by the Trust itself. Whereas the aforementioned Charitable Lead Trusts and Charitable Remainder Trusts may be maintained by an individual or financial institution as Trustee, a Pooled Income Fund is maintained by the charitable organization that will receive the remainder interest. See section 642(c)(5).

One interesting facet of a Charitable Remainder Trust is that a Grantor can also serve as Trustee. Typically, any Trust, in which a Grantor can also serve as Trustee will be referred to as a Grantor Trust and have no significant estate or gift tax benefit.

However, an important exception is made for the Charitable Remainder Trust. In doing so, a Trust can make investments consistent with the Grantor’s plans. However, in doing so, the Grantor, in his or her capacity as Trustee, must balance the goal of investment control with the fiduciary duty owed to the charitable remainderman. Morever, a Grantor, who serves as Trustee, must be certain that no powers are retained which would cause the Trust to be subject to the Grantor Trust rules of Sections 671-678. Otherwise, the Trust will be considered a Grantor Trust and will not qualify as a Charitable Remainder Trust. Typically, the type of assets, which can be contributed to Charitable Remainder Trusts, is unlimited. However, in the aforementioned event when the Grantor is also the Trustee, the Trust interest must hold clearly identifiable assets. Real estate, stock in closely held companies, and personal effects are often difficult to value, and could disqualify a Trust for the Grantor’s charitable deduction.

Upon the death of a Grantor, the estate tax deduction for the Charitable Remainder Annuity Trust will equal the actual or fair market value of the remainder interest of the Trust. It is determined by taking the fair market value of the property placed in the Trust and reducing it by the present value of the non-charitable annuity interest. These values are to be determined as of the Decedent’s date of death or by the alternate valuation date.