August 01, 2018
1. Grantor, settlor, or trustor
These three terms – grantor, settlor, and trustor – are commonly used interchangeably to refer to the person who has created and funded the trust. If the person who creates a trust agreement is the only person who can ever transfer property to the trust, little more would need to be said about identifying the settlor. Unfortunately, things are not so simple. A single trust may have multiple “settlors”. A trust’s settlor is not always easy to identify and all persons who are settlors with respect to a particular trust may not be equal.
Usually, the settlor is identified in the trust agreement and is the person who has given shape to the particular provisions set out in the trust agreement. In this case, the “settlor” becomes the defined term. “Settlor” means one person who is specifically identified in the trust agreement.
There may be more than one settlor with respect to any particular trust who may not be directly identified in the trust agreement. For example, assume that Adam Smith creates a trust naming Big Bank as the trustee and identifying himself as the “Settlor”. If Adam’s father, Bob, transfers property to Adam’s trust, Bob will be treated as a “settlor” with respect to that part of the trust attributable to his transfer. In other words, Bob creates a trust with respect to the property he transfers to Big Bank, but the trust agreement is Adam’s work product. References in that trust agreement to the “Settlor” would mean only Adam. Thus, if the trust agreement gives the “Settlor” a right to amend, Adam could exercise that right but Bob could not.
However, to the extent the general law of trusts governs the relationship of a settlor to the trust, each person transferring property to a trust may have the rights or obligations associated with being a “settlor”. For example, 60 O.S. Sec. 175.41 provides that any trust (including one that is expressly irrevocable) may be revoked by the “trustor” with the consent of all living vested and contingent beneficiaries. Thus, Adam Smith’s trust could not be completely revoked unless both Adam and Bob, and all of the living vested and contingent beneficiaries, consent. Likewise, Bob and all of the beneficiaries might be able to revoke the trust as to the property transferred by Bob, but not with respect to the property transferred by Adam.
Identifying the “settlor” can also be difficult if co-owners transfer property to a trust that has been created by only one of them. If, in our example, Adam and his wife, Eve, transfer to the trust created by Adam property owned as joint tenants with right of survivorship, each may be a “settlor” with respect to one-half of the transferred property for general trust law purposes, even though Adam is the only person holding the rights of the “Settlor” under the trust agreement.
The term “grantor” (as opposed to either “settlor” or “trustor”) also has a very particular meaning for tax purposes. A “grantor trust” is a trust the income of which is taxed to the person who, for tax purposes”, is considered to be the “owner” of the trust rather than being taxed to the trust or the beneficiaries. A person may be treated as the “owner” of a “grantor trust” even though someone else is identified as the “Settlor” in the trust agreement. In addition, under some circumstances, a person may be treated as the “owner” of a “grantor trust” even though he has not created the trust agreement and has never transferred property of his own to the trust.
Similarly, a person who has transferred property in trust and retained certain powers over the property, or a person is the beneficiary under a trust agreement giving him certain powers, may be treated as the “owner” of the trust for estate tax purposes, thereby triggering an estate tax on the trust assets at his death. It is possible for a person to be treated as the owner of a trust for income tax purposes without being treated as the owner for estate tax purposes.
Once the settlor has created the trust and transferred property to the trustee, the settlor (as settlor) generally ceases to have any interest in the trust or its operations except to the extent provided in the trust agreement. Thereafter, policing the trust will be up to the beneficiaries since the settlor cannot enforce the trust against the trustee.
The trustee is the legal owner of the trust property and is charged with a duty to administer the estate according to the provisions of the trust agreement and in the interests of the beneficiaries. There are few legal restrictions on who can be a trustee, but those that exist are important. While any adult (including the settlor or a beneficiary) may act as a trustee, only an entity having trust powers (or, certain limited circumstances, a charitable organization) can act as a trustee in Oklahoma. Thus, the settlor is relatively free to select as trustee someone who she believes will best be able to carry out her wishes as expressed in the trust agreement.
There may be one trustee, or there may be several co-trustees. If the settlor uses co-trustees, they may exercise their powers as a committee, or the settlor may believe that the trustee’s power should be divided among the trustees. For example, Adam Smith may feel that a bank is best equipped to make investment decisions for his trust, but he believes his father is in a better position to decide when and how much to distribute to the beneficiaries. Adam could appoint Big Bank and Bob to serve as co-trustees, but separate their duties by giving investment related trustee powers only to Big Bank and giving distribution powers only to Bob.
This sort of split of duties may not seem equitable; in practice it may prevent unwanted delays. As an example, in a co-fiduciary situation with a corporate trustee, investment decisions made by parties other than that corporate trustee typically need specific authorization – which usually means some form of signed direction (for example, a letter directing the purchase or sale of a particular investment). If the individual cotrustee is someone who may not either a) want to or b) be able to be involved in investment decisions, then the investment process for the trust risks getting slowed unnecessarily. One option, if the co-trustee falls into one or both of those categories, is to establish a courtesy notification process, which requires the corporate trustee to notify the other fiduciary either before or after investment decisions are made. For the individual trustee, this provides information about investment activities on a timely basis and (in the case of notification before) some opportunity to object; for the corporate trustee, it allows a more timely and efficient investment management process.
It may be that a single trustee is desirable under certain circumstances, and cotrustees are desirable under others. In our example, Adam may never want Bob to serve as the only trustee, and may also believe there is no individual who could replace Bob if he ceases to be a trustee. In that case, Adam could appoint both Big Bank and Bob to serve as co-trustees and divide the powers as described. Adam could also provide that if Bob ceases to serve as a co-trustee, Big Bank will continue to serve alone (and have the distribution powers formerly exercisable only by Bob); but if Big Bank ever ceases to serve, another bank will be appointed to replace it. The term of a trustee’s service can be limited or indefinite. If the term is indefinite, the trustee’s services will end when the trustee dies or becomes legally incapacitated (if the trustee is an individual), or when the trustee is discharged for cause by the court. Alternatively, the settlor can provide that a trustee may be terminated by someone other than a court (e.g., a co-trustee, a beneficiary, or a family friend) with or without cause if flexibility over time is desirable.
If a trustee ceases to serve, the settlor may identify one or more successors, or may provide a procedure for appointing a successor. Permitting a trustee to be discharged and a successor to be appointed, allows flexibility for an entity that may exist for a considerable time.
A person appointed as a trustee is not required to accept. If the appointee wishes, service may be declined (or an acting trustee can resign). However, if property has been transferred to the trustee, he will continue to hold it for the beneficiaries until a successor is appointed and the trust property is transferred to the new trustee.
Finally, one does not become a “trustee” simply by reason of having power over the trust property without also having legal title. Thus, if Adam Smith transfers property to Big Bank as trustee under a trust agreement that gives Bob the power to appoint trust income or principal to Adam’s children, Bob holds a power of appointment and is not a trustee.
3. Vested beneficiaries
In a general sense, vested beneficiaries have a present right to enjoy some part of the income or principal of the trust. Although the vested beneficiary’s identity is fixed, the time and extent of enjoyment may not be. For example, assume Adam Smith’s trust provides that, while Eve is alive, the trustee is to distribute income and principal to provide for her maintenance and support. Eve’s beneficial interest is vested, but the timing and amount of distributions will depend on the trustee’s exercise of its discretion.
4. Contingent beneficiaries
Contingent beneficiaries have a conditional right to some part of the income or principal of the trust. If the contingency comes to pass, the beneficiary’s interest becomes vested; if the contingency does not come to pass, the interest lapses. One of the most common contingencies is survivorship. If Adam Smith’s trust provides for the income to be paid to Eve for her lifetime and the remainder of the trust to be distributed to those of Adam’s children who are living at Eve’s death, Adam’s children are contingent beneficiaries until Eve’s death, at which time those children who are living become vested beneficiaries.
5. Investment advisors
An investment advisor is one of many kinds of advisors that might be hired by the trustee to assist with administration of the trust. The significance of being an investment advisor as opposed to a lawyer or accountant stems from certain provisions of the Uniform Prudent Investor Act which permit a trustee to delegate investment and management functions without retaining liability to the trust beneficiaries for actions of the delegate. 60 O.S. Sec. 175.69. In order for such a delegation of the trustee’s authority to shift liability for investment decisions from the trustee to the delegate, several requirements must be satisfied:
• The trustee must use reasonable care in selecting the delegate.
• The trustee must use reasonable care in establishing the terms and scope of the delegation.
• The trustee must monitor the delegate’s actions to assure compliance with the terms of the delegation.
Additional details with respect to investment advisers will be presented in later sections. Of significance with respect to delegation, however, is the different result reached with respect to delegation of investment discretion by national banks (including national trust banks). In addition to federal and state statutes national banks are subject to 12 CFR 9 (typically referred to as “Reg 9”) when conducting fiduciary activities. With respect to delegation, the regulation reaches a conclusion opposite that of 60 O.S. 175.69 as a result of its definition of “investment discretion:”
(i) Investment discretion means, with respect to an account, the sole or shared authority (whether or not that authority is exercised) to determine what securities or other assets to purchase or sell on behalf of the account. A bank that delegates its authority over investments and a bank that receives delegated authority over investments are both deemed to have investment discretion. [61 FR 68554, Dec.30, 1996, as amended at 66 FR 34797, July 2, 2001]
Therefore, a national bank may not be liable for the actions of the agent to whom it delegates investment authority under state law, but the liability remains under federal regulation.
From the perspective of the drafter of the trust instrument, the focus should be on the order in which the appointment is accepted and the delegation occurs. If a national bank becomes trustee under an instrument, and that trust instrument grants the trustee investment discretion, then any subsequent delegation by the trustee would result in the trustee retaining investment responsibility under Reg 9. If the trustor or beneficiaries wish another party to have sole responsibility for investments, then the national bank will likely want to become trustee subsequent to the delegation of such responsibility – in effect, the trusteeship accepted by the national bank should have already been modified to be a directed trusteeship prior to the acceptance of appointment by that national bank.
Types of Trusts
1. Revocable inter vivos trusts
The revocable trust is, as the name suggests, revocable by the grantor at any time prior to his or her death. These trusts are often used to accomplish management of certain assets during the grantor’s life, without parting definitely and finally with the benefit of the assets. Revocable trusts can greatly simply the process of managing a person’s assets during times of incapacity. A revocable trust instrument will typically provide for successor trustees who can step into the asset management function if the grantor becomes unable to act as trustee of the trust. This process holds significant advantages over a guardianship proceeding.
One common purpose for revocable trusts is to avoid probate. Specifically, for assets held in a revocable trust, probate procedure is not required to accomplish transfer of title following the grantor’s death. Thus, the costs (attorney fees and court costs) of probate procedure would be saved. Avoiding probate may offer other benefits in the case of a complex estate – for example, the estate of a person who holds assets in multiple states.
Property held by a revocable trust is subject to estate taxation at the time of the grantor’s death, but is not subject to gift taxation at the time the trust is funded. Furthermore, property held in a revocable trust is generally subject to the grantor’s debts. Upon the grantor’s death, the distribution of the trust corpus should be delayed until state and federal estate tax liabilities (and, typically, other debts of the grantor) are satisfied. Thus, although revocable trusts can be used in some instances to avoid the delays associated with probate proceedings, a complicated estate tax return can also substantially delay distributions from a revocable trust.
Generally speaking, under Oklahoma law, if a trust instrument does not specifically state that it is irrevocable, the trust will be a revocable trust. “Every trust shall be revocable by the trustor, unless expressly made irrevocable by the terms of the instrument creating the same.” Okla. Stat. tit. 60, § 175.41.
One key factor for attorneys and administrators to remember regarding revocable trusts is that they generally are reachable by the settlors’ creditors. First, 60 O.S. 175.92 (the Oklahoma Discretionary and Special Needs Trust Act) provides:
Subject to the provisions of the Family Wealth Preservation Trust Act:
1. Whether or not the terms of a trust contain a spendthrift provision, the following rules apply:
a. during the lifetime of the settlor, the property of a revocable trust is subject to the claims of the creditors of the settlor, and
b. a spendthrift provision is ineffective with respect to the settlor of a revocable trust while the trust is revocable; and
2. A creditor or assignee of the settlor may reach the maximum amount that can be distributed to or for the benefit of the settlor. If a trust has more than one settlor, the amount the creditor or assignee of a particular settlor may reach may not exceed the interest of the settlor in the portion of the trust attributable to the contribution of that settlor.
Second, 60 O.S. 299.15 provides:
When the grantor in a conveyance reserves to himself, for his own benefit, an absolute power of revocation, the grantor shall still be the absolute owner of the estate conveyed, so far as the rights of creditors and purchasers are concerned.
2. Irrevocable trusts
In a narrow sense, an irrevocable trust is simply a trust agreement that cannot be revoked by the settlor, thereby preventing the settlor from recovering property after it has been transferred to the trust. The term “irrevocable trust” is also sometimes used in a broader sense to include a trust agreement that cannot be revoked or amended by the settlor. In this case, the settlor is not only prevented from recovering ownership of transferred property, but is also prevented from altering any of the trust provisions. Since the provisions of an irrevocable trust are fixed “forever”, such a trust may not be able to adapt to changes in the law or in the settlor’s underlying assumptions that occur over the life of the trust.
The relative inflexibility of an irrevocable trust can be either a burden or a blessing. The inability to respond to change that occurs over the life of such a trust can have unintended results and may actually defeat the settlor’s original intention. A classic example of such a circumstance is the trust provides for payment of a fixed annuity amount to the beneficiary. If inflation erodes the value of the fixed payment, a beneficiary who was once well provided for may become impoverished. Yet, the inability to change may allow the settlor to exert control over the beneficiaries long after property is transferred to the trust or permit the settlor to accomplish a specific goal. For example, a trust must be irrevocable and unamendable by the settlor if the trust is to be used to reduce estate taxes at the settlor’s death.
Because of their relative inflexibility, irrevocable trusts must be used with care. The settlor must understand that he will not be able to change his mind once the ink dries on the trust agreement and the transfers to the trustee. The drafter must appreciate the fact that it may not be possible to fix problems that later crop up.
As noted above, the legal presumption is that a trust is revocable by the settlor unless the instrument specifically provides otherwise. Therefore, the language of the trust should be clear and unambiguous in this respect.
Even though a trust has been made expressly irrevocable, there are a few circumstances which will permit its revocation.
Sometimes, an irrevocable trust is created for a purpose which is impossible of accomplishment. For instance, the trust income is not sufficient to pay expenses of administration, or the trust is impossible of performance except by the designated trustee and he dies. Under such circumstances, the trust may be terminated. Also, a trust may be terminated when its continuance would be useless. If the result sought to be reached by the establishment of the trust has been achieved, equity will either regard the trust as ended or will end it. If a trust is terminated, its assets will be distributed to the then living remaindermen (whose interests are accelerated as a result of the termination). For example, if Adam Smith’s trust provided that the income would be distributed to Eve for her lifetime and, at her death, the remainder would be distributed to his then living issue by right of representation, an early termination of the trust would end Eve’s income interest and, even though she is still alive, would distribute the remainder as though she had then died.
Finally, an expressly irrevocable trust may be revoked by the settlor with the written consent of all living vested and contingent trust beneficiaries so long as it is not a spendthrift trust (other than a spendthrift trust that the settlor has created for herself).
Several important principles are implied by this rule:
• The trustee cannot prevent or cause revocation of the trust.
• The beneficiaries cannot unilaterally cause the trust to be revoked, even if the trustee consents -- the settlor must consent. Of course, this means that once the settlor dies, an “irrevocable” trust becomes truly irrevocable since, thereafter, her consent never be obtained.
• The settlor cannot unilaterally revoke the trust.
• Since the right to revoke a trust is more drastic than mere amendment, the same procedure that permits revocation also permits amendment.
The last of these principles may be the most important, since it provides a limited way of fixing unforeseen problems with the trust structure while the settlor is still alive. From a trust administration standpoint, care should be taken to ensure that the trust provisions are enforced without shortcuts. While the settlor is alive, the trustee may be pressured to just return the property and “forget” that there was ever a trust agreement.
After the settlor’s death, the trustee may be pressured by the beneficiaries to just terminate the trust and distribute all of the property immediately. In the former case, the trustee will be liable to the trust beneficiaries (both those who are alive at the time and those who be born during the normal term of the trust). In the latter case, the trustee will be liable to unborn trust beneficiaries even though all presently living beneficiaries are in agreement. Additionally, if the trustee serves as such for other trusts, there may be pressure on the trustee to act similarly regarding the other trusts from the settlors and beneficiaries of those trusts.
3. Life insurance trusts
Life insurance is normally subject to estate tax when the owner-insured dies, unless the policy has been irrevocably assigned to another more than three years before death. Since life insurance will have an estate tax value (its face amount) greater than its gift tax value (roughly, its cash surrender value), life insurance policies are perfect candidates for gifts. Often, the owner wants to give away the policy as a part of his estate tax planning, but control the way in which the policy proceeds are made available to the beneficiaries. An irrevocable life insurance trust is the mechanism for accomplishing this task.
A life insurance trust can be either revocable or irrevocable, and can be created while the settlor is alive or after his death as a testamentary trust. Typically, a life insurance trust is used in an estate plan as a means of reducing the estate tax burden by removing the proceeds from the owner’s taxable estate. This requires the use of an irrevocable life insurance trust (an “ILIT”) and a transfer of policy ownership to the trustee while the insured is alive.
All of the general income, gift, estate, and generation skipping tax considerations relevant to irrevocable trusts in general are equally applicable to the irrevocable life insurance trust. In addition, there are specific provisions that must be present in or absent from a life insurance trust in order to assure that the policy will be removed from the owner’s taxable estate.
In general, the instrument should be carefully drafted so as to be certain that the grantor has not retained any incident of ownership in the transferred policy. Similarly, the trust instrument must not require that the policy proceeds to be used for the benefit of the grantor’s estate.
Since the life insurance proceeds may be a major source of liquidity for the estate of the trustor, it becomes important to find a way to remove the life insurance trust from the trustor’s estate, and, at the same time, allow access to the cash for the payment of estate taxes. This can be accomplished by a provision in the trust that gives the trustee the discretionary authority to purchase assets from the trustor’s estate at fair market value or to make a loan to the trustor’s estate at a reasonable interest rate. With such authority in hand, the trustee can trade the trust’s cash for non-liquid assets of the trustor’s probate estate.
If the beneficiaries of the trustor’s probate estate and the beneficiaries of the life insurance trust are the same, this approach presents no real difficulties. However, if the beneficiaries are not the same, the trustee of the life insurance trust will have to determine whether the exercise of the discretionary right to purchase assets from, or make a loan to, the trustor’s probate estate will breach his fiduciary obligations to the trust beneficiaries since the trust beneficiaries may not view such an investment to be desirable or prudent.
Some insurance trusts are revocable.
As a general rule, a revocable life insurance trust may be used when the primary objective is management of the estate for the beneficiaries rather than reduction of estate taxes. Such a trust permits the use of discretionary and elastic provisions which cannot be obtained by various options permitted by insurance companies. Also, when a person has policies with different insurance companies, the plan can be better handled by an insurance trust under one instrument and one trustee. The tax consequences of such a trust, if revocable, are the same as direct ownership of the polity -- i.e. the insurance is subject to estate tax when the owner-insured dies.
Since the use of a revocable life insurance trust will bring about the same tax consequences as continued ownership of the policy, an alternative way of accomplishing the same management objectives is the use of a testamentary trust which is named as the beneficiary of the life insurance policy. If the estate plan contemplates the use of a testamentary trust for other purposes, the cost of a second trust instrument can be avoided by this approach.
While the settlor is alive, the primary duty of the trustee will be to receive the settlor’s gifts and pay the premiums to keep the policy in force. If the trustee inadvertently allows the policy to lapse, it may become liable to the beneficiaries for the death benefit that would have been paid under the policy. Unfortunately, with no real assets to manage until the policy matures, it is difficult to justify a fee that is commensurate with the liability assumed by the trustee.
4. Testamentary trusts
A testamentary trust is simply a trust that is established and funded by the provisions of the settlor’s will. Unlike the “living trust”, a testamentary trust comes into being only after the settlor’s death. As long as the settlor can change his will, he can amend or “revoke” a testamentary trust. However, the validity of a testamentary trust depends on the validity of the will, and therein lies a potential problem. Wills are subject to more stringent execution requirements than are trusts. If a will fails, all its provisions, including any testamentary trust, will fail with it.
Although a testamentary trust must be a part of a valid will, it is an entity with an identity separate from the probate estate. In effect, it becomes a beneficiary that is “born” as a consequence of the settlor’s death. The distinction between a testamentary trust and the probate estate is an important one. Because of that distinction, if a testamentary trust is made the beneficiary of life insurance or other contractual death benefits, payments to it are not considered property of the estate which can be subjected to creditors’ claims.
5. Credit shelter trust or family trust
In calculating the amount of federal estate tax owed by reason of a decedent’s death, an estate tax credit of is allowed to offset the decedent’s federal estate tax liability. This credit replaces the exemption which was available under earlier versions of the estate tax which permitted the decedent to transmit a limited amount of property to anyone free of federal estate tax. The “exemption equivalent” or “applicable exclusion amount” is that amount which would generate an estate tax exactly equal to the federal estate tax credit. Since the credit is available to every decedent without regard to who the beneficiaries might be, the “exemption equivalent” represents the maximum value of a decedent’s taxable estate that can be passed to beneficiaries free of federal estate tax. The federal estate tax credit is now coordinated with the federal gift tax, so that the credit is a unified transfer tax credit which applies both to the gift tax and the estate tax. Thus, to the extent a decedent has used his unified credit to shelter gifts made during his lifetime, the credit is not available to shelter transfers after his death from federal estate tax. Because of interrelationship of the gift tax and the estate tax, tax planning clauses designed to make use of the credit ordinarily used as a formula rather than referring to a specific dollar amount. This allows the document to automatically adjust to actual transactions entered into by the decedent during his lifetime without requiring manual amendments.
Since each taxpayer is entitled to a separate credit, the most common estate planning for married couples is designed to make sure that the exemption equivalents of both husband and wife can be used to the fullest extent for the benefit of the family. This “simple” tax planning requires the use of a trust that has come to be known as a “Credit Shelter Trust”.
The purpose of the Credit Shelter Trust is to give the surviving spouse the enjoyment of that part of the decedent’s estate that would be “sheltered” from estate tax by the credit, while limiting the surviving spouse’s interest so that when he dies, those assets will not be taxable as a part of his estate. It is essential that the Credit Shelter Trust be designed so that the surviving spouse is not given any power over the trust that would be considered a general power of appointment for estate tax purposes.
6. Marital deduction trust
For federal estate tax purposes, the value of all property which is transferred by a decedent to the surviving spouse is fully deductible. This is the unlimited marital deduction which, together with the unified credit, comprises a basic estate planning tool. Although the marital deduction will reduce the estate tax that is to be paid with respect to the estate of the first spouse, it should be thought of as a tax deferral rather than as a permanent tax reduction (as is the case with the exemption equivalent). The marital deduction simply defers subjecting the assets to estate tax until both spouses have died. This deferral results from the fact that the rules which must be satisfied in order for the marital deduction to be available require that the property be transferred to the surviving spouse in a form which will cause it to be taxed in the survivor’s estate.
As a general rule, property transferred to a surviving spouse will qualify for the marital deduction if the survivor’s right to enjoy the use of the property is not contingent or terminable. Thus, the transfer of a life estate or remainder interest in property will not qualify for the marital deduction because the spouse’s interest terminates at death.
Similarly, a transfer of property the use of which is conditioned upon the survivor remaining unmarried will not qualify for the marital deduction because the spouse’s interest will terminate upon remarriage.
A transfer in trust will qualify for the marital deduction if (1) the trustee is required to distribute all of the trust income to the survivor at least annually, and (2) the surviving spouse is granted a general testamentary power of appointment over the trust remainder. The power of appointment must permit the survivor to appoint the trust (either before or after the survivor’s death) to creditors, the survivor’s estate, or anyone else designated by the survivor. Such a trust may (and normally does) contain a provision which governs distribution of the trust remainder in the event that the survivor fails to validly exercise the general testamentary power of appointment. Such trust may also permit the trustee to make discretionary distributions of principal to the surviving spouse. Alternatively, since the survivor’s power of appointment will assure inclusion of the trust in the survivor’s taxable estate, it is possible to give the survivor broader authority over the trust and its distributions than can be done in the case of a Credit Shelter Trust. For example, instead of discretionary distributions of principal, such trust could permit the survivor to withdraw amounts of principal from a trust on demand.
7. Qualified Terminable Interest Property (QTIP) Trust
As an alternative to the general power of appointment trust, a trust known as a “qualified terminable interest property” (QTIP) Trust will qualify for the marital deduction, but only if a special tax election (the QTIP election) is timely made after the decedent’s death.. In order for the QTIP election to be available, all of the income of the trust must be distributable each year to the surviving spouse, and no one other than the surviving spouse can benefit from the property while the survivor is alive. If the trust satisfies these requirements, the decedent’s personal representative may elect to claim the marital deduction for property that passes to the trust. This election is irrevocable and is made on a timely filed estate tax return for the decedent’s estate. If the election is not made, the trust will not qualify for the marital deduction even though it contains the required provisions.
If the QTIP election is made by the decedent’s personal representative, the transferred property will be subjected to estate tax in the survivor’s estate, thus assuring the preservation of tax deferral associated with the marital deduction. As a result, the marital deduction becomes available even though the surviving spouse’s interest is terminable.
A typical trust which would qualify for the QTIP election would provide for mandatory distribution of income to the surviving spouse, discretionary distributions of principal to the surviving spouse, and distribution of the remainder to beneficiaries designated by the decedent after the survivor’s death. Such trust may be very similar to a Credit Shelter Trust, and if the QTIP election is not made, would similarly be taxed at the decedent’s death to the extent the decedent’s exemption equivalent is unavailable (but would not be taxed as a part of the survivor’s estate upon her subsequent death). If property qualifies for the QTIP election, it is not necessary for the decedent’s personal representative to make the election with respect to all of such property. It is possible for a fractional election to be made so that only a part of the property qualifies for the marital deduction. Creative use of partial QTIP elections may provide the personal representative with a range of post mortem estate tax planning opportunities that would otherwise be unavailable.
If the decedent’s taxable estate includes property with respect to which the QTIP election had been made upon the prior death of the decedent’s spouse, the personal representative will have the right to recover the federal estate tax attributable to such property from it. The exercise of this right of recovery will be particularly important when the beneficiaries taking the qualified terminable interest property are not identical with the beneficiaries taking the surviving spouse’s estate. Since a will that provides for payment of estate taxes from the residue of the estate would prohibit a personal representative from exercising this right of recovery, whenever the possibility of a QTIP election exists, a carefully drafted will should expressly permit the personal representative to exercise this election.
8. Qualified Personal Residence Trust (QPRT)
A qualified personal residence trust (“QPRT”) is an irrevocable trust that satisfies certain requirements under the Internal Revenue Code. The settlor transfers the settlor’s interest in a residence to the trust, and the trust grants the settlor the right to occupy the residence for a fixed term of years. At the end of the term of years, the residence passes to the beneficiaries the settlor has named in the trust. After the expiration of the term of years, any use or occupancy of the residence by the settlor must be based upon a lease in which the settlor pays fair market rental value.
A QPRT may hold a principal residence or a second residence. A settlor may have no more than two QPRTs.
When a settlor funds a QPRT, the settlor makes a gift of the residence to the beneficiaries of the trust. The amount of the gift is the fair market value of the residence, less a discount based on the delay in the beneficiaries’ receipt of the residence and the settlor’s age. The gift will use some of the settlor’s $1,000,000 tax-free amount (“unified credit”) or, if that amount is exhausted from prior gifts, require the payment of gift tax. If the settlor survives the term of years, the residence is not taxed in the settlor’s estate, thereby shifting the post-transfer appreciation to the beneficiaries without gift or estate tax.
If the settlor fails to survive the term of years, the trust terminates and the residence remains in the settlor’s estate at the then fair market value. Any unified credit is restored, so failing to survive the term is the same as if the QPRT had not been created, if no gift tax was paid. During the term of years, the QPRT is a “grantor trust” for income tax purposes. This means that the trust is not a separate taxpayer, and all of the income or capital gain during the term is taxed to the settlor and reported on the settlor’s personal income tax return.
The longer the term of the QPRT, the greater the discount and, thus, the greater the tax savings. However, there are estate tax savings even with QPRTs with very short terms. The settlor’s retained interest reduces the gift, but no value is added to the settlor’s estate due to the settlor’s occupancy.
9. Qualified domestic trust (QDOT)
The unlimited estate tax marital deduction is not available if the transferee-spouse is not a U.S. citizen. A special marital deduction is permitted, however, for property passing at the death of one spouse to a surviving non-citizen spouse if that property is put into a qualified domestic trust (QDOT) for the benefit of the surviving spouse. The QDOT can be a trust created by the decedent or it can be a trust created by the surviving spouse or the personal representative after death. Properly structured, a QDOT can provide a deferral of estate tax that is roughly similar to that provided by the normal marital deduction.
A QDOT must satisfy several requirements:
• At least one trustee of the trust must be an individual citizen of the United States or a United States corporation.
• No distribution of trust principal is permitted, unless the United States trustee has the right to withhold the United States tax imposed on the distribution.
• The trust must meet certain requirements imposed by the Treasury Regulations that are intended to ensure that the taxes will be collected. If these requirements are satisfied, an unlimited marital deduction will be allowed if two more conditions are met: (1) the executor of the decedent’s estate makes an irrevocable election to treat the trust as a QDOT; and (2) the QDOT meets a separate set of marital deduction rules which apply to all trusts created for the benefit of a spouse, whether or not the surviving spouse is a United States citizen.
Although assets transferred to a QDOT qualify for the marital deduction, a special QDOT tax is charged on principal distributions (income distributions are not subject to the QDOT tax). The QDOT tax is calculated by using the highest estate tax rate applicable to the deceased spouse’s estate. The QDOT tax is withheld by the trustee from the principal distribution and paid over to the IRS. The QDOT tax does not apply to principal distributions made due to hardship. Thus, if the surviving spouse takes the principal for an immediate and substantial financial need relating to his or her health, education, or support, or the needs of a child or other person whom he or she is legally obligated to support, no QDOT tax will be imposed on the principal distribution.
When the trust terminates, usually at the death of the surviving spouse, the QDOT tax must be paid with respect to the remaining principal. To the extent that QDOT property is also included in the surviving spouse’s estate, the noncitizen surviving spouse is entitled to a credit for any United States estate tax (including the QDOT tax) that was paid with respect to the QDOT property when the first spouse died or thereafter. This credit ensures that, in most cases, the property of a married couple will be subject to United States estate tax only once.
If the death of a U.S. citizen results in a direct transfer of assets to a non-citizen spouse, the surviving non-citizen spouse may voluntarily establish a QDOT, and transfer the assets to the trust before the date on which the tax return is due. If the surviving spouse becomes a U.S. citizen before the estate tax return is due, a QDOT is not required for the marital deduction.
A gift tax marital deduction is not allowed for any gift to a noncitizen spouse. There is no provision in the law for a QDOT with respect to gifts. However, United States law does provide that $100,000 per year can be transferred to a noncitizen spouse free of gift tax. As a result, it may be possible to reduce taxes by planning the timing of gifts.
10. Split interest trusts
Like surviving spouses, charities are favored beneficiaries under the federal estate tax law. A deduction is allowed for the value of property which is distributed to charity in much the same way as the marital deduction is allowed for property which is distributed to a surviving spouse.
In its most straightforward form, the charitable deduction may be claimed when the property is to be distributed outright to the charitable beneficiary. However, there are a variety of circumstances which permit a charitable deduction to be claimed for transfers of only partial interests in property to charity. These are generally referred to as “split interest” trusts, i.e. trusts whose beneficial interest are “split” between charitable and non-charitable beneficiaries. These split interest trusts generally take two forms:
(1) Charitable remainder trusts which, as the name implies, designate a noncharitable beneficiary and leave the remainder to a charitable beneficiary.
(2) Charitable lead trusts, which name a charity as the beneficiary for a specified time period and leave the remainder to a non-charitable beneficiary. Since split interest trusts are intended to benefit a charity and a non-charity, a very lengthy and detailed set of anti-abuse rules must be satisfied in order for the charitable deduction to be allowed. The purpose of these rules is to assure that the charitable beneficiary will actually receive the amount which is claimed as a charitable deduction. In order to qualify for a charitable deduction, a charitable remainder trust must either be a “unitrust” and “annuity trust”. These two forms of charitable remainder trusts differ considerably both in formal structure and in the economic consequences for the beneficiaries.
A charitable remainder unitrust must fix a percentage of the trust value which is to be distributed to the non-charitable beneficiary each year the “unitrust amount”. Although the unitrust amount is a fixed percentage, the actual dollar amount to be distributed will vary as the fair market value of the trust assets changes from year to year. In addition, a charitable remainder unitrust may provide that the distribution to the non-charitable beneficiary will be limited to the actual income of the trust in years in which the income is less than the unitrust amount, so long as the deficiency is made up in those years for which the trust income exceeds the unitrust amount. For example, assume a charitable remainder unitrust which provides that a non-charitable beneficiary will be distributed a unitrust amount equal to 5% of the fair market value of the trust assets as determined on the first day of each year. If the terms of the trust do not tie the distributable amount to trust income, the 5% distribution will be made to the noncharitable beneficiary regardless whether the trust has actually earned 3% or 10%.
However, if the amount to be distributed to the non-charitable beneficiary is linked to trust income, in those years in which the trust earns 3%, only 3% would be distributed, and in those years in which the trust earns 10%, the distributable amount would be the 5% unitrust amount plus the accrued distribution deficiencies (up to the trust’s income for the year). CAUTION: The 1997 version of the Uniform Principal and Income Act (“UPIA”), as adopted in Oklahoma in 1999 (“OUPIA”), could impede the trustee’s ability to make “make up” distributions when administering a CRUT. The OUPIA prevents exercise of the power of adjustment “From any amount that is permanently set aside for charitable purposes under a will or the terms of a trust unless both income and principal are so set aside . . . .” 60 O.S. 175.104(C)(4). See generally Ted R. Batson, Jr., Note, Net Income with Make-Up Charitable Remainder Unitrusts and the Trustee’s Power to Adjust Under Indiana’s Uniform Principal and Income Act, 45 Ind. L. Rev. 841 (2012) (describing the conflict between federal tax law authorizing certain types of CRUTs and provisions of the UPIA restricting the power to adjust).
The charitable remainder annuity trust takes a fundamentally different approach. Instead of fixing a percentage and allowing the distributable dollar amount to fluctuate, the annuity trust fixes the dollar amount to be distributed each year. Changes in asset value will not affect the amount distributable to the non-charitable beneficiary. The distributions to the non-charitable beneficiary may be made over the beneficiary’s life or over a fixed term of years. If there are several non-charitable beneficiaries, the distributions may be made over their joint and survivor lifetimes. The amount of the charitable deduction will be the actuarial value of the charity’s remainder interest. The mechanics of these computations are set forth in great detail in the regulations, and must be carefully reviewed whenever it is necessary to calculate the value of the charitable remainder.
Charitable lead trusts must also follow the unitrust or annuity trust requirements in describing the current distributions that are to be made to the charity. In the case of the charitable lead trust, the amount of the charitable deduction will be the actuarial value of the charity’s interest. When the term for such payments to charity ends, the remainder will be distributed to the designated non-charitable beneficiary.
It is important to note that distributions from a charitable remainder trust to a noncharitable beneficiary will not be exempt from income tax. The normal income tax rules regarding distributions from a trust to its beneficiary, and the characterization of those distributions for tax purposes, will be followed.
11. Other testamentary trusts
The most common testamentary trust is one designed to hold the interest of a minor beneficiary. In the absence of a trust, a guardian would have to be appointed for the minor beneficiary. Such a trust can be very complex or quite simple, depending on the settlor’s goals.
12. Education trusts for children or grandchildren
An education trust is usually an irrevocable trust created by the settlor for the purpose of providing funds for the education of the settlor’s children or grandchildren. The trust may express a single purpose for which distributions may be made, or may give the trustee discretion to make distributions for a variety of purposes. Except for its purpose, an education trust is no different than irrevocable trusts created for other purposes. The greatest difficulty is in defining the distribution rules in a way that is both practical and that satisfies the settlor’s goals.
13. Special needs trusts
An individual who makes a gift to a disabled individual must consider whether the beneficial effects of the transfer will be neutralized by a reduction in government benefits and whether the transferred funds will have to be used to meet cost-of-care contributions. Many third-party special needs trusts are designed to assist the disabled beneficiary by limiting the uses to which the trustee may put the trust funds, so that the beneficiary is not disqualified from receiving Medicaid assistance. These trusts are based on the principle that an individual who is eligible for SSI benefits is automatically eligible for Medicaid. Individuals are not eligible for SSI benefits if they have too many resources or too much income. Thus, these trusts attempt to make distributions in such a way so as to avoid being treated as assets or income of the beneficiary for SSI purposes.
SSI eligibility requires that the individual have no more than a minimal amount of financial resources, and any excess of assets must be spent before the individual receives SSI benefits. SSI benefits also require that the individual receive no more than a modest amount of income, and the SSI benefits received are reduced by any excessive income. SSI benefits are also reduced to the extent that the applicant receives in-kind benefits of food, shelter, or clothing. SSI benefits are not reduced, however, to reflect in-kind benefits, other than food, shelter, or clothing, received by a trust beneficiary. Some special needs trusts, therefore, simply deny the trustee the ability to provide food, shelter, clothing, or cash to the beneficiary. The beneficiary is, therefore, supported by public funds, with supplemental benefits being provided by the trust. These benefits include, for example, vacations, extraordinary medical services (not provided by government programs), and third-party personal services, such as at-home care givers. Special needs trusts are highly specialized, although their terms can be relatively simple. When in doubt regarding the efficacy of a special needs trust (whether in draft or final form), it is always best to communicate directly with the entitlement administrators who will be enforcing applicable guidelines.
One must keep in mind that the identity of the donor and settlor is critical when drafting, evaluating, and administering special needs trusts. Self-settled trusts cannot be used in the same manner as third-party-settled special needs trusts. Self-settled trusts will be reachable by entitlement agencies, as described in a little more detail below.
Avoidance of this feature is quite difficult. Medicaid and SSI guidelines contain lookback requirements, such that a person seeking Medicaid or SSI benefits cannot simply transfer or convey property to a third party and allow the third party to hold it or place it in trust for the donor’s benefit. (Currently, the SSI lookback period is 36 months, while the Medicaid lookback period is 5 years.)
If the person seeking Medicaid or SSI benefits holds resources that would disqualify her from the benefits, one solution would be the creation and funding of a “pay-back” trust – a self-settled irrevocable trust that provides for reimbursement of a state providing medical assistance to the beneficiary after the beneficiary’s death. 1 Joan M. Krauskopf et al., ElderLaw: Advocacy for the Aging § 11:54 (2009).