Domestic and Global Trust Review - A.U.S. Perspective
By Peter Trieu, Rowbotham International
We wish to present in a three part series, comments on the use of trusts for United States income, estate, and charitable planning. This series is intended to summarize the possible trust structures; the permutations are many. Part 1, following below, covers the use of domestic trusts for income and estate planning. Part 2 will cover the use of foreign trusts for income and estate planning. Part 3 will cover the use of charitable trusts and foundations.
Trust planning primarily involves (1) asset management; and (2) coordination with one’s estate plan. Transferring assets to trusts where the transferor retains control and remains a potential beneficiary generally results in no income or estate tax. Transferring an asset out of one’s control, on the other hand, removes it from the estate which may result in transfer taxes or the use of an exemption against such taxes.
The U.S. transfer taxes apply to two different transactions: transfers during life and transfers at death. For each, certain exclusions and exemptions apply.
For U.S. citizens and tax residents, gifts to individuals that do not exceed $14,000 (USD) during the tax year are allowed free of tax and without any reporting required. Gifts in excess of $14,000 to a recipient in a given year can still be made free of transfer taxes, but will use up a portion of the donor’s lifetime exemption of $5.43mm (2015). For foreign nationals not domiciled in the U.S., they may also gift up to $14,000 of U.S. sited assets annually to any number of individuals free of U.S. transfer gift taxes without reporting the transfers. There is no lifetime exemption, however, for foreign nationals so gifts of U.S. assets in excess of the $14,000 limit are subject to U.S. gift taxes at 18%-40%. Foreign nationals, however, can gift an unlimited amount of non-U.S. assets to anyone including U.S. recipients.
Transfers at the death of U.S. citizens and residents enjoy the same $5.43mm (2015) exemption provided during life. Accordingly, any gifts during life utilizing some or all of the exemption reduce the amount left available to shield assets from estate taxes at death. For foreign nationals, an exemption of only $60,000 is available for transfers of U.S. sited assets transferred upon death. After the exemption, the estate tax is 18%-40%. Again, an unlimited amount of non-U.S. assets may be left at death free of U.S. transfer taxes regardless of the residency of the recipient.
Below is a short commentary on the more common types of trusts that are employed. We have limited our comments for each trust to (a) explaining the purpose of the trust, and (b) summarizing the U.S. tax treatment of the trust.
Domestic Trust Planning Vehicles
1. Revocable Living Trust
a. The purpose of a living trust is to hold title to assets, avoid costly probate, and provide privacy and speed for transferring assets upon death. As the name suggests, the grantors can amend or revoke the trust at any point. This trust can take a few different forms depending upon the marital status of the grantor and the desire, if any, to limit the access of the surviving spouse to trust assets.
b. Because the grantors of a revocable living trust retain 100% control over the trust and its assets, the trust is completely transparent for U.S. tax purposes. The general terms and form of such a trust, however, can provide the post death structure necessary to maximize an individual’s use of the estate tax exemption amount and proper administration of the assets. See, for example, the QTIP, QDoT and Credit Shelter trusts discussed below, and the sample diagrams at the end showing how the trusts come into being.
2. Intentionally Defective Grantor Trust (“IDGT”)
a. A “defective” grantor trust is an estate planning tool used to effectively transfer additional assets to beneficiaries free of transfer taxes. Transfers to a “defective” grantor trust are completed gifts subject to U.S. gift taxes because the grantor relinquishes all dominion and control over the assets transferred to such a trust. The grantor, however, will retain certain other powers that qualify the trust as a grantor trust for income tax purposes. Accordingly, the trust is “defective” since the grantor has made a completed gift, having given up all control of the transferred asset, but still owes the taxes on all income generated by the assets gifted away.
b. Because the income of a grantor trust is taxed to the grantor, not the trust nor its beneficiaries, all trust assets which are passing to the beneficiaries effectively grow income tax free. The grantor pays the tax, and so is essentially transferring this additional gift (payment of income taxes) to the beneficiaries free of additional transfer taxes. The result is a further decrease in the taxable estate of the grantor, and a bigger increase in assets passing to beneficiaries free of taxes.
3. Grantor Retained Annuity Trust (“GRAT”)
a. A GRAT is another effective estate planning tool used to transfer assets to beneficiaries for little to no transfer taxes. In a GRAT, the grantor transfers an asset (ideally of low value but with substantial growth potential, e.g. pre-IPO stock), and takes back an annuity equal to some value necessary to reduce or eliminate gift taxes on the transfer. With proper asset selection, the growth of the asset will increase in value far beyond the value of the annuity that is required to be paid. The asset (or more accurately its appreciation), meanwhile, will have been transferred for little to no transfer taxes and no utilization of the grantor’s lifetime exemption.
b. A typical GRAT is set up for a short term (e.g. 2 years) since the grantor must survive the term of the GRAT for the tax planning to be effective. To further leverage the use of the discounted values provided by a GRAT, while hedging against the likelihood of death within the annuity term, “rolling” GRATs, which effectively renew every two years, are sometimes used.
4. Qualified Personal Resident Trust (“QPRT”)
a. Similar to the GRAT, a QPRT is a trust used to transfer the grantor’s principal residence or vacation home at discounted values resulting in reduced or eliminated transfer taxes. The grantor of a QPRT transfers his home or vacation home to the trust, and takes back the right to reside in the property for a number of years. The greater the number of years, the greater the discount on the gift.
b. As with the GRAT, the grantor of a QPRT must survive the reserved term in order to reap the tax benefits of the transfer. If the grantor survives, the property and all appreciation will have been transferred for little to no transfer taxes. The grantor can then continue to live in the property if he pays fair market value rent. This rent will be income to the trust, but will further decrease the grantor’s taxable estate free of transfer taxes.
5. Qualified Terminable Interest Trust (“QTIP”)
a. A QTIP trust is typically established as a subtrust to a revocable living trust. Following the death of the first spouse of a married couple that has established a revocable living trust, a QTIP may be set up to hold some portion of the decedent’s share of the trust assets for the benefit of the surviving spouse.
b. The terms of a QTIP trust generally provide that the assets may be used for the benefit of the surviving spouse, but the remainder must be disposed according to the wishes of the decedent spouse. The QTIP trust provides the parameters necessary to benefit the survivor, qualify for the marital deduction, but ultimately benefit beneficiaries chosen by the decedent spouse.
6. Qualified Domestic Trust (“QDoT”)
a. Also typically established as a subtrust to a revocable living trust, the QDoT is employed to qualify for the unlimited marital deduction in the event the surviving spouse is not a U.S. citizen. Transfers from a U.S. citizen or U.S. resident to a surviving U.S. citizen spouse are allowed free of transfer taxes without limitation since transfers to a U.S. citizen spouse qualify for the unlimited marital deduction. Transfers to non-U.S. citizen spouses, however, are capped. During life, instead of a $14,000 annual exclusion, the amount is capped at $147,000 (2015) annually. At death, they must either fall under the estate tax exemption or be placed into a QDoT for the benefit of the noncitizen spouse.
b. Income generated from assets in a QDoT benefit the spouse during their life. Distributions, however, are subject to estate tax rates at the time of distribution. Additionally, only a U.S. person/corporation may serve as trustee. Moreover, the QDoT (depending upon its size) may need to post a bond, and may need to have a U.S. bank serve as trustee if the assets in the trust exceed $2mm.
7. Credit Shelter Trust
a. Also typically established as a subtrust to a revocable living trust, the Credit Shelter Trust or Exemption Trust is used to maximize the lifetime exemptions of two spouses. While anindividual can shelter up to $5.43mm (2015) from U.S. transfer taxes, a married couple can shelter double this amount. Historically, this doubling up has been utilized through the use of a Credit Shelter Trust. Prior to 2010, assets that passed to a surviving spouse passed free of U.S. estate taxes due to the unlimited marital deduction, and the estate tax exemption is wasted. Since all the assets ended up in the hands of the surviving spouse, however, estate taxes would likely apply since only the survivor’s exemption was available to shelter what would then be the assets of two persons held by just one person. To guard against that result, a Credit Shelter Trust is used.
b. As with a QTIP, a Credit Shelter Trust is established for the benefit of the surviving spouse following the death of the first spouse for the benefit of the survivor. Because the assets in the Credit Shelter Trust do not pass outright to the survivor, however, it (intentionally) does not qualify for the marital deduction. Amounts passing to this trust would instead avoid U.S. estate tax to the extent of the estate tax exemption amount. Upon the death of the survivor, since her ownership in the Credit Shelter Trust is nonexistent (as she held only a life interest), the assets are not included in the survivor’s estate, and therefore, not subject to estate taxes. The remaining assets of the trust then pass on to the remainder beneficiaries free of estate taxes.
c. With the advent of portability beginning in 2010, a decedent’s unused estate exemption passes on to the surviving spouse without the use of a Credit Shelter Trust, thus, allowing for the doubling up on the exemption with the use of the trust. The trust, however, remains a good planning device since it removes all appreciation from the date of death of the first spouse to die on trust assets from estate taxes at the survivor’s death.
8. Irrevocable Life Insurance Trust (“ILIT”)
a. Proceeds from life insurance are not subject to income taxes. They are, however, included in the decedent’s estate for estate tax purposes if the policy is owned by the decedent at death. Using an ILIT prevents this result. Since the ILIT, and not the grantor, owns the policy, the proceeds will not be subject to estate taxes at the grantor’s death.
b. Funding an ILIT generally requires providing sufficient money to the trust to pay the annual premiums for the life of the policy. Doing so can be done free of transfer taxes by making annual gifts to the trust in a manner that qualifies for the $14,000 annual exclusion. While such exclusion only applies to gifts of present interests, particular powers (known as Crummey Powers) can be provided to the trust beneficiaries that qualify the annual gifts for the exclusion.
As one can see, the types of U.S. trusts are many and provide for varying issues in estate planning. Each trust addresses a different issue and set of facts. Accordingly, it is not uncommon for clients of substantial wealth to utilize a multiplicity of these trusts. If the client is multinational, the use of foreign trusts (discussed in the upcoming Part 2) may be additionally employed.
Peter Trieu, Partner
Rowbotham International, 101 2nd Street, Suite 1200, San Francisco, CA 94105
T: 415-433-1177; F: 415-433-1653
published: July 2015