Avoid probate administrationGift & Estate Planning Concepts: Trusts
Former Harvard law professor and trust expert, Austin Scott, said, "Trusts can be used for purposes as unlimited as the imagination of lawyers." Professor Scott's words have been continuously affirmed. Today thousands of trusts are currently set up in the United States, whose purposes and beneficiaries are as varied as the individuals who form them.
Trusts have become an increasingly popular tool in estate planning, especially in the field of charitable giving. Nonprofit organizations use this "will substitute" to aid donors with their individual needs while attracting sizable donations.
Individuals form different kinds of trusts to:
Avoid probate administration
Secure income, gift and estate tax savings
Decrease gross estate size
Assure preservation of wealth and to protect assets from creditors
Diminish asset management responsibilities
Control disposition of assets to beneficiaries
Background On the Nature Of Trusts
A trust basically requires five items to be complete:
Grantor - The grantor is the individual who sets up the trust by transferring his assets to a third party. The grantor is also known as the settlor.
Trustee - The trustee is an individual, corporation or a bank, who keeps legal title, possession and control over the trust property.
Trust property - The trust property, or "corpus," may include almost anything capable of being legally owned, such as real or personal property, or a contract right (such as a life insurance policy).
Beneficiaries - The beneficiaries are the recipients of the trust income and corpus.
Trust terms - A trust must include instructions, referred to as trust terms, directing the trustee as to his duties and distribution requirements.
The trustee holds legal title to the trust property, with the beneficiaries owning an equitable title. As legal titleholder, the trustee can exercise most of the usual property rights over the trust assets. Among the exercisable rights, a trustee may invest or sell assets, enter into contracts, or pay taxes on the trust.
A trustee has a fiduciary duty to the trust beneficiaries, and may not act in his own interest. A fiduciary duty means a trustee must place the beneficiaries' interest above his own. For example, a trustee may not loan or purchase trust property for his own benefit. At all times, the trustee must act in accordance with the terms of the trust.
A grantor may set up a trust either during his lifetime or at his death. An inter vivos trust, or a living trust, operates during the grantor's lifetime. A living trust is attractive for the grantor who wants professional management of assets during life, who wants to establish a pourover receptacle that will become active at his or her death, or who wants to achieve tax savings (for inter vivos trusts that are irrevocable).
A testamentary trust is a trust which becomes effective upon the testator's death through his will. Because this transaction uses a will, the trust property must proceed through the probate system, with its added costs and delays.
A grantor wanting to set up a trust may be leery about being "locked into" the terms of a trust upon formation. To lessen the grantor's anxiety, a revocable trust may be formed. A revocable trust provides the grantor with the right to revoke, alter or amend the trust. In addition, the grantor may hold the right to receive trust income during his or her lifetime. The revocable trust gives the grantor the flexibility to change his mind with changing life circumstances.
Although versatile, revocable trusts do not create tax advantages nor do they provide asset protection from creditors. Because the grantor holds "strings" on the transfer, the Internal Revenue Service treats the property as if it still belongs to the grantor for tax purposes. Therefore, the grantor or his/her estate will be responsible for the payment of income and estate taxes.
A grantor seeking to avoid the income and estate tax implications of a revocable trust, or who wants to protect assets from creditors, may decide to use an irrevocable trust. An irrevocable trust means the grantor relinquishes total control over the trust property upon formation of the trust. Consequently, the grantor is not considered the owner of the trust property for tax or legal purposes.
Federal tax law distinguishes between complex and simple trusts.
A complex trust is generally a trust that may accumulate income. If, by the terms of its governing instrument, a complex trust authorizes the trustee to make charitable gifts, the trust is allowed an income tax charitable deduction for amounts paid, permanently set aside, or used for charitable purposes during the taxable year [IRC Sec. 642(c)].
By contrast, a simple trust is defined as a trust in which the trustee (1) is required to distribute all income currently, and (2) is not authorized to make charitable gifts [IRC Sec. 651(a)]. A simple trust cannot take the Sec. 642(c) charitable deduction.
Suppose a trust that meets the definition of a simple trust is a partner in a partnership. The partnership makes a charitable contribution and reflects this contribution on the respective K-1s of its partners. Can the simple trust take a "pass-through" charitable deduction in these circumstances?
Yes, says the IRS [Rev. Rul. 2004-5, 2004-3 IRB 295]. The trust must report its distributive share of partnership income, gains, losses, deductions and credits. The lack of authorization to make direct gifts in the trust instrument will not cause a pass-through charitable deduction to be disallowed.
Whether a grantor sets up a grantor or nongrantor trust will drastically affect both his/her income and estate tax liability. In a grantor trust, the maker holds control or "strings" over the property, making him/her the "owner" of the trust property for tax purposes. The type of transfer that is classified as a grantor trust will depend on whether the individual is calculating income or estate tax liability.
Under income tax rules, if the grantor holds one of the following powers, a grantor trust is formed:
The grantor holds a reversionary interest, or a right to receive assets in the future after the present interest is terminated. The reversionary interest must exceed 5% of the value of the portion of the grantor's interest in either the trust corpus (principal of the trust) or the income at the inception of the trust.
Note: An exception exists to this rule for trusts that are set up to give a present interest, i.e. life estate, solely for the benefit of a minor lineal descendant, with a reversionary interest to the grantor upon the death of the minor before the minor reaches age 21.
The grantor holds a discretionary power, either in an individual or trustee capacity, to choose who will enjoy the corpus or the income, without an adverse party's approval.
Note: Several exceptions exist to this rule. For instance, the grantor sets up an irrevocable trust that can benefit only qualified charitable organizations, yet keeps the power to choose the particular charitable organizations to which the income or corpus will be paid, the transfer is not treated as a grantor trust.
The grantor holds administrative power exercisable without the approval of an adverse party, that includes: purchasing trust assets for less than adequate consideration, borrowing trust assets, voting to acquire stock in which the grantor has a significant voting interest, and reacquiring trust corpus.
The grantor holds the power to revoke.
The grantor holds the power to distribute trust income to himself or herself or a spouse.
Note: The transaction will not be considered a grantor trust if the trustee holds the discretionary power to distribute trust income to an individual the grantor is legally obligated to support, except to the extent that trust income is actually applied to discharge the grantor's legal support obligation.
Under estate tax rules, if the grantor holds one of the following powers, the trust property is included in the grantor's gross estate:
The grantor holds the power for life, or for a period undeterminable without referencing the grantor's death, to the right to income from the property, or the right to designate the person who shall enjoy the income property.
The grantor holds a reversionary interest in the property that exceeds 5% of the value of the property.
The grantor holds the power to revoke the trust.
A grantor could be treated as the owner of the trust for income tax purposes but not for estate tax purposes. For example, if the trustee can use trust income to pay premiums on a life insurance policy on the grantor or the grantor's spouse, this will make such income taxable to the grantor, but will not be a "string" that pulls the trust into the grantor's gross estate at death.
Mary, a wealthy retired movie star, was just diagnosed with a mentally and physically degenerative disease. On the advice of a doctor, she begins to think how she wants to handle her financial affairs. She will need money to pay her medical bills during life. In addition, her husband, from whom she is estranged, will need to be supported. At death, she wants the money to go to her struggling actor son, William, from her first marriage. Could a trust work for Mary?
Mary's situation invokes several considerations. First, as a public figure, Mary is probably concerned about her family's privacy. Second, Mary may not want to give money outright to her husband, since she indicated that they are estranged. Third, because Mary's son is struggling financially, she wants to provide for her son. Finally, as her disease progresses, Mary will need someone to manage and be able to control her assets.
The best suggestion for Mary would be to form a revocable living trust.
A revocable living trust is a trust created during the grantor's lifetime providing both lifetime and death benefits. During life, the grantor may alter, amend or revoke the transfer up until his death. At the grantor's death, the living trust usually becomes irrevocable or terminates.
Revocable living trusts are classified as "will substitutes" because they can be used to dispose of a person's estate.
The revocable living trust is an attractive option because the trust assets avoid the probate system, in which a court supervises the distribution of assets at an individual's death. Upon forming the trust, legal title over the trust property passes to the trustee. Therefore, at the grantor's death, the trustee does not need to change the trust asset's title through the probate court.
Avoiding the probate court means eliminating the costs and delays associated with the process. Assets subject to probate generally take around six months to a year or more to be distributed to beneficiaries. During this time, the beneficiaries may not possess the assets the probate court has control over. The assets the beneficiaries finally receive will be reduced by court costs, attorney and executor fees, and taxes.
Estate planners often recommend a revocable living trust for their elderly or incapacitated clients. A revocable living trust removes the trust management responsibility from the grantor, placing the obligation on a third-party trustee.
Tim and Nancy, a married couple, decide to plan their estates. The couple has no children together, but Tim has two children from his first marriage. Both Tim and Nancy form separate wills, and mutually agree on where the assets will go upon the death of the last surviving spouse, to Tim's children. If Tim predeceases Nancy, how can he be assured that the couple's assets will go to his children upon his death?
The revocable living trust is attractive for individuals who want to control the disposition of their assets at death, commonly used in second-marriage situations. Using a revocable living trust, both spouses can create a revocable trust which will then become irrevocable on the death of the grantor.
For example, Tim could set up a revocable living trust with income payable to Nancy for life following his death. Upon Nancy's death, the trust principal would be distributed to the two children from Tim's previous marriage.
Receptacle for Assets & Life Insurance
A revocable living trust can be a pourover receptacle for probate assets and life insurance.
A revocable living trust may not necessarily terminate at the grantor's death. Instead, the trust may receive assets passing under the will (after probate) and from life insurance policies, referred to as a "pourover trust." At the grantor's death, the trust then becomes irrevocable, and the grantor's comprehensive plan for the disposition of assets will be carried out via the trust terms.
With respect to life insurance proceeds, the trust can provide more flexibility in the payout to the beneficiaries than is possible with the standard settlement options offered by the insurer. Also, where there are a number of different policies, the proceeds can be consolidated in the trust and administered under one comprehensive plan of disposition.
Individuals protective of their privacy may use a revocable living trust. By law, wills are public documents, open to inspection by displeased heirs, the media or curious on-lookers. Therefore, the public may discover the identity and amount of a deceased's property, along with the amounts received by each beneficiary.
Revocable living trusts are not open to public inspection, becoming especially attractive for the individual mindful of the public eye.
Click here for an example of a privacy need.
The Hearst family became concerned about the public discovering information about their family after the kidnapping of Patty Hearst. In 1977, the Hearst family requested the will of William Randolph Hearst be made private because it contained the names and addresses of family members. A California court agreed to restrict public access to the document. In re Estate of Hearst, 67 Cal. App. 3d 777, 136 Cal. Rptr. 821 (1977). Mr. Hearst could have used a revocable living trust, and saved his family anxiety and legal hassles.
Characteristics of a Revocable Living Trust
Typically, a revocable living trust will be divided into two parts. The first part will direct how the trust is to be managed during life. The second part of the instrument directs how the trust properties will be managed and the disposition at death.
During the grantor's life—The trust agreement will generally provide that, during the grantor's life:
The grantor is to receive all trust income
The grantor may add property to the trust or take property from the trust at any time
The grantor can change any of the trust provisions, or cancel the whole arrangement, for any reason and at any time
The grantor can name himself or herself as the sole trustee of the trust. However, if the grantor wants to avoid day-to-day investment responsibility, a bank or some other person can be named trustee.
After the grantor's death—The second part of the trust instrument will direct exactly how the trust properties are to be used and disposed of after the grantor's death. In this sense, the revocable living trust is like a will. It can be changed at any time during life, but the terms of the trust instrument become unchangeable at the grantor's death.
Click here to look at a graphic that shows how a revocable living trust works.
With all the advantages associated with revocable living trust, why isn't everyone using one? The main disincentive for individuals considering revocable living trust is the lack of tax advantages. A maker who creates a revocable living trust holds control or "strings" on the property, maintaining his ownership over the property. As the owner of the property, the maker will be charged with income and estate tax liability assessed on the property.
The revocable living trust is a grantor trust. As owner of the property, the grantor of a revocable living trust will be responsible for any income tax liability. The grantor will pay the tax regardless of to whom the income is paid.
The beneficiaries will not be income taxed on the amount received. The income is treated as a gift, which is not taxed under federal income tax laws, but the grantor may have to file a gift tax return for gifts of income or corpus.
Commonly, individuals assume that when they form a revocable living trust their estate tax liability will be diminished at death. These individuals think the trust property will be removed from their gross estate when figuring total estate tax liability.
However, the grantor holds "strings" on the revocable living trust property, placing the property back into the grantor's estate at death. Therefore, an estate tax may be assessed on the trust property in the grantor's estate.
The grantor will not be responsible for paying a gift tax on the formation of a revocable living trust. The federal gift tax is only assessed on individuals who make a gift which requires the donor to give up complete dominion and control. The owner of a revocable trust still maintains control over the property. However, distributions of income and corpus from the trust to third-party beneficiaries may result in gift tax liability for the grantor.
When advising an individual about whether to create a revocable living trust, the following advantages and disadvantages should be considered.
|
Advantages |
Disadvantages |
|
|
|
Bypass (a.k.a. Credit Shelter) Trust
The bypass trust is an estate planning device often used to minimize the combined estate taxes payable by both spouses at death. The trust may be formed either via lifetime or death transfer. The general idea of the trust is to make full use of each spouse's applicable credit amount at death, but the bypass trust offers other advantages as well.
A bypass trust works in this way: At the first spouse's death, the estate transfers a sum equal to the applicable exclusion amount into the bypass trust. Although the trust property will bypass the surviving spouse's estate, the spouse will still be able to receive benefits from this trust during life, including income and some corpus distributions.
Upon the death of the first spouse, no estate taxes will be assessed on the transfer of estate property to the bypass trust because the amount in the trust equals the applicable exclusion amount. For example, in 2025 the trust could hold up to $13.99 million, which is the amount that will be protected from estate tax liability by the estate tax applicable exclusion.
The second portion of the estate will be either given outright to the spouse or placed in a marital trust, or "A" trust. The marital trust will hold the amount of the estate above the applicable exemption amount. The trust property will pass as the surviving spouse directs under a general power of appointment.
Upon the death of the first spouse, no estate taxes will be assessed on the transfer of estate property to the martial trust because the transfer qualifies for the unlimited marital deduction allowing assets to pass tax-free to the surviving spouse.
Later, upon the death of the surviving spouse, the estate of the surviving spouse can make full use of his or her available applicable exclusion amount to shelter part of the marital share from estate tax.
Click here for a table that presents an overview of the bypass trust.
For years, the primary purpose of the bypass trust had been to allow both spouses to take full advantage of their applicable credit amounts. If a married couple were to use a bypass trust, only one applicable exclusion amount would be used (at the second spouse's death). The first spouse to die would use the unlimited marital deduction to eliminate completely any estate taxes on the first transfer. Only when the second spouse dies will the estate be taxed, and that estate tax will then be reduced by the applicable exclusion amount.
However, married couples may be less inclined to use the bypass trust because of the availability of the deceased spousal unused exclusion amount. This means the applicable exclusion amount not used by the estate of a deceased spouse would not be wasted - any part of the exclusion amount not used would eventually be available to the estate of the surviving spouse, so none of the credit amount is lost as a result of not planning with a bypass trust. This concept is commonly called "portability" (so long as the first spouse's estate complies with the IRS's filing requirements to take advantage of the portability).
Still, a bypass trust may be useful for several reasons:
To start, the deceased spousal unused exclusion amount transferred at the time of the first spouse's death may not suffice to protect assets in an estate which continues to grow.
Click here for an example.
A husband dies in 2025 with an estate of $15 million. He uses none of his estate tax applicable exclusion amount. If the executor elects that the surviving spouse benefit from the unused amount, the $13.99 million amount will (eventually) be added to the wife's applicable exclusion amount. But it is possible that after the husband's death the assets will continue to grow. The applicable exclusion amount is adjusted for inflation every year, but the growth of the assets may be at a greater rate, while the $13.99 million unused spousal applicable exclusion amount the husband left behind in 2025 remains fixed. In such a case, the wife's estate could outgrow the combined exclusion amounts and be subject to the estate tax.
Also, the portability of a spouse’s unused exclusion amount may not apply to state estate taxes. Many states have effectively de-coupled their own estate tax from the current federal estate tax law.
Plus, a bypass trust can provide protection from creditors of the surviving spouse.
Another advantage is that the assets in a bypass trust will eventually benefit family members or loved ones upon the death of the surviving spouse--not the spouse of a second marriage and his/her extended family.
Keep in mind that the unused exclusion amount does not apply to the generation-skipping transfer tax.
Although the surviving spouse will not include the bypass trust property into his or her estate, that does not mean the spouse fails to receive any benefits.
The surviving spouse may receive any or all of the following from the bypass trust, including:
All or part of the trust income
A "sprinkling power" that allows the spouse to distribute trust income or corpus to other trust beneficiaries
An annual right to withdraw the greater of $5,000 or 5% of the trust principal
Principal distributions limited by an "ascertainable standard" relating to the spouse's health, education, support and maintenance
A limited power of appointment over the trust property
A couple may form a trust requiring the trustee to distribute to the surviving spouse all income earned by the bypass trust, or the trustee may be given the discretion to pay out or to accumulate income. The trust usually provides some standard for the trustee to go by in exercising such discretion, related to the spouse's need for income.
A bypass trust may be set up as a sprinkling trust, meaning the trustee is given the power to "sprinkle," or distribute, income among several beneficiaries. In some cases the surviving spouse, rather than the trustee, may hold the sprinkling power. The spouse may only hold this power, while still retaining his tax benefits, if he cannot exercise the sprinkling power to benefit himself in any way. For example, the spouse could have the power to "sprinkle" distributions among children and grandchildren.
Giving the trustee or surviving spouse a sprinkling power enables the first-to-die spouse to avoid carving in stone the distribution of trust income and principal before "all the facts are in." For example, some of the children may have a greater financial need than others, and the sprinkling provision allows this to be taken into account after the first spouse's death.
The spouse, or other trust beneficiaries, can be given the power to withdraw annually from the trust the greater of $5,000 or 5% of the trust principal.
Although providing the surviving spouse with trust corpus benefits may sound advantageous, the tax implications of the distribution can be a major disincentive. For example, the property removed from the trust will be included in the surviving spouse's gross estate at death, unless consumed.
In addition, in the year the surviving spouse dies, the amount that spouse could have withdrawn in that year is included in the gross estate even if the surviving spouse did not in fact withdraw it. If we think of 5% of a $1 million dollar trust, that would mean an extra $50,000 in the spouse's gross estate each year the power is unexercised.
Because of these potential tax problems, some trusts just give the spouse the right to borrow from the principal of the trust instead of the withdrawal power. Thus, the spouse has access to the principal without potentially adverse tax consequences.
Distribution of Principal Powers
Under the bypass trust arrangement, the trustee may distribute principal to the spouse for purposes of health, education, support and maintenance from the bypass trust. The trustee's discretion over distributions is limited here by an "ascertainable standard," which keeps the trust out of the spouse's gross estate at death.
Similarly, under a bypass trust, the surviving spouse may hold a limited power of appointment. For example, if the husband survives, he may appoint the principal to anyone except himself, his estate, his creditors and the creditors of his estate.
While the surviving spouse is usually the major income beneficiary of the bypass trust, this is not a requirement. If the spouse is independently well-off, then the first-to-die spouse may want to name children, grandchildren or an aging parent as the beneficiary(ies). The same estate tax result will hold: the trust will generally not be includible in the gross estate of any beneficiary who dies while the trust is in existence, if it does not give the beneficiary a general power of appointment over the assets of the trust.
Click here for a graphic showing how a bypass trust works.
Forming a bypass trust may offer many tax advantages. However, if the trust is formed incorrectly, the property or income may be subject to additional tax liability.
Accumulation vs. simple trusts —A trust that provides the trustee with the discretion to pay income should be mindful of the tax consequences. If the trustee exercises its discretion so as to accumulate income, instead of paying out all income to the surviving spouse or other beneficiaries, the trust becomes a separate taxpayer for income tax purposes.
Avoids estate tax at spouse's death—The main advantage of the bypass trust is the estate tax savings to the spouses. Forming a bypass trust can completely eliminate any payment of estate tax on the first-to-die spouse's estate. The spouses fully utilize their respective "applicable credit amount" to shelter the maximum possible estate assets from taxation.
Any individual seriously considering forming a bypass trust should carefully examine the advantages and disadvantages of such a decision including an analysis of how the spousal portability provisions impact the decision to use a bypass trust.
Advantages:
The property placed into the trusts on the death of the first spouse to die will not be estate taxed.
The property placed in the bypass trust will be excluded from the gross estate of the second spouse to die.
The spouses can make maximum use of their respective applicable credit amounts at each death.
The surviving spouse can receive the income from the bypass trust for his or her lifetime, and also have fairly liberal rights to withdraw or sprinkle the principal. Alternatively, the income may be accumulated, or distributed to the spouse and other beneficiaries in the discretion of the trustee.
The first spouse to die is assured that the property placed in the trust will ultimately pass to those he or she wishes.
Disadvantages:
The surviving spouse will not be able to have full access to the deceased spouse's estate, which may be a drawback for a surviving spouse in financial need.
The trust may be responsible for paying an income tax on the amount of trust income which a trustee with discretionary authority over income distributions elects to accumulate.
The transfer to the trust is irrevocable upon the first spouse's death, and cannot be altered to suit changing circumstances.
Qualified Terminable Interest Property (QTIP) Trust
A qualified terminable interest property (QTIP) trust is property in a decedent's estate that, even though subject to certain restrictions, can still qualify for the estate and gift tax marital deduction.
Under normal tax rules, an individual who leaves or gives property to a surviving spouse may claim the martial deduction on the transfer. Assuming the surviving spouse is a United States citizen, the marital deduction shields 100% of the transfer from the imposition of transfer taxes.
However, the marital deduction may not be claimed on certain transfers. For example, a transfer to a spouse of a terminable interest, i.e., an interest which terminates upon the death of the holder or on the occurrence or nonoccurrence of a certain event, will not qualify for the marital deduction.
While terminable interests generally do not qualify for the marital deduction, an exception exists for QTIP trusts.
A QTIP is property placed in trust which must:
Pass from the decedent
Give the surviving spouse a qualifying income interest for life
Be elected to qualify as a QTIP trust by an executor
There are several reasons why individuals form QTIPs, including:
Flexibility in estate planning - Since the final decision regarding whether to qualify the QTIP property for the marital deduction is delayed until after the estate owner's death, the current circumstances of the surviving spouse and other beneficiaries can be taken into account.
Income for life to a surviving spouse - The surviving spouse can be assured of receiving all of the income from the QTIP property for his or her entire lifetime.
Placing restrictions and still claiming the marital deduction - The estate owner can restrict the ultimate disposition of the QTIP property without sacrificing the marital deduction.
Failing to leave property outright to a surviving spouse - Sometimes it is inappropriate to leave property outright to a surviving spouse-perhaps because the spouse is aged, infirm or not sophisticated in financial affairs or property management. The QTIP trust allows property to be managed for the spouse's benefit without these burdens.
Second marriage situations - The QTIP trust is especially useful in second marriage situations. The first spouse to die can be assured that the property will pass eventually to his or her children or other heirs, rather than to the surviving spouse's children from a prior marriage, while still providing lifetime financial security to the surviving spouse.
Eases remarriage fears - The QTIP also addresses the "remarriage fear" that many estate owners have. If property is left outright to a surviving spouse who later remarries, the property could wind up in the hands of the new spouse. The QTIP trust provides for a surviving spouse, but retains control over the ultimate disposition of property.
A QTIP requires a "qualified terminable interest." Under the Internal Revenue Code, two kinds of terminable interest are classified as qualified:
lifetime income interest
income interest in a charitable remainder trust
A lifetime income interest must meet the following requirements:
The trust must pay income to the surviving spouse, at least annually
The surviving spouse must hold the right to all of the income from the property as long as she or he lives
Upon the surviving spouse's death, the trust principal will pass to the beneficiaries designated by the first spouse to die, unless the surviving spouse exercises her power of appointment
No person may have the power to appoint any part of the property to anyone other than the surviving spouse (except the surviving spouse may have a power of appointment if the power is exercisable only at or after the surviving spouse's death)
The executor must irrevocably elect to qualify the property as qualified terminable interest property on the decedent's estate tax return
Income Interest in a Charitable Remainder Trust
A qualified terminable interest may be an income interest in a charitable remainder trust. In this arrangement, the surviving spouse is an income beneficiary of a charitable remainder annuity trust or unitrust. The spouse's interest is a terminable interest because the interest will expire at his or her death or a term of years. The spouse has no power to dispose of the trust property by will, and the charity will succeed to the full interest in the trust property upon the termination of the surviving spouse's interest. If the spouse and the charity are the only trust beneficiaries, the trust can qualify for the marital deduction.
Click here to see a graphic of how QTIP trust works.
Under normal death transfers between spouses, the first-to-die spouse's estate receives the martial deduction on the transfer to the surviving spouse. The surviving spouse will then be taxed at death.
The Internal Revenue Service attempted to make the QTIP taxed in the same manner as a normal transfer. Therefore, a QTIP will be taxed in the following way:
At the first spouse's death, the marital deduction may be claimed (even though the transfer is a terminable interest).
At the second spouse's death, the transfer will be taxed (even though the spouse has no ownership or interest over the property).
Forming a QTIP should be the result of a carefully thought-out process, and a study of the advantages and disadvantages. The following chart demonstrates the advantages and disadvantages associated with forming this trust.
|
Advantages |
Disadvantages |
|
|
|
Irrevocable Life Insurance Trust
Many people use life insurance in their estate planning decisions. Individuals find the policies attractive in deciding how to support surviving loved ones or paying off debts, taxes and other costs assessed on their estate.
Although life insurance policies are commonly used in estate planning, not many incorporate a trust arrangement with their life insurance decisions. The irrevocable life insurance trust allows the grantor (maker of the trust) to achieve the benefits of life insurance policies with the tax advantages of using a trust arrangement.
To understand the concept of an irrevocable life insurance trust, you must first have a clear understanding of irrevocable trusts in general. An irrevocable trust is a trust where the grantor completely gives up all rights in the property transferred to the trust. At that point, the grantor holds no rights to revoke, terminate or modify the trust in any material way.
An irrevocable life insurance trust is an irrevocable trust containing a life insurance policy, usually on the grantor's life. The trust may be either funded or "unfunded."
A grantor creates a funded trust when he or she transfers the life insurance policy and other property to the trust for premium payments to be made. For example, the grantor may transfer to the trust the life insurance policy and $100,000 in cash.
An unfunded trust only contains the life insurance policy. Because the trust only holds an illiquid (non-cash) asset, the trustee has no funds within the trust to make the premium payments. Consequently, the grantor must annually contribute gifts of cash or property to the trust to pay the premiums. Whether a trust is unfunded or funded will affect the taxation of the trust.
The following is a run-down of the irrevocable life insurance trust:
Trust creation - usually for the benefit of surviving family members.
Trust composition - from a life insurance policy on the grantor's life (the policy may either be an existing policy or a new one applied for by the trust).
Life insurance premium payments - may be satisfied by the trust income (funded) or the grantor may provide the trust annually with funds to pay the premiums (unfunded).
Although a grantor who forms an irrevocable trust technically gives up control over the trust, an irrevocable life insurance trust does provide the following advantages to the grantor or the grantor's estate:
Helps to meet the liquidity needs of the grantor's estate
Helps provide for the income needs of survivors after liquidity costs have been satisfied
Avoids the estate taxation of the death proceeds.
An irrevocable life insurance trust may include a liquidity provision, or a provision allowing the life insurance death proceeds to be used for the liquidity needs of the grantor's estate.
To provide such liquidity, the trustee must be authorized to make the proceeds available to the estate's executor. This is usually done in two ways:
By authorizing the purchase of illiquid assets from the estate
By authorizing bona fide loans to the estate
The executor may then use the cash proceeds to pay: funeral costs, death taxes, probate expenses, claims of the creditors, or expenses from the decedent's last illness.
For tax purposes, the grantor must be extremely careful in the manner of forming a liquidity provision if he or she wants to retain the tax advantages of forming an irrevocable trust. A grantor should be mindful of the following categories when engaging in liquidity planning:
It is critical that the trust document merely authorizes the trustee to make proceeds available to the executor. If the trustee is required to make proceeds available, the policy proceeds would likely be included in the grantor's gross estate.
The estate should not be a direct or indirect beneficiary of the proceeds if the grantor wishes to eliminate the trust property from his or her gross estate. To the extent the amount is actually used to pay the estate obligation (i.e. without any bona fide loan or asset purchase taking place), that amount will be included in his or her gross estate.
Trustee Purchasing Assets from the Estate
A trustee must purchase assets from the estate at a fair price. If the trustee "overpays" to pump additional cash into the estate, this could be deemed a taxable distribution of trust income.
A trustee may make a loan to the estate if the terms fall under the "prevailing commercial credit" conditions. A loan should: (1) bear a reasonable rate of interest, (2) provide a repayment schedule, and (3) be secured by estate assets as collateral. A trustee who makes a loan with terms more favorable than the prevailing commercial credit could subject the trust's loan to income taxation as well as jeopardize the exclusion of the death proceeds from the gross estate.
A donor may have conflicting estate planning ambitions—for example, a passionate desire to give to charity coupled with a dedication to leave an undiminished inheritance to children or other loved ones. Can a donor satisfy both of these goals with an irrevocable life insurance trust?
An irrevocable life insurance trust may aid this donor. The trust may accomplish "wealth replacement" if created in the correct manner. This is how it works:
The grantor sets up a charitable remainder unitrust (CRUT) to benefit a qualified charitable organization.
The grantor also sets up an irrevocable life insurance trust with his surviving loved ones as the beneficiaries.
The CRUT income is payable to the grantor.
The grantor then uses the CRUT income to pay the premiums on the policy held in the irrevocable life insurance trust.
Forming a trust in this manner serves both goals: benefiting a charitable organization with the CRUT, while maintaining the amount given to the beneficiaries. In addition, the grantor will receive a charitable tax deduction with the CRUT.
An irrevocable life insurance trust may provide various tax advantages depending on the manner in which the trust is formed.
An irrevocable life insurance trust is foremost an irrevocable trust. Trusts are classified as irrevocable if the grantor transfers all rights in the property to the trust, and retains no rights to revoke, terminate, or modify the trust in any material way. Once a grantor relinquishes these rights, the trust property will not be included in his or her gross estate at death. Therefore, the grantor and his or her estate will not be subject to estate or income taxes on the trust property.
One of the reasons a grantor uses an irrevocable life insurance trust is to diminish the amount of income and estate taxes. Basically, the grantor wants to avoid creating a grantor trust.
A grantor trust is a trust in which the grantor holds too much control or "strings" over the trust property. Income tax and estate tax rules contain different standards for determining a grantor trust. For example, under income tax rules, if the trustee can use trust income to pay premiums on a life insurance policy on the grantor or the grantor's spouse (funded life insurance trust), this will make such income taxable to the grantor, but will not be a "string" that pulls the trust into the grantor's gross estate at death.
A grantor may avoid the imposition of income tax by forming an unfunded trust. An unfunded trust requires the grantor to make annual cash gifts to cover the cost of the life insurance premiums. Although the grantor will avoid the imposition of income taxation by forming an unfunded trust, he still may be responsible for gift tax on the annual transfers, unless "Crummey powers" are used.
In order for the life insurance premium payments to be made, some grantors make annual payments to a trust to cover the payment costs. Gift tax law generally classifies these transfers as future interest gifts. If you remember back to gift tax rules, only present interest gifts qualify for the annual exclusion which exempts $19,000 per year (as indexed in 2025), per donee from gift taxation.
The Crummey powers, named after a famous 1968 court case of the same name, are meant to secure the gift tax annual exclusion for annual gifts made by the grantor to cover the life insurance premium payments. Crummey powers are powers held by the trust beneficiaries. The trust beneficiaries hold the power to withdraw annual cash transfers to the trust, each year for a limited period of time.
The fact that a beneficiary has the power to withdraw, even if he or she doesn't exercise it, is enough to convert a future-interest gift into a present-interest gift qualifying for the annual exclusion. For example, if three beneficiaries hold Crummey powers, the grantor can exclude up to $57,000 (2025, indexed annually) of cash transfers annually from the gift taxation.
Click here for an IRS ruling in which charities were given Crummey powers.
A grantor formed an irrevocable life insurance trust naming both charitable and noncharitable beneficiaries. Under the terms of the trust, the trustee could make, at her discretion, distributions from the trust for the beneficiaries' health, education, maintenance or support. Each beneficiary had the right to withdraw equal amounts of each transfer from the trust. The grantor claimed a gift tax charitable deduction for the amounts subject to the charities' withdrawal power. And, upon the grantor's death, his executor did not report any of the transfers as taxable gifts on his estate tax return.
In a technical advice memorandum, the IRS ruled that no gift tax charitable deduction or annual exclusions were available for the transfers to the trust subject to the charities' right to withdraw. In addition, the IRS determined that the transfers to the trust subject to the charities' withdrawal rights constituted taxable gifts. [TAM 200341002]
Click here for a graphic of how the irrevocable life insurance trust works.
The manner in which an irrevocable life insurance trust is formed determines whether the grantor, beneficiary or trust itself will be subject to gift, estate or income taxes.
Gift tax upon trust creation—Because an irrevocable trust is involved, and the grantor has given up all control over the trust, a completed gift is made. At that point, the grantors are subject to gift tax on the transfer. The grantor may reduce his gift tax liability by using the annual exclusion.
Gift tax on annual transfer—If the grantor makes annual transfers of cash to the trust for the trustee to pay premiums, the transfer is considered a gift. The Internal Revenue Code generally considers this transfer a future interest gift, ineligible for the annual exclusion. However, the annual exclusion may be claimed on annual cash transfers to the trust if the beneficiaries have properly drafted Crummey powers.
Income tax during grantor's lifetime—A funded trust produces income which will be assessed to the beneficiary upon distribution. However, if the income is accumulated, the trust will be taxed on that amount.
If the trust is classified as a grantor trust (under income tax rules) and the trust produces income, the income will be taxed to the grantor. The trustee's ability to use trust income to pay premiums on a policy on the life of the grantor or the grantor's spouse is one of the factors that would make the irrevocable living trust a grantor trust.
Estate tax at grantor's death—The trust property, including the life insurance, generally avoids being included in the grantor's gross estate for estate tax purposes, as long as:
The trust is irrevocable
The grantor is not the trustee
The grantor has no incidents of ownership over the insurance policy
The insurance proceeds are only used to purchase estate assets or to make loans to the estate in reasonable, arm's-length transactions, not to pay estate costs in a direct manner
The insured lives for at least three years after transferring the policy to the trust
Alan, a 65-year-old, wants to engage in estate planning. Alan has several goals upon death he hopes to accomplish. Mainly, he wants to provide for his surviving three daughters. As a secondary goal, he wants his estate to avoid taxation and the probate process. On the advice of an attorney, he sets up an irrevocable life insurance trust.
Alan transferred $15,000 in cash into the trust. Upon trust formation, the trustee used the $15,000 in cash to purchase a life insurance policy, by paying the first annual premium to bring the policy into existence. The policy will provide $2,000,000 to his daughters upon his death. Alan will make a payment of $15,000 each year to cover the premiums.
Alan has not used any of his applicable credit amount.
What are Alan's tax consequences?
Gift tax upon creation of the trust - Alan made an initial gift of $15,000 to the trust. Alan may reduce his tax liability by taking the annual exclusion and applying part of his lifetime applicable credit for gift taxes. If his three daughters have Crummey powers to withdraw up to $5,000 each, no gift would occur upon creation of the trust.
Gift tax upon annual transfers - In each year Alan contributes cash to the trust to pay the premium, he will be responsible for paying a gift tax, unless Alan established Crummey powers for his daughters, in order to claim the annual exclusion on the gift. If Crummey powers were not used, Alan would draw on his remaining applicable exclusion amount each year to shelter the gifts from tax.
Income tax upon grantor's trust - Because the trust is unfunded, no income is distributed subject to income tax.
Estate tax upon grantor's death - At Alan's death, the life insurance policy will not go into his estate because he formed an irrevocable trust. Instead, the policy proceeds go straight to the trust without the need for court-supervision under the probate process.
|
Advantages |
Disadvantages |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Bob wants to provide for his 12-year-old nephew, Chris. His nephew will need financial support for medical expenses associated with his severe asthma, and eventually for college tuition costs. Bob has $800,000 he wants to give his nephew.
Should Bob give his nephew the $800,000 outright?
Most 12-year-olds, and some adults, would not be financially responsible enough to handle an $800,000 outright gift. Therefore, trusts provide an attractive option for the donor who wants to provide for a minor, but wants some supervision over the distribution of the funds.
Prior to the enactment of IRC 2503(c), individuals ran into a dilemma. The donor, having the same concerns as Bob, did not want to make an outright gift to a minor. However, unless the donor enacted the trust in a certain way, the tax advantages of making an outright gift would not be able to be claimed.
Therefore, Congress enacted the Internal Revenue Code provision, 2503(c), which provides guidelines for donors to use when forming a minor trust, while still retaining the tax advantages similar to making an outright gift.
The 2503(c) trust is a trust set up to provide income and property benefits to a minor for the period of his minority. The trust must meet the requirements of section 2503(c) in order to be eligible for advantageous tax treatment.
To minimize management responsibilities and asset mismanagement, gifts to minors are often made in trusts. A trust allows the minor to receive income or property, without giving the minor total control over the disposition and use of the assets.
The tax problem in setting up a trust to benefit a minor is that the transfer will fail to qualify for the annual exclusion, unless certain conditions are met. If you remember back to gift tax, the annual exclusion allows a donor to exclude up to $19,000 (in 2025) of gifts per donee, per year from gift taxation. For example, if a father makes a gift of $57,000 to each of his two sons ($114,000 total), he is only taxed on $76,000 [$114,000 total gifts - ($19,000 x 2) total exclusions].
The annual exclusion may only be claimed on present interest gifts. A present interest gift means: (1) the owner is entitled to immediate possession of the property, and (2) the transfer may not be subject to the will or contingencies of others.
If not properly structured, gifts to minors are classified as a transfer of a future interest, since the donee's use and enjoyment of the property may be subject to the trustee's discretion (subject to the will or contingencies of others).
Congress enacted Internal Revenue Code provision 2503(c) to provide donors with requirements a trust must meet to be categorized as a present interest gift.
Under 2503(c), gifts to minors are considered gifts of a present interest when the principal and income from the trust are subject to these requirements:
Principal and current income may be expended by, or for the benefit of, the minor before the minor reaches age 21
Principal and undistributed income will pass to the minor at age 21 or before
Principal and undistributed income are payable to the minor's estate or the minor's appointee under a general power of appointment, if the minor should die before the age of 21
Note: Various state law limitations placed on a minor's ability to exercise a power of appointment will not cause the gift to be denied present interest status. However, if the trust instrument places greater restrictions than does applicable state law, the gift will not satisfy the requirements of the Code for purposes of the exclusion.
Income during trust term—Normally, a trust will distribute income to a minor beneficiary to provide for his or her needs. To qualify under 2503(c), the trust must be expended for the benefit of a minor until he or she reaches the age of 21.
To receive the annual exclusion, the income distribution must not be limited to a specific purpose or subject to a substantial restriction. For example, the annual exclusion was disallowed where the trust income could be distributed by the trustee only for a minor's medical care.
Principal when beneficiary attains 21—The second requirement of a 2503(c) trust is for the trust property to pass to the minor upon the age of 21. If the minor should die before the age of 21, the property must pass to the donee's estate or to a person appointed by him under a general power of appointment.
The principal may remain in the trust after the minor reaches age 21, if the minor voluntarily consents to this. The annual exclusion is available in this case if the 21-year-old has a continuing or limited right to: (1) compel immediate distribution of the trust corpus by giving a written notice to the trustee, or (2) to permit the trust to continue on its own terms.
Click here for a graphic of how a 2503(c) trust works.
Donors and minor beneficiaries should be mindful of the income, gift and estate tax consequences of setting up a 2503(c) trust.
Gift tax annual exclusion—The donor of a 2503(c) trust may claim the gift tax annual exclusion on the transfer. The annual exclusion will shield the first $19,000 of a transfer from gift tax liability (in 2025). If the gift is of an amount exceeding $19,000, that sum will be subject to gift taxation, but the donor may draw on his or her applicable exclusion amount to shelter the gift from tax.
Income tax during trust term—Whether or not the income is distributed from the trust will determine who is responsible for payment. Income which is not distributed from the trust is taxable to the trust. On the other hand, income distributed from the trust will be taxed to the minor beneficiary. Distributed income will generally be taxed to the minor at his or her own income tax bracket. However, children under age 18 who receive unearned income will be subject to the "kiddie tax" on the income. Above a certain threshold amount ($2,700 for 2025), the child's unearned income is taxed at the parents' highest marginal tax rate.
Click here for an example of the "kiddie tax".
For example, if Chris, age 12, receives $2,800 in unearned income in 2025, he will be taxed on $100 at his parents' highest marginal tax rate, which could be as high as 37% (or more, if the 3.8% net investment income tax applies).
Estate tax if beneficiary or grantor dies—If the minor should die before reaching age 21, under 2503(c), the trust property must be payable to the minor's estate or to the minor's appointee under a general power of appointment. Generally, then the minor's estate will be subject to estate tax liability. However, a donor who serves as a trustee under 2503(c) trust risks having the principal of the trust included in his or her gross estate.
Compared to a custodianship under UTMA—To meet the requirements under 2503(c), the transfer of assets does not have to be made solely by a trust. A donor may provide for a minor under a custodianship, rather than a trust, and still claim the annual exclusion under 2503(c).
Custodianships are established under the Uniform Transfers to Minors Act (UTMA), which has been enacted in all but two states (Georgia and South Carolina have the Uniform Gift to Minors Act.) Under a custodianship, an adult custodian maintains charge or custody of the property for the minor. Under UTMA, the custodian has discretionary power to expend property for the minor's benefit without needing a court order to distribute the property.
A 2503(c) trust offers many advantages to donors who want to support a child financially, without giving the child total control over the assets. The following is a list of advantages and disadvantages associated with the trust.
|
Advantages |
Disadvantages |
|
|
|
Disclaimer
Copyright © 2025, Endowment Development Services, a PGI Partners Company, 921 East 86th Street, Suite 100, Indianapolis, Indiana 46240. All rights reserved.
This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any distributor is engaged in rendering legal, accounting, tax, investment, or other professional advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any distributor of this service shall be liable for any loss or damage caused or alleged to have been caused by the use or reliance upon this service.