June 23, 2022
Many Estate Plans rely upon a revocable trust as one of the foundational documents in the plan to avoid probate. Sometimes, plans include irrevocable trusts to achieve tax-driven results or for other reasons. No matter which kind of trust a client considers, of the many decisions that clients make when creating an Estate Plan, naming a trustee tops the list in importance. Clients often want to serve as trustee, usually to retain a degree of control over the assets placed in the trust. This second part of a three-part series will review certain trust provisions the retention of which could cause unfavorable income, gift, or estate tax consequences. The first part, How Do I Trust Thee…Part I, of the series focused on issues to consider in naming any individual as trustee, and the third part will explore the decision to name an entity to serve as trustee.
After clients create the basic documents in their Estate Plan, they begin to consider more advanced techniques, usually involving the use of irrevocable trusts. Many clients use irrevocable trusts to lower their potential estate tax liability. These same clients may want to ensure that the beneficiaries cannot retrieve the funds before their death or to prevent a beneficiary’s creditors from acquiring trust assets. Some even want assurances that they could access the funds, if necessary. In most circumstances, retaining too much power causes the gift to fail, resulting in estate tax inclusion thereby thwarting the original goal.
If a client creates an irrevocable trust to remove rapidly appreciating assets from his or her taxable estate, then any appreciation on those assets will escape taxation upon the client’s later death if the drafting attorney structures the trust correctly. If the trust gives the trustee the sole, unlimited, or absolute discretion to make distributions of income or principal to the beneficiaries, then the Internal Revenue Service (“IRS”) considers that an incomplete gift for gift tax purposes, and Internal Revenue Code (“Code”) Sections 2036(a)(2) and 2038 would pull those assets into the trustor’s estate if the trustor is the trustee. If, however, the estate planning attorney included the ascertainable standard of health, education, maintenance, or support (“HEMS”), then the IRS considers the gift complete and the assets outside of the grantor’s estate. If the trustor insists upon serving as trustee, any power to make distributions not limited by the HEMS standard needs to be exercisable by a trustee other than the trustor. As explained in more detail below, other trust powers could cause inclusion in the trustor’s estate if the trustor serves as trustee. For that reason, if the trustor desires to avoid estate tax inclusion above all else, then the trustor should name another individual to serve as trustee.
Related to Code Section 2036(a)(2), Code Section 2036(a)(1) includes assets in the trustor’s estate if the trustor makes a gift but retains the possession or enjoyment of, or the right to income from, the property. If the trust named the trustor as a permissible beneficiary of the trust and an independent trustee had the sole, unlimited, and absolute discretion to make distributions from the trust, then it seems that the trustor Ha avoided this Code Section. However, that’s not always the case. In many states, even if the trustor has named an independent trustee, acting in their sole, unlimited, and absolute discretion to make distributions to the trustor, that causes the inclusion of the trust assets in the grantor’s estate. Although a handful of states including Alaska, Colorado, Delaware, Missouri, Nevada, Rhode Island, and Utah have passed statutes that permit the grantor to be a discretionary beneficiary of a trust without causing estate tax inclusion, if there is an understanding regarding distributions to the trustor, then that could lead to estate tax inclusion. Even in these states and even absent an implied understanding regarding distributions to the trustor, the planner needs to follow the statutory requirements carefully, otherwise, the trust may not achieve the desired result.
By serving as trustee of an improperly drafted trust, the trustor could defeat that plan. This is the case even if the trustor is a co-trustee rather than the sole trustee, or if the trustor retains the power to veto power of distributions. Thus, it’s usually best for the trustor to refrain from serving as trustee unless the drafting attorney understands and explains the permissible exercise of power, includes the appropriate distribution standard, and sanitizes the trust of any power that could cause inclusion. However, most Estate Planners recommend that the Trustor name another individual to serve as Trustee to avoid any possibility of inclusion. Thankfully, the trustor need not ignore the office of trustee entirely. The trustor may retain the power to appoint a co-trustee or successor trustee without causing inclusion of the trust assets in the trustor’s estate upon death. In fact, according to Revenue Ruling 95-58, the trustor may even retain the right to remove a trustee and appoint a successor trustee not related or subordinate to the trustor within the meaning of Code Section 672(c).
Finally, if the trustor is not serving as trustee, the trustor needs to understand whether the trust contains powers to make it a grantor trust. If the trust contains certain powers that make it a grantor trust, then the grantor will be treated as the owner of the trust for income tax purposes and will need to include any trust income on their Form 1040. Certain powers, for example, the power to pay life insurance premiums, the power to add beneficiaries, or a charity, to the trust, and the power to substitute assets in a non-fiduciary capacity all-cause grantor trust status. Well-drafted trusts cause grantor trust status for income tax purposes but avoid estate tax inclusion for the trustor upon the trustor’s death and often serve as the base for advanced estate planning techniques.
Most clients understand the need for foundational documents and have less trouble deciding who should serve as trustee because that trustee will not serve as trustee until after the trustor’s death. Those clients who want to take advantage of tax planning and create irrevocable trusts during life inevitably want to name themselves as trustee. As this article demonstrates, a trustor needs to consider the purpose and the provisions of the trust to comprehend the potential income, gift, and estate tax consequences that could result from serving as trustee. Our qualified Estate Planning attorneys understand how much control the client can maintain while achieving the desired tax consequences.
Tereina Stidd, J.D., LL.M.