Tag Archives: Type of Trusts

Charitable Remainder Trusts & IRAs

After the changes to the Internal Revenue Code made by the SECURE Act, there is a substantially reduced time that the income taxation of assets in a plan or IRA can be postponed once the plan participant or IRA owner dies. (Special rules apply to what are called Roth IRAs which are not addressed in this article).

After the SECURE Act, long-term income tax deferral remains unchanged for select beneficiaries such as a surviving spouse, a minor child of the participant or owner, a disabled person, a person who is chronically ill, or someone who is not more than ten years younger than the participant or owner. All others, however, must take out the entire amount in the plan or IRA within ten years (or, in some cases, five years).

The options can be complicated when deciding the best way to continue to postpone taxation of interests in plans or IRAs; however, one strategy is to make use of a charitable remainder trust.

An Answer for Some: A Charitable Remainder Trust

A charitable remainder trust (CRT) is a trust where one or more individuals receive benefits for life or a fixed term (of not more than 20 years) and then the remaining property in the trust passes to charity. Both the Internal Revenue Code and regulations have detailed rules about CRTs. Generally, these trusts have been used to postpone taxation. For example, if a taxpayer decides to sell appreciated stock, the shares instead can be contributed to a CRT and the trust can then sell them without any tax because the trust is exempt from income tax.

Distributions from the trust are included in the recipient’s income under somewhat complex rules. Because a CRT is income tax-exempt, proceeds from a qualified plan or IRA can be paid to the trust when the participant or owner dies and no income tax will then be payable. However, as the plan or IRA proceeds are distributed out of the CRT, they will be taxed to the recipient.

A Special Kind of CRT: The NIMCRUT

The rules related to CRTs are complicated. One of the complications is choosing what kind of CRT to use. There are three types of CRT. One type, called a charitable remainder annuity trust (CRAT), pays a fixed amount (an annuity) each year to the beneficiary or beneficiaries. Actuarial rules limit how much of an annuity and for how long the CRAT can pay.

The second type, called a charitable remainder unitrust (CRUT), pays an annual amount equal to a fixed percentage of the annual value of the trust. If the trust grows in value, the beneficiaries receive more. If the trust declines in value, they will receive less. Actuarial rules also limit how much of a unitrust amount can be paid and for how long, but there is greater flexibility with a unitrust than with an annuity trust.

The third type is the most complicated but may offer the best results. It pays the lesser of either the unitrust amount or the “fiduciary accounting income” (“FAI” or simply “Trust Income”). This type of CRT is sometimes called a “Net Income” CRT. Trust Income is itself a complicated topic. Generally, it means income (as opposed to principal or corpus) under state law rules relating to trusts. Trust Income usually consists of dividends and interest and normally not capital gains, however, there are exceptions that a taxpayer may use to produce a better result.

With this third type, the law allows for amounts to be “made up” or paid in future years. For example, if Trust In- come is lower than the unitrust payment, the annual payment can be postponed until a year when Trust Income is greater than the unitrust amount. This type of CRT is sometimes called a “Net Income with Make-up Charitable Remainder Unitrust” or “NIMCRUT".

Why a NIMCRUT May Help with Plan and IRA Proceeds

Making plan or IRA proceeds payable at death to a CRT means they must be paid out within five years of the death of the participant or owner, however, there is no adverse income tax due to the CRT’s tax exemption. The CRT would invest the proceeds and, even if a NIMCRUT is used, Trust Income (such as a dividend or interest) would be earned and would have to be distributed to and taxed to the trust beneficiary, however, by “sandwiching” an entity, such as a limited liability company or LLC, between the CRT and the assets it invests in, Trust Income can be kept at zero. If and when it is desirable to generate Trust Income, the entity (that is, the LLC) can voluntarily make a distribution to the NIMCRUT which will then make distributions to the beneficiary for the unitrust amount for that year and for shortfalls in prior years.

As long as no Trust Income is generated (because the LLC makes no distributions), the value of the trust can grow entirely free of income tax. In fact, a NIMCRUT can provide for a yearly unitrust payment of 11% for 20 years. It will be noted that if the LLC (and thereby the trust) grows over time, the 11% will apply to ever-increasing amounts meaning more will be accruing for the beneficiary. If the LLC makes no distributions until the 20th year, no income tax will be due regardless of how much the LLC earns. If the beneficiary is under the age of 30, the payments can be made for the life of the beneficiary, but payments will usually be under 11% a year.

A limitation to keep in mind is that to have a valid CRT, the value of the remainder in the trust for charity must be at least 10% of the value of the assets when they are first transferred to the trust. That does not mean that the charity must receive 10% of what is in the trust when it ends. In fact, with the current low interest rates the IRS uses, the amount a charity receives at the end may be a very small percentage of what is in the trust when it ends.

Key Considerations for Drafting a CRT

The IRS has issued sample forms for CRTs which, if used, practically guarantees a valid CRT; however, these IRS forms can be modified to ensure a better result. It will almost always be best to have the value of the remainder when the CRT is created to be the minimum required, which is 10%. As indicated, the best benefit of a CRT is its exemption from income taxation. That exemption is available whether the remainder is 10% or greater. Since the family member of the participant or owner benefits from this exemption and loses the benefit to the extent the trust goes to charity, it usually is best to keep the charitable remainder value at 10% and not more. Those drafting a CRT may consider the included sample provisions to obtain this result.

Sample Language

Unitrust Amount. The Unitrust Amount shall be the lesser of: (i) the trust income for the taxable year (Trust Income), as defined in Internal Revenue Code Sec. 643(b) and the Regulations thereunder, and (ii) the “Unitrust Percentage Amount,” which shall be equal to the largest percentage, paid with the frequency provided below and using the highest rate published by the Internal Revenue Service pursuant to Internal Revenue Code Sec. 7520 that may be used to determine the value of the remainder of this trust under Internal Revenue Code Sec. 664(d)(2)(D), which percentage is not less than five percent (5%) and not greater than fifty percent (50%) of the net fair market value of the assets of the trust valued as of the first business day of each taxable year (the “valuation date”) rounded to the nearest one one-thousandths of one percent, paid for the term and at the manner specified above, such that the value of the remainder within the meaning of Internal Revenue Code Sec. 664(d)(2)(D) of this charitable remainder trust as of the date this trust commences shall be ten percent (10%) or, if it is not mathematically possible for the remainder to equal ten percent (10%), as mathematically close to but greater than ten percent (10%) as possible.

The LLC and Trust Income

In order to provide the greatest flexibility to produce as much or as little Trust Income as possible, the NIMCRUT should be funded with an LLC or similar entity. However, none of the trustees, the grantor of the trust, or any beneficiary of the trust can determine when distributions from the LLC may be made to the trust. However, some independent person, such as legal counsel to the grantor, can be given the power to control distributions from the LLC, by naming that person as a “non-member manager” of the LLC. That means that the person will have no ownership interest in the LLC and the LLC can be a “disregarded entity” for income tax purposes so its income will be attributed to the NIMCRUT, which being tax-exempt will owe no income tax on the income earned by the LLC. The included provision may be considered to obtain this result.

Sample Language

Limitation on Determination of Income.The determination of what is and is not Trust Income of this trust shall be made under Alaska law. In addition, the following rules shall apply: (1) proceeds from the sale or exchange of any assets contributed to the Charitable Remainder Trust herein created must be allocated to the principal and not to Trust Income, at least to the extent of the fair market value of those assets on the date of contribution, (2) proceeds of any sale or exchange of any asset purchased by the Charitable Remainder Trust herein created must be allocated to the principal and not to Trust Income, at least to the extent of the Trust’s purchase price of those assets, and (3) Trust Income may not be determined by reference to a fixed percentage of the annual fair market value of the trust property, notwithstanding any contrary provision and applicable state law.

Notwithstanding the foregoing, the following rules shall apply except to the extent but only to the extent that they depart fundamentally from traditional principles of income and principal within the meaning of Treas. Reg. 1.643(b)-1. The trust will not be deemed to have any Trust Income merely by the imputation of tax income to the trust from an entity, such as a limited liability company or a partnership, whether it is owed in whole or in part by the trust or of which the trust is a partner or member. Any cash distribution from such an entity shall be considered Trust Income except to the extent the entity advises the trust it constitutes a liquidating distribution.

It likely will be best if the NIMCRUT is created and funded with an entity, such as an LLC, prior to the death of the plan participant or IRA owner. The LLC (or other entity) may be named as the beneficiary of the plan or IRA. This way, the proceeds can be paid from the plan or IRA to the entity soon after the death of the participant or owner. The entire plan or IRA must be paid within five years of the death of the owner or participant.

Although the entity will be deemed to receive taxable income from the distributions, this income will be imputed to the NIMCRUT which is income tax exempt. In many cases, this may prove ultimately beneficial. For example, all distributions from a plan or IRA are taxed as ordinary income, but distributions from a CRT follow a more favorable tax regime. If capital gain income is earned in the plan or IRA after the death of the participant or owner, it will be treated and taxed as ordinary income. But, if the entity (LLC) receives qualified dividends, long-term capital gain or other income which is more favorably taxed than ordinary income, this better character or flavor of the income will be retained when and if paid out to the NIMCRUT beneficiary.

What Is a Life Insurance Trust?

By Amber Gunn, CTFA and Mariam Hall

As the name suggests, a life insurance trust is a trust designed to own life insurance. This type of trust will most often be irrevocable. An irrevocable life insurance trust, or “ILIT” is a trust created to own and control a life insurance policy while the insured is alive, and then to manage and distribute the proceeds paid out after the insured’s passing according to the terms of the trust and the grantor’s intent. If a couple sets up a life insurance trust jointly, the insurance policy purchased inside the trust is often a “survivorship” or “second to die” policy, which pays the death benefit on the passing of the last surviving spouse.

Funded vs Unfunded Life Insurance Trusts

Life insurance trusts can be either “funded,” where the trust owns both a policy and income earning assets that provide for the payment of insurance premiums, or “unfunded,” where the trust owns the policy and the grantor makes an annual contribution to the trust that is used to pay the insurance premiums.

Funded and unfunded life insurance trusts are effective tools. However, keep in mind that with a funded life insurance trust, the transfers to fund the trust may be subject to the gift tax (when transferring income-producing assets to the trust) and income tax for a grantor trust. Unfunded insurance trusts make use of the grantor’s annual gift tax allowance to maximize tax savings and pay the annual insurance premiums.

Insurance Premium Tax

When establishing a life insurance trust, one of the several factors in deciding where the trust will be domiciled is the insurance premium tax rate in the state where the trust will be located. All states charge some form of tax on insurance premiums, including life insurance premiums. While this tax is rarely noticeable on most insurance products, for large life insurance policies with high annual premium amounts, it can make a big difference. This consideration becomes particularly relevant for annual premium amounts in excess of $100,000 a year, which is usually the case with private placement life insurance.

Insurance premium tax rates vary significantly among states. Alaska and Delaware are two states with particularly competitive insurance premium tax rates for large premium amounts. Alaska’s insurance premium tax rate is 2.7% on the first $100,000 of the premium, and then 0.08% on premium amounts in excess of $100,000. Delaware’s insurance premium tax rate is 2.0% on the first $100,000 of the premium, and premium amounts in excess of $100,000 are tax free. In contrast, most other states average between 1.75% to 2.5% on the entire premium amount, for example, California 2.35%, Nevada 3.5%, Florida 1.75%, New Jersey 2.0%, and New York 2.0%.

Nevada Incomplete Gift Non-Grantor Trusts (NINGs)

What Exactly is a NING Trust?

A NING is a Nevada Trust where gifts are considered “incomplete" for gift and estate tax purposes. Incomplete gifts are so named because the grantor may retain control over or access to the contributed asset. NING trusts are non-grantor trusts, which means that the trust is the taxpayer for income tax purposes. This allows the income from trust assets to be taxed based on the residence of the trustee rather than that of the grantor. For grantors living in a high-income state, like California, this can offer significant tax savings. If, for example, the sale of a highly appreciated asset is anticipated, doing so through a NING could limit the capital gains tax which might be higher if done under the laws of the grantor’s state of residence.

How do NINGs Work?

A NING works exceptionally well if a client lives in a high-income tax jurisdiction and is either looking to eliminate state income taxes or is selling an asset with a significant capital gain.

Here’s how a Nevada Incomplete Gift Non-Grantor Trust strategy works:
1. The grantor transfers an asset or brokerage account with income tax liability to a NING trust. This is often a portfolio of marketable securities or shares in a family business.

2. Once the transfer is complete, the grantor is no longer responsible for the income tax liability because a NING is a non-grantor trust. As a non-grantor trust, the NING will be a separate entity for federal income tax purposes and will file a Form 1041 return.

3. The trust is responsible for the income tax, and since the trust is set up in Nevada, where there is no state income tax, the income earned on the assets in the Nevada Incomplete Gift Non-Grantor Trust trust is not subject to state income tax.

An experienced attorney should draft a NING trust to ensure it is a non-grantor trust per IRS regulations. Having a properly drafted NING Trust is crucial to shift the income tax liability away from the grantor and to the trust.

Example NING Trust Scenario

Let’s say you have a client who is a successful business owner in California and is looking to sell their business for a significant profit. The client has a basis of $500,000 in the business which is now worth $10 million. If the business owner were to sell the business, they would incur a capital gain of approximately $9.5 million.

Given that California has a state income tax rate of 13.3%, in this scenario, your client would be responsible for paying approximately $1.3 million in California state income taxes, not considering any other facts and circumstances. However, if you set up a NING trust for your client and transfer ownership to the trust, the trustee in Nevada could then sell the business, potentially avoiding the $1.3 million in state income taxes. Of course, federal income tax would be applicable whether the grantor or the trust sold the asset. However, significant state income tax savings are possible using an appropriately structured Nevada Incomplete Gift Non-Grantor Trust.

After the sale, the proceeds could be invested by your client’s preferred financial advisor, and as long as the funds remain in the NING trust, there would be no state income tax liability. Additionally, if your client were to move to a state without state income taxes, they could avoid paying any state taxes on the trust distributions. Many clients set up a NING Trust with the intent of moving to a state without state income taxes before they start taking distributions from the trust. Others simply use the NING Trust as a legacy preservation vehicle for their children.

Ideal Candidate for a NING

The ideal candidate for a NING trust is someone who is looking to sell an asset with a significant capital gain and wants to eliminate or reduce state income taxes. This person may also be looking for asset protection and privacy and may be open to establishing a trust in Nevada to take advantage of the other benefits of Nevada’s favorable trust laws, such as asset protection, perpetual trusts, and privacy. Additionally, the ideal candidate may be open to relocating to a state without a state income tax or is interested in using the trust as a legacy preservation vehicle for their heirs.

Ultimately, the suitability of a Nevada Incomplete Gift Non-Grantor Trust will depend on the individual’s unique financial and personal circumstances and should be evaluated with the help of legal, tax, and financial advisors familiar with this advanced planning technique.

Here are some questions you may want to ask your client to see if a NING strategy makes sense for their situation:

Are you a high-income earner in the top tax brackets and live in a state with a high-income tax environment like California, Massachusetts, or New Jersey?
Do you have intangible assets with an embedded large capital gain that you would want to sell?
Do you plan on moving to a state with no state income tax? Do your beneficiaries reside in a state with no state income tax?
Have you done any estate tax planning? (Assets transferred to a NING trust are still includible in the grantor’s estate at death because the gift is “incomplete” for estate and gift tax purposes.)

Considerations for Establishing a NING

A NING works well if it owns intangible assets, such as shares in a business or a brokerage account. However, a Nevada Incomplete Gift Non-Grantor Trust cannot own tangible assets or assets sourced to the state in which the taxpayer resides. For example, if the asset is physically located in a high-income tax state (source income), the strategy will not work. Sometimes, tangible assets can be converted to intangible assets, but this requires additional careful planning with the help of specialized legal and tax advice.

A NING trust may not work for your client, depending on the state in which your client resides and how that state views the taxation of a trust. New York, for example, has enacted a law to negate the use of the NING trust strategy. Other states automatically impose a state income tax if the grantor is a state resident when the trust is established. Therefore, consulting knowledgeable tax and legal advisors is critical to determine whether the Nevada Incomplete Gift Non-Grantor Trust strategy will work for your client.

NINGs are complex trust structures that must be drafted according to specific rules to achieve the planning benefits. Therefore, working with a qualified attorney with experience creating such complex trusts is critical.

Nevada Directed Trusts

Directed trusts are a relatively modern estate planning tool that allow for the separation of investment management and trustee duties. With a directed trust, the trustee has limited responsibilities, and the grantor can appoint outside advisors to manage investments or direct distributions to beneficiaries. Directed trusts have gained popularity in recent years in estate planning. Nevada has become a go-to state for many individuals and families seeking to establish directed trusts due to its excellent directed trust statutes and other favorable trust laws.

What is a Directed Trust?

A directed trust is a trust structure in which the trustee is directed by one or more designated individuals or entities in making certain decisions related to the trust administration. The person or entity that directs the trustee is called the directing party or directing advisor. Some examples of directing parties include an investment advisor, a distribution committee, or a trust protector. The responsibilities of a directed trustee generally involve the following:

Carrying out the instructions given by the directing party.
Maintaining legal ownership of the trust’s assets.
Providing for the preparation of tax returns.
Maintaining trust records.
Accounting to the beneficiaries.

The trust document outlines the specific duties and responsibilities of the directed trustee and other trust participants.

Choosing the Right State: Why Nevada

Nevada has become a popular state for directed trusts due to its favorable trust laws, including its directed trust statutes. Nevada statutes permit directed trusts and provide certain protections for directed trustees. One of these protections is that a directed trustee is not held responsible for the actions of the advisor with discretion under the trust agreement, as long as the trustee acts in good faith and does not engage in willful misconduct or gross negligence.

Additionally, the law in Nevada considers a trust advisor to be a fiduciary by default unless the trust instrument specifies otherwise. This means that the trust advisor is legally obligated to act in the best interests of the beneficiaries and to exercise reasonable care, skill, and caution in carrying out his or her duties.

In addition to its directed trust statutes, Nevada law offers numerous other benefits for modern trust planning, such as no state income tax, asset protection, and the ability to create perpetual trusts.

Directed Trust Structures: Different Responsibilities for Different Roles

In a directed trust, various roles can be defined in the trust instrument. One of the key roles is the investment advisor, who is responsible for directing the trustee on investment decisions. The investment advisor can be a financial advisor, a family member, or even the grantor of the trust. Another critical role is the distribution advisor, who directs the trustee on distribution decisions. The distribution advisor can be the same person as the directing advisor or a different individual altogether. It should be noted however, that in most scenarios, the grantor should not act as distribution advisor.

Sometimes, a trust protector may also be appointed to oversee the trustee’s actions and ensure the trust’s terms are followed correctly. In addition, the trust protector may have other powers defined in the trust, such as removing the trustee and appointing a successor or changing the trust situs.

The roles and responsibilities of each participant are defined in the trust document. Depending on how the trust is drafted, it can be directed for investment, distribution, or both. This means that the directing advisor and distribution advisor can direct the trustee on specific investment choices and distribution decisions, allowing for a more tailored and customized approach to managing and distributing the trust assets.

Modern Trusts: Directed Versus Delegated

Before the inception of the modern-day directed trust, most trusts were drafted the old way: either a single trustee held all powers and responsibilities, or joint trustees shared equal authority and responsibility. The problem with this structure is that trustees, in many cases, were not the best choice for managing the trust assets. At the same time, a manager of a closely held family business or an investment advisor was not fully equipped to undertake all aspects of trust administration. If the trustee lacked the expertise to perform all necessary trustee functions, such as investing trust assets, the trustee’s only option was to delegate those duties to a professional equipped to perform the function. The solution to this problem? Update modern trust laws to allow for the separation of trustee duties and responsibilities – hence the modern-day directed trust.

The main difference between directed and delegated trusts is the trustee’s level of responsibility. In a directed trust, the advisor has the power to direct the trustee, while in a delegated trust, the trustee is responsible for making investment and distribution decisions. In a delegated trust scenario, the trustee is responsible for all trustee duties, including investment and distribution decisions, and can delegate some or all of those duties to other professionals. However, the trustee remains responsible for ensuring the delegated duties are appropriately executed. In contrast, since a directed trust separates the powers and responsibilities between the trustee and other participants, the trustee responsible for carrying out the directives of the other participants is relieved of liability for complying with those directives, unless the trustee acted in bad faith. This division of responsibilities allows for greater flexibility and customization for trust management.

Solving for Separation of Trustee Duties: “Old and Cold” Trust Documents

What about all the trusts drafted without the flexibility of the directed trust? Plenty of “old and cold” trust documents were drafted before the widespread inception of directed trusts. These trusts do not provide for the separation of trustee duties. As a result, regardless of who controls the trust assets, the trustee remains responsible which often results in difficulty finding a trustee willing to serve with an outside investment advisor who manages the trust assets. In these cases, there are generally three options.

Option 1: Decant the Trust to a Directed Trust with Updated Terms or Create a Non-Judicial Settlement Agreement
Nevada has favorable laws which give trustees the ability to decant a trust to one with updated, modern terms that allow for separation of trustee duties. This will involve the help of a skilled trust attorney familiar with complex trust structures. Nevada also has a well-established Non-Judicial Settlement process, which allows interested parties in a trust agreement to correct mistakes, address ambiguities, and change administrative provisions without the need for court approval.
Option 2: Find a Trustee Who Will Delegate
Another option, if the terms of a trust do not provide for the separation of trustee duties, is to find a trustee willing to delegate investment management authority to a non-trustee investment advisor. However, because of the increased liability to the trustee under this arrangement, delegated trusts generally incur higher trust administration fees than directed trusts. In addition, under this arrangement, the trustee is required to take on additional monitoring, due diligence, and oversight actions with respect to the investment activities.
Option 3: Create an “LLC Wrapper” for Trust Assets to be Managed by Non-Trustee Advisor
A third option to mitigate risk for the trustee and allow a non-trustee to manage trust assets is to create an LLC and structure ownership so that the only asset at the trust level is an LLC of which the trust is a sole member. In this scenario, the investment advisor or a family member may be appointed as manager of the LLC and will manage the underlying assets held in the LLC.

Summary

Estate planning attorneys should consider using directed trusts because they can be a valuable tool for clients seeking more control over investment and distribution decisions than traditionally structured trusts. Directed trusts have gained popularity in recent years, and Nevada has become a popular state for directed trusts due to its favorable trust laws. Directed trusts offer flexibility and customization for trust management, allowing for tailored investment and distribution decisions. Compared to delegated trusts, where the trustee is responsible for all trustee duties, directed trusts divide powers and responsibilities between the trustee and other participants. However, as always, it is important to carefully consider all aspects of a trust structure and seek the guidance of legal and financial professionals when creating a trust.

What is a Spousal Lifetime Access Trust (SLAT)?

By Jamie Rowley and Mariam Hall

A Spousal Lifetime Access Trust (SLAT) is an irrevocable trust created by one spouse for the benefit of the other spouse. The grantor uses their gift tax exemption to make a gift to the SLAT for the benefit of their spouse. Similar to other planning techniques to make completed gifts that are outside of the grantor’s estate, the grantor gives up his or her right to the property transferred into the trust while the beneficiary spouse maintains access to that same property.

The goal of a SLAT is to get assets out of a grantor’s estate and into a trust that can provide financial support for one’s spouse while sheltering those assets and any future growth from estate and gift tax. By creating a trust for one’s spouse, the grantor may continue to benefit from the property through the spouse without concern of creditor claims or estate tax inclusion.

Key Considerations When Creating a SLAT

There are several important considerations to keep in mind when setting up a SLAT. For example, who will be the trustee as the grantor should not serve as trustee? Who will the beneficiaries be – Spouse, children, other descendants? Do you want to assign a trust protector and what duties will be assigned to them, such as the power to remove a trustee? How will the trust be funded? Are both spouses using a SLAT? If so, it is very important to avoid reciprocal trust doctrines. Do you need language regarding the possibility of divorce? Learn more here about the key considerations when creating a SLAT.