“Every Client’s Dream: Eliminate Estate Taxes, Retain a Benefit in the Assets and Achieve Creditor Protection all at the Same Time”
QPRTs (Qualified Personal Residence Trusts), GRATs (Grantor Retained Annuity Trusts), SPITs (Spousal Income Trusts) and Rainy Day Trusts
Perfect Time for Estate Planning
- The estate tax is here to stay (repeal is not going to happen).
- We just received a $5m gift exemption for the first time in history (and Congress may take it away in 2 years).
- An additional factor favorable to clients is the fact that most of our assets are 50% of the values they were a few years ago.
- The last factor that is extremely favorable to people willing to plan now, is the fact that the IRS and the gifting rules have always been extremely liberal in allowing clients to give away future anticipated growth in assets, without any negative estate or gift tax consequences.
- First and foremost, techniques that will lock in current values for estate tax purposes and allow for the future growth and appreciation to take place in the hands of the children or grandchildren.
- Second, I selected techniques that have a “dual purpose”. These are techniques that give us some great tax savings, and at the same time offer significant creditor protection.
- These techniques are all “retained benefit techniques”. These are techniques where the client retained some benefit, or the use and enjoyment of the assets that were given away while giving to the kids the future growth in the assets. Compare this to “pure gifting” techniques where the client makes outright gifts to the kids or the grandkids.
- Retained benefit techniques – clients are more willing to embrace these strategies because the client has retained some “string” or benefit from the assets gifted away. At the end of the day, in most cases the client has retained the right to receive all of the gifted assets back (or at least retained the right to use and enjoy all of the assets) while giving to the children and the grandchildren the future anticipated growth in the assets.
- Pure gifting technique – these are techniques where the client makes outright gifts to the kids or to charity. Clients are reluctant to embrace these techniques, particularly in this economy, because the client retains no benefit for himself or for his spouse. (This outline will not discuss the pure gifting techniques of creating a trust strictly for the benefit of the children, and making outright gifts to that trust.
- These strategies that are fairly easy to understand and easy to put in place.
- Last, I chose strategies that are low in the annual maintenance costs to operate these strategies.
Retained Benefit Strategies that we will discuss in this session are:
- QPRT – Qualified Personal Residence Trust
- GRAT – Grantor Retained Annuity Trust
- SPIT – Spousal Income Trusts
- Rainy Day Trust
This Outline will attempt to share with you the most common estate planning techniques that will allow you to “freeze” the size of your estate for estate tax purposes, give away future growth and appreciation to the kids or grandkids estate and gift tax free, retain some sort of benefit or use and enjoyment for you and receive creditor protection along the way.
In selecting the hottest techniques to discuss with you today, I have focused on techniques that have the following characteristics:
II. Understanding some basic legal concepts that affect all of these strategies.
Transfer Tax Rules:
- Estate Tax: tax imposed on the fair market value of all assets as of the death of the decedent.
- Exemption – $5 MILLION (2011 and 2012)
- Marital Deduction – Postpones the estate tax until the death of the surviving spouse. Unlimited amount.
- Portability – any estate tax exemption not used by the first spouse to die, will transfer to the surviving spouse to use without the need for a Credit Shelter Trust. (“B” Trust)
- Gifting Rules- (based upon the fair market value of what was gifted away)
- Annual Exclusion – $13,000 per year per donee and per donor. Example, Husband and Wife could gift $26,000 per year to anyone in the world without reporting any gift tax.
- Marital Deduction – no gift tax imposed on transfers to a spouse. Unlimited in value.
- Exemption –you can now use all of the $5,000,000 death exemption during life.
- Gifts made today not only remove the value of the asset from the estate, but also removes the value of all future appreciation on the asset from the date of the gift until the date of death of the donor.
- Gift tax is 1/3 cheaper then the estate tax. The tax is “exclusive” of the amount of the gift. (pay gift tax only on the value of the gift, not the value of the tax used to pay the gift tax) The estate tax is “inclusive” in the value of the gift. (pay estate tax on the amount that is used to pay the estate tax)
- The $5m gift exemption is now the same as the estate tax exemption (never before).
- Portability – good idea, but don’t get rid of your “B” Trust.
- Exemption is lost if the surviving spouse remarries and the new spouse dies.
- Surviving Spouse may use the exemption to benefit different individuals than the first spouse intended.
- The GST exemption is not portable and cannot be easily protected without a B trust.
- B trust offers creditor protection.
- B trust protects the heirs of the deceased spouse from being disinherited.
- Family Partnerships and Discounts are still beneficial.
- Crummey Withdrawal Powers are still beneficial (advantage of gifting to a Trust rather than people).
Since the tax benefit of exemption gifts is limited to avoiding estate tax on the future income and appreciation of the gifted property, it may be better to transfer the property using a “freeze” technique designed to use the exemption, such as a QPRT, a GRAT or an installment sale to a Grantor Trust. These techniques will be discussed below.
Review all Tax Formula Clauses to prevent a beneficiary from being unintentionally disinherited.
For example, you might have a trust that says “give my estate tax exempt portion of my trust to my kids, and my remainder to my wife.” If this was done when the exemption was $600,000, and the exemption is now $5 million, then the surviving spouse may be completely disinherited.
Advantage of making lifetime gifts versus paying estate tax at death.
Surprises under the New Tax Law:
III. QPRT (Qualified Personal Residence Trust)
An ideal strategy to leverage your estate tax exemption would be to establish a Qualified Personal Residence Trust (“QPRT”). The Internal Revenue Code recognizes that the complete ownership of a residence may be divided into two partial ownership interests: a “present” interest and a “remainder” interest. The present interest includes the right to occupy the residence now; the remainder includes the right to occupy the residence where the present interest expires. Because the service allows us to give away each component separately, it is possible for a home-owner to gift away the remainder value of his or her home, or vacation home (or both), while continuing to use and control the asset for a term of years. Naturally, the longer the duration of the present interest, the smaller the value of the remainder interest and correspondingly the smaller the value of the gift.
Where’s the juice? (Two huge tax advantages to a QPRT:
- valuation, (gift is based upon a fraction of the value of the home) and
- (2) future appreciation in value of the home is removed from the estate.
- We will set up an irrevocable trust (called a Qualified Personal Residence Trust, or “QPRT”) that is separate from your Revocable Living Trust
- You transfer your residence to the QPRT (our office will prepare the deed and record it with the County)
- During a set period of years (you get to choose how long), you retain the right to the use and enjoyment of the property
- The property interest that you are giving to the kids is the right to own the property after the period expires
- When the period expires, you will elect either to: (1) stay in the house and pay market rent to the kids, or (2) move out and let the kids take over ownership of the property
- Low maintenance strategy (i.e. no annual meetings or maintenance fees such as tax returns)
- Very good result if you survive for the specified term
- All appreciation from the date of the transfer is out of your estate
- The amount of federal exemption you use in this strategy is very small compared to the amount that you are reducing your estate, since you are giving away only a remainder interest
- If you do survive the specified term and pay rent to the kids, then you essentially are accomplishing the objective of reducing your estate by downloading assets to the kids without being subject to the gifting rules
- Creditor protection features of an irrevocable trust – since the trust was established by you, for the benefit of your children, it achieves creditor protection.
- The trust qualifies as a “Grantor Trust” so that all of the income tax code provisions that are favorable to a residence still pass thru to the Grantors of the trust, even though they don’t own the home any longer. (ie the $500,000 capital gain exemption)
- It is specifically exempted from the reach of IRC 2036 even though the grantor retained a benefit.
- It’s an “all or nothing strategy”. If you do not outlive the specified term, then property reverts back into your estate as though you didn’t do anything. (essentially, break-even)
- Loss of basis step-up – normally, when you die, the children receive a cost basis in the asset equal to its fair market value at the time of your death. However, when an asset is received by gift, rather then thru your estate, the kids receive a “carryover” basis. (your same basis)
- However, in most cases, saving a 35% estate tax on the entire value of the home is better for the family even though the children will have to pay some capital gains (usually at 15%) of the value of the home in excess of your basis.
Pros
Cons
This strategy is “Qualified” – meaning it is sanctioned by the IRS – see Internal Revenue Code §2702(a)(3) (applies to a primary residence and a vacation home)
A married couple could do 3 QPRTs. One for the sole and separate property of each spouse, and one for the community property of the spouse together)
How a QPRT works:
IV. GRAT(a Grantor Retained Annuity Trust)
A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named “remainder” beneficiary (ies). In some cases other interests, such as the right to have assets revert back to the transferor’s estate in the event of the transferor’s premature death, may be included.
GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. For example, if $1,000,000 is placed in trust and the initial annuity payout rate is 6 percent, the trust would be $60,000 each year, regardless of the value of the trust assets in subsequent years. If income earned on the trust assets is insufficient to cover the annuity amount, the payments will be made from principal. Therefore, the client-transferor is assured steady and consistent payments (at least until principal is exhausted).
All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary (ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.
The gift tax value of the transferred assets is determined at the time the trust is created and is based upon the present value of the remainder interest that will ultimately pass to the kids (a mere fraction of the total value of the assets placed in the trust).
The right to receive a “fixed amount” means the annuity must be a specified fixed dollar amount or a fixed percentage of the initial value of the trust payable each year rather than merely the income produced by the assets in the trust. The smaller the annuity percentage retained by the Grantor, the more likely there will be appreciated value of the assets passing to the children free of estate taxes. The IRS dictates the percentage of the annuity payment to the Grantor and is currently must be at least 4% and can be even greater.
Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments you have retained, the GRAT should be treated as a grantor trust for income tax purposes. This means you (the transferor-annuitant) are taxed on income and realized gains on trust assets even if these amounts are greater than the trust’s annuity payments. This further enhances this tool’s effectiveness as a family wealth-shifting and estate-tax-saving device. In essence you are effectively allowed to make gift tax-free gifts of the income taxes that are really attributable to assets backing the remainder beneficiary’s interest in the trust.
A GRAT (Grantor Retained Interest Trust) is a similar concept to a QPRT, but instead of your residence, you retain an interest in investment type assets (usually, part of your financial portfolio or investment real estate)
How a GRAT works:
- We will set up an irrevocable trust (called a Grantor Retained Interest Trust, or “GRAT”) that is separate from your Revocable Living Trust
- You fund the GRAT by transferring a portion of your financial portfolio into the GRAT
- During a set period of years (you get to choose how long, but not more than 20 years), you retain the right to the use and enjoyment of the property
- The GRAT pays you an “annuity”, consisting of interest and principal (amount is dictated by the IRS but generally, must be at least 4%)
- The property interest that you are giving to the kids is the right to own any property remaining in the trust after the period expires
- Low maintenance strategy (i.e. no annual meetings, but an annual tax return may or may not be required)
- Very good result if you survive for the specified term
- All appreciation from the date of the transfer is out of your estate (reduced by the amounts paid to you as the annuity)
- The amount of federal exemption you use in this strategy is very small compared to the amount that you are reducing your estate, since you are giving away only a future interest
- Although you are giving the property away, your income does not change substantially because you receive an annuity stream from the GRAT
- Creditor protection features of an irrevocable trust
- It is specifically exempted from the reach of IRC 2036 even though the grantor retained a benefit.
- It is also a “Qualified” strategy and is described in the IRS Code and Regs.
- All or nothing strategy – Worst-case scenario is that you do not outlive the specified term, and the property reverts back into your estate (essentially, break-even)
- Loss of basis step-up- like the QPRT, the children receive your carryover basis in the asset.
Pros
Cons
V. Creating a discretionary income trust for your spouse – the Spousal Income Trust
This is an irrevocable Trust that is created in Arizona, by one spouse using his or her sole and separate property, for the benefit of the other spouse. The Grantor or creator of the trust is not a beneficiary. But, his or her spouse is the primary beneficiary and his or her children are the remainder beneficiaries.
Steps to Create the Spousal Gift Trust:
- Grantor creates an Irrevocable Trust for the benefit of his spouse and children.
- Appoints an independent Trustee.
- Trustee has discretionary powers to distribute income and principal to the beneficiaries for their “health, education, support and maintenance”.
- Grantor files a gift tax return on the fair market value of the assets used to fund the trust.
- Fixation of value – the grantor uses the gifting rules, either annual exclusion or a portion of his gift exemption, to get the assets out of his estate. All future appreciation in the value of the assets are no longer part of the Grantor’s estate, nor are they part of the Grantor’s spouse’s estate.
- The income and principal of the asset is held for the benefit of the Grantor’s spouse and children. So, although the grantor does not benefit directly, he does benefit indirectly. (works really well for a cabin or vacation property)
- Can be established as a “defective trust” for income tax purposes so that the grantor still pays all income tax attributable to the Trust.
- Achieves creditor protection because the trust is irrevocable and was not established for the benefit of the grantor (Note, if the grantor had given the trustee discretionary powers to make distributions to the grantor, then this trust could be reached by the creditors. That is why it is critical that the grantor not retain any benefit in the trust).
- Is not an “all or nothing” strategy. If client dies relatively soon after the gift, any appreciation obtained to date would still pass estate tax free to the wife and kids.
- Divorce – clients end up getting a divorce, then the grantor of the trust cannot receive anything back. (But could be established for a “Spouse” and if divorce happens, the ex-spouse would no longer benefit)
- Must make sure the assets are the sole and separate property of one spouse. If they are community assets, then one spouse must disclaim any benefit of their community property interest and you must let some time pass before the grantor spouse creates the trust.
- Like any gifting strategy, there is no step up in basis at the death of the grantor. As such, you should try to use assets that already have a high cost basis to them.
- Generally, if a client makes a lifetime gift, but reserves the income from the gift, or the use and enjoyment of the asset that was gifted, or retained the ability to determine who will ultimately get the use and enjoyment of the asset, then the fair market value of the asset is included in the estate of the donor, even though the asset was transferred during life. (IRC 2036 and 2038)
- Creditor Protection laws in Arizona – Generally, in the event a grantor, creates a trust and reserves any benefit in the trust (discretionary right to receive the income or principal from the trust, even though the discretion is in the hands of an independent trustee, creditors can reach that trust whether the trust is revocable or irrevocable.
Cons:
Creating a “Rainy Day Trust” in Nevada
Legal Concepts to Consider and Background –
- Trusts that are subject to the Grantor’s Creditors – The tax law has long provided that a transfer to a self- settled trust, which is subject to the claims of the creditors of the grantor, is not a completed gift and is therefore subject to estate taxes. (See Otwin v. Commissioner, 76 TC 153 (1981), Rev Ruling 76-103 and Rev. Ruling 2004-64) Self-settled trusts, even though irrevocable with an independent trustee, will still be included in the Grantor’s estate at death under most jurisdictions, including Arizona. (2036(a)(2))
- Trusts that are not subject to the Grantor’s Creditors – The IRS has ruled that a self-settled trust created under Alaska law will not be included in the grantor’s gross estate unless there is an implied understanding or other factor that would cause estate tax inclusion, even though the Grantor is still a beneficiary of such trust. PLR 2009-44002 (not precedent)
- Domestic Asset Protection Trusts (Nevada, Alaska, Delaware, etc) – There are 7 or 8 states that have changed their asset protection statutes, repealing the general common law rule described above, in favor of asset protection laws similar to the offshore jurisdictions. (such as the Cayman Islands, Isle of Man, Turks and Caicos, etc) In these jurisdictions, if you create an irrevocable trust, name an independent trustee who can make discretionary distributions of income and principal to a class of beneficiaries, including the grantor, the creditors of the Grantor cannot reach the corpus of the trust (Revokes the old common law rule stated above).
- Alaska was the first state to change its laws. Now, there are 7 or 8 other states, including Nevada and Utah that have repealed the common law statutes relating to creditor protection. In these states, you can achieve creditor protection even though the grantor and creator of the trust is a beneficiary of the trust.
- Unlike the Spousal Gift trust discussed above, the Grantor, or creator of the trust, is a member of a class of beneficiaries including his spouse and children.
Pros:
Steps to Create the Rainy Day Trust:
- Grantor creates an Irrevocable Trust for the benefit of himself, his spouse and children as well as his grandchildren.
- Appoints an independent Trustee. (trustee must be independent or it will lose its creditor protection feature and will also lose its estate tax benefit of excluding the assets from the grantor’s estate at the time of his or her death)
- Trustee has discretionary powers to distribute income and principal to the beneficiaries for their “health, education, support and maintenance”.
- Grantor files a gift tax return on the fair market value of the assets used to fund the trust. (achieves fixation of value)
Pros:
- Fixation of value – the grantor uses the gifting rules, either annual exclusion or a portion of his gift exemption, to get the assets out of his estate. All future appreciation in the value of the assets are no longer part of the Grantor’s estate, nor are they part of the Grantor’s spouse’s estate.
- The income and principal of the asset is held for the benefit of the Grantor, his spouse and his children. Here, the grantor does benefit directly from the trust, unlike the spousal gift trust discussed above.
- Can be established as a “defective trust” for income tax purposes so that the grantor still pays all income tax attributable to the Trust.
- Achieves creditor protection because the trust is irrevocable, and although it was established for the benefit of the grantor, his or her creditors cannot reach the trust because the state laws of that state have been changed to achieve creditor protection even though the grantor retained a benefit.
- Is not an “all or nothing” strategy. If client dies relatively soon after the gift, any appreciation obtained to date would still pass estate tax free to the wife and kids.
Cons:
- There is a constitutional question of whether or not a non resident of a DAPT state can be protected by the laws of that state. (Full Faith and Credit provision of the Constitution) There has not been a case make it to the Supreme Court. However, the fact that these states have adopted these statutes more then 10 years ago, and that we have not have a challenge, is a pretty good indication that they probably will stand up. Furthermore, it seems to be a trend in the law for more and more states to adopt these statutes. Arizona is considering such a statute.
- Like any gifting strategy, there is no step up in basis at the death of the grantor. As such, you should try to use assets that already have a high cost basis to them.
Notice – this maternal was put together for discussion purposes only by the Dana Law Firm. It does not constitute legal or tax advice. Each client’s situation is different and warrants individual one-on-one consultations with one of our attorneys or other tax professionals.
**In accordance with IRS Circular 230, we are required to disclose that: (i) this update is not intended or written by us to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; (ii) this update was written to support the promotion or marketing of the transactions or matters addressed by such materials; and (iii) each taxpayer should seek advice on his or her particular circumstances from an independent tax advisor.