Irrevocable Trust Seminar Presented by Anthony L. Barney, Esq. March 11, 2014 I. Irrevocable Trust A. Definition: Unless a trust is defined as a revocable trust, the presumption is that a trust is irrevocable when so stated. 1 B. Differences between Revocable Trust v. Irrevocable Trust: The main difference between a revocable and an irrevocable trust is that one can be amended, and one cannot. The Nevada legislature added statutory decanting to create flexibility to irrevocable trusts. C. Tax Implications: An irrevocable trust is typically taxed as its own entity, however there are many irrevocable trusts that structured as a grantor trust, and therefore taxable to the grantor. D. Portability Rules, Claiming Unused Exemption 1. The American Taxpayer Relief Act of 2012 (ATRA) extended and made permanent several tax rules for the year 2013 and beyond. Currently, $5 million (indexed for inflation at $5.25 million in 2013) is exempted per individual from estate taxation. A taxable estate is taxed at current rate of 40%. 2. The portability rules between spouses became permanent under ATRA. In order to understand the portability rules, please consider the following examples that illustrate estate taxation prior the portability rules: Example 1: John and Jane are married, and each has a net worth of $3 million in their respective estates. With a $5 million exemption under the pre-atra rules prior to portability, if John died and left all of his estate to Jane, there are no estate taxes due upon his death, because John receives an unlimited marital deduction for giving his entire estate to Jane. However, Jane would have an estate worth $6 million, but would only have an exemption equal to $5 million (because John s exemption is extinguished at his 1 NRS 163.560 Irrevocable trust not to be construed as revocable. 1. If the settlor of any trust specifically declares in the instrument creating the trust that such trust is irrevocable it shall be irrevocable for all purposes, even though the settlor is also the beneficiary of such trust. 2. Such trust shall, under no circumstances, be construed to be revocable for the reason that the settlor and beneficiary is the same person. 1
death). If Jane dies shortly after John, her estate would be subject to estate tax on $1 million due to the combined net worth of both estates. Example 2: John and Jane are married, and each has a net worth of $3 million in their respective estates. Prior to death, John leaves his estate in a credit-shelter trust (also known as an A-B trust, a bypass trust, or an exemption equivalent trust) for the benefit of Jane. The credit-shelter trust is structured to not be included in Jane s estate. John dies. The credit-shelter trust is funded with John s estate and is designed to utilize John s exemption of up to $5 million. If Jane dies shortly after John, her estate is not subject to tax, because her own $5 million dollar exemption would shelter her estate from estate tax. 3. Under the portability rules between spouses, the following example will illustrate the transfer of a spouse s estate tax exemption commonly referred to as a deceased spouse unused exclusion ( DSUE ) to the other spouse : Example 3: John and Jane are married, and each has a net worth of $3 million in their respective estates. John leaves all of his assets to Jane in a will or trust. John dies and portability is elected by the filing of a proper federal estate tax return. Jane then inherits both his estate and his estate tax exemption. As a result of her net worth at $6 million is sheltered by her estate tax exemption at $10.5 million), and there will be no tax federal estate tax due upon Jane s death. 4. In order to take advantage of the DSUE exemption, the executor must timely file IRS Form 706 in the estate of the predeceasing spouse. The estate return must include information identifying the surviving spouse and further indicate that the decedent did not use all due available credit. If the executor of such an estate chooses not to make the portability election and is not otherwise obligated to file a Form 706, not timely filing a Form 706 will effectively prevent the making of that election. II. Types of Irrevocable Trusts A. Irrevocable Life Insurance Trust (ILIT) 2 1. Definition: An ILIT is used to keep life insurance proceeds on the life of the insured outside of the gross taxable estate of the insured. a. Life insurance proceeds are includable in the federal estate tax of a decedent if there are incidents of ownership held by the decedent. i. One incident of ownership is when an individual is both the insured and the owner of the policy. This is a common problem that can generate unnecessary estate tax when selling a policy to a high net worth individual. ii. Another incident of ownership is when the trustor makes the payment of the premiums on the insurance. 2 Brown, William A., Trusts, Thompson West 2004. 2
iii. Another incident of ownership is when the trustor has the right to change the beneficiaries. iv. Another incident of ownership is when the trustor has the right to dividends of the policy, or is entitled to the cash surrender value of the policy. b. Life insurance proceeds are used to purpose assets from the family trust, and the family trust then used the liquidity to pay the federal estate tax. The trustee of the ILIT does NOT pay for the federal estate tax directly, because this would create inclusion in gross taxable estate. c. Discuss Crummey withdrawal rights or the right to withdraw in the year the gift is made, the lesser of the amount of the gift or the amount of the gift tax exclusion, currently at $14,000. The beneficiary must be adequately informed of their withdrawal right through proper notice. Typically 30 days is a sufficient period to withdrawal. d. Avoid giving the trustor any of the following rights: i. The right to income from the trust, or any principal; income or principal; ii. iii. iv. The power to alter or amend the trust, revoke, or terminate; A retained power to vote stock, distribute or accumulate A power to substitute trustees; and B. Nevada Asset Protect Trusts v. The power to control trust investments. 1. Definition: A NAPT or Nevada self-settled spendthrift trust is an irrevocable trust that is set up by an individual or business to protect their current or future assets from unforeseen future creditors. a. Assets can be transferred to an irrevocable trust for the protection of the trustor(s) as well as the beneficiaries from unforeseen future creditors. b. These trusts must have a Nevada trustee, and typically employ the a trust protector in addition to the Trustor-trustee and independent trustee. c. These trusts can be established as grantor trusts, and add flexibility to what is typically a more rigid framework for irrevocable trusts. A grantor trust is trust in which the settlor retains control over the trust property or its income to such an extent that the settlor is taxed on the trust s income. 3 3 BLACK S LAW DICTIONARY 1516 (7 th ed. 1999). 3
Both a revocable and irrevocable trust may be structured as a grantor trust for tax purposes if the settlor is the deemed owner for tax purposes. The rules contained in section 671-677 are commonly known as the grantor trust rules. 1. When the grantor trust rules apply to a trust, IRC 671 provides that, there shall be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual. 4 2. The settlor will be the deemed owner of the trust upon the occurrence of one or more the following conditions, which include but are not limited to: i. The grantor s spouse is designated as a permissible beneficiary of the trust; 5 ii. The grantor is given the power to borrow from the trust income or corpus without adequate interest or adequate security; 6 iii. The grantor is given the power to make payment toward life insurance policy premiums on the life of the grantor or the grantor s spouse; 7 iv. The grantor is given the power to reacquire trust assets by substituting assets of equivalent value; 8 and v. The grantor is given the power to dispose of any corpus or income of the trust. 9 3. A grantor trust is commonly referred to as a tax neutral trust, because the income, deductions, and credits are applied to the settlor of the trust, rather than to the trust as individual entity apart from the settlor. 4 IRC 671. 5 IRC 677(a)(1). 6 IRC 675(2). 7 IRC 677(a)(3). 8 IRC 675(4). 9 IRC 674(a). 4
10 Instructions to Form SS-4 (2011). 4. Typically, a grantor trust would not apply for a federal tax identification number. 10 However, many banking institutions are requiring as part of their customer identification programs ( CIP ) which have been established under section 326 of the USA Patriot Act, that a grantor trust apply for a separate federal tax identification number, especially if the trust is irrevocable 11 5. The purpose of section 326 of the USA Patriot Act is to strengthen the Bank Secrecy Act (BSA) by requiring that all financial institutions, including banks, savings associations, credit unions and certain non-federally regulated banks ( bank ), implement a customer identification program (CIP) in order to reasonably and practicably verify the identity of customers who are opening accounts. 12 11 See Interagency Interpretive Guidance on Customer Identification Program Requirements under Section 326 fo the USA Patriot Act. by Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Financial Crimes Enforcement Network, National Credit Union Administration, Office of Comptroller of the Currency, Office of Thrift Supervision, and the United States Department of the Treasury dated April 28, 2005. (31 C.F.R. 103.121(b)(2)(i) The CIP rule requires a bank to obtain a taxpayer identification number (EIN). If the trust is not required to have an EIN under tax law, then the bank may obtain the grantor s taxpayer identification number, consistent with section 6109 of the Internal Revenue Code and the regulations thereunder.) (31 C.F.R. 103.121(a)(3) In the case of a trust account, the customer is the trust whether or not the bank is the trustee for the trust. A bank will not be required to look through trust, escrow, or similar accounts to verify the identities of beneficiaries and instead will only be required to verify the identity of the named account holder. See 68 FR 25090, 25094 (May 9, 2003). However the CIP rule also provides that, based on the bank s risk assessment of a new account opened by a customer that is not an individual, the bank may need to obtain information about individuals with authority or control over such an account, including signatories, in order to verify customer s identity. See 31 C.F.R. 103.121(b)(2)(ii)(C).) 12 Section 326 of the Act adds a new subsection (l) to 31 U.S.C. 5318 of the Bank Secrecy Act, which states, (l) Identification and Verification of Accountholders.-- (1) In general.--subject to the requirements of this subsection, the Secretary of the Treasury shall prescribe regulations setting forth the minimum standards for financial institutions and their customers regarding the identity of the customer that shall apply in connection with the opening of an account at a financial institution. (2) Minimum requirements.-- The regulations shall, at a minimum, require financial institutions to implement, and customers (after being given adequate notice) to comply with, reasonable procedures for (A) verifying the identity of any person seeking to open an account to the extent reasonable and practicable; (B) maintaining records of the information used to verify a person's identity, including name, address, and other identifying information; and (C) consulting lists of known or suspected terrorists or terrorist organizations provided to the financial institution by any government agency to determine whether a person seeking to open an account appears on any such list. (3) Factors to be considered.--in prescribing regulations under this subsection, the Secretary shall take into consideration the various types of accounts maintained by various types of financial institutions, the various methods of opening accounts, and the various types of identifying information available. (4) Certain financial institutions.--in the case of any financial institution the business of which is engaging in financial activities described in section 4(k) of the Bank Holding Company Act of 1956 (including financial activities subject to the jurisdiction of the Commodity Futures Trading Commission), the regulations prescribed by the Secretary under paragraph (1) shall be prescribed jointly with each Federal functional regulator (as defined in section 509 of the Gramm-Leach-Bliley Act, including the 5
6. If a federal tax identification number is required, the Trustee should file an IRS Form 1041 (fiduciary income tax return) each year for the Trust, however, income, deductions, and credits are not reported on the Form 1041, but instead a separate statement identifying the grantor and the showing the income, deductions, and credits is attached to the return. 13 The IRS has also provided for alternative methods of reporting. 14 Commodity Futures Trading Commission) appropriate for such financial institution. (5) Exemptions.--The Secretary (and, in the case of any financial institution described in paragraph (4), any Federal agency described in such paragraph) may, by regulation or order, exempt any financial institution or type of account from the requirements of any regulation prescribed under this subsection in accordance with such standards and procedures as the Secretary may prescribe.(6) Effective date.--final regulations prescribed under this subsection shall take effect before the end of the 1-year period beginning on the date of enactment of the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001. 13 Treas. Reg. Sec. 1.671-4 (a) Portion of trust treated as owned by the grantor or another person. Except as otherwise provided in paragraph (b) of this section, items of income, deduction, and credit attributable to any portion of a trust which, under the provisions of subpart E (section 671 and following), part I, subchapter J, chapter 1 of the Internal Revenue Code, is treated as owned by the grantor or another person are not reported by the trust on Form 1041, but are shown on a separate statement to be attached to that form. Section 301.7701 4(e)(2) of this chapter provides guidance on how these reporting rules apply to an environmental remediation trust. 14 Treas. Reg. Sec. 1.671-4 (b) A trust all of which is treated as owned by one or more grantors or other persons (1) In general. In the case of a trust all of which is treated as owned by one or more grantors or other persons, and which is not described in paragraph (b)(6) or (7) of this section, the trustee may, but is not required to, report by one of the methods described in this paragraph (b) rather than by the method described in paragraph (a) of this section. A trustee may not report, however, pursuant to paragraph (b)(2)(i)(a) of this section unless the grantor or other person treated as the owner of the trust provides to the trustee a complete Form W 9 or acceptable substitute Form W 9 signed under penalties of perjury. See section 3406 and the regulations thereunder for the information to include on, and the manner of executing, the Form W 9, depending upon the type of reportable payments made. (2) A trust all of which is treated as owned by one grantor or by one other person (i) In general. In the case of a trust all of which is treated as owned by one grantor or one other person, the trustee reporting under this paragraph (b) must either (A) Furnish the name and taxpayer identification number (TIN) of the grantor or other person treated as the owner of the trust, and the address of the trust, to all payors during the taxable year, and comply with the additional requirements described in paragraph (b)(2)(ii) of this section; or (B) Furnish the name, TIN, and address of the trust to all payors during the taxable year, and comply with the additional requirements described in paragraph (b)(2)(iii) of this section. (ii) Additional obligations of the trustee when name and TIN of the grantor or other person treated as the owner of the trust and the address of the trust are furnished to payors. (A) Unless the grantor or other person treated as the owner of the trust is the trustee or a co-trustee of the trust, the trustee must furnish the grantor or other person treated as the owner of the trust with a statement that (1) Shows all items of income, deduction, and credit of the trust for the taxable year; (2) Identifies the payor of each item of income; 6
d. A two trust system using a revocable trust and NAPT can add even greater flexibility to an estate plan. 2. Decanting. 15 Administrative modifications can be made, and if necessary, decanting can be used to add flexibility to an irrevocable trust a. Under NRS 163.556, the Trustee must have the following power in order to decant: 1. Power to distribute trust income or principal to or for beneficiary of the first trust, however the power does not have to be unlimited. (the trustee may distribute part or all of the principal or income from the first trust to the second trust.) (3) Provides the grantor or other person treated as the owner of the trust with the information necessary to take the items into account in computing the grantor's or other person's taxable income; and (4) Informs the grantor or other person treated as the owner of the trust that the items of income, deduction and credit and other information shown on the statement must be included in computing the taxable income and credits of the grantor or other person on the income tax return of the grantor or other person. (B) The trustee is not required to file any type of return with the Internal Revenue Service. (iii) Additional obligations of the trustee when name, TIN, and address of the trust are furnished to payors (A) Obligation to file Forms 1099. The trustee must file with the Internal Revenue Service the appropriate Forms 1099, reporting the income or gross proceeds paid to the trust during the taxable year, and showing the trust as the payor and the grantor or other person treated as the owner of the trust as the payee. The trustee has the same obligations for filing the appropriate Forms 1099 as would a payor making reportable payments, except that the trustee must report each type of income in the aggregate, and each item of gross proceeds separately. See paragraph (b)(5) of this section regarding the amounts required to be included on any Forms 1099 filed by the trustee. (B) Obligation to furnish statement. (1) Unless the grantor or other person treated as the owner of the trust is the trustee or a co-trustee of the trust, the trustee must also furnish to the grantor or other person treated as the owner of the trust a statement that (i) Shows all items of income, deduction, and credit of the trust for the taxable year; (ii) Provides the grantor or other person treated as the owner of the trust with the information necessary to take the items into account in computing the grantor's or other person's taxable income; and (iii) Informs the grantor or other person treated as the owner of the trust that the items of income, deduction and credit and other information shown on the statement must be included in computing the taxable income and credits of the grantor or other person on the income tax return of the grantor or other person. (2) By furnishing the statement, the trustee satisfies the obligation to furnish statements to recipients with respect to the Forms 1099 filed by the trustee. 15 Fulbright & Jaworski, Trust Decanting, National Business Institute, 2012. 7
2. The trustees power to distribute trust corpus may be exercised in favor of the second trust for the benefit of one or more beneficiaries of the first trust, however the second trust must not include a beneficiary who is not a beneficiary of the first trust. (A permissible appointee of a power of appointment exercised by the beneficiary of the second trust is not considered a beneficiary of the second trust.) NRS 163.556 permits the elimination of beneficiaries of the first trust, but the second trust may not add new beneficiaries or accelerate remainder interests). 3. NRS 163.556 prohibits the reduction of any current fixed income, annuity or unitrust interest of a beneficiary of the first trust, and therefore future interests are not protected. 4. NRS 163.556 prohibits application where a marital or charitable deduction would be lost or frustrated. 5. A trustees power to appoint in further trust does not apply to any property held in the first trust that is subject to right of withdrawal, such as Crummey power. b. Decanting power can only be exercised by a written instrument signed by the trustee and filed with the records of the trust. Beneficiaries must be given notice if their beneficial interest would be extinguished under the first or second trust. 8