LAW OFFICES OF OSHINS & ASSOCIATES, LLC

by

 Richard A. Oshins 

and 

Jerry A. Kasner

Introduction

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("the Act") will require all practitioners to reexamine traditional estate planning techniques, and in particular, the use of trusts in estate planning. If, in fact, the federal estate and generation-skipping transfer (GST) taxes are repealed, which is admittedly problematical, the focus of estate planning will shift to problems of family wealth preservation and creditor protection. If repeal does not occur, any vehicle used in estate planning should be flexible enough to adjust to that possibility.

A solution is a structure created for the benefit of one's descendants -- which might also include his or her spouse -- that can insulate the family wealth from creditors and erode the impact of any transfer taxes on that wealth. This vehicle can then be enjoyed and controlled by the family well into the future and is limited only by the applicable rule against perpetuities. Obtaining sufficient nexus to use the laws of a state that does not have a perpetuities restriction can eliminate this restraint.

Under both the current transfer tax system and the property laws in the United States, properly structured inherited wealth is a far more valuable commodity than wealth earned and saved. Earned wealth is subject to transfer taxes and may be subject to creditors. Although it is generally true that neither our transfer tax system nor our property law system distinguishes between wealth a transferee taxpayer owns and retransmits and wealth that is earned and subsequently transferred, proper planning can dramatically alter these general rules.

An excellent vehicle that can be used to achieve and maintain this differential is an irrevocable trust -- particularly a dynastic trust. In the typical family setting, the trust is created by a senior family member for the benefit of his or her descendants, and perhaps also for the creator's spouse. The trust corpus would form a "family wealth pool" for the use, benefit, and enjoyment of the family unit. Further, under the 2001 Act, such a dynastic trust can be structured to take advantage of larger exemptions, estate and GST tax repeal, or in the alternative, to operate very nicely under the existing transfer tax system, if it is preserved. The judicious use of special powers of appointment can enable the trust to avoid any adverse changes in the law.

Basic Transfer Tax Provisions in the Act

Under the Act, section 501, estate and GST taxes are reduced and will, if nothing changes, be repealed in the year 2010. Here is the phase-in schedule for the repeal and new estate tax and GST tax (not gift tax) exemptions and rates under Act sections 511(a)-(c) and 521(a):

2002     $1 million     50 percent

2003     $1 million     49 percent

2004     $1.5 million   48 percent

2005     $1.5 million   47 percent

2006     $2 million     46 percent

2007     $2 million     45 percent

2008     $2 million     45 percent

2009     $3.5 million   45 percent

2010     Estate and GST tax repealed

All transfer taxes may be reinstituted under the so-called "sunset" provision.

The GST exemption and rates will be adjusted by the same amounts under section 521(c) of the Act. However, the effective date of the provision is December 31, 2003, so the inflation adjustments over $1 million will still apply to the GST exemption until 2004. Note that the five percent surtax on large estates is also repealed, effective January 1, 2002.

The gift tax exclusion amount will increase to $1,000,000 in 2002 and remain there. See Act section 521(b). The gift tax rates will be the same as the estate tax rates, and after 2009 -- when the estate tax is supposedly repealed -- the top gift tax rate will be the top individual income tax rate (i.e., 35 percent). See section 511(a)-(d) of the Act.

Section 511(e) of the Act, effective December 31, 2009, provides that any transfer of property to a trust is a taxable gift unless the trust is treated as a grantor trust as to the grantor or grantor's spouse for income tax purposes in its entirety.

This particular provision has turned out to be the most perplexing in the Act. The authors' information, all hearsay, is that since the announced purpose of retaining the gift tax is to eliminate income-shifting devices, Congress decided that transfers to a trust that does not shift income is a nontaxable gift. Others dispute this. One alternative interpretation is that this is an indirect way of eliminating Crummey clauses. In other words, since all other transfers to trusts are deemed taxable gifts under section 2503, there would be no present interest exclusion. The authors have some doubts about this, since the annual gift tax exclusion applies only to taxable gifts to begin with.

The technical explanation of this provision from the Finance Committee states: ". . . except as provided in regulations, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions of the Code."

Regardless of the reasons for this special rule, in the opinion of the authors, it will become a solid basis for planning dynastic trusts.

Can the Dynastic Trust Be Made "Congress Proof"?

While the dynastic trust may be structured to avoid creditors and the current transfer tax, it may also function to avoid future changes in the tax law by Congress. If, in fact, the federal estate tax is repealed, the assets owned by a dynastic trust will or should be immune to any future return of the federal death tax in any form. There is considerable concern that what Congress gives, it can take away. A change in the political or economic climate could certainly result in either a suspension of the repeal of the federal estate and GST taxes, or the return of some form of federal death tax. Since the dynastic trust results in a complete transfer of ownership rights in the trust assets by the grantor, there would appear to be no theory under the U.S. Constitution that Congress could subsequently seek to "get the trust assets back" by passing new legislation that would subject those trust assets to tax. Here is why –- it would be almost impossible to impose a tax directly on the trust assets, since this would be a direct tax on property, which is unconstitutional under Article I, section 9, clause 4. It reads:

No capitation, or other direct, Tax shall be paid, unless in Proportion to the Census or Enumeration herein before directed to be taken.

It is, of course, possible Congress will seek to get around this, as it has in the past, by arguing the tax is on the particular use of, or exercise of, power over the property. See Bromley v. McCaughn, 280 U.S. 124 (1929), 1994 TNT 241-12, upholding the federal gift tax. However, that same decision pointed out that since one use of property is keeping it, a tax on the possession of property is no different than a tax on the property itself. Note the problem with defective trusts, discussed subsequently.

The authors are not constitutional scholars and claim no expertise in that area. However, the bottom line certainly appears to be that attempts to impose taxes on property held in trust will run into all kinds of obstacles, as well as political turbulence. In addition, such an attempt could also be seen as violating due process requirements.

Using the Gift Tax Exemption

Since the gift tax exemption will be fixed at $1 million in 2002, a married couple can shelter up to approximately $2 million through the use of the dynastic trust. This amount can be leveraged dramatically through the use of advanced estate planning techniques such as defective trusts, installment sales to the trust, shifting favorable economic opportunities to the trust, etc. Some clients may seek to use the 35 percent top gift tax bracket, after it phases in. It is, however, difficult to justify paying a gift tax when there is no estate tax. Assuming the estate tax repeal fully phases in, the basic estate plan at death may end up being a dynastic trust. Paradoxically, this could include a dynastic qualified terminable interest property (QTIP) trust, which would obtain a basis adjustment of up to $3 million at the death of the first spouse, but no basis adjustment at the death of the second spouse.

Making the Trust "Defective"

A trust that is taxed to the grantor is commonly known as a "grantor trust" or a "defective trust." A trust that violates one or more of the provisions contained in sections 673 through 679 is a defective trust for income tax purposes. Since the grantor trust rules are different for income tax purposes than for transfer tax purposes, grantor trust exposure for either income tax purposes or transfer tax purposes or both depends upon which code sections are being violated.

Alternatively, the exemption and transfers can be augmented by Crummey gifts that are exempt from the gift tax but are allocated to the increased GST exemption. Finally, assuming the estate tax is repealed, the clients will be able to bequeath unlimited amounts to the trust under the authority of section 511(e) of the Act, effective December 31, 2009.

Whether or not the federal estate tax is repealed, the dynastic trust could function in the same manner as a bypass or credit shelter trust by pouring over assets from the decedent's estate at death.

By paying the tax on the trust income, the grantor is making the functional equivalent of a tax-free addition to the trust for both gift and GST tax purposes. Moreover, the grantor will reduce his or her taxable estate by the income tax paid. Any potential growth on the "tax" money not paid will inure to the benefit of the trust rather than increase the wealth of the grantor.

Since the grantor will be taxed on the trust income, it may be desirable to include a provision authorizing the trustee to reimburse the grantor for any income tax liability he incurs. Such a trust provision will not have any adverse tax consequences. For example, in LTR 200120021, Doc 2001-14281 (3 original pages), 2001 TNT 98-51, the IRS ruled that a trustee and trust protector who are not related or subordinate to the grantor had the reimbursement power. In the absence of reimbursement authority, the tax on the trust income could become so large so as to create a hardship and even bankrupt the grantor.

Many Faces of the Defective Dynastic Trust

The trust device discussed in this article is designed to cover a variety of contingencies and circumstances including future change in the law. These may be summarized as follows:

1. During the life of the grantor until 2010, the trust functions as a gift-giving vehicle, intended to take advantage of increased estate and GST tax exemptions. It is made defective to maximize several advantages of defective trusts, such as the ability to hold S corporation stock, to transfer life insurance on the life of the grantor in and out of the trust without concern about the transfer for value rule of section 101, installment sales to the trust, and the transfer tax benefits of the grantor paying tax on wealth owned by the trust.

2. During this period, for large estate owners, consideration should be given to making actual taxable gifts to the trust to take advantage of all or part of the larger GST exemptions as they phase in.

3. On the death of the grantor, that individual's will or revocable trust may provide for a pour-over of other assets to the trust if the estate tax is repealed. This provision should be expressly conditioned on repeal of the tax at the date of death to deal with the sunset provision, or preferably incorporating a formula clause separating the GST exempt trust disposition from the nonexempt.

4. If the grantor dies during the phase-in period, or the estate tax repeal does not happen, or the sunset provision kicks in, the trust is in place, exempt from any additional transfer taxes.

5. If the donor dies during a time when the estate tax is repealed, the carryover basis rules would apply. If so, the trust may be drafted to carve out a QTIP in favor of a surviving spouse. This would permit the executor to elect to adjust the basis of assets added to the trust at the death of the grantor by up to $3 million (indexed for inflation), not to exceed the fair market value of the property. This provision would apply only if the repeal was in effect at the date of death.

6. The trust may also grant the trustee power to make a direct distribution of assets from the trust to the surviving spouse or any other trust beneficiary to take advantage of the $1 million -- indexed for inflation -- basis adjustment for assets in the survivor's estate. However, there will be no creditor protection for such assets.

Structure and Operation After Death

In most instances the trust will be designed as a single "pot" trust for the benefit of the family as a whole and often will include the grantor's spouse. Upon the grantor's death -- and perhaps his spouse's -- the trust would split into separate trusts on a per stirpetal basis.

A viable alternative is for separate trusts to be set up for each branch of the family at the inception, for example, each child or the grantor. The grantor's spouse can be a beneficiary, and perhaps the primary beneficiary of each child's trust, without adversely affecting either the transfer tax or creditor protection inherent in the trust vehicle. In fact, the inclusion of the spouse as a beneficiary will enable the trust to achieve grantor trust status under section 677(a). The problem with this approach is that it restricts the ability to toggle or get out of grantor trust treatment. The planner might consider including the spouse as a beneficiary, even a preferred beneficiary, but only with the consent of an adverse party.

By giving the spouse a power of appointment enabling the spouse to eliminate the adverse party as a trust beneficiary, the family should feel fairly comfortable the spouse is protected and will receive appropriate distributions if necessary. Alternatively, giving the spouse the "use" of the property without consent of the adverse party can eliminate the problem. In either case, a different defect would be used, terminating the grantor trust tax treatment.

To maximize the flexibility, tax savings, and creditor protection, the trust should be designed as a discretionary trust whereby the trustee will have broad power to distribute income or principal to, and provide the use of trust assets for, the trust beneficiaries, subject to a set of guidelines.

Operationally, however, it is anticipated that few, if any, distributions will be made in the absence of a compelling reason to make such distributions. The beneficiaries will be expected to absorb most family expenditures such as food, schooling, vacations, etc. Additionally, the trust funds will generally not be expended on consumable assets since use of protected funds in this manner would be wasteful.

The trustee would be encouraged to acquire assets for the "use" of the beneficiaries rather than funding the individual's personal acquisition of the assets. To allow for this result, the trust should contain specific language to permit investments in assets such as homes, artwork, jewelry, businesses (including start-up businesses), and the like, that have significant potential for appreciation. For example, if a beneficiary wishes to go into business, the trustee could acquire the business as an asset of the trust, rather than distribute funds to the beneficiary who would utilize such funds to acquire the business personally. As a result, the beneficiary will have the use and enjoyment of the business (including distributions therefrom) without the transfer tax problems and creditor exposure.

Broad use of powers of appointment should also be considered to deal with changing family circumstances and changing tax law. Typically in dynastic trust planning, the power holder will be the member of the oldest generation of any separate trust (representing a family branch) of the trust. Thus, adjustment can be made in the event of changes in the law or family circumstances. Generally, the primary beneficiary of each would be given a broad power of appointment in situations where the trust creator wishes to give the beneficiary the functional equivalent of outright ownership and control while obtaining the tax and creditor benefits not obtainable with outright ownership. Armed with a broad power of appointment, the primary beneficiary could rewrite the trust. This ability to effectively redraft the trust should negate any argument that the trust vehicle will "lock" the family into an inflexible arrangement.

For those grantors who desire to "keep it in the family" on a per stirpetal basis, the trust need not provide for powers of appointment. Alternatively, a limited power of appointment exercisable only on a per stirpetal basis could be used to retain some degree of flexibility within the family unit.

Some Planning Opportunities and Caveats

Do not mix apples and oranges. As a general rule, do not create a trust with hybrid tax results. The adverse tax and planning problems for GST tax purposes of partially exempt trusts are well known to estate planners. The most tax efficient use of the GST exemption is to create separate trusts that are wholly exempt and wholly nonexempt. A partially exempt trust will waste some exemption on distributions made to children and cause some unnecessary tax on distributions to grandchildren. A separate, nonexempt trust can make distributions to children without wasting GST protected assets and distributions of protected funds from an exempt trust can be made to members of younger generations without incurring GST tax.

It is important to create separate trusts if the funding results in different income tax consequences. For example, don't mix annual exclusion gifts and taxable gifts in the same trust. The result will be an accounting nightmare.

The separateness should even be observed between spouses, although initially it is immaterial because of section 1041. Upon death or divorce, dual income tax treatment will occur. Certainly in operation that rule should be observed. Consideration should be given to drafting a requirement that the trustee establish separate trusts for separate income tax payers just like GST exempt trusts and nonexempt trusts are generally mandated as a matter of course.

Consider authorizing an independent trustee to set up a secondary or subtrust for the benefit of a trust beneficiary whereby that person would be given a temporary, lapsing power of withdrawal so as to obtain grantor trust status as to the trust beneficiary under section 678. For example, assume that a beneficiary has the opportunity to get into a predictably highly profitable venture that requires a relatively modest investment. If a secondary trust were created by the independent trustee with a hanging power of withdrawal over the entire initial trust corpus, grantor trust status could be obtained, offering income tax-free growth for the trust as well as the ability of the beneficiary to transact with the trust tax free, taking advantage of Rev. Rul. 85-13, 1985-1 C.B. 184. This would enhance the ability of the family to move a greater amount of assets into a transfer tax free and creditor protected arena from one without such attributes.

In sum, the use of dynastic trusts as a significant wealth planning vehicle continues after the Relief Act of 2001 and should be considered by many to form the centerpiece of their estate plan.