High-net-worth clients recognize that they need to be prepared for sudden changes in tax laws and market valuations. But in the face of political uncertainty and market volatility, it may be difficult to choose which assets to transfer into trust, or determine fair market value. Attorneys and appraisers may be backlogged with similarly situated clients.
Here are some tips for setting up trusts for estate planning with flexibility to pivot quickly as possibilities turn to actualities.
1. Use “intentionally defective” irrevocable grantor trusts.
“Intentionally defective” grantor trusts that are not considered a separate income tax entity (i.e., the income of the trust is taxable to the grantor) enhance the flexibility of irrevocable trusts, because transactions between the grantor trust and the grantor are not income- taxable events.
In other words, gains are not recognized when a grantor trust purchases an appreciated asset (including a life insurance policy worth more than its basis) from the grantor for fair market value or vice versa. If the grantor lends funds to their grantor trust (private finance), the interest paid by the trust back to the grantor is also not taxable.
2. Choose a jurisdiction with favorable trust modification (i.e. “decanting”) rules.
Concerned about needing to change terms of the trust in the future, such as modifying beneficiaries or responding to unanticipated tax law changes?
Trusts operate according to state laws, which vary substantially in their options for modifying or replacing an irrevocable trust. The applicable state law is generally determined by the state in which the trust is “administered” (generally, this is where the trustee is located).
So, clients can set up a trust in a different state from their usual residence with the selection of a professional trustee located in a more favorable jurisdiction.
3. Include “swap powers” (grantor right of substitution) in the trust terms.
When a trust gives any person (including the grantor), in a non-fiduciary capacity, the ability to substitute assets of equal value (without requiring the consent of any adverse party), it will automatically be classified as a grantor trust while the grantor is alive.
The “swap” power gives grantors the ability to change their minds about which assets should be inside or outside the trust, and make adjustments without needing the approval of a trustee. (However, the trustee should still have the power to determine the value of the assets being swapped to ensure they are actually equivalent.)