Intentionally Defective Grantor Trusts: Asset Transfer Planning Strategies and Form 1041 and 1099 Reporting Compliance

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1 Presenting a 110-Minute Encore Presentation of the Webinar with Live, Interactive Q&A Intentionally Defective Grantor Trusts: Asset Transfer Planning Strategies and Form 1041 and 1099 Reporting Compliance MONDAY, NOVEMBER 24, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Lawrence M. Lipoff, Consultant, Friedman LLP, New York, N.Y. Donna J. Jackson, Attorney, Donna J. Jackson, Attorney at Law, Oklahoma City, Okla. Eido M. Walny, Founder, Walny Legal Group, Milwaukee, Wis. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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4 IDGT Advantages and Applications Donna J. Jackson, Attorney at Law Oklahoma City (405)

5 What Is IDGT? A grantor trust is a trust in which the grantor, sometimes called a settlor or trustor, retains an interest. One particular type of grantor trust, called an intentionally defective grantor trust (IDGT), leverages disparities in the federal income and estate taxes to provide opportunities for tax, Medicaid and asset protection planning. *Irrevocable *Not included in Estate *Subject to income tax in Grantor s return 5

6 What Is IDGT? (Cont.) An IDGT can allow a grantor to freeze his/her federal estate and/or gift tax obligations associated with an appreciating asset and allow the IDGT to receive the income from the asset free of federal income tax. An IDGT can also enable a grantor to become eligible for Medicaid coverage while permitting the grantor to claim some federal income tax exclusions and/or deductions. 6

7 What Is IDGT? (Cont.) The federal estate and gift taxes are distinct taxes, but they are both concerned with the same thing: the taxation of wealth transfers 7

8 What Is IDGT? (Cont.) The law associated with both taxes effectively creates a lifetime unified credit against which a person can transfer assets without incurring federal estate or gift tax obligations, either while alive or at death. The credit is currently $5.34 million per person or $10.68 million per married couple. 8

9 What Is IDGT? (Cont.) The reason an IDGT is often called intentionally defective stems from the federal income tax laws that disregard the existence of the trust for federal income tax purposes, thereby imposing the federal income tax obligations associated with the asset upon the grantor as opposed to the trust. Although this may seem undesirable, it can actually enable the asset owner to transfer significant wealth to beneficiaries, tax-free. 9

10 What Is IDGT? (Cont.) The interests that cause a trust to be defective are set forth in sections 671 through 677 of the Internal Revenue Code (IRC). The following is a list of some interests that can cause a trust to be defective, that are often considered significant interests, and that often do not result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts: 10

11 What Is IDGT? (Cont.) Power to revoke (IRC 676) Power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC 674) 11

12 What Is IDGT? (Cont.) Power to control the investment of the trust funds, either by directing investments or reinvestments or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC 675) 12

13 What Is IDGT? (Cont.) The following is a list of some interest that can cause a trust to be defective, that are often considered less significant interests, and that often do result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts: Power to alter beneficial enjoyment (IRC 674) 13

14 What Is IDGT? (Cont.) Power to deal for less than adequate and full consideration (IRC 675) Power to borrow without adequate interest or security (IRC 675) Power to reacquire the trust corpus by substituting other property of an equivalent value (IRC 675) 14

15 Lifetime Gifting A major incentive for making lifetime gifts is the ability to avoid including future appreciation of, and income from, the transferred property in the donor's estate. After the transfer, the recipient of the gift is generally responsible for paying taxes on the income and appreciation attributable to the transferred property. 15

16 Lifetime Gifting (Cont.) It may be possible, however, to structure the gift so that the donor rather than the donee is responsible for paying the income taxes. Why would the donor want to pay taxes on income from property he or she no longer owns? Because, by relieving the donee of this responsibility, the donor in effect makes an additional gift, free of any gift tax. The use of an intentionally defective grantor trust (IDGT) as the recipient of the transfer is a way to structure this transaction. 16

17 Lifetime Gifting (Cont.) The use of IDGT provides for substantial saving. A transfer to a properly structured IDGT is considered a completed transfer for estate and gift tax purposes, but incomplete for income tax purposes. Therefore, an IDGT would not be included in the donor's estate upon his or her death, yet it would be considered a grantor trust for income tax purposes. As a grantor trust, the donor is taxed currently on the trust income. By paying the income taxes attributable to the income earned by the trust, the donor in effect is making additional transfers to the trust beneficiaries without being subject to gift tax. 17

18 Lifetime Gifting (Cont.) One of issues in establishing an IDGT is ensuring that the trust is not included in the grantor's estate. The Trust must be properly drafted so that the transfer does not run afoul of the estate tax inclusion rules on prior transfers (IRC Secs ). The trust must, at the same time, fall under the grantor trust income tax rules (IRC Secs ). Therefore, the grantor needs to retain enough control for grantor trust status, but not enough to cause the trust assets to be included in the grantor's estate. There are various ways that the drafter of the trust instrument can accomplish this. 18

19 Lifetime Gifting (Cont.) Another issue is that the IRS will not treat the income taxes paid by the grantor as a taxable gift. Practitioners feel that since the income taxes are the obligation of the grantor under IRC Sect. 671, no gift tax will be imposed. By satisfying his own liability to pay taxes, the grantor should not be treated as making taxable gifts to those who have no legal obligation to pay such taxes. 19

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21 Common Uses Of IDGT: Medicaid Planning Individuals can also leverage the same disparities between the federal income and federal estate tax laws during Medicaid planning, i.e. structuring ownership of assets to enable eligibility for coverage through Medicaid. If a man transfers his house to trust and meets the lookback requirements and other requirements of his state, e.g. not retaining a significant interest in the trust, in addition to the requirements of Sect. 121 of the IRC, he may be able to claim the capital gain exclusion on the sale of the residence as set forth in IRC

22 Asset Protection If structured correctly, an IDGT can also shield a person s assets from liabilities associated with the asset, thereby providing significant asset protection. Principally, this is because IDGTs are irrevocable trusts, and the trust assets generally cannot be attached to satisfy judgments against a grantor if the assets were not illegally transferred to the trust. 22

23 VA & Medicaid Trust Veterans Asset Protection Trusts (VAPTs) and Medicaid Asset Protection Trusts (MAPTs) are generally drafted as irrevocable trusts with non-grantor trust provisions. Often times, estate planning clients who need an irrevocable trust for Veterans' or Medicaid asset protection purposes also have a separate revocable trust drafted to hold "non-countable" assets. Traditional "pure" irrevocable trusts include non-grantor trust provisions while revocable trusts include grantor trust provisions. However, it is possible, and it's becoming more common, to draft a single irrevocable trust that has both non-grantor trust provisions and grantor trust provisions. 23

24 Va Trusts Grantor trusts are classified as disregarded entities for tax purposes; therefore, any taxable income or deduction earned by the trust will be taxed on the grantor's personal tax return. For Veterans' asset protection planning and Medicaid asset protection planning purposes, many estate planning professionals will draft irrevocable trusts with dual provisions. In order to draft a trust with dual provisions, careful attention must be paid by the drafter to ensure that the grantor isn't treated as the owner of any portion of the non-grantor sub-trust in accordance with IRC 671. As CPAs, how do we know what those provisions look like and how do we identify them? 24

25 Following the Internal Revenue Code and the Regulations provide a great deal of guidance on this issue when the trust agreements aren't ambiguous. Unfortunately, more often than not, drafters inadvertently include provisions in their trust agreements that confuse the grantor or non-grantor status of the trust. 25

26 How do CPAs determine grantor and non-grantor trust status? If you've been dealing with trust tax returns for any amount of time, I don't have to tell you that there is a vast difference between drafting styles with each trust. A "good trust" will include a detailed table of contents, introduction, or provisions that will provide you some indication as to whether or not the trust is intended to be a grantor trust, non-grantor trust, or will have both types of sub-trusts. Unfortunately, more commonly we are faced with trusts whose grantor/non-grantor status isn't so apparent. Furthermore, even when the drafter does us the favor of making the trust's intended status apparent, the language used by the drafter can often undermine those objectives. 26

27 As CPAs, how can we tell which type of trust we're dealing with? Generally, in order for a trust to maintain non-grantor status, the provisions of the trust agreement must avoid granting the grantor or any other person one or more of the powers described in Sections of the Internal Revenue Code. More specifically, non-grantor trusts (or subtrusts) should include four general provisions: 27

28 Excluding transactions for less than adequate consideration; Excluding any powers to borrow money from the trust without adequate interest or security; Allowing only independent trustees to vote or direct the voting of any corporate shares or other securities of any trust created by said trust agreement; Allowing only independent trustees to control the investments or reinvestments of the trust by direction or by veto; Forbidding anyone from compelling the trustee to exchange trust property by substituting other property of equivalent value; and Excluding the trustee from using trust income to pay the premiums on any life insurance policies insuring the grantor's life or the life of the grantor's spouse. 28

29 What s the point of having an irrevocable trust with dual provisions? You may be wondering why people go through the trouble of drafting "irrevocable" trusts with grantor, also commonly referred to as residence, sub-trust provisions. From a practical standpoint, it makes homeowners nervous when you tell them they have to hand over control of their assets to the trustee of an irrevocable trust, particularly when one of their assets is their home. Plus, transferring the principal residence isn't really necessary. 29

30 The purpose of transferring most assets to an irrevocable trust with non-grantor status is so that those assets will not be countable for the purpose of calculating income and assets for public benefits. However, the principal residence isn't typically a countable asset for public benefits calculations. Additionally, from a tax standpoint, transferring the principal residence can mean the loss of property tax exemptions for Veterans and their spouses. Accordingly, it has become a popular method of estate planning for drafters to draft irrevocable trusts with a non-grantor sub-trust and a grantor/residence sub-trust. The nongrantor sub-trust holds all of the grantor's assets except for the principal residence, which is held in the grantor/residence subtrust. 30

31 Tax Issues Surrounding MAPTs and VAPTs with Sub-Trusts Here are a couple of tax issues I believe you should be aware of when preparing tax returns for irrevocable trusts with nongrantor and grantor/residence sub-trusts: 1. Does a Residence/Grantor Trust Qualify for Exemptions under IRC 121? Just last week I had a trustee of one my VAPTs call in a panic because her parents' (the grantors') CPA had told her that her parents wouldn't qualify for any exclusions under section 121, which is FALSE! 31

32 If a residence is owned by a grantor trust or sub-trust, for the period that a taxpayer is treated under section 671 through 679 as the owner of the trust or the portion of the trust that includes the residence, the taxpayer will be treated as owning the residence for purposes of satisfying the 2- year ownership requirement of section 121, and the sale or exchange by the trust will be treated as if made by the taxpayer! 32

33 Net Investment Income Tax (NIIT) of 3.8 Percent. The "new" NIIT applies to certain income retained by trusts and estates if taxable income exceeds $11,950. Net investment income includes interest and dividend income and capital gains, but also includes passive income from rental and business activities, and from pass-through entities such as partnerships, limited liability companies (LLCs), and S Corporations. As a result, many trusts and estates will be taxed in 2013 and future years at 43.4 percent ( ) on ordinary income and 23.8 percent ( ) on qualified dividends and long-term capital gains, plus state income taxes. 33

34 Sample Provision While I am alive, I intend that this trust be a grantor trust for federal income tax purposes. A grantor trust means the income of my trust will be taxed to me under IRC To carry out this intent, the following provisions shall apply in the administration of my trust. 1. Power of substitution: During my lifetime, the Trust Protector has the right to direct that the Trustee transfer trust property to me in exchange for property of equivalent value. 34

35 Sample Provision (Cont.) 2. Power to add charities as beneficiaries: During my lifetime, the Trust Protector shall have the power to add charitable organizations described in IRC 170 as an additional beneficiary of the net income of the trust. My Trustee may, but is not required to, distribute the net income to the additional charitable beneficiary, in such amounts and proportions as my Trustee may determine. 35

36 Sample Provision (Cont.) 3. Power to enable grantor to borrow: During my lifetime, the Trust Protector shall have the power to grant me the power to borrow income or principal of my trust without adequate interest and/or without adequate security. The power to borrow shall be granted me by the Trust Protector in writing which will also specify the terms under and the amount that I may borrow. 36

37 Sample Provision (Cont.) 4. Powers granted herein are exercisable solely in a non-fiduciary capacity without approval of any person acting in a fiduciary capacity. No claim for breach of fiduciary duty may be imposed upon my Trust Protector, my Trustee or any other person as a result of the exercise or non-exercise of the powers granted herein. 37

38 Sample Provision (Cont.) The powers described in this Section shall not be exercisable to the extent that their exercise would reasonably be expected to cause the assets of the trust or any portion thereof to be included in my gross estate for federal estate tax purposes or subject to my creditors for asset protection purposes. 38

39 Sample Provision (Cont.) Thank you! 39

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41 Transactions with Grantor Defective Trusts Eido M. Walny, Esq. Walny Legal Group LLC 751 N. Jefferson Street Milwaukee, WI Phone: Fax: Website: Copyright All rights reserved.

42 IDGT Transactions Transactions: 1. Gift 2. Sales 3. Sales to a Beneficiary Defective Inheritor s Trust (BDIT) For internal use only. Not for distribution. 42

43 IDGT Transactions Objectives to consider: Remove any future asset appreciation from the grantor s estate ( estate freeze ); Sell assets at a discount ( estate squeeze ); Have the Grantor pay income taxes ( estate burn ); For internal use only. Not for distribution. 43

44 Gifts Transfer to a trust is treated as a transfer of property by gift, unless the trust is treated as wholly owned by the donor or the donor s spouse Transfer is considered a completed gift for gift tax purposes Only subject to gift tax if over annual exclusion amount or lifetime exemption amount $14,000 $5,340,000 For internal use only. Not for distribution. 44

45 Gifts Only present interest gifts qualify for the annual exclusion Crummey Powers For internal use only. Not for distribution. 45

46 Crummey Powers Allows gifts to irrevocable trusts (including IDGTs) to qualify for annual exclusion Beneficiary has right to withdraw gifts to trusts for a specified period (30 days) After that time period, the right lapses and the gift is completed and vests in the trust For internal use only. Not for distribution. 46

47 5 x 5 Rule Crummey Powers Beneficiary s lapse could result in taxable consequences Release of power of appointment is considered a transfer of property Taxable to the extent lapse exceeds the greater of $5,000 or 5% of the aggregate trust assets For internal use only. Not for distribution. 47

48 Crummey Powers Solution Consider using Lifetime exemption Contribute $5,000 or 5% Hanging Crummey powers Right to withdraw all of the contribution up to the annual exclusion amount Withdrawal power lapse at the 5 x 5 rule limitations For internal use only. Not for distribution. 48

49 Steps: Establish an IDGT Fund Sale Options: Sales to IDGT Promissory Note Self-cancelling Installment Note (SCIN) For internal use only. Not for distribution. 49

50 Drafting Establishing an IDGT Structure as a defective grantor trust Funding Grantor makes an initial gift to the trust (i.e. seed money) 10% equity funding Reduces the risk that the sale will be treated as a transfer with a retained interest under Section 2036 Cash or marketable securities Avoids valuation issue For internal use only. Not for distribution. 50

51 Sale IDGT Sales Overview Grantor sells an asset with potential for appreciation to the IDGT at FMV in exchange for a note at a low interest rate IDGT can also distribute in-kind asset to make note payments Income and appreciation accumulate inside the trust gift and GST tax free Plan to repay the note during the seller s lifetime For internal use only. Not for distribution. 51

52 IDGT Sales Overview KEY ISSUE: STEP TRANSACTION PROBLEM The key to avoid step transaction argument is to be patient and wait. For internal use only. Not for distribution. 52

53 Promissory Notes How it works? The asset is sold to the IDGT in exchange for the promissory note secured by the IDGT assets Note provides for periodic payments Income generated by the asset sold or other IDGT assets utilized to make note payments For internal use only. Not for distribution. 53

54 Promissory Notes Terms Payments Annual with a balloon payment at the end of the term Prepayment permitted Interest Rate Section 7872 (AFR) For internal use only. Not for distribution. 54

55 Guarantee Personal guarantee Can be made by the beneficiaries to substantiate it as an arm s length transaction May be treated as a contribution to the IDGT by the beneficiary and affect grantor trust status» To avoid, consider having the IDGT pay annual fee to the beneficiary or use a 3d party. For internal use only. Not for distribution. 55

56 SCINs Self-Cancelling Installment Note An installment note that contains a provision under which the buyer s obligation to pay automatically ceases upon the death of a specified person Compared to Promissory Note Will not be included in the transferor s estate For internal use only. Not for distribution. 56

57 Risk Premium SCINs Grantor must pay an increased premium to avoid making a gift on the sale The older the transferor, the greater the premium Increase purchase price Higher interest rate For internal use only. Not for distribution. 57

58 SCINs Valuation Purchase price Independent written appraisal Adjustment Clause Typically drafted into the IDGT and not the sales agreement For internal use only. Not for distribution. 58

59 Beneficiary Defective Inheritor s Trusts (BDITs) Established and funded by a third party for the benefit of the inheritor Inheritor s descendants and spouse included as permissible discretionary distributees Dynastic Trust Special Power of Appointment (SPOA) Include grantor trust provisions to make it defective to a beneficiary under Section 678(a). For internal use only. Not for distribution. 59

60 BDITS and SPOA Broad special POA given to inheritor to rewrite the trust based on changed circumstances in future and to avoid transfer tax issues Usually given to trust descendants at the time they become primary beneficiaries Protect inheritor against interference in administration by subordinate beneficiaries Eliminate significant gift tax issues SPA prevents IRS from determining a completed gift has been made For internal use only. Not for distribution. 60

61 Family Trustee BDITS and Trustees Control trust investment and management decisions Also control who holds the office of independent trustee Independent Trustee One or more third party trustees Makes all tax sensitive decisions, represents the trust in arms length transactions, exercises powers which would otherwise cause tax and/or creditor issues For internal use only. Not for distribution. 61

62 BDITs & Sales How it works? Transactions between the BDIT and inheritor are income tax free Inheritor can engage in sales of discountable, incomeproducing assets to the trust Funding By a third party May require a guarantee Guarantors should receive reasonable payment in order to avoid gift tax issues For internal use only. Not for distribution. 62

63 Arms-Length Transactions Inheritor should not act as both the buyer (as Trustee) and the seller (Individually) Valuation and interest rates should be welldocumented by qualified appraisers and other experts Current market interest rate as opposed to AFR For internal use only. Not for distribution. 63

64 BDIT Benefits Combines the benefits of IDGTs with the enhanced wealth, transfer tax and asset protection advantages of a third party settled trust IDGT enhanced with asset protection and transfer tax avoidance qualities Enjoyment and control/flexibility Upon inheritor s death, passes to beneficiaries subject to POA For internal use only. Not for distribution. 64

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66 Intentionally Defective Grantor Trusts on behalf of Strafford Publications Foreign Trust Compliance Section July 25, 2014 Lawrence M. Lipoff Consultant Friedman LLP 1700 Broadway New York, New York Managing Director Lipoff Global Advisors 46 Powder Horn Drive Suffern, New York

67 Illustrative Cases Grantor Trust Ceases to be Grantor Trust ( 684) Pre-immigration Planning Five Year Rule Foreign Trusts Often Have Foreign Business Company Holding Assets CFC & PFIC Rules United States Filing Information Not Available 67

68 Defining Foreign Trust All trusts are deemed to be foreign unless both the Court Test and Control Test met Court Test: Court in United States able to exercise primary supervision over trust administration Control Test: One of more United States persons have authority to control all substantial decisions of the trust Accidental tripping of Control Test rules to become foreign trust does have twelve month opportunity to correct 68

69 Foreign Grantor Trust Compliance New FBAR FinCEN Form 114 Report of Foreign Bank and Financial Accounts Form 3520 Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts Form 3520-A Annual Information Return of Foreign Trust With a U.S. Owner Form 4970 Tax on Accumulation Distribution of Trusts Form Entity Classification Election 69

70 Section 684 Direct or deemed transfers by a United States person to a foreign trust are taxable under 684 as a sale or exchange for the amount of the property s fair market value Gains but not losses are recognized Death of grantor creates an exception 70

71 679 & Pre-Immigration Planning (1/2) To avoid future United States gift and estate tax exposure, non-united States person might place assets in trust before becoming United States resident alien There is a difference in being a United States person for income (objective) and transfer (subjective) tax purposes can be RA for one and NRA for the other 71

72 679 & Pre-Immigration Planning (2/2) If a nonresident alien transfers property to a foreign trust within five years of making a transfer to a foreign trust, 679(a)(4) makes trust a grantor trust from the residency starting date An intermediary s transfer to foreign trust will also toll 679(a)(4) 72

73 Foreign Trusts & Foreign Business Company Controlled Foreign Corporation (CFC) generally include proportionate share of investment and other Subpart F income 50% of vote or value owned by US shareholders with 10% of voting stock Passive Foreign Investment Company (PFIC) US shareholders taxed on direct and indirect dispositions of stock and excess distributions - 75% of gross income is passive or 50% average passive assets CFC trumps PFIC classification Planning often involves checking-the-box either up to 12 months prospective or 75 days retroactively (or 3 years and 75 days retroactively with IRS permission) Various elections to potentially mitigate anti-deferral provisions 73

74 United States Filing Information For Foreign Trusts September 19, 1995 was end of former grantor trust rules are grandfathered if compliant Current rules, effective after August 20, 1996, basically (i) revocable or (ii) during lifetime distributable only to grantor and/or spouse 74