Introduction.
Wills and trusts are two of the most basic of the estate planner's tools, Virtually all estate plans involve a will, and many employ one or more trusts.
Table of Contents:
Discussion of Wills in General
A properly drafted will is the cornerstone of a person's estate plan. Without a will, an Individual's estate passes under a statutory scheme of descent and distribution, the provisions of which rarely accomplish the objectives of the estate owner. In contrast, a will allows the estate owner to make a precise, planned, and well-ordered distribution of property at his death. It allows the individual to provide for family protection according to the needs and varying situations of the family members. The will also allows the estate owner to appoint a qualified executor of his estate, broaden the estate representative's powers (and, therefore, the estate's nexibility), and lessen administration expenses. Further, significant estate tax savings can be achieved with a properly structured will.
The effect, validity, interpretation, and required form of execution of a will is determined under applicable state law. Accordingly, the legal effect of wills executed during the interval an estate owner might have been domiciled in another state should be carefully analyzed.
The type and complexity of the will required in a particular estate plan will depend on factors such as (1) the estate's size, (2) the nature of the property bequeathed, (3) the mode of property distribution (including whether trusts will be employed), and (4) the measures necessary to effect estate and other death tax savings.
In its most basic form, a will contains the necessary administrative provisions to effectuate the testator's intent and disposes of all property to the beneficiaries upon final distribution of the estate assets. If a decedent's estate will generate little or no estate tax liability, the basic will, coupled with sound estate tax planning with respect to assets that pass "outside" the will (such as jointly held property and proceeds of life insurance policies passing to named beneficiaries), may suit the testator's needs. However, if a larger estate tax liability is contemplated, more complex will arrangements (usually involving trusts) are often required.
Joint and Mutual Wills. Persons (usually married couples) having a common plan of testamentary disposition sometimes wish to effect the plan through the use of a joint or a mutual will. A joint will is a single will document that is legally sufficient to dispose of the property of each person at his or her death. A mutual will is a separate will executed by each of two persons under an agreement to dispose of property in a certain manner.
Although state law varies on the question of whether a joint or a mutual will can be changed without consent of both parties to the instrument, the general rule is that, once either of the parties to such a will dies, the other party is contractually bound to dispose of the property at his or her death according to the prearranged agreement. Because the arrangements may make it impossible to adjust the dispository plan to reflect changed circumstances (such as changed income requirements of a beneficiary or significant tax law changes), they are not recommended tools for estate planning.
A Concise Checklist for Drawing a Will
Will Provisions Which Minimize Estate Taxation.
In order to maximize estate tax savings, there are certain will provisions that every estate owner whose federal gross estate may be sufficiently large to generate estate tax liability should consider.
Provision Ensuring Marital Deduction
For many estate plans, the marital deduction produces the largest amount of estate tax savings. An unlimited marital deduction is available for property interests passing to a surviving spouse.
Survivorship and Order of Death Presumptions
If the combined value of an individual's gross estate and his or her spouse's federal estate (or, for that matter, the gross estate of any will beneficiary) is expected to be of sufficient size to subject either spouse to federal estate tax liability, consideration should be given to inclusion of a provision relating to survivorship in each spouse's will.
The first type of survivorship provision relates to death of the surviving spouse within a short period of time after the first spouse. Although the estate of the first spouse to die generally will avoid estate taxes on property passing to the surviving spouse (and, with respect to nonspouses, a credit for estate taxes paid on prior transfers will be available to the survivor's estate), such property may generate estate tax liability upon the second spouse's death. This liability can be avoided by a "simultaneous death" provision in each spouse's will that conditions all bequests upon the survival of the taker of the bequest for a specified time period after the original decedent's death, as illustrated in the following example:
Example 1:
Bob dies in 1998 leaving his spouse, Betty, his $700,000 gross estate. Betty dies three weeks thereafter, also in 1998, owning property (exclusive of the property owned by Bob at death) worth $700,000. Without a survivorship provision, as discussed above, Betty dies with a gross estate of $1,400,000. Because the marital deduction will not be available to pass the property to the children, an estate tax liability of $310,750 -$512,800 (tax on $1,400,000) - $202,050 (unified credit)) will be incurred.
Had Bob's will contained a provision that conditioned the bequest to Betty on her survival for 30 days after his death, each would have died with an estate tax liability of $27,750 ($229,800 (tax on $700,000) - $202,050 (unified credit)). The combined estate tax cost of transferring the $1,400,000 to their children would be $55,500-- $255,250 ($310,750 - $55,500) less than if the survivorship clause were not used. Additionally, the $700,000 bequest passing from Bob to Betty (in the absence of the survivorship clause) would increase Betty's estate settlement and probate costs.
Because a marital deduction will be denied if a survivorship provision conditions a bequest to a surviving spouse for a period in excess of six months, such provisions relating to spousal bequests should ordinarily not be of a greater duration. Survivorship provisions relating to nonspouses can be of greater duration, although it would probably result in additional probate costs if the provision is of a duration that would delay the closing of the decedent's estate.
Another type of survivorship provision, involving a presumption of the order of death between two persons (typically, married individuals) is often used. Such a will provision specifies the individual to be deemed to survive the other if they are killed in a common disaster of such a nature that the order of their deaths cannot be determined. A presumption-of-death provision of this type is designed to override the Uniform Simultaneous Death Act, which provides that, in instances where the order of death cannot be determined, the testator is deemed to survive the beneficiary. Although the Uniform Simultaneous Death Act provision avoids duplication of probate expenses by avoiding distribution of assets to the estate of another decedent, it also results in the loss of the marital deduction, which can lead to greater estate tax liability, as illustrated below.
Example 2:
Jack and Jill die in a common disaster in 1998, and the order of their deaths cannot be determined. Jack had a taxable estate of $100,000. Jill had a taxable estate of $625,000 and had exhausted her gift tax unified credit through lifetime gifts (that had not been joined in by Jack). Under the provisions of their wills, Jack and Jill each devise all property to each other, with all property to be divided among their three children upon the death of the survivor. Under the provisions of the Uniform Simultaneous Death Act, Jack would have no estate tax liability; Jill would have an estate tax liability of $202,050.
If, however, provisions in their wills specify that Jack is deemed to survive Jill in the event of a common disaster, their estates would be taxed as follows: Jill's $625,000 taxable estate passes estate tax-free to Jack by reason of the unlimited marital deduction. Upon receipt of this $625,000, Jack has a taxable estate at death of $725,000. Based on this amount, a tentative tax of $239,050 is computed.
After reduction of this amount by the amount of the unified credit available to Jack ($202,050, assuming he did not make any taxable lifetime gifts), Jack's estate must pay $37,000 in estate taxes. Thus, by inclusion of the survivorship presumption provision, $165,050 ($202,050 - $37,000) more of the estate passes to the children of Jack and Jill. This saving is made possible because the survivorship operates to make use of Jack's otherwise "wasted" unified transfer tax credit.
Before an order-of-death survivorship presumption or simultaneous death provision is inserted into a will, full consideration should be given, not only to the estate tax consequences, but also to all other relevant estate settlement charges that may be affected by the provision (such as state death taxes, probate costs, etc.). If spouses employ survivorship provisions, their separate wills must, of course, agree as to which spouse will be deemed to be the survivor.
A will clause that specifies the source of payment of the estate tax liability is probably advisable if only to avoid possible dispute among various will beneficiaries.
Estate planners are warned, however, that for wills or trusts that were created prior to September 12, 1981, and that contain a formula marital deduction clause, the unlimited marital deduction will not apply if
In order to effect an estate plan that employs a testamentary trust, the will must include a provision transferring the assets to the trust. To avoid possible dispute among beneficiaries, the provision making the bequest should clearly state that the transfer to the trustee is in trust for the benefit of the beneficiaries. Consideration must also be given to applicable state law with respect to any specific mandatory language required to make a testamentary disposition in trust.
In many situations, the estate plan may require, or at least benefit from, a trust or trusts. Although it is impossible to identify all the uses of a trust, in general terms, trusts are employed if the estate owner wants to have a person enjoy the benefits of an asset without the burdens of managing it. The beneficiary may lack the experience or mental or physical capacity to manage the trust. Trusts may also be used to limit an individual's (or his creditors) rights in the trust property. Trusts also have the advantage of providing for confidential disposition of assets. In contrast, upon admission to probate, a will is a public document.
As is the case in regard to wills, questions of operation, validity and interpretation of trusts are determined by applicable state law.
Estate Tax Treatment of Trusts
If there is a transfer of property to a trust within three years of death and the decedent had retained an interest in, or power over, the property so that it would be included in the gross estate because of retention of controls (i.e., those provisions listed in (3), above, with the exception of powers of appointment) or if there is a transfer of the proceeds of life insurance policies on the life of the decedent, then the value of the property is includible in the gross estate.
The value of trust property may also be includible in the settlor's gross estate if the trust agreement does not provide for disposition of the trust assets after termination. In such instance, state law may provide that the beneficial interest returns to the settlor.
Although lifetime transfers into trust can be excluded from the settlor's gross estate, they are still generally subject to gift tax. Despite the fact that, under the unified transfer tax system, lifetime gifts are cumulated with the assets included in the settlor's gross estate at death for purposes of computing his transfer tax liability, lifetime gifts can still sometimes result in estate tax savings in light of the annual gift tax exclusion.
In addition, with respect to property that is likely to appreciate in value or generate income during the settlor's lifetime, a lifetime gift will avoid estate tax on any appreciation occurring or income that is generated after the gift is made.
Generation-Skipping Transfer Tax
A tax is imposed upon the distribution of trust assets to a generation-skipping heir (i.e., a "skip person")-for example, a great-grandchild of the transferor--or upon the termination of an intervening interest in the trust--for example, the termination of an interest held by the transferor's grandchild. The tax is also imposed (except for transfers that do not come under the generation-skipping transfer tax provisions as revised under the Tax Reform Act of 1986 upon the outright transfer of property for the benefit of a generation-skipping beneficiary (i.e., direct skips).
All generation-skipping transfers are subject to tax at a flat rate equal to the product of the maximum estate tax rate (55 percent) and the "inclusion ratio" with respect to the transfer.
The former $250,000 grantor-grandchild exemption has been replaced with three new
exemptions: (1) a $1,000,000 per transferor exemption that can be allocated among several
generation-skipping transfers; (2) a special $2,000,000 per grandchild exemption for
direct skips made before 1990; and (3) an exemption that applies to a direct skip from a
grantor to a grandchild of the grantor when the grandchild's parent who is a lineal
descendant of the grantor is deceased.
Major Types of Trusts Used in Estate Planning
Many different types of trusts have been structured to accomplish the objectives of individual estate owners regarding the disposition and management of their property. Some of these trusts are tailored to take advantage of various provisions of the estate tax law; others exist despite adverse estate tax.
Irrevocable Living (Inter Vivos) Trust
An estate owner wishing to avoid taxation of property transferred into a trust in his gross estate must (unless the transfer would qualify for the unlimited marital deduction) make a lifetime transfer of the property to an irrevocable trust in which he retains no power to alter or vary its terms. This general rule does not apply to interspousal gifts and bequests that, by reason of the unlimited marital deduction, do not generate transfer tax liability.)
Although the settlor who transfers property into an irrevocable living (inter vivos) trust incurs gift tax liability or reduction of the amount of his available unified credit to the extent that the transfer into trust is not shielded by the gift tax annual exclusion, post-transfer income and appreciation in value is not taxed to the settlor during lifetime, or at his death-clearly a major estate tax advantage.
Another advantage of the irrevocable living trust is the possible probate and miscellaneous estate settlement savings. Because assets transferred into the trust are not part of the settlor's probate estate :(nor do they in any way come under the control of the estate executor), the assets do not generate additional probate or other estate settlement expenses such as executors' and attorneys' fees. Although setting up an irrevocable trust usually involves legal expenses and trustees' fees, these costs are not likely to be as high as those involved in probate.
As is the case generally with respect to trusts, an irrevocable living trust offers the opportunity for professional asset management and investment.
Despite the estate tax advantages that may be derived from the use of the irrevocable lifetime trust, it is a device that must be used with caution. Use of irrevocable trusts for the benefit of a surviving spouse will generally not be indicated as a transfer tax savings device. Availability of the unlimited estate and gift tax marital deductions means that a transfer to an irrevocable trust for the benefit of a spouse will not produce more transfer tax savings than a transfer at death made via a revocable trust. Also, the factors that generate the tax savings features of these trusts between non-spouses-irrevocability and lack of control on the part of the settlor--can cause hardship to the settlor and his intended beneficiaries.
On the one hand, unanticipated financial reverses to the settlor or members of his family occurring after creation of the trust may mean that the settlor or his family may be forced to change their lifestyle because the trust assets are beyond their reach. On the other hand, family situations and relationships may change after the trust is created. A divorce situation may arise. A member of the family may come to require more money than can be provided without change in the trust provision. Any number of changed circumstances may occur retroactively to make the irrevocable transfer into the trust unwise.
Thus, before opting for the estate tax advantages possible with an irrevocable lifetime trust, prudence demands that the estate owner be certain that the assets transferred to the trust will not be needed for other purposes and that the family relationships and concerns underlying the trust arrangement are stable.
Revocable Living (Inter Vivos) Trust
In contrast to the irrevocable living trust, the revocable living trust is generally not an estate tax savings device. Although a revocable living trust may save probate costs and related expenses, the fact that the settlor retains the right to revoke it causes the trust assets to be included in the settlor's gross estate at their date-of-death value (or alternate valuation) under the rules relating to transfers with retained life estates, transfers taking effect at death and so-called revocable transfers.
A testamentary trust is a trust created by the settlor's will. Because the settlor retains the assets until their transfer into trust at his death, the value of the trust assets is includible in the settlor's gross estate.
Although the testamentary trust will not diminish the settlor's estate tax liability (except to the extent that it serves to effect a marital deduction bequest), it can confer lifetime benefits,without estate tax cost, to the beneficiaries. Under such an arrangement the senior transfers property into a trust that gives a life income interest to one beneficiary and the remainder interest to other beneficiaries. Because the life income beneficiary would not have an interest in the trust assets at his death, his lifetime right to income would not give rise to estate tax liability.
Lifetime income rights in testamentary trusts are frequently used with "non-marital" interests conferred to a spouse in conjunction with an interest in another trust that qualifies for the marital deduction.
A grantor trust is generally used when planning a person's will and distribution of an estate. A grantor trust is a specific type of trust that allows the person who creates the trust (grantor) to control the assets in the trust and recognize income generated by the trust. This type of trust is also referred to as a revocable, living, or inter-vivos trust. Assets held in a grantor trust are not subject to the probate process because at the death of the grantor, the trust is considered a separate legal entity. Therefore, beneficiaries have immediate access to the trust assets.
A grantor trust is a trust to which a grantor has transferred property and retained certain powers or interests such that the grantor is treated as the owner of the trust for federal income tax purposes under the so-called "grantor trust provisions." As a result, the income and deductions attributable to that trust are included directly in the computation of the grantor's taxable income.
The grantor trust rules have been expanded so that the income of such a trust also is generally taxed to its grantor if the trust corpus will revert to either the grantor or (1) the grantor's spouse if that spouse is living with the grantor at the time the property is transferred to the trust, or (2) a spouse who marries the grantor after creation of the power or interest, but only with respect to periods after the individual becomes the spouse of the grantor. Individuals are not considered married for these purposes if they are legally separated under a decree of divorce or separate maintenance. A grantor is considered the owner of any portion of a trust in which he has a reversionary interest in either the trust corpus or the income if the value of the reversionary interest exceeds five percent of the value of that portion of the trust. The value of the reversionary interest is measured as of the inception of the portion of the trust in which the grantor holds an interest. However, a grantor is exempt from this rule if he retains a reversionary interest that takes effect only upon the death of a minor lineal descendant (under age 21). In order for this exception to be applicable, the beneficiary must have the entire present interest in the trust or a trust portion.
For tax planning purposes, the repeal of the l0-year (Clifford ) trust exception to the grantor trust rules has greatly curtailed the advantages of using grantor trusts. However, the use of a trust that avoids classification as a grantor trust because the reversionary interest either is less than five percent of the value of the transferred property or takes effect only upon the death of a minor lineal descendant under age 21 (see above) may still provide some tax advantages. For estate tax purposes, any trust income that is paid to a beneficiary is excluded from the grantor's estate. For income tax purposes, income-splitting among family members may still be accomplished. However, besides the fact that the grantor must not retain greater than the five-percent reversionary interest, it should be noted that intra-family transfers of income-producing property can no longer be used to reduce income tax liability by shifting income ~om the parents' high marginal tax rate to the generally lower tax bracket of a child under 14 years of age. Instead, a child's net unearned income in excess of $700, reduced by the child's standard or itemized deductions allocated to-such income, is subject to tax at the top marginal rate of his parents. Since the applicable standard deduction is generally limited to $700, unearned income of a minor child in excess of $1,400 is taxed at the parents' rates in 1995.
A "pour-over" trust is a lifetime trust that receives assets passed through a will or assets from other sources. Pour-over trusts are frequently used to collect and manage the proceeds of insurance policies and/or employee benefits. Such a trust allows effective management, investment, and distribution of diverse assets.
Whether a pour-over trust will generate estate tax savings will depend upon whether it is revocable or irrevocable and upon whether it is funded (such as with the right to receive the proceeds of life insurance policies transferred to it) or whether it collects its assets under the settlor's will. In the latter case, the settlor does not avoid estate tax liability because the assets would be owned by him at death.
Life Insurance Trusts. Special problems arise in connection with trusts if life insurance policies are part of the assets or are the only assets. Under a life insurance trust, the trustee agrees either merely to receive and administer the proceeds of life insurance policies after the death of the insured or to perform these duties after first acting during the insured's lifetime as trustee of the rights of the insured in the policies and in any other property made subject to the trusts. The trust may be created to implement a business purchase agreement or for the benefit of individual beneficiaries with no business interest being involved.
The business life insurance trust adapts life insurance to business purposes. The business life insurance trust is the ordinary arrangement for retirement of business interests through the use of life insurance. A "buy-sell" agreement is one kind of business transaction that can be funded with the proceeds of a life insurance policy. The life insurance policy proceeds are typically made payable to a trustee who collects and distributes the proceeds in accordance with the directions of the trust agreement Sometimes the trustee also monitors the payment of premiums to discourage discontinuance and to preserve the trust.
Estate shrinkage may frequently be lessened through use of the trust device. Thus, the trust estate, consisting of the insurance proceeds, passes to the beneficiary at the death of the creator of the trust under the terms of a trust agreement executed during the creator's life. The trust agreement, being effective at the time of its execution, does not pass under will and is not, in ordinary circumstances, a part of the deceased's estate subject to probate and administration costs. Moreover, various tax savings are possible under the trust arrangement.
Funded Personal Insurance Trust
The funded personal insurance trust provides an excellent means of restoring funds lost as a result of the payment of death taxes and administration expenses. In one form, this involves the use of some of the trust income to purchase insurance on the life of the settlor's spouse. Then, upon the death of the spouse, the insurance proceeds, representing both an accumulation of income and the natural increase resulting under insurance contracts, will serve to restore funds distributed in payment for death taxes and expenses upon the death of the settlor. State statutes, if any, against accumulations must be examined before such trusts are created. In many instances, however, it will be found that income, if any, can be used for the purchase of insurance even though it cannot be accumulated for other purposes.
Life insurance trusts are funded or unfunded on the basis of the manner in which premium payments are met. These classes are subdivided into partly Funded, fully funded, and investment trusts.
1. The funded trust (the fully funded trust) sets up a fund to ensure the payment of the premiums on the policies of insurance. This fund, ordinarily composed of securities, provides an income during the life of the creator of the trust that the trustee applies to meet the premiums on the insurance policies supporting the life insurance trust plan. The~cnded trust is a "living" trust combined with the life insurance trust arrangement. It is essential, however, to check state laws restricting the accumulation of income when the parties desire to fund their business life insurance agreement.
2. The unfunded trust may be revocable or irrevocable, and makes no provision for premium payment by the trustee, who serves merely as depositary for the policies.
3. The investment or partly funded trust is a practical arrangement to ensure greater protection against premium lapses when the parties ~nd complete funding of the trust impractical. The creator of an investment trust periodically deposits' C~ish or securities, a portion of which is applied to the payment of premiums on the insurance policies, whose proceeds are handled and distributed as one trust fund on the death of the creator of the trust. Any surplus remaining after premiums are met is accumulated in a second trust fund until the death of the creator of the trust, when the surplus is distributed under the terms of a second trust agreement.
When the creator of a trust authorizes or directs the trustee to purchase insurance on the creator's life and pay the premiums out of trust funds, the trust income constitutes taxable income to the creator. In such a case, the creator is merely directing the trustee to do what he himself might ordinarily do.
On the other hand, if the creator of a trust grants general and broad investment powers to the trustee, the latter can, of his own volition and in his duty as trustee, purchase insurance as a form of trust investment. Then, if the trustee does invest in insurance and the premiums are paid out of trust corpus, they are not taxable to the settlor even though the insurance may be on his own life.
In many states, statutes have been enacted specifically authorizing trustees and guardians to invest trust funds in forms of insurance contracts so that express direction for the investments need not be included in the trust. These statutes should be kept in mind, therefore, when an insurance or ordinary trust is being drafted. These particular features in each law should be observed: whether trust income or corpus may be used to purchase the insurance and pay the premiums; whether the trust beneficiary must be a minor or may be an adult, in order for the fiduciary to be permitted to purchase insurance; whether the insured must be the trust beneficiary or may be the creator of the trust or his spouse; and whether the specific statute grants authority to purchase insurance to trustees or only to guardians of miners and incompetents.
While some states have enacted statutes specifically authorizing trustees and guardians to invest in life insurance contracts, in other states, trustees may, nevertheless, be authorized to invest in insurance or annuity contracts under the more general investment laws in effect in the particular state. For example, a statute that adopts the prudent man rule concerning investments is likely to permit the purchase of insurance.
In setting up an insurance trust, whether personal or business, the method of best distributing the proceeds is of great concern. Should the proceeds be left with the life insurance companies and distributed under the available settlement options? Or is it more advantageous to have the proceeds paid to a corporate trustee and administered under a trust agreement in accordance with directions set forth by the insured during his lifetime?
Both methods have their advantages and disadvantages, and the problems of the insured and his beneficiaries must be carefully analyzed before definite steps are taken. Among the necessary considerations are:
The answers to these questions will aid in deciding whether the proceeds should be distributed directly from the life insurance companies or through a corporate trustee under a written trust agreement.
There are ordinarily four options for settlement of proceeds in a life insurance policy (although companies will sometimes enter into special agreements), as follows:
The marital deduction provides the means of avoiding the assessment of a tax on a part of one's estate at the time of death. As to that part, it postpones assessment of the tax until the death of the surviving spouse. On the other hand, a trust that does not qualify for the marital deduction at the death of the donor or testator can, given careful planning, escape a second tax upon the death of a primary beneficiary.
Either way, one can benefit two generations with but a single exposure to death tax liability. The unlimited marital deduction can reduce taxes on the first transfer, whether the transfer is in trust or otherwise. A nonmarital deduction trust, while taxable in the first estate, can be set up to avoid exposure to estate taxes upon the death of a life beneficiary. Thus, not only is the frequency of taxing reduced, but, in addition, each tax that is imposed is imposed at a lower rate because it falls on a smaller taxable estate.
The use of the trust as a means of taking advantage of the marital deduction greatly increases the probability that the trust corpus will not be dissipated before being received by the next generation. Further, the use of a power of appointment in conjunction with such a trust may often result in state death tax savings upon the death of the life beneficiary while, at the same time, providing the means for quickly meeting any financial emergency.
When a surviving spouse is the beneficiary and donee of a power of appointment with respect to a marital deduction trust, another trust, with remainders over to children or others, can be used to increase the income available to the surviving spouse. A "qualified terminable interest property" (popularly known as a QTIP) trust may also be used to provide the surviving spouse with an income interest, while retaining for the testator the power to control the disposition of the trust property at the surviving spouse's death.
Usefulness of the trust for marital deduction purposes stems from the marital deduction philosophy that any property that is deducted from the gross estate of the first spouse to die must be transferred in a manner requiring inclusion in the estate of the surviving spouse unless he or she has already disposed of it. When the property is transferred in trust, however, even though the surviving spouse is given all the rights necessary to make the trust qualify for the marital deduction, there is a substantial probability that the trust corpus will remain intact for the lifetime of the surviving spouse. This probability can be further increased if a power of appointment can be exercised only in favor of the estate of the surviving spouse and if a QTIP trust is used.
It is even possible to give a life interest in trust to one's parent to precede a remainder interest in one's spouse, thus taking advantage of the marital deduction while still accomplishing another important purpose.
Effect of Lifetime Gifts in Trust
Trusts created during an estate owner's lifetime can provide the means of transferring the income from the trust property from the settlor's high bracket to the lower bracket of the recipient's income. ~is income tax saving is eliminated if the grantor's spouse is the beneficiary of the trust.) However, if the beneficiary of the trust is a child of the grantor and is under 14 years of age, trust income generally in excess of $1,400 is taxed to the child at the grantor parent's top marginal rate. Testamentary trusts are used for any of several purposes. They should, however, be considered carefully in the light of any trusts created during the grantor's lifetime.
Whenever a person creates a trust during his lifetime, it is necessary to reexamine his will. Since transfers made before death generally are not taxed in a decedent's gross estate, there need be no hesitancy in most instances about changing a will to correspond with the creation of an inter vivos trust. .
How a trust is funded in a given instance depends upon all the circumstances, and upon the purposes of its creation. The trust may be created in a manner designed primarily to benefit the income bene~ciary or primarily to benefit the remaindermen. It may be created primarily to keep certain assets intact. Sometimes it is used to make certain that other transactions are properly carried out.
Even if the income beneficiary is the settlor's primary concern, the size of the trust corpus affects the investment policy. The larger the trust corpus, the more conservative the policy to be followed, because the larger the trust, the smaller the yield necessary to achieve a desired result.
Assuming that cash is transferred to the trustee, the settlor may leave the investment of the transferred funds to the discretion of the trustee, or may himself dictate the investment policy to be followed. If he leaves investment to the trustee, without further provision, the trustee's discretion will be limited by investment policies prescribed by the laws of his state or by court decision. The settlor may, however, extend the discretionary powers of the trustee by authorizing the trustee to invest in securities other than those prescribed by law, by directing that a preference be given to certain types of securities, or by providing for investment in real estate or insurance.
If the settlor transfers property other than money to the trust, he may direct the
trustee to keep the property intact or he may authorize or direct the sale of the property
and the substitution of other properties. On the other hand, he may merely authorize the
trustee to retain the property transferred, while, at the same time, authorizing
investments just as though money had been transferred.
Sometimes the property transferred to the trust is non-income producing property that the
settlor wishes kept intact. In such instances, if the trust is expected to be used for the
marital deduction purposes, the regulations governing that deduction should be examined.
Persons or corporations who act regularly in a trust capacity are well aware of the types of investments in which the laws of their particular state permit them to invest. The type of property transferred in trust is largely a matter for the -settlor to determine after discussing his goals with his advisers.
Selection of Beneficiaries. If the trust being created is a marital deduction trust, the primary beneficiary is, of course, the settlor's spouse. In such trusts, the settlor cannot control the disposition of the funds beyond the time of the spouse's death. He can, however, include provisions that will guide disposition of the remainders. This guidance is usually provided by giving the spouse a power of appointment while, at the same time, providing for the transfer to designated persons in the event the power should not be exercised. By so doing, he makes it necessary for the surviving spouse to take positive action to change the course of the disposition.
If the trust is not a marital deduction trust, the settlor can choose to benefit almost anyone he sees fit, and in almost any manner he wishes. He is, of course, limited by the restrictions against perpetuities, accumulations, and voting trusts and, if the beneficiaries are members of younger generations, by the generation-skipping transfer tax rules. He can create separate trusts for each beneficiary or set up one trust and provide for each beneficiary to have a specified share in the income or remainder. Frequently, he may wish to provide for some disposition to charity, which is governed by special rules.
If trust income or corpus may be applied to discharge the settlor's legal obligations, actual distributions in discharge of the obligation are taxable to the settlor. However, the power to use corpus or income to provide support for persons the settlor is legally obligated to support will cause taxation of the trust in the settlor's gross estate only if it is exercisable by him. Thus, discretion in a third-party trustee to distribute for any purpose would avoid an estate tax.
Having selected the persons who are to benefit from a trust, the settlor can provide a number of different types of benefits of varying durations. He may provide:
Interests in the trust remainders may be created to vest after one life or two lives or even more, provided they do not violate the state's rule against perpetuities. The interests may be vested or contingent. The contingencies may be based upon any of a variety of events.
A settlor may protect a beneficiary against his own follies by setting up the trust in such a manner as to prevent alienation of funds either by the beneficiary or by his creditors, i.e., the so called spendthrift clause. The extent to which he may prevent the alienation is prescribed by statute or court decisions in the state whose laws will govern the trust.
Sometimes the settlor is more concerned with the future than with the present, as, for instance, when a beneficiary is a minor. In these instances, provisions made for accumulations of income for specified periods, such periods, however, being limited by statutes against accumulations.
Estate Tax Exclusion for Qualified Benefit Plans
Individuals who are weighing the estate tax consequences of their retirement plans that are administered by an underlying trust instrument should be aware that, for the estates of decedents dying after 1984 who were (1) participants in,any plan, (2) in pay status on December 31, 1984, or who separated from service before 1985, and (3) had irrevocably elected the form of benefit before July 18, 1984, an estate tax exclusion of up to $100,000 is available for benefits payable to a beneficiary (other than the executor) of a deceased employee under a qualified plan (pension, profit-sharing, etc.), a tax-sheltered annuity, an individual retirement arrangement (IRA), or certain military retirement plans. For all other decedents dying after 1984, generally, there is no estate tax exclusion for payments from qualified benefits plans.
Remainder Interest Payable to Charity
If a remainder interest is payable to a charity, care must be taken in giving to an income beneficiary rights to invade principal. If the right to invade principal is not sufficiently limited, or if rights of the income beneficiary are not adequately described, the charitable deduction for the remainder interest may be lost.
Income Interest Payable to Charity
To be deductible, a charitable contribution of an income interest in a trust must -be in the form of a guaranteed annuity or the right to an annual distribution of a fixed percentage of the fair market value of the trust assets, i.e., a unitrust interest. Moreover, if the income interest is a unitrust interest, it cannot be delayed but must begin upon the death of the decedent and cannot be preceded by another unitrust interest held by a member of the decedent's family or other private entity. However, at least one estate has successfully challenged this timing regulation as an impermissible extension of the relevant statute and has established its right to a charitable deduction for the devise of a unitrust interest, even though the interest was preceded by another unitrust interest that was devised to the decedent's spouse To the IRS subsequently acquiesced in that case, but in result only.) Also, the IRS General Counsel has recommended that the regulation be modified to permit a charitable deduction for the present value of a unitrust interest passing to charity, even where this interest follows a private unitrust interest .
