Parts 4-6: A Primer on Trusts | Everything You Need To Know (and a whole lot more)
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This primer is meant for instructional purposes only. It has been created with the intent of providing only a surface-level overview of common trust types for a non-attorney audience. This primer is not a substitute for proper legal guidance. The trust arrangements described below should not be attempted without an experienced professional who can provide this counsel.
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Part Four: Inter-Vivos Trusts
Inter-vivos trusts are trusts which have been created during the lifetime of the trust’s grantor. The very common RLT, discussed earlier, is one type of inter-vivos trust. As a reminder however, an RLT is often unique (or almost unique) on account of its revocability, and this case is no exception. Nearly all other inter-vivos trusts are irrevocable. Inter-vivos trusts can be exceptionally powerful but require a tremendous amount of caution in their use. After all, “irrevocable” has a finality about it that demands more respect than is required to create revocable trusts or wills (which can be changed whenever a person desires). Consequently, inter-vivos trusts are typically created only after a person’s core estate planning documents have been put into place.
What are some of the reasons why someone might choose to create an irrevocable instrument during their life? Some of the most common are listed below. Be aware that they are not necessarily mutually exclusive, and that several of these motivations may exist at once:
Estate tax planning utilizing gifting strategies to leverage gift tax exemption.
Structured a plan for minor or problematic beneficiaries.
Charitable or “split-interest” (part charitable, part non-charitable) planning.
Planning for people with disabilities or special/supplemental needs.
Asset protection for oneself or others.
As we will see in the following Parts dealing with specific types of inter-vivos trusts, one or more of the above planning concerns is usually present. In nearly all these inter-vivos trust cases, a stand-alone trust vehicle is created and then funded with some asset or assets of value. Sometimes these assets can be tangible property, like land or titled vehicles. Other times these trusts are funded with intangible property, such as marketable securities, business interest, or even a promissory note. These types of trusts are often much more closely linked to a specific type of asset or investment strategy than an ordinary will or RLT, which are designed more broadly to handle most anything and everything. These inter-vivos trusts are usually narrower in scope than the trusts we have discussed so far but are also exceedingly powerful.
On a final note about inter-vivos trusts generally in Washington, it is quite common to see these types of irrevocable trusts in a very simplified format to allow for basic gifting by a relative. For our purposes, we can simply call them “Irrevocable Gifting Trusts.” They ordinarily have no special name. They are particularly common in our state because Washington has no gift tax regime, and so gifting before death represents an easy solution to a pending Washington estate tax problem. Be warned, however, that gifting creates many important federal income tax consequences along the way, and many needless dollars of taxes (whether they be income taxes or otherwise) have been paid simply because people relied too heavily on aggressive gifting strategies without thinking about other taxes consequences. Anyone looking to utilize gifting (whether outright or in an irrevocable inter-vivos trust) as a strategy to manage a pending Washington estate tax liability is strongly advised to seek professional assistance.
Part Five: Credit Shelter Trusts (including the QTIP)
“Credit Shelter Trusts” (CSTs), sometimes called “bypass trusts,” “marital trusts,” or “family trusts”, are a special type of testamentary trust used by married couples. These trusts were briefly referenced earlier in Part Three during the discussion on testamentary trusts. Rather than leaving assets outright to each other, married spouses often leave assets in trust for the benefit of each other. A testamentary trust is written into the couple’s joint estate plan while they are both alive, where it waits on standby until the first death. This can be done using a will or an RLT—it does not matter which estate planning tool the couple uses, or whether a probate occurs.[6]
CSTs are used for several purposes, which is partly why they have so many different names. Traditionally, CSTs shelter a certain “credit”—in this case, a tax credit—referring to a certain calculation under the federal estate tax regime. Under current law in 2023, the federal exemption against estate tax is $12,920,000 per person. That number could increase or decrease over time. Traditionally, a CST was used to pour as much of the first spouse’s assets as possible into an irrevocable trust for the surviving spouse’s benefit, without causing any additional estate tax to be owing. This would allow the surviving spouse to continue benefiting from those assets but without those assets being taxed in the surviving spouse’s estate when the spouse eventually passed away. Assets over this exemption must go to the surviving spouse or to charity (both of which are eligible for unlimited deductions against estate tax), or else estate tax may be owing.
CSTs have become more uncommon in much of the country over the last decade after Congress instituted a taxpayer-friendly feature known as “portability,” allowing the first spouse to die leaving any unused exemption to the surviving spouse. Before portability, couples who left all the assets to the survivor could be punished with additional estate taxes after the survivor passed. This was because the survivor owned both “halves” of the estate, but only had their own exemption to shelter the assets—the first spouse’s exemption was wasted as it could not be left to the survivor to cover those extra assets. For many decades, couples whose joint assets approached the federal estate tax exemption (which was under $1,000,000 at the turn of the millennium) would use a testamentary CST to ensure that they got the full benefit both estate tax exemptions. The first spouse’s estate would try to consume as much exemption as they could by leaving assets in trust for spouse, because any exemption not consumed would be lost. This strategy has disappeared for most couples in the US because high federal estate tax exemptions combined with portability mean that there is substantially less federal benefit from these more complex planning strategies.
In Washington, however, CSTs are still extremely commonplace for tax planning, and are only becoming more common. Washington administers its own estate tax regime, which is levied on all assets over $2,193,000 (far lower than the nearly $13m federal exemption).[7] In Washington, no portability exists at the state level. Washington residents therefore have to deal with estate tax liability concerns at a much lower threshold of asset value than most other Americans; and so more commonly utilize CST planning for their state estate tax problems. In most other states, “all-to-spouse” estate plans (using wills or RLTs) do not typically incur additional taxes, but Washington’s estate tax regime encourages married couples to think carefully or risk higher taxes.
Although CSTs serve fewer tax planning purposes for residents of most other states, the concept of holding assets in trusts for the benefit of a spouse is still used for other non-tax purposes. Sometimes people desire to leave assets in trust for the benefit of a spouse because they have children from prior relationships. Another common non-tax reasoning for leaving assets in a CST for a spouse is fear of creditors/predators. While most states (Washington included) do not allow a person to create self-settled asset protection (ie, putting one’s assets in a trust for that person’s own benefit and denying those assets from the person’s creditors), all states allow such protection to be created by a third party. This includes a deceased spouse. These non-tax situations commonly call for leaving assets in trust for a spouse rather than outright, and so marital trusts which function like CSTs are often found in estate plans even when the tax benefits are unlikely.
Finally, the QTIP. In most cases when creating a CST, some consideration should be given as to whether the CST should be eligible for an estate tax election called the “qualified terminable interest property” election (the “QTIP election” or just “QTIP”). This is most important for CSTs which were created for estate tax efficiency but is also true even of CSTs which were not driven by estate tax motivations. A QTIP election treats the trust as if it were the spouse when it comes to the estate tax. Assets going to the QTIP trust qualify for the unlimited marital deduction (no taxes between spouses) but are also includable in the taxable estate of the surviving spouse at that survivor’s death. At its heart, QTIP planning is about tax deferral—not avoidance.
For taxable estates using CSTs, QTIPs provide an easy tax-deferral tool. As much as can pass tax free would go into a CST, with any overage going into a separate share eligible for the QTIP election. No part of that excess should have any tax owing at first death, where taxes will be deferred until the survivor dies. Without the eligibility for the QTIP, the CST could have estate taxes owing before the survivor died. For non-taxable estates which use CSTs (or for estates which are taxable only for Washington estate tax purposes), utilizing the QTIP election can provide tremendous income tax benefits which could otherwise have been lost if it were not available.[6]
In order to be eligible for the QTIP election, a trust traditionally requires three features: (1) all of the income must be payable to the surviving spouse; (2) it must be payable no less frequently than annually; and (3) no one else can benefit from the trust while the survivor is still alive. These requirements typically do not represent a radical departure from what married couples would have already wanted, but there are times where these generous requirements can be problematic too. In any case, QTIP eligibility is an extremely common feature found in testamentary trusts created for the benefit of a surviving spouse, and they are commonly found in estate plans of all sizes—even if no QTIP election is ever actually made or needed.
Part Six: Grantor Trusts, Generally
Grantor trusts are trusts which are ignored for income tax purposes. Assets in a grantor trust which produce income are instead reported on an individual’s personal income tax return. This is done because trusts tend to pay higher amounts of income tax than individuals do. Although revocable living trusts (RLTs) are usually grantor trusts by default, many people who create irrevocable inter-vivos trusts also desire the same positive income tax treatment. “Grantor trusts” contain one or more features found in IRC §§ 671–678. With one exception outside the scope of this primer,[7] the individual who reports the trust’s income tax consequences on their personal income tax return is the trust’s original grantor or their spouse. Irrevocable grantor trusts are usually created for one or more of the reasons discussed in Part Four on inter-vivos trusts.
We discussed in Part Two that RLTs are grantor trusts. They are revocable by their grantor, which means that they are ignored for income tax purposes under IRC § 676. This ease and simplicity for income tax compliance is part of what makes RLTs so attractive as estate planning vehicles. As a cost, however, revocability also ensures no estate tax protection. Any trust over which the decedent retained the right to revoke or modify is includable in the taxable estate of that decedent for estate tax purposes under IRC § 2038.
Revocability, however, is just one of many ways to achieve grantor trust status; there are others, and not all of them come with the cost of total estate inclusion for estate tax purposes. For example, it has been understood for several decades (but could always change in the future) that a grantor who retained the right to swap assets with the trust would be treated as the income tax owner of the trust for grantor trust status—yet this does not cause inclusion for estate tax treatment, like revocability does. This disparate treatment for income tax purposes provides enormous planning avenues, because it allows a certain degree of control and income tax regularity to a trust which, after gifting, may be wholly outside of a person’s estate for estate tax purposes.
For inter-vivos trusts where the grantor hopes to avoid estate tax inclusion while maintaining income tax flexibility, it is quite common to see grantor trust provisions which make the trust ignored for income tax purposes, but which do not cause estate tax inclusion. Trusts which are not included in a grantor’s estate at death but are reportable on the grantor’s income tax return during their lifetime are often called “intentionally defective.” This somewhat misleading and unattractive term means the trust is “defective” solely from an income tax analysis, which is exactly the way the grantor often wants it. It is (or should not be) defective from an estate or transfer tax analysis. Let us now look at three specific types of grantor trusts which are usually ignored for income tax purposes, but which—unlike an RLT—typically accomplish important estate and transfer tax results at the same time.
(a) Sales to Intentionally Defective Grantor Trusts (IDGTs)
Intentionally utilizing trust provisions which are defective for income tax purpuses (we call these “intentionally defective grantor trusts” or IDGTs) can provide tremendous estate and transfer tax benefits for sophisticated grantors who require more time to part ways with a valuable asset. Sometimes people want to make a large gift to avoid paying estate taxes on the asset at death. By making a gift now, the grantor is generally able to avoid paying estate taxes on the future growth. If that is all that is needed, a simple gift to an irrevocable trust may suffice, and the general information contained in Part Five regarding inter-vivos irrevocable gifting trusts may be all that is required. A trust can be written, the property transferred, and the benefit provided in exactly the way the grantor wishes. At this point, the property is no longer owned by the grantor, and the grantor can never use it again (without the new owner’s consent, of course).
In many cases, however, what is desired requires more complexity than a simple completed gift to a trust. It is common to see situations where a person fully understands the tax benefits of making the gift now, but still wants to retain benefit from that asset because it may be what pays for that person’s lifestyle. Estate tax law is clear that a person cannot both gift assets to a trust while also retaining the right to receive income from that trust, while hoping to avoid estate tax inclusion at their death. IRC § 2036 specifically disallows this. Any asset that a person gifts away but retains the income stream is includable in the person’s taxable estate for estate tax purposes. More thought is required if a person wishes to derive a benefit from an asset they have gifted away.
Instead, a person can sell the property in exchange for a promissory note. That note can be calculated so that it provides a stream of payment back to the grantor in installments. This could be calculated to be the entire value of the property (in which case no gift has occurred if it has been earmarked to fully come back to the grantor) or a portion of the value of property (the portion in addition to the sale value would be a part gift). At the time the installment note is calculated, the fair market value of this note must consider the governing interest rate in the month of the transfer. For our purposes, this is the monthly rate in IRC § 7520 (henceforth “the 7520 rate”).[8]
So long as the note is genuine and is representative of the fair market value right to receive income, this arms-length business arrangement does not trigger a complete estate tax pull-back at death—only a pull-back of the current value of the unpaid portion of the note (if any) as a receivable. For example, a person could create an IDGT and sell their property to the trust for an installment note which runs over twenty years, adjusted for the 7520 rate. If this person died in year eighteen, having yet to receive their final three years’ payments, then the value of those three remaining payments—but not the prior payments, the value of the property, nor any growth on the property since the transfer—would be all that would be includable in the grantor’s taxable estate.
Finally, it is important to note that a sale of an asset ordinarily recognizes capital gain. It is critical for income tax purposes that the trust be ignored and treated as the same as the grantor, to whom no gain would be recognized. This is why they are nearly always grantor trusts. Without this intentionally defective feature, the sale would likely result in taxable gain.
(b) Grantor-Retained Annuity Trusts (GRATs)
Grantor-retained annuity trusts (GRATs) are typically more limited and less flexible than IDGT sales, but they work similarly. In the case of most GRATs, the purpose is to carve off the future appreciation of an asset while also making as small a gift as possible. Like the sale to the IDGT, a GRAT involves a transfer to an intentionally defective grantor trust in exchange for a right to receive payment. In this case, the right to receive payment is an annuity interest sale in exchange for a promissory note. The grantor transfers property to the GRAT and retains a right to receive a fixed annual annuity amount from the trust for a set number of years, set by the grantor. The grantor must outlive this term of years or the whole GRAT is includable in the grantor’s estate, for the same reasons outlined earlier under IRC § 2036. Unlike an IDGT sale, where only the unpaid portion of income stream is includable if a grantor dies too early, a failure of a GRAT generally represents a total loss. It is common to find GRATs which run for only a few years.
Like the IDGT sale discussed earlier, GRATs also rely on the 7520 rate in the month of the transfer. In the case of a GRAT (and in some IDGT sales), the grantor tends to get the best result when the 7520 rate is low. A grantor can contribute property to a GRAT and retain an annuity stream equal to the value of the transfer (adjusted by the interest rate), thereby making a $0 gift. For example, if a person contributed $5,000,000 to a 5-year GRAT and retains an income stream of that exact value, adjusted by the 7520 rate, they have effectively made a gift of $0. Every dollar is indexed to return to the grantor.
How could a GRAT help if every dollar was returned to the grantor? For starters, the 7520 rate is notoriously not reflective of actual rate of growth. Throughout most of 2021, the 7520 rate was under 2%—and yet the S&P 500 grew 26.9% that same year. The assumption baked into the GRAT that every dollar would come back to the grantor is true only if the asset actually grows at the same rate as the 7520 rate. What if it instead grows at a higher rate? Each year the difference accrues and is accumulated within the trust. At the end of the GRAT term, any remaining balance transfers to the trust’s beneficiaries without any type of taxable gift having been made. In effect, a person makes a GRAT when they are convinced that an asset will grow much more rapidly than the current rate of the month. The lower the rate, the more attractive a GRAT becomes, because it is easier to beat. As interest rates increase, GRATs become less attractive.
It should be mentioned that many GRATs these days are not always “zeroed-out” (a $0 taxable gift) as in our example. Zeroed-out GRATs are easy to illustrate but have become somewhat disfavored by practitioners, as well as Congress, who has tried (unsuccessfully in most cases) to curtail their use several times over the last two decades. In any case, the principle of the GRAT should be clear—it provides a method of leveraging a certain amount of gift exemption (sometimes little or none) into a larger value and works best in low interest rate environments.
Finally, we should briefly mention that GRATs and sales-to-IDGTs are similar but often used for different situations. IDGT sales are common for complex family business transfers, where the owner needs to transition a complex piece of private business interest, while still retaining some value through a term of years. GRATs are more attractive for a person who likes trading publicly held securities, where trades can be conducted quickly and where the values of those securities can be easily derived.
(c) Qualified Personal Residence Trusts (QPRTs)
The last type of grantor trust we will discuss in this section is a type of grantor trust which works well when interest rates are high, unlikely the GRAT and IDGT-sales described earlier: the qualified personal residence trust (QPRT). This trust requires a residential home (a qualifying personal residence[6]) owned by a person who wants to (1) continue residing in the home for several more years; and (2) make a smaller, more efficient taxable gift than simple gifting allows.
QPRTs are attractive for people who believe they may owe federal estate tax at their death, and who want to maximize the use of their federal gift tax exemption to minimize any eventual estate tax following their death. A QPRT begins with the grantor writing the trust and then transferring their residence to the trust, where it remains for a term of years set by the grantor. The grantor typically stays in charge of the trust as trustee and makes decisions involving the day-to-day use of the residence in much the same way they did when they owned the residence in their personal capacity. The transferor makes a taxable gift at the time the residence is transferred into the trust. The value of the taxable gift is reduced by the value of the grantor’s right to reside in the property over the term of years they set, using the same 7520 rate discussed in earlier sections. A higher 7520 rate results in a larger retained interest, with a smaller taxable gift made to pass on a much larger value. The value is then further reduced by the actuarial likelihood that the grantor does not survive the term. Because the gift to a QPRT is completed at the time it is made, all future growth is removed from the grantor’s estate. Like a GRAT, however, the consequence of not surviving the term is total inclusion for estate tax. Failure to outlive the term is total failure.
Although Washington administers a separate state estate tax, it does not administer a gift tax. Gifts for Washington purposes do not reduce available exemption at death, unlike the federal system’s unified gift and estate tax regime.[7] Although risky for many other reasons, Washington residents can freely gift with no state estate tax detriment. For Washington estate tax purposes alone, the complexity of a QPRT provides no state benefit versus gifting. Those who benefit from QPRTs in Washington are those who believe they will owe federal estate taxes. They use QPRTs to maximize their federal gift tax exemption during life to minimize federal estate taxes at death. QPRTs are not effective tools for a person who will not be subject to federal estate tax.
Although it may sound self-evident, any QPRT should be created with some expectation that it actually succeeds. It is not uncommon for a QPRT grantor to become resentful of a successful QPRT because the grantor was not adequately prepared for it. After the term of years expires, the grantor loses their right to reside in the home. The QPRT has now been completed and any interest possessed by the grantor risks complete estate tax inclusion. In many cases, however, the grantor still wants to reside in the home. To respect the validity of the QPRT, the IRS requires that the original grantor begin paying fair market rent to continue residing there. This often feels much more bitter or punitive than it actually is. This rent payment can be a helpful tax tool if considered correctly.[8] In any case, everyone who contemplates a QPRT must understand they may be paying rent to live in their own home. Is that situation truly as palatable as it sounds?
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[4] This exception is contained in IRC § 678 and deals with situations where a trust’s grantor can force a person other than the grantor be treated as the owner of the trust for income tax purposes, typically a beneficiary of the trust. These trusts are called “Beneficiary Deemed Owner Trusts” or “Beneficiary Defective Inheritance Trusts”—BDIT/BDOTs. They are uncommon but are growing in popularity for creative income taxation management solutions.
[5] Pursuant to Internal Revenue Code § 7520, the interest rate for a particular month is the rate that is 120 percent of the applicable federal midterm rate (compounded annually) for the month in which the valuation date falls. That rate is then rounded to the nearest two-tenths of one percent.
[6] A person may only have two qualifying personal residences at any given time.
[7] The unified federal system says that anything gifted in life reduces the amount of exemption available at death.
[8] A Washington estate paying federal estate tax is already paying the highest Washington estate tax rate for an effective marginal rate of around 53% on every dollar over the federal exemption. Turning that same dollar into rental income, taxed at a beneficiary’s ordinary income tax rates, could very well end up saving taxes in the long run.
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