by Mary Lago, CFP®, CTFA
Executive Vice President
Wealth Management Chair
If you are feeling anxious about possible changes to estate taxes, expect to have a taxable estate, and want to take action – it may be worth learning a little bit about irrevocable trusts.
Irrevocable trusts vary widely in their purpose and use. The confusion of these distinct and sometimes opposing purposes along with their many acronyms, have earned irrevocable trusts the nickname of “alphabet soup.” Irrevocable trusts can be complex, but their plentiful advantages are worth deciphering for those who expect to have a taxable estate.
Building on the concepts outlined in our article on page three of our second quarter publication called, “Advantages of Irrevocable Trusts,” we covered:
layering more sophisticated planning structures as assets, complexity and preferences increase;
general differences between revocable and irrevocable trusts; and
the income and estate tax environment that often motivates the use of irrevocable trusts.
Our goal in this communication is to highlight unique attributes of more common irrevocable trust structures.
You will notice that a key goal of most irrevocable trusts is tax mitigation, but they also may be attractive for those who wish to specify allowable purposes for distributions, want to provide a legacy for future generations or charitable beneficiaries, or seek to protect assets from subsequent lawsuits or divorce.
Irrevocable Life Insurance Trusts (ILITs) are generally formed to be the owner of life insurance policies and avoid inclusion of the policy value or death benefit in the taxable estate of the trustor(s). These trusts typically include Crummey provisions, allowing the trustor(s) to make contributions up to the federal annual gift exclusion (currently $15,000 per recipient/beneficiary) that may be used for premium payments on the policy.
Exemption/ Credit Shelter/ Bypass/ Family Trusts are known by a variety of names. These trusts may be established either during one’s life or upon their death and are generally funded with a portion, or all, of the federal lifetime exemption amount (currently $11.7 million). For those who die in a state with a state level estate tax, a separate trust may be established in the amount of the state estate tax exemption. The primary purpose is often to avoid estate tax inclusion upon the future death of the trustor (creator) or their spouse. While frequently designed to benefit children and/or grandchildren, spouses are also allowable beneficiaries without foregoing tax benefits in most instances. This strategy can be highly effective for limiting state estate taxes by effectively using both spouses state and federal estate tax exemptions. These trusts may include one or more attributes of the other trusts described herein.
Generation-Skipping Transfer Trusts (GSTs) are used to provide benefits to future generations, including grandchildren, while eliminating exposure to estate taxation in the middle generation. These trusts often are funded using both the lifetime federal estate tax exemption and generation-skipping transfer tax exemption (also currently $11.7 million), thus avoiding a 40 percent estate tax and a 40 percent generation-skipping transfer tax.
Intentionally Defective Grantor Trusts (IDGTs) are one of the more sophisticated uses of irrevocable trusts. This structure results in a completed gift for estate tax purposes, but an incomplete gift for income tax purposes. The benefits include the removal of assets from one’s taxable estate while allowing the trustor to pay the ongoing income tax liability, without subjecting these tax payments to the 40 percent federal gift tax.
Grantor Retained Annuity Trusts (GRATs) are compelling for those who face significant future estate tax liability, may have exhausted their lifetime exemption and expect assets to grow at rates in excess of “Applicable Federal Rates” established by the IRS. These trusts include a stream of payments back to the trustor/grantor that reduce the value of the initial gift and therefore reduce transfer tax liability. Low interest rates increase the potential wealth that can be transferred free of transfer tax.
Charitable Remainder Unitrusts (CRUTs) are a split gift to charity and one or more individuals. The individual receives a stream of distributions for a period of time and then the charity receives the remainder in value that is left once the term is complete. A minimum calculated value of 10 percent must be projected to remain at the end of the trusts term to be distributed to charity. In exchange, the trustor receives a current income tax deduction upon the funding of the trust and will likely benefit from the deferral of capital gains tax. Charitable trusts are generally deemed most appropriate for those who want to benefit charity through their estate and will benefit from deferring capital gains tax on the sale of a low-cost-basis asset.
Charitable Lead Annuity Trusts (CLATs) are also a split-interest gift benefiting charity and individuals, but the order is reversed. In a lead trust, the charity receives the lead distributions and it is the individual(s) who receives the balance when the trust term ends. Charitable lead trusts are extremely compelling in the right circumstances, but are less common than charitable remainder trust. There are several variations of these trusts and some include charitable income tax deductions while others are most beneficial for those who have maxed out their charitable giving as a percentage of their adjusted gross income, want to provide current funding to charity and are seeking estate-tax-efficient ways to transfer assets to heirs. Low interest rates make these trusts potentially even more beneficial.
Qualified Personal Residence Trusts (QPRTs) are used to transfer ownership of one’s home to another beneficiary at a specified point in the future. The concept is that a willing buyer would pay less to take possession of the home at a later date, say in five years, and therefore the value of the taxable gift is reduced. However, this is an irrevocable structure and more than one person has regretted giving away their home or being compelled to pay rent to remain in their home. QPRTs require a very high level of trust and respect among the trustor and beneficiaries and a willingness to follow the specified terms and rules.
Spousal Lifetime Access Trusts (SLATs) are used as a mechanism for removing assets from one’s taxable estate, while providing a lifetime of benefits to one’s spouse. If each spouse establishes a similar, but specifically not “reciprocal” or identical trust for each other, each spouse could have access to funds for their benefit while circumventing rules requiring the taxation of “retained” funds, or trusts established for oneself. These trusts are frequently used to avoid state level estate taxes, but also affect federal transfer tax.
As you digest the myriad of options, keep in mind that the most effective planning generally occurs when you are equipped with a solid understanding of your financial circumstances, carefully consider and articulate your goals and rely on qualified counsel to determine the most appropriate strategies for your specific priorities. Our hope is that these brief descriptions encourage you to explore the benefits you might realize through a robust and collaborative planning relationship.
Drafting and implementing any of these irrevocable trusts is often quite complex and requires careful coordination with your wealth planning team, accountants and legal counsel.
Ferguson Wellman and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.