Estate Defective Trusts Offer A Wealth Of Planning Opportunities

For decades, estate planning largely has been about the avoidance of a confiscatory federal transfer tax.

However, the changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) significantly decrease the number of taxpayers subject to a federal estate tax. And if, as expected, President Bush and Congress continue increases in the unified credit applicable exclusion (currently $1.5 million for federal estate tax purposes and $1 million for federal gift tax purposes), for the vast majority of taxpayers, estate planning will no longer be driven by the avoidance of a federal transfer tax. Instead, personal issues, family concerns and other tax issues (e.g., state inheritance taxes and income taxes) will drive the estate planning process for most clients.

As this revolutionary process continues, the avoidance of income taxes may become more important than the avoidance of an inapplicable federal estate tax. This new tax environment creates income tax planning opportunities using Estate Defective Trusts.

Because the basic purposes of income taxes and transfer taxes differ, the rules governing the income taxation of trusts, grantors and beneficiaries differ markedly from the rules governing transfer taxation. For years, planners have used the differences to create “Income Defective Trusts” that provide significant transfer estate tax benefits to their clients. When an Income Defective Trust is used, the grantor remains taxable on the income earned by the trust pursuant to the grantor trust income tax rules of Code section 671-679. However, the transfer to the trust is a completed gift for gift tax purposes and the assets of the trust are not included in the grantors federal taxable estate.

Virtually the entire discussion of defective trusts has been about the use of Income Defective Trusts. However, with the recent increases in the unified credit (and the increases still to come), the gap between the income tax and transfer tax rules may create planning opportunities for Estate Defective Trusts. Such trusts are purposely created to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantors taxable estate. Ironically, an Income Defective Trust is primarily an estate tax planning tool, while the Estate Defective Trust is primarily an Income Tax Planning tool.

The Estate Defective Trust (“EDT”) offers a number of planning opportunities for planners and their clients, including:

Income Taxation. Until March 2, 1986, grantors could place assets in trust for a period of not less than 10 years and have the income taxable to the trust beneficiaries, even when there was a reversionary interest to the grantor after the 10 years. In 1986, Congress effectively eliminated the use of these “Clifford Trusts.” The EDT can restore the income tax benefits of a Clifford Trust.

Planning: Assume a client has a son in college and the client owns a low basis asset which generates an annual income stream of $50,000. The client is in an effective state and federal income tax bracket of 40%, while the son is in an effective tax bracket of 10%. Using an EDT, the family saves $15,000 in annual income taxes, while the low basis asset remains in the clients estate for federal estate tax purposes, allowing a step-up in basis at the grantors death.

Two benefits can result from this income reallocation: First, as shown above, the income can be allocated to beneficiaries who are in a lower tax bracket than the trust grantor. Second, because the grantor does not receive the income, the after-tax value of the income is not includable in the grantors estate, reducing the possibility that the grantor may be subject to either state or federal transfer taxes.

Planning: Assume in the above example that the client dies in 20 years. Assuming an annual 6% return, the annual after-tax income (even at a 40% income tax rate) could create an additional estate value of over $685,000 at the grantors death.

Basis Issues. The use of an EDT can fix many of the basis issues in a clients estate. Many clients have appreciated assets in their taxable estate. If the client gifts the asset to heirs, the clients low basis in the asset will pass to the donee, effectively reducing the value of the gift by the inherent income tax cost. If the asset is held until death, the asset will step up to its fair market value.

With higher estate tax unified credit applicable exclusion and a date of death step-up in basis to a fair market value, we may see a reversal in asset valuation planning and arguments. For years much of the estate tax conflict with the Internal Revenue Service has been to counter its argument that the estate was worth more than the client indicated. With the higher exemptions, clients may want to drive up the value of the estate assets in order to obtain a higher step-up in basis and thereby reduce an heirs future ordinary income (e.g., depreciation of depreciable assets) or capital gains (e.g., upon the sale of the asset).

But the EDT provides more than a tax benefit of a step-up in basis. In many cases, the client lacks sufficient information to compute properly the basis of gifted property. For example, assume a grandfather wanted to gift a family farm to his children. In many cases, determining the donors basis (which will become the donees basis at the time of a gift) can be an insurmountable task. Assuming a non-taxable estate, the retention of the asset in the taxable estate of the trust grantor cleanses most questions about basis because of the fair market value step-up in basis that occurs at death.

Many clients have depreciated their assets to a nominal income tax value. The sale of the asset may create depreciation recapture. If the asset is gifted, the donee may be responsible for the income tax payment associated with the depreciation recapture. If the asset is retained in the clients taxable estate until death, the depreciation recapture disappears when the basis steps up to fair market value. Not only does the depreciation recapture disappear, but the inheritors also have a new basis and can start depreciating the asset again using a new higher basis.

Future Appreciation. The EDT also provides the ability to grow the value of the assets after the creation of the trust and receive a step-up in basis at the donors later death.

Planning: Assume a client has an asset that is currently worth $200,000 with a $10,000 basis. The asset is expected to grow at a rate of 5% per year while generating an annual income stream of $30,000 per year. The client places the $200,000 asset in an EDT and dies 20 years later. Over the term of the trust prior to his death, $600,000 in income has been moved to the children who pay the related income tax at a potentially lower rate than the grantor. Second, in 20 years the value of the assets placed in the EDT is over $677,000. When the EDT assets step-up to a fair market value (assuming a 25% state and federal capital gain bracket), the post-death sale of the assets would save almost $170,000.

Non-Tax Opportunities. Many client estate planning decisions have been dictated by the requirements of the avoidance of a federal estate tax. For example, a grantor to a trust could not retain a power of appointment to reconfigure the trust at some later date without the trust assets remaining in the grantors taxable estate. However, because the vast majority of estates will no longer be taxable, the dictation of trust terms to avoid the federal estate tax will no longer apply to a majority of estates. Instead planners should examine the income tax implications of trusts and draft language to minimize the income tax exposes, not the estate tax exposures.

Planning: Assume a client creates an irrevocable trust, naming his three children as beneficiaries. The clients children have not shown themselves to be financially responsible and the client wants to retain some ability to reconfigure the assets among the beneficiaries or give the assets to charity in the future. A retained testamentary power of appointment over the EDT will result in the inclusion of the trust assets in the grantors estate. However, a testamentary power of appointment does not result in the trust being treated as a grantor trust for income tax purposes if the trust income cannot accumulate without the consent of an adverse party. Therefore, the income of the trust would be taxable to the recipient beneficiaries, the EDT assets would be includable in the grantors estate at the time of his death permitting a step-up in basis, and the grantor retains a power over the EDT to satisfy his personal concerns about his children.

Secrecy. In many cases a client wants to make sure that his or her disposition decisions are not reflected in public records. By placing assets in the EDT, the client effectively can remove how assets are being passed from the scrutiny of other parties.

Planning: Assume a client does not want his new wife to know what he does for the benefit of estranged family members or ex-wives. Assuming the estate is not taxable, the use of an EDT could provide a mechanism for transferring low basis assets to “unacceptable” family members without disclosure to all of the family members. If a federal estate tax return is not due, there may be no documents which disclose the existence of the trust and unless the trustee or the beneficiary makes this disclosure, the veil of secrecy remains.

Risks of EDTs. The Estate Defective Trust does carry significant risks. First, an EDT is normally created on the assumption that the grantor will not have a federal taxable estate. Inheritances, unexpected growth in the estate or other factors could increase the size of the estate. Moreover, the transfer tax exclusions which are currently available could be decreased by a future Congress.

Second, without careful planning, the transfer to the EDT could be treated as a completed gift for federal gift tax purposes (i.e., using portions of the clients available unified credit applicable exclusion) while remaining taxable in the grantors estate. Because of the differences between the estate and gift tax rules, double taxation is possible. For example, assume a grantor retains the right to change the time or manner of a beneficiarys interest in the EDT but cannot take away the beneficial interest. Such a transfer would be complete for gift tax purposes, but the retained power would result in the grantor including the EDT assets in his taxable estate.

Third, if the estate is below the unified credit applicable exclusion amount, a federal estate tax return is generally not due. However, clients still need to document properly the value of the assets in the EDT as of the date of death of the grantor. It is an absolute necessity that any unmarketable EDT assets which are included in the grantors taxable estate be appraised properly at the time of the death of the grantor. The trust should probably include language requiring the trustees to obtain such an appraisal.

Fourth, even though there will be substantial reductions in federal transfer taxes, state death taxes will offset at least part of the reduction. As a part of EGTRRA, Congress replaced the state death tax credit with a federal estate tax deduction. Thirty-eight states used the federal credit as their state estate tax. Most of these states now are revising their statutes to impose new state inheritance taxes. Some states will ignore the higher federal exemption amounts, creating a state death tax when no federal estate tax is due.

The Estate Defective Trust adds one more tool to the arsenal of planning tools. Like the Income Defective Trust, the EDT will not work for every client, but for those clients who fit its criteria, it can be an excellent part of their plan.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at jeff@scrogginlaw.com.


Reproduced from National Underwriter Edition, December 30, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.