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.
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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.