Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company1 An irrevocable trust in which: –Transfers of property to the trust are completed gifts for federal gift tax purposes –Trust assets will not be included in the taxable estate of the grantor or grantors –Trust income is taxed to the grantor, who is treated as the owner of the trust for federal income tax purposes –The trust intentionally violates the grantor trust rules discussed in Chapter 19 What Is An Intentionally “Defective” Trust?

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company2 When the grantor wishes to remove an appreciating asset from his estate without making a gift –appreciating assets are sold to the defective trust in exchange for an installment note with adequate interest –no capital gain is recognized on the sale since the grantor and the trust are treated as one for income tax purposes Grantor further reduces his estate by paying income taxes for the trust and allows the trust assets to grow essentially tax-free When Is Use Of An Intentionally Defective Trust Appropriate?

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company3 Trust is irrevocable, but grantor or trustee that is not adverse may retain certain powers in a nonfiduciary capacity Grantor can retain nonfiduciary power to remove trust assets and substitute assets of equal value Nonadverse party acting as fiduciary may retain power to add new beneficiaries, triggering grantor trust rules (may allow S Corporation stock to be held) In an installment sale, make sure assets that are the subject of the sale are not the only source of payments on the note What Are The Requirements?

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company4 Grantor should “seed” the trust with cash or assets worth 10% - 20% of the assets being purchased in the installment sale If the trust is a dynasty or GST trust, grantor can allocate GST exemption to the “seed” gift so the purchased asset will be excluded from the beneficiary’s estate Trust beneficiary should not have a Crummey withdrawal right What Are The Requirements? (cont’d)

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company5 –George owns a business that he expects to significantly increase in value over the next 10 years –George establishes an intentionally defective grantor trust for the benefit of his two children –George sells the business to the defective trust to remove the increased value from his estate, without incurring any income tax on the sale –After obtaining an appraisal of the business, George “seeds” the trust with cash and other assets equal to 20% of the business value How It Is Done – An example

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company6 –George will receive a promissory note from the trust at the current AFR rate, and the note can be Interest only with a balloon payment at the end, or Principal and interest amortized over the term of the note –If George dies before the note is paid off, the balance will be included in his estate and may trigger a capital gain tax Having the trust purchase life insurance on the grantor for the term of the note will ensure liquid funds are available to pay the note off at the grantor’s death How It Is Done – An Example (cont’d)

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company7 The Grantor Trust Rules apply to the following: –Where grantor retains a reversionary interest in the trust –Retention of control over the enjoyment of the trust by the grantor or certain other persons –Grantor treated as owner when retains certain administrative powers over trust (often used in defective trust planning) –Grantor treated as owner if able to revoke trust –Where the trust income is used to pay premiums on life insurance on the grantor or grantor’s spouse Tax Implications

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company8 To avoid inclusion of the trust in the grantor’s taxable estate the following powers should not be granted to the grantor: –Grantor retains a reversionary interest valued at more than 5% of the value of the trust at date of death –Grantor personally retains control over enjoyment of the trust –Grantor retains certain administrative powers, such as the power to vote stock transferred to the trust –Grantor retains the income Tax Implications (cont’d)

Defective Trust Chapter 27 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company9 Where community assets are transferred to a defective trust: –Grantor of trust will be each spouse as to his or her community interest –Each spouse should retain the power to remove and replace assets, so the grantor trust rules will apply to each individual’s community property interest –Grantor trust status normally terminates at death, but the surviving spouse will retain grantor trust status as to their portion of the trust Issues In Community Property States