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Financial Planning > Trusts and Estates > Trust Planning

6 trusts you should know about

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Estate planning is primarily about people and their desire to provide for their loved ones. Given proper motivation, most clients will devote the time and energy that is necessary to develop and adopt an effective estate plan.

The nontax reasons for estate planning. The primary objectives of most estate plans involve estate creation, support and care of a surviving family and the orderly transfer of property during lifetime or at death. This often involves providing for the care of minor children, support for disabled children and elderly parents, and protection of loved ones from creditors. For some individuals the motivation to plan their estates is found in a strong desire to assure the survival of a business, or to provide for their church or a charity.

Life insurance. Are there enough life insurance proceeds, liquid assets, and other sources of income to maintain the current living standards of your client’s surviving family? Unfortunately, all too many individuals remain underinsured. For those clients needing insurance to pay taxes, delaying the purchase of currently needed life insurance could be disastrous.

Valuation of today’s life insurance products is very unsettled. The IRS has not provided clear guidance and carriers use inconsistent methodology. The “net cash value,” “interpolated terminal reserve,” and statutory “book” reserve methods have all been used. 

Coordination is important. It is often difficult, if not impossible; to design an effective estate plan without considering your client’s employee benefit programs and business disposition plans. Effective planning cannot be achieved unless there is an awareness of the interplay between the various strategies and techniques of estate planning, business planning, and employee benefits. For example, the liquidity needs of a business owner’s estate plan are directly influenced by whether the business is to be sold, continued, or liquidated. If the business is to be sold, then a funded purchase agreement may well provide all of the dollars needed for estate liquidity and family income. If the business is to be continued, then an employee benefit, such as split-dollar, could provide the necessary funds.

1. Revocable living trust

The revocable living trust (RLT) is a will substitute that can accomplish many estate planning objectives. It is an agreement established during the grantor’s lifetime that may be amended or revoked at any time prior to the grantor’s disability or death. The primary advantages of the RLT include: (1) providing for the management of grantor’s assets upon his mental or physical disability thus avoiding conservatorship proceeding; (2) reducing costs and time delays by avoiding probate; (3) reducing the chances of a successful challenge or election against a will; (4) maintaining confidentiality by not having to file a public will; and (5) avoiding ancillary administration of out-of-state assets.

Two additional documents are typically executed together with the RLT:

  • The durable power of attorney authorizes the power-holder to act for the grantor when the grantor is disabled.
  • The pour-over will functions asa “fail safe” device to transfer at death any remaining probate assets into the RLT, to undergo minimal probate as a means of clearing the estate of creditor claims, and to appoint guardians of any minor children.

DURING LIFETIME. The grantor establishes the RLT and typically names himself as the sole trustee. Following creation of the trust the grantor retitles and transfers his property to the trust. Because the grantor maintains full control over trust assets there are no income, gift, or estate tax consequences.

UPON DISABILITY. If the grantor becomes disabled due to legal incompetency or physical incapacity, a designated successor trustee steps in to manage the grantor’s financial affairs. Disability is determined under trust provisions providing a standard of incapacity (e.g., certification by two physicians that the grantor is unable to manage his financial affairs). Also, during the grantor’s disability, the holder of the durable power of attorney is authorized to transfer additional grantor-owned assets to the trust.

UPON DEATH.The RLT becomes irrevocable when the grantor dies. Under the grantor’s pour-over will, any probate assets not previously transferred to the RLT during lifetime are transferred to the RLT as part of the grantor’s residuary estate. Assets held in trust are then disposed of according to the terms of the trust. This can include an outright distribution to the trust beneficiaries, or the trust may contain provisions establishing separate tax-savings subtrusts similar to the marital and family trusts under the exemption trust will.

Although the RLT is not for everyone, it clearly offers substantial benefits for many individuals. The utility of a funded revocable trust increases with the grantor’s age, when there is an increased likelihood of incompetency or incapacity and the need for asset management.

Information required for analysis & proposal

Attorney Drafting Trust Instrument Must Know

1. Name of trust grantor.

2. Name of trust grantor’s spouse.

3. Name of individual who will be successor trustee.

4. Name of institution that will be alternate successor trustee.

5. Name of beneficiaries other than grantor.

6. Ages of minor beneficiaries.

7. Approximate size of grantor’s gross estate (i.e., will estate be subject to federal estate taxes or state death taxes).

8. To who, in what amounts, and when trust income is to be paid.

9. To who, in what amounts, and when trust corpus is to be paid.

Attorney Drafting Pour-Over Will Must Know

1. Name of testator.

2. Name of testator’s spouse.

3. Name of individual who will be personal representative or executor.

4. Name of individual or institution who will be successor personal representative or alternate executor.

Attorney Drafting Durable Power Of Attorney Must Know

1. Name of grantor.

2. Name of individual to be given the power.

3. Type of power to be given (e.g., general durable power of attorney or special durable power of attorney). 

QTIP Trust

With large estates the QTIP trust provides a way to defer estate taxes by taking advantage of the marital deduction, yet “control from the grave” by directing who will eventually receive the property upon the death of the surviving spouse.

Under such a trust all income must be paid at least annually to the surviving spouse. The trust can be invaded only for the benefit of the surviving spouse, and no conditions can be placed upon the surviving spouse’s right to the income (e.g., it is not permitted to terminate payments of income should the spouse remarry). However, in order to qualify the executor must make an irrevocable election to have the marital deduction apply to property placed in the trust. This requirement not only gives the executor the power to determine how much, if any, of the estate will be taxed at the first death, it also provides great flexibility for post death planning based upon changing circumstances.

Our example assumes that in 2013 we have an estate of $11,500,000.

UPON THE FIRST DEATH, the estate is divided into two parts, with one part equal to $5,250,000 placed in a family or nonmarital trust (“B” trust in the chart). No taxes are paid on this amount since the trust takes full advantage of the $2,045,800 unified credit (i.e., the amount of credit in 2013 that allows each individual to pass $5,250,000 tax-free to the next generation). The remaining $6,250,000 is placed in the QTIP trust.

The executor may elect to have all, some, or none of this property treated as marital deduction property. Assume that in order to avoid appreciation of assets in the surviving spouse’s estate and obtain a stepped-up basis for additional assets taxed upon the first death the executor decides to make a partial election of $5,750,000 (i.e., of the $6,250,000 placed in the QTIP trust only $5,750,000 will be sheltered from estate taxes at the first death). This means that $500,000, the “nonelected” property, will be taxed at the first death. Although $200,000 of estate taxes must be paid, the remaining $300,000 will now be excluded from the taxable estate of the surviving spouse (any appreciation of this property after the first death will also be excluded). If authorized under the trust document or by state law, the executor can sever the QTIP trust into separate trusts.

UPON THE SECOND DEATH, the estate subject to taxation is limited to $5,750,000 (the amount remaining in the trust for which estate taxes were deferred). After paying taxes of $200,000, there remains $5,550,000. This amount, together with the $300,000 from the severed trust and the $5,250,000 from the “B” trust, are passed to the beneficiaries under the terms previously established in these trusts.

Information required for analysis & proposal

Attorney Drafting Will And Trust Must Know

1. Spouse’s name.

2. Children’s names.

3. Name of executor/executrix.

4. Ages of minor children.

5. Information regarding children of prior marriages.

6. Names and ages of other beneficiaries.

7. Trustee after testator’s death.

8. To whom, in what amounts, and when trust income is to be paid.

9. To whom, in what amounts, and when trust corpus is to be paid.

Life insurance trust

The trust is one of the most basic tools of estate planning. When made irrevocable and funded with life insurance, it accomplishes multiple objectives. For example, it can:

  • Provide Creditor Protection
  • Provide Income for a Family
  • Provide Liquidity for Estate Settlement Costs
  • Reduce Estate Taxes
  • Avoid Probate Costs
  • Provide for Management of Assets
  • Maintain Confidentiality
  • Take Advantage of Gift Tax Laws

DURING LIFETIME, it is possible for a grantor to establish a trust that will accomplish all of these objectives. The beneficiaries of such a trust are normally members of the grantor’s family and likely to be estate beneficiaries.

Once the trust is created, policies on the life of the grantor can be given to the trust. If no such policies are available, then the trustee would obtain the needed life insurance. In either case, funds are given to the trust, which, in turn, pays the premiums to the insurance company.

In order to take full advantage of the gift tax annual exclusion, the beneficiaries must have a limited right to demand the value of any gifts made to the trust each year. However, in order not to defeat the purpose of the trust, the beneficiaries should not exercise this right to demand. In this way, each year up to $14,000 per beneficiary, as indexed for inflation in 2013, can be given gift tax-free to the trust.

UPON DEATH, the grantor’s property passes to his estate. At the same time, the insurance company also pays a death benefit to the trust. If the trustee was the original applicant for and owner of the policies, or if the grantor lived at least three years following the gift of existing policies  to the trust, the death benefit will be received free of federal estate taxes.

There are two ways the trustee can provide the liquidity to pay estate settlement costs. Either the trust makes loans to the estate, or the estate sells assets to the trust. In any event, guided by specific will and trust provisions the beneficiaries can receive distributions of income and principal.

Information required for analysis & proposal

1. Name of individual to be insured (usually trust grantor).

2. Sex.

3. Date of birth.

4. Smoker/nonsmoker.

Attorney Drafting Trust Instrument Must Also Know

5. To whom, in what amounts, and when trust income is to be paid.

6. To whom, in what amounts, and when trust corpus is to be paid.

7. Trustee during insured’s lifetime.

8. Trustee after insured’s death.

9. Names of beneficiaries.

10. Ages of minor beneficiaries.

Charitable remainder trust

The charitable remainder trust enables an individual to make a substantial deferred gift to a favored charity while retaining a right to payments from the trust. Under the right circumstances use of such a trust offers multiple tax and nontax advantages, particularly to the individual who owns substantially appreciated property. These advantages include a charitable deduction resulting in reduced taxes, an increase in current cash flow, avoidance of capital gains upon a sale of the appreciated property, the eventual reduction or elimination of estate taxes, and the satisfaction of knowing that property placed in the trust will eventually pass to charity. When combined with a wealth replacement trust, the full value of the estate can still be preserved for heirs.

DURING LIFETIME the grantor, after establishing a charitable remainder trust, gives property to the trust while retaining a right to payments from the trust. A unitrust provides for the grantor to receive annually a fixed percentage of the trust value (valued annually), whereas an annuity trust provides for the grantor to receive annually a fixed amount. Either type of trust could require that payments be made for the joint lives of the grantor and another person, such as the grantor’s spouse.

At the time the property is given to the trust, the grantor can claim a current income tax deduction equal to the present value of the charity’s remainder interest. Upon receipt of the gift, the trustee will often sell the appreciated property and reinvest the proceeds in order to better provide the cash flow required to make the payments to the grantor. This sale by the trust is usually free of any capital gains tax.

The tax savings and increased cash flow offered by the use of a charitable remainder trust will often enable the grantor to use some or all of these savings to fund a wealth replacement trust for the benefit of his heirs, thereby providing for the tax effective replacement of the property transferred to the charitable remainder trust. If the wealth replacement trust is established as an irrevocable life insurance trust it is often possible to gain gift tax advantages during the grantor’s lifetime, while at death entirely avoiding inclusion of the life insurance proceeds in the estates of the grantor and the grantor’s spouse.

UPON DEATH the property placed in the charitable remainder trust passes to the designated charity. At the same time a tax-free death benefit is paid to the wealth replacement trust, which funds can then be held or distributed to the grantor’s heirs pursuant to the terms of this trust.

Information required for analysis & proposal

1. Fair market value of property transferred to trust.

2. Date of transfer to trust.

3. Payout rate (if unitrust) or amount (if annuity trust).

4. Payment frequency (annually, semiannually, quarterly, or monthly).

5. Age of person whose life determines length of payments.

6. Age of joint annuitant (if payout for two lives).

7. Discount rate (as published monthly by IRS).

Grantor retained annuity trust (GRAT)

The grantor retained annuity trust (GRAT) is an estate planning technique that can be used to transfer future appreciation to family members, or others, free of gift and estate taxes provided the grantor survives the trust term.

TRUST ESTABLISHED. In order to implement a GRAT, the grantor creates an irrevocable trust for a specified number of years, names his children as trust beneficiaries, and transfers to the trust property that has a potential for substantial appreciation. The grantor retains the right to receive, for the term of the GRAT, a “qualified annuity interest” based on either a specified sum or fixed percentage of the initial value of the property transferred to the trust. This annuity is mandatory and must be paid at least annually. The annual payment may be increased, provided the increase is not greater than 120 percent of the prior year’s payment. Additional contributions to the GRAT are not permitted.

Only the value of the remainder interest payable to the trust beneficiaries is subject to the gift tax. This value is determined by subtracting from the fair market value of the property transferred to the trust the present value of the annuity retained by the grantor. The value of this annuity is increased by a longer-term trust, larger annuity payments, and lower assumed interest rate used to make the present value calculation. To summarize, gift tax exposure is reduced if the present value of the retained annuity is increased and the value of the remainder interest is decreased:


             Exposure to Gift Tax                  Value of Retained Annuity            Value of Remainder Interest

                             ↓                                                                                          ↓

DURING TRUST TERM. Tax-free annuity payments are made to the grantor. Trust assets may be used to make these payments. For federal tax purposes the GRAT is considered a grantor trust, meaning that the grantor pays taxes on all trust income. Should the grantor die before the end of the trust term, the annuity payments continue to be made to the Grantor’s Estate and the property is subject to estate taxes.

AT END OF TRUST TERM. Any property remaining in the trust, including appreciation and earnings, is paid to the trust beneficiaries (i.e., the remainder interest). Provided the grantor lives to the end of the trust term (and does not die within 3 years of the transfer), this property is not subject to estate taxes.

Information required for analysis & proposal

1. Fair market value of property transferred to trust (provide appropriate appraisals).

2. Term of trust (in years).

3. Annuity to be paid (as dollar amount or percent of initial trust value).

4. Payment frequency (annually, semiannually, quarterly, or monthly).

5. Increase in annuity as a percent, if any (not to exceed 120 percent of prior year).

6. Age of grantor (if grantor retains reversion).

7. Date of transfer to trust (needed to set payment dates and determine Section 7520 interest rate as published monthly by IRS).

Intentionally defective trust

The intentionally defective trust is a wealth-transferring device used by larger estates. It is an irrevocable trust that has been carefully drafted to cause the grantor to be taxed on trust income, yet have trust assets excluded from the grantor’s estate. Once established, it can offer multiple planning opportunities and benefits, particularly when combined with both gifts and installment sales.

TRUST ESTABLISHED. When establishing the trust, the grantor will typically retain a right to substitute assets of equivalent value. Retention of this right in a nonfiduciary capacity violates one of the grantor trust rules. The grantor is then considered the “owner” of the trust for income tax purposes, but not for estate, gift, and generation-skipping tax purposes. As to income taxes, the grantor and the trust are considered one and the same; trust income, deductions, and credits are passed through to the grantor.

Once established, the grantor then makes a gift of cash or other liquid assets to the trust, equal in value to 10 percent or more of the value of the property that will be sold to the trust in the subsequent installment sale.

INSTALLMENT SALE. Thereafter, the grantor and the trustee enter into a sales agreement providing for the purchase of additional assets from the grantor at fair market value. Under this agreement the trustee gives the grantor an installment note providing for payment of interest only for a number of years, followed by a balloon payment of principal at the end of the term. The assets sold will typically consist of property subject to a valuation discount (e.g., a non-controlling interest in a limited partnership, a limited liability company, or an S corporation). The amount of this valuation discount is immediately removed from the grantor’s estate.

SUBSEQUENT ADVANTAGES. Payment of taxes by the grantor upon the trust income enables the trust to grow income tax-free, and is a tax-free gift from the grantor to the trust beneficiaries. The interest and principal payments by the trust are “tax neutral,” meaning that they have no income tax consequences for either the grantor or the trust. Any growth of invested trust assets is excluded from the grantor’s estate.

If appropriate, the trustee could also use cash flow in excess of required interest payments to purchase life insurance on the grantor. Since the grantor/insured is not the “owner” of the trust for estate tax purposes, the death proceeds would be excluded from the grantor’s estate.

Information required for analysis & proposal

1. Names and ages of trust beneficiaries.

2. To who, in what amounts, and when trust income is to be paid?

3. To who, in what amounts, and when trust corpus is to be paid?

4. Trustee(s) of trust (both before and after grantor’s death).

5. Client’s: (a) Date of birth; (b) Sex; (c) Smoker/nonsmoker.

6. Client’s annual taxable income (to determine marginal tax bracket).

7. Approximate size of estates of both client and spouse (generally, gross estates less outstanding debts and liabilities).

8. Extent to which client and spouse have used their annual gift exclusion ($14,000 each in 2013).

9. Extent to which client and spouse have each used their available gift tax unified credit ($2,045,800 each in 2013, allowing them to each give $5,250,000 of property).

10. Property available for the initial gift.

11. Nature of income-property available for installment sale (preferably, an asset subject to valuation discount).

12. Client’s cost basis in income-property.

13. Anticipated annual income from income-property.

14. Length (term) of the installment note.

15. Minimum interest rate to be paid on installment note (applicable federal rate).


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