An irrevocable trust is an incredibly flexible planning tool. But with great flexibility comes the need to make many decisions. This column provides a guide for helping clients identify and work through some fundamental decisions so the final product will reflect their non-tax and tax objectives. The advice is limited to standard irrevocable trusts. Other considerations are raised by charitable trusts, grantor retained annuity trusts, irrevocable life insurance trusts, and other special purpose trusts.
A candid conversation with a client at the outset of the representation about the specifics of the beneficiaries’ life circumstances is a necessary first step in structuring a trust agreement that furthers the client’s objectives.
Financial security. A common non-tax objective is providing security to the client’s family and other loved ones. But many also wish to limit the extent to which young adults have direct access to the resources set aside for them until it is clear that they have the maturity and good judgment to use the resources responsibly.
Spendthrift planning. Often another non-tax objective is protecting beneficiaries, especially those with substance abuse or other mental health challenges, from the poor decisions they likely would make if given control over the assets.
Creditor protection. Most clients are interested in protecting trust assets from the claims of the beneficiaries’ creditors, including divorcing spouses.
Trust structure. Once a client’s non-tax objectives are clear, the estate planning attorney has many tools that may prove useful. In a conventional trust, the trustee holds legal title to the trust assets in a fiduciary capacity and is charged with properly making distributions, investing the trust’s assets, transacting on behalf of the trust, filing tax returns, and generally acting as a custodian to maintain the books and records of the trust. Now, however, jurisdictions are increasingly permitting the responsibilities of a trustee to be split to allow certain decision-making authority to be delegated among advisors separate from the trustee. Before taking certain actions the trustee must solicit or obtain the advisor’s direction or consent.
For example, a separate advisor or group of advisors may be delegated the power to make distribution decisions concerning the trust, often called a distribution advisor, whereas another advisor may control the investment decisions (i.e., an investment advisor), sometimes in a manner unrestricted by the prudent investor rules. This structure is generally referred to as a directed trust. The division of trustee decision-making powers among advisors can help guard against a corporate trustee, in the business of mechanically administering thousands of trusts and sometimes apt to lose sight of a grantor’s original intent, from exerting too much control and impeding the intended function and administration of the trust for a grantor’s beneficiaries.
An additional consideration is that each state jurisdiction has its own specific laws regarding the taxation of trusts. Each jurisdiction also has differing criteria for establishing minimum contacts to serve as the basis for trust income taxation. For example, some states look to the grantor, whether living or dead, and the facts and circumstances surrounding the creation of the trust. But other jurisdictions emphasize the predominant place of administration of the trust and focus on the trustee. Still other jurisdictions focus on the locations of primary beneficiaries receiving current distributions to establish minimum contacts for taxation of trust income. This can lead to a situation where a trust is subject to income tax in several states. Moreover, each jurisdiction also has its own laws governing trusts covering everything from permissible trustee duties and powers, to nuts-and-bolts trust administration and how, if at all, a trust may be manipulated or modified, either with or without court participation.
Distribution provisions. Distributions from the trust fund may be structured to be either mandatory or discretionary, of income only or of principal and income, under any number of broad or limited conditions, to a single beneficiary or a class of beneficiaries, and with or without restrictions to conserve the trust fund for remainder beneficiaries. A distribution structure may provide for the accumulation of the trust fund while children are still maturing and still allow discretionary distributions under limited circumstances for emergencies. Then upon the occurrence of a certain event or the attainment of a certain age by one or all of the children, the pot may split into separate trusts for the benefit of each child and commence either compulsory or discretionary distributions of income or principal.
Regardless of whether a client seeks assistance with tax objectives in mind, the estate planning attorney assisting him must identify the alternatives and decisions that go along with them.
Grantor vs. non-grantor. One fundamental tax-focused decision when structuring a trust is whether the trust should be a grantor trust or a non-grantor trust. If the former, the grantor will be responsible for paying the income tax on income (including capital gains) produced by the trust assets. If the latter, the trust will pay its own taxes. A grantor trust effectively allows the grantor to make additional gifts to the trust beneficiaries without using additional gift tax exemption or paying gift tax.
Generation-skipping transfer tax. Another tax-focused decision is whether to structure the trust to be fully exempt from the generation-skipping transfer (GST) tax. This is an important consideration for clients that are intending to benefit “skip-persons,” or someone 37½ years younger than the donor, generally grandchildren and more remote descendants. So, a grantor wanting to create a trust to benefit her grandchildren and more remote descendants would want to consider all of the following: (i) whether during the grantor’s life to make the trust a grantor or non-grantor trust, (ii) application of unused GST exemption to the transfer of assets to fund the trust, and (iii) depending on the ages of the grandchildren, whether an accumulation period would be useful before the beneficiaries become eligible for, or entitled to, distributions.
Although not exhaustive, the above considerations will assist you when undertaking irrevocable trust planning with clients.
