Trusts
and Funds FAQ
What
is a Special Needs Trust (SNT)?
what is an AB Trust?
What are Split-Interest
Charitable Gifts?
What is an Irrevocable Life
Insurance Trust (ILIT)?
What is a Donor-Advised
Fund (DAF)?
What is a Pooled
Income Fund (PIF)?
What is a Family Limited
Partnership (FLIP)?
What is a Qualified Personal
Residence Trust (QPRT)?
What is a Qualified Domestic
Trust (QDOT)?
What is a Qualified Terminable
Interest Property Trust (QTIP)?
What is a Dynasty Trust?
What is the Generation-Skipping
Transfer (GST) Tax?
Q: What is a Special
Needs Trust?
A: A
Special Needs Trusts (SNT), sometimes called
a Supplemental Needs Trust, is a valuable
estate-planning tool. It preserves the eligibility
of government benefits and provides assets
that address the extra needs of a person
with a disability. These needs are those
that go beyond food, shelter and clothing
and the medical services and support of
Medicaid. The SNT must supplement and not
replace government benefits. A SNT can be
used for a variety of needs. Examples include
the following:
- Electronic equipment
like computers, etc.; internet service
- Experimental or elective
surgery
- Advocacy, including
attorney fees
- Special therapies or
adaptive equipment not available through
Medicaid or other government programs
- Essential dietary needs
- Annual independent
checkups
- Programs of training,
education, treatment and rehabilitation
- Transportation (including
vehicle purchase)
- Maintenance of vehicles
- Insurance premiums
- Materials for a hobby
or recreational activity
- Trips or vacations;
entertainment like movies, concerts, ballgames,
etc.
- Goods or services that
add pleasure or quality of life like television
or videos
- Personal care attendant
or escort
Many kinds of assets can
be used to fund this trust. These assets
include insurance proceeds, inheritances,
lump-sum payments from Social Security Disability
or Supplemental Security Income, funds from
legal settlements and savings. Additional
property may be added to the SNT during
life, by will or living trust, by life insurance
policies, retirement or pension plan benefits,
etc.
Having a SNT requires
the appointment of a trustee who holds,
administers and distributes the property
for the disabled person during their lifetime.
A trustee can be an individual or an institution,
like a bank.
A special form of a SNT
is a Pooled Income Trust, also known as
a Community Trust. This trust is established
and maintained by a nonprofit organization,
which maintains separate accounts for each
disabled individual, but for management
of the funds, the accounts in the trust
fund are pooled. Hattie Larlham provides
access to this type of trust through its
partnership with the Community Fund Management
Foundation (CFMF). For more information,
please visit www.cfmf.org.
Because a Special Needs
Trust is a complex document and is subject
to changes in legislation that vary by state,
it should be drafted by an attorney with
expertise in disabilities laws and related
matters.
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Q: What is an
AB Trust?
A: An
AB Trust, sometimes called a Credit Shelter
Trust, a Marital Bypass Trust or an Exemption
Trust, is a powerful estate-planning tool.
It allows couples to reduce or avoid estate
taxes. Under current law, the estate tax
will be gradually phased out until 2010,
when it will be repealed. Unless additional
legislative steps are taken, it will be
restored in 2011. Because an AB Living Trust
is flexible and revocable while both spouses
are alive, it can be modified or amended
if circumstances change. Upon the death
of the first spouse, the trust becomes irrevocable.
The federal government
exempts transfers between a husband and
wife from estate and gift taxes. Consequently,
the AB trust takes advantage of two tools:
the unlimited marital deduction and the
“unified credit.” Through 2008,
the unified credit exempts the first $2
million of your estate from federal estate
taxes and using an AB trust can enable a
couple to pass on up to $4 million free
of federal estate taxes. You can use the
unified credit during your lifetime to reduce
or eliminate gift taxes; otherwise, it will
be applied to reduce estate taxes.
Couples with an estate
valued over the applicable exemption amount
who rely completely on the unlimited marital
deduction may not benefit fully from their
unified credit. Using the marital deduction
upon the death of the first spouse simply
postpones estate taxes until the death of
the surviving spouse. When the survivor
dies, the estate tax burden may be larger
than necessary.
The AB trust ensures that
both spouses benefit from the unified credit—at
the death of the first spouse and again
at the death of the second spouse. Typically,
an AB trust is structured so that when the
first spouse dies, two separate trusts are
created. The assets of the survivor are
transferred to the A trust and an amount
up to the exemption amount of the deceased
spouse’s assets is transferred to
the B trust. This creates two taxable trusts,
each of which can use the exemption.
The B trust is subject
to estate taxes. Because of the unified
credit, no taxes will be owed. The surviving
spouse maintains control over the assets
in the A trust and receives income from
the B trust. When the survivor dies, only
the A trust is subject to estate taxes because
the B trust was already taxed at the first
death. After the death of the surviving
spouse, the B trust can continue for the
benefit of the grantors’ family. Commonly,
the trust assets are divided into separate
equal trusts to provide net income for their
children for a specified period and then
the receipt of the principal.
Although an AB trust offers
significant potential benefits, it may not
be appropriate for everyone. Those who may
not need or desire this trust include couples
where one spouse is much younger than the
other, younger couples and some couples
with children from prior marriages. Possible
drawbacks of an AB trust include uncertainty
about future tax laws, assets being tied
up if one spouse dies prematurely, obligatory
annual trust tax returns, the accompanying
recordkeeping and attorney and accountant
fees, etc.
The information above
is solely for educational purposes and is
not intended to substitute for the professional
services of a qualified estate-planning
attorney.
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Q: What are Split-Interest
Charitable Gifts?
A: With
a split-interest gift, the asset is split
into two parts: a stream of income produced
by the asset (income interest) and the principal
remaining after the interest is paid (remainder
interest). This gift is split because two
interests are established--the interest
retained and the interest given away. Besides
gift annuities, these gifts include various
types of trusts.
Split-interest trusts
commonly involve some type of asset that
can generate income. Examples include financial
investments that can generate interest income
and land that can generate rental income.
These trusts are designed to give one party
income during the period of the trust while
another partly gets full ownership of the
income-generating property when the trust
ends. The interests, or different parts
of ownership, are divided between the charity,
the donor and sometimes other beneficiaries.
In considering the establishment
of a trust, donors should consider several
factors: family situation, philanthropic
objectives, cash flow, etc. Additionally,
split interest gifts are significantly affected
by interest rates at the time the trust
is established and future rates. Low interest
rates at the time of creation benefit the
following: GRAT--grantor retained annuity
trust; CLAT--charitable lead annuity trust
and transfers of a remainder interest in
a residence or farm to charity. Low interest
rates at the time of creation harm these:
GRIT--grantor retained interest trust and
CRAT--charitable remainder annuity trust.
Split-interest tools where changing interest
rates do not affect the value of the current
and remainder interests include: GRUT--grantor
retained unitrust; CRUT--charitable remainder
unitrust; CLUT--charitable lead unitrust.
Split-interest trusts
are complex and should be tailored to your
specific circumstances. Please consult your
legal, financial and tax advisors for more
about the advantages and disadvantages of
each type of trust.
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Q: What is an
Irrevocable Life Insurance Trust (ILIT)?
A: An
ILIT is an irrevocable life insurance trust,
sometimes known as a wealth replacement
trust. This trust is designed to generate
liquidity to pay estate taxes, preserve
assets and wealth for beneficiaries and/or
fund charitable bequests. An ILIT purchases
a life insurance policy on the donor, which
keeps the proceeds out of the grantor’s
estate. It cannot be modified once it is
established.
An ILIT must be carefully
structured and worded to ensure that all
tax law requirements are met and premiums
must be according to specific guidelines,
including the granting of “Crummey
powers” which allow for beneficiary
withdrawal rights. While you are alive,
the trustee will take the money you transfer
to the ILIT each year and use it to pay
your insurance premiums. The trustee may
also oversee administrative duties like
the annual notification to your beneficiaries,
called a “Crummey Letter”. The
Crummey Letter is named after the taxpayer
who challenged the IRS and won the right
to apply his annual insurance premiums toward
his gift tax exclusion.
Upon death, the life insurance
proceeds are paid to the trust. The trustee
manages and distributes the proceeds according
to the terms of the trust document. If you
die more than three years after the transfer,
the life insurance proceeds with not be
included in the estate tax calculations.
To avoid the three-year look-back period,
the trust is created first and then the
trust purchases the life insurance policy.
In addition to its other advantages, an
ILIT does not require giving away your assets
other than what may be necessary to pay
annual premiums.
An ILIT is especially
beneficial for those who have large amounts
of illiquid assets like real estate or a
family business and for people who want
to potentially leverage their annual gifts.
This trust must be carefully drafted to
avoid any gift tax liability.
The information above
is solely for educational purposes. If you
are interested in establishing an ILIT,
please contact qualified and experienced
legal and tax advisors.
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Q: What is a Donor-Advised
Fund (DAF)?
A: A
Donor-Advised Fund (DAF) is a popular, flexible,
simple, cost-effective charitable-giving
tool. It provides an alternative to direct
giving or the creation of a private foundation.
Donors benefit from administrative convenience,
cost savings and tax advantages. On August
17, 2006, President Bush signed the Pension
Protection Act of 2006. This legislation
provides a legal definition of these funds,
a list of prohibited payments to donors
and advisors to a DAF, new rules regarding
what grants can be made from a DAF and the
documentation required for all contributions
to these funds.
A DAF, sometimes called
“a foundation in a box,” involves
less work, complexity and cost than a private
foundation. The typical minimum is $10,000.
Services to establish and maintain a DAF
are available at community foundations;
nonprofit organizations; commercial sponsors
like Vanguard, Fidelity and Schwab and independent
sponsors like the National Philanthropic
Trust. The charitable contribution triggers
tax benefits like an immediate federal income
tax deduction, avoidance of capital gains
tax if the gift is appreciated property
and a reduction of the gross estate by the
amount of the excluded asset.
Donor-Advised Funds are
either endowed or non-endowed. With an endowment,
the donor contributes assets to a DAF and
awards an annual amount to charities from
the earnings, typically five percent, with
any additional savings accumulating in the
fund. The goal here is perpetual gifting.
This creates a family philanthropic legacy
and allows donations for causes they care
deeply about for many years. In a non-endowed
situation, the donor grants the charities
at least the minimum distribution each year.
The fund may last a short or long time and
the donor can make gifts to many organizations
or focus on a specific cause.
A DAF is not a technique
to generate income from the donated asset.
If income is desired, the donor should consider
options like gift annuities, charitable
remainder trusts and pooled income funds.
Sponsoring organizations
vary in regard to what assets they will
accept, the minimum amount to set up a named
fund, restrictions on grants, investment
options, fees, services, etc. A prospective
donor should consult with their legal, financial
and tax counsel before finalizing a DAF.
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Q: What is a Pooled
Income Fund (PIF)?
A: A
Pooled Income Fund (PIF), sometimes called
a “charitable mutual fund,”
is a type of split-interest
gift. It is an irrevocable trust established
and maintained by a public charity to which
many donors can make contributions. Pooled
income funds can be considered a cross between
mutual funds and charitable remainder trusts.
Like the latter, the PIF is a vehicle through
which cash or appreciated property can be
given in exchange for a life income interest
and the tax deduction for the gift is based
on an actuarial computation of the charity’s
remainder interest.
Donors may contribute
cash or securities. They are assigned units
in the fund based on the value of their
gifts and the value of other assets at the
time of the gift. All of the income earned
by the fund each year is distributed to
the beneficiaries on a regular basis (quarterly,
yearly, etc.). The income beneficiary may
be the donor and/or another designated individual.
Often, income is paid to the donor and then
to their spouse as survivor beneficiary.
When this second beneficiary dies, a pro
rata share of the fund’s principal
is removed and distributed to the charity
for its general purposes or purposes specified
by the donor.
A gift to a PIF entitles
the donor to an immediate federal income
tax charitable deduction. The calculation
for the deduction is based on an IRS formula
that accounts for the size of the gift,
the fund’s rate of return and the
age(s) of the income beneficiary(ies). You
pay no capital gains tax on any appreciated
assets that you donate. In addition, the
donated assets are removed from your estate
for gift and estate tax purposes (this may
not be true if the income interest is payable
to someone other than the donor or their
spouse).
Fund minimums, fees, investment
objectives and allocations, etc. vary and
should be reviewed with your philanthropic
and financial advisors.
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Q: What is a Family
Limited Partnership (FLIP)?
A: A
Family Limited Partnership (FLIP) is a limited
partnership created and governed by state
law where all the partners are family members.
A FLIP is a powerful, complex estate-planning
device. FLIPs are used to protect assets
from creditors, conserve and transfer family
wealth, minimize gift and estate taxes on
wealth transfer to younger family members,
provide for successor ownership of a family
business and split income and capital gains
among family members to keep income in lower
tax brackets.
As a limited partnership,
only the general partners run the FLIP.
No limited partner has any vote or voice
in running the partnership. A general partner,
who may only own 1 or 2 percent of the assets,
controls 100 percent of those assets.
Typically, the parents
put their assets into the partnership as
both general and limited partners and then
gift their limited partnership interests
to their children. The limited partners
become general partners upon the death of
both parents. Now that a completed gift
has been made to the next generation, gift
tax may be due. However, the parents can
use their unified gift and estate tax credit
to pay that tax. With a completed gift,
if both parents are age 50 when the transfer
is made and one lives another 30 years,
then 30 years of appreciation are excluded
from the parents’ estates.
The FLIP is very attractive
because the donor/parent can significantly
discount the values of gifts made to the
donee/children that might not be discountable
if made outright. First, a lack of marketability
discount reflects that the partnership agreement
will restrict the sales or transfer of the
partnership interests so that there is no
ready market for those interests. Second,
a minority discount reflects the inability
of the limited partner to compel partnership
distributions or to compel liquidation to
obtain his or her share of the assets, which
the partnership owns. It also reflects the
inability of the limited partner to control
partnership investments. The combined discounts
can range from 25 to 60 percent (typically
30 to 40 percent). Valuation experts can
provide detailed appraisals filed with yearly
gift tax returns to avoid challenges to
the discounts by the IRS. These discounts
allow the donor to leverage his or her annual
gift tax exclusion, unified credit and generation
skipping tax exemption.
Given its complexity,
a FLIP should be drafted by experienced
legal counsel specializing in estate and
tax law.
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Q: What is a Qualified
Personal Residence Trust (QPRT)?
A: A
QPRT is an irrevocable Qualified Personal
Residence Trust, to which the grantor transfers
a primary residence or vacation home, reserving
the right to occupy that residence for a
set term of years. At the end of the term,
the trustee either distributes the residence
to the designated beneficiaries (usually
the grantor’s children) or retains
the residence in trust for later distribution.
If the trust continues, the trustee can
lease the residence back to the grantor
at a market rental rate without including
the residence in the grantor’s estate.
The transfer of a residence
to a QPRT involves a gift of the actuarially
determined value of the right to receive
the property at the end of the term. Consequently,
the gift amount is not the residence’s
full value. The gift amount is the residence’s
value minus the value of the grantor’s
retained right of occupancy. For federal
gift tax purposes, this is a major benefit.
The value of this retained occupancy right
is calculated by applying the current federally
prescribed interest rate to the full value
of the residence. In effect, the interest
retained by the grantor is treated as having
a value equal to the present value of the
right, for a term of years, to receive interest
at a fixed rate on the full value of the
residence at the time the QPRT is established.
If the grantor outlives
the term of the QPRT, the house, including
all post-gift appreciation, passes to the
children or other named beneficiaries free
of any additional federal or state estate
or gift taxes. There is no real tax risk
because if the grantor dies during the term,
the full value of the residence is includable
in his or her estate but the tax position
is no worse than if the QPRT had not been
created.
A QPRT is most advantageous
when interest rates are high. A higher interest
rate increases the discount and the tax
savings. When a home is put into the trust
its value is the “present value”
of the future gift determined by IRS formulas,
not the current value. This represents a
deep discount.
In regard to capital gains
and estate taxes, the best time for a QPRT
is after one parent dies. The family benefits
because the surviving spouse inherits the
property at its “stepped-up”
value rather than the original purchase
price or cost basis.
Current law allows each
individual to transfer no more than two
residences to QPRTs, one of which must be
a personal residence. QPRTs are not right
for everyone; please consult your professional
advisors for more information.
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Q: What is a Qualified
Domestic Trust (QDOT)?
A: A
qualified domestic trust (QDOT) is a trust
created to qualify for the federal estate
tax marital deduction where the surviving
spouse is not a US citizen. A QDOT is the
only transfer that will qualify for the
marital deduction for a decedent who leaves
an alien spouse. The current tax laws prohibit
surviving spouses who are not US citizens
from claiming the marital deduction. The
creation of a QDOT can provide for major
asset protection to the non-US citizen surviving
spouse. Without a QDOT, an estate would
be immediately taxable. The marital deduction
generally allows estate assets to pass to
a spouse without tax consequences.
There are a number of
special requirements to ensure that these
taxes are eventually paid. For example,
the trustee of the trust, or one of the
co-trustees, must be a US citizen or a domestic
US corporation. No distribution may be made
without the consent of the trustee. In addition,
a QDOT election must be made on the decedent’s
estate tax return.
A QDOT can be combined
with a charitable
remainder trust (CRT). This CRT-QDOT
operates like a CRT for a surviving spouse.
When the first spouse dies, there will be
a marital deduction. After the death of
the surviving spouse, the remainder is distributed
to charity and qualifies for a charitable
estate deduction.
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Q: What is a Qualified
Terminable Interest Property Trust (QTIP)?
A: A
QTIP trust is established for asset control,
not tax savings. It is often used in combination
with an AB trust.
Any excess assets above the personal exemption
amount are placed in the trust. In most
cases, the surviving spouse must receive
all income from the trust, the income must
be distributed annually and any invasion
of the trust principal must be for the benefit
of the surviving spouse.
The QTIP trust is typically
used to qualify for the marital deduction,
provide income and principal for the surviving
spouse and then benefit the children of
any earlier marriages. The distribution
of the remainder is governed by the will
or revocable trust of the first spouse to
die, so the children of his or her earlier
marriage(s) will usually receive the QTIP
trust principal.
A QTIP trust can also
serve as a gifting tool to benefit charities
chosen by the first spouse to die. If the
QTIP remainder is transferred to charity,
the estate of the surviving spouse will
receive a charitable deduction. Additionally,
the children can make the decision regarding
charity if the trust is drafted to provide
for a contingent transfer to charity. If
they disclaim, then the remainder assets
may be distributed to qualified named charities.
Also, the disclaimer can allow children
to influence the charitable distributions
if the disclaimed charity is a donor-advised
fund or a supporting organization.
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Q:
What is a Dynasty Trust?
A: A
dynasty trust is a long-term trust designed
to hold assets without direct ownership
being transferred to beneficiaries. Successive
generations may receive distributions from
the trust assets to allow for future growth
and appreciation. Regarding transfer taxes,
the trust’s assets are valued at their
worth when the trust was created as long
as they stay in the trust. Appreciation
is usually exempt from estate taxes. An
additional benefit is that assets usually
are not subject to claims of creditors or
ex-spouses, because they do not belong to
any of the beneficiaries.
Typically, the grantor’s
or settlor’s children are the beneficiaries
of a dynasty trust during their lifetimes
and after the death of the last child, the
settlor’s grandchildren (and sometimes
great-grandchildren) become the preferred
beneficiaries.
Laws in some states subject
dynasty trusts to the Rule Against Perpetuities.
In this case, the dynasty trust lasts for
a period that extends 21 years beyond the
death of the last to die of all of the trust
beneficiaries who are living when the trust
is created. This rule forces trusts to end
approximately 80 to 120 years after creation.
However, many states have revoked the Rule
Against Perpetuities, resulting in unlimited
duration. In those jurisdictions, this trust
can continue until all of its funds have
been distributed or until the last living
descendant of the trust’s creator
dies. Other states have retained the Rule
Against Perpetuities but have lengthened
the terms considerably.
The trustee’s discretion
can be narrow or broad with respect to the
use of trust income or principal for beneficiaries.
“Spendthrift” provisions can
provide for beneficiaries that may not be
sufficiently financially responsible or
who have unstable family situations.
Due to heavy taxation
of the income, only certain types of assets
are appropriate for placement inside a dynasty
trust. Many grantors establish this trust
as an irrevocable life insurance
trust (ILIT).
Because dynasty trusts
allowed wealth to avoid federal taxation,
Congress enacted the generation-skipping
transfer (GST) tax to recapture lost
revenue. Maximizing use of the GST tax exemption
can significantly reduce taxes on wealth
transfers to individuals more than one generation
below you. In addition, you can apply you
lifetime gift tax exemption to the assets
going into the trust.
In light of the complexity
of these matters, please retain experienced
legal, financial, tax and accounting counsel
for professional advice and guidance.
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Q:
What is the Generation-Skipping Transfer
(GST) Tax?
A: The
GST tax is a flat-rate tax tied to the top
marginal federal estate tax. In general,
generation skipping is a transfer, outright
or in trust, that avoids the estate tax
in one or more generations junior to the
transferor. This tax applies at the time
of the generation-skipping transfer. It
was enacted because multi-generation trusts,
called dynasty trusts,
resulted in the loss of federal tax revenue.
It is designed to tax transfers that skip
one generation, like the grantor’s
children, to reach a more remote generation,
like grandchildren. The GST tax can also
apply in non-family situations—the
tax may be due if a non-relative beneficiary
of a gift or estate is 37 ½ years
younger than the donor or deceased.
A single wealth transfer
may be subject to the gift tax and the generation-skipping
transfer tax, or the estate tax and the
generation-skipping transfer tax. Usually,
the same transfer is not subject to both
the gift tax and the estate tax.
Many estate plans are
designed to preserve wealth through long-term
trusts while leveraging a taxpayer’s
lifetime exemption from the GST tax. An
individual may allocate this exemption among
transfers during lifetime and at death that
will or may result in a generation-skip.
A GST trust is created
to achieve an indirect skip and can give
children protection from creditors and a
gift of the applicable exclusion amount,
plus future appreciation, exempt from estate
taxes in his or her estate. If the GST trust
is created during the grantor’s lifetime,
all or part of the GST tax exemption will
be allocated to the trust on the grantor’s
gift tax return; if established at death,
the executor of the estate allocates the
exemption on the grantor/decedent’s
estate tax return. With the goal of maximizing
wealth for future generations while minimizing
total transfer taxes, it is advantageous
to place assets with growth potential into
a GST trust during the grantor’s lifetime.
Life insurance is a beneficial asset here
because the GST tax exclusion is applied
to the premium, not to the death benefit
proceeds. This potentially significantly
leverages the GST exemption.
For more information,
please contact qualified legal and financial
advisors specializing in estate and tax
matters.
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