Many of our firm’s estate planning strategies focus on the use of long term planning techniques designed to maximize protection of family wealth and the potential for tax-free transfers of wealth to successive generations. Strategic lifetime gifting of assets has, for many years, been an integral part of these plans. Most of this gifting has been outright gifts to family members. However, as the amounts being transferred by gift have increased and the concern over long term asset protection planning has grown, we have developed new planning techniques to reflect these developments. Our most recent planning development has been creating Family Gift Trusts. This article explores the significant issues surrounding the use of these trusts.
WHAT IS A FAMILY GIFT TRUST?
A Family Gift Trust (FGT) is a separate legal entity that is designed to receive and hold gifts of property. The beneficiaries are usually family members of the Donor, but can be other persons if desired. The terms of the trust are set forth in a document that describes how the trust property is to be invested and distributed. The gifts are primarily made to achieve the estate planning goals of the Donor. The Donor is the person who creates the trust and makes gifts to the trust. The Trustee is the person who agrees to run the trust for the benefit of the trust’s beneficiaries and is named in the trust document. This type of trust is an irrevocable trust.
WHY ARE GIFTS MADE?
The primary tax reason for making gifts is to reduce the taxable estate of the Donor. The gift and any future appreciation in the value of the gift are removed from the Donor’s taxable estate. Secondary reasons for making these gifts include satisfying the Donor’s desire to: see children and grandchildren benefit during the Donor’s lifetime; see how the beneficiaries handle an “inheritance”; provide funds for an education for grandchildren in situations where the student’s parents might not be in a position to fund that education.
WHY ARE THE GIFTS MADE TO A TRUST?
Gifts are made to a Family Gift Trust (FGT) to obtain benefits not available if the property is given outright to a person. This is important for achieving goals such as asset protection planning, tax savings and equalization among family members. These benefits are discussed in more detail later in this article. A trust can be very useful for accelerating annual exclusion gifts in order to quickly diminish a taxable estate.
HOW MUCH CAN BE GIFTED EACH YEAR?
The federal gift tax law provides that every person can give a present interest gift of up to $14,000 each year to any individual they want. This means that each parent can each give each of their children and grandchildren $14,000 (two parents permits a total gift per recipient of $28,000). These gifts are called annual exclusion gifts and they are totally excluded from the gift tax system.
Also, during a person’s lifetime or at death, each person can give an amount that is equal to the Applicable Exclusion Amount for lifetime gifts. In 2014, this amount is $5,340,000. This is the total amount that can be given away without the payment of any gift or estate taxes, in addition to annual exclusion gifts discussed above.
In some cases, the Donor will use up this entire lifetime gift exclusion amount during his lifetime with a large gift to a FGT (instead of waiting until the Donor’s death). The purpose of this lifetime gift is to leverage the use of the exclusion amount by removing all of the growth of the gifted property from the date of the gift to the Donor’s death from the Donor’s taxable estate. This, however, is only done in certain situations after careful discussion and analysis.
Gifts that are in excess of the available annual exclusions and lifetime applicable exclusion are subject to gift tax. There may even be instances where the payment of a gift tax is desired to take advantage of the different way that the gift tax and the estate tax is calculated on property owned by a Donor! Again, this is undertaken only after counseled deliberation. Contact either John Tullio or Lindsey Smith for more details on this matter.
WHO CAN BE THE TRUST BENEFICIARIES?
Usually, the beneficiaries are the members of the Donor’s family. However, there is no requirement that they are family members and the Donor can include as beneficiaries anyone he or she wants.
CAN A SPOUSE OF THE DONOR BE A BENEFICIARY OF THE TRUST?
Yes, and there are potential distinct advantages to this such as the ability to continue to remove assets from both the Donor’s estate and from the surviving spouse’s estate. Several things need to be kept in mind, however. The gift to the trust must be from a separate account in the name of the Donor only. If the gift is made from a joint account it will not be effective because it will be treated as being made by the spouse as well. Further, while there is an unlimited marital deduction for gifts to spouse (any amount can be given to a spouse gift tax free), for tax reasons, we need to separately analyze how much should be gifted to the trust for a spouse.
WHAT ARE THE MECHANICS OF SETTING UP AND OPERATING THE TRUST?
These are the important steps that need to be performed after the irrevocable trust agreement is signed:
- A separate trust is set up for each trust beneficiary (and the beneficiaries issue) and this share will have its own federal tax identification number. The Trustee will sign a separate application for a tax number for each beneficiary’s trust. This form is filed with the IRS, who assigns the tax id number.
- The Trustee will set up an investment account for each trust beneficiary and allocate to that account a portion of the property given to the trust (in accordance with instructions contained in the trust). This property needs to be invested in a prudent manner by the Trustee. Investment related issues are discussed later in this memorandum.
- Upon receiving the gift, the Trustee sends a letter to each beneficiary advising them of the gift and their right to withdraw it for a limited time. In order to qualify each gift as annual exclusion gifts, the beneficiaries must be aware of the gift to the trust and must have a right to withdraw the gift, even if for a limited period of time. This is the reason for the notification letter to the beneficiaries (sometimes called a “Crummey” letter after the man who presented the idea to the IRS for approval). A sample letter for gifts to adults and to minors is attached to the end of this memorandum. If a beneficiary is a minor, the letter is addressed to his parent. If the parent is also the Trustee, a gift letter is not required.
- The Trustee is to keep a copy of each letter that is sent. This is to prove that the beneficiaries were notified of the gift and their right of withdrawal, in the event there is an audit by the IRS.
- The Trustee may make distributions of the trust share of each beneficiary to such beneficiary in accordance with the instructions contained in the trust. Generally, distributions can be made for the beneficiary’s support, health care and/or educational needs.
WHAT IS THE NAME OF THE TRUST FOR EACH BENEFICIARY?
This is the format for the name of each separate trust:
Name of person acting as Trustee, Trustee of Name of Donor Family Trust dated Date trust signed (x/x/xx) fbo Name of child, grandchild or other beneficiary
“fbo” means “for the benefit of.”
Frequently, a child of the Donor will be the Trustee of his own share and also will be the Trustee for any separate shares established for such child’s children. This does not always occur and someone else may be named as Trustee for various reasons. The Donor may even choose to serve as Trustee, but the Trust has to be specially drafted to also preclude the trust assets from being included in the Donor’s gross estate (subject to tax) at death
WILL THERE BE GIFTS EACH YEAR?
The frequency of gifts will be determined by the Donor. There is no requirement that there be any gifts. Further, a Donor can make gifts to one beneficiary and not to any others. The Donor may elect to make gifts one year, and then not make gifts the succeeding year.
CAN PEOPLE OTHER THAN THE DONORS MAKE GIFTS?
Yes, but this must be discussed with us before this is done. A beneficiary can neither make a gift to a trust held for his/her benefit nor to a trust of which he/she is Trustee.
WHAT ARE THE BENEFITS OF RECEIVING GIFTS THROUGH A TRUST?
These are the most important reasons:
- The trust property will be protected from the claims of creditors of the beneficiary. If the beneficiary runs into financial problems, causes an accident or is otherwise liable, the creditors will be unable to reach the trust assets.
- If a beneficiary gets divorced, the gift to the trust is not subject to division in a divorce proceeding. This is because the gift is “separate property”, not “marital property” that would be subject to division.
- If a beneficiary becomes incapacitated, the trust property will be controlled by the trust and expensive, time consuming guardianship proceedings will be avoided as to the property in the trust.
- There is an opportunity to manage distributions to minimize income taxes. Examples are in select circumstances using the initial lower tax brackets of the trust versus those of the beneficiary and avoiding the “kiddie tax” on distributions to beneficiaries who are fourteen or less.
- There will be no probate administration of trust property. The trust contains instructions directing who the next beneficiaries are in the event of a beneficiary’s death and the terms under which they receive distributions.
- Quite likely, all or a significant portion of the trust assets will not be in the estate of the deceased beneficiary for estate tax purposes.
- There can be a cohesive, professional investment program put into place by the Trustee and the trust investment advisor.
WHEN AND HOW ARE DISTRIBUTIONS MADE FROM THE TRUST?
The trust document contains specific instructions as to when distributions to the beneficiaries can be made. The Trustee has the discretion to determine when trust property is to be distributed. The primary reasons, typically, are to provide for the beneficiary’s health, support, maintenance and education. The trust may limit distributions to any one or more of those standards, and may have other provisions reflecting special issues for particular beneficiaries.
The Trustee may consult with the Donor before making distributions from the trust (but this is not required). For pure tax planning considerations, generally it is not anticipated that any distributions will be made from the trust during the Donor’s life. However, distributions for education for a grandchild, or for a down payment on a home for a child, are just two examples of exceptions to this general statement.
HOW IS THE INCOME OF THE TRUST TAXED?
Each trust held for a beneficiary is a separate taxable entity. All income, gains and losses are taxed to the trust unless the trust makes distributions. To the extent that the trust distributes property, it is first (a) income to the extent the trust has income, then (b) capital gains to the extent the trust has capital gains, next (c) non-taxable income to the extent the trust has non-taxable income and finally (d) any remaining portion of the distribution is a non-taxable distribution of principal.
If a beneficiary receives the distribution, the beneficiary treats the distribution in the same manner as the trust: income, then capital gains, etc.
Because trust marginal income tax rates get to the higher brackets much quicker than the individual income tax rates, it is common for Trustees to make distributions to the beneficiaries to save on income taxes. However, this is a question that should be reviewed periodically either with us or the tax accountant. There are other considerations that may play into the decision-making.
ARE THERE ALTERNATIVES TO HOW TRUST INCOME IS TAXED?
Yes. Family Gift Trusts can be structured so that the person creating the trust (the Donor but also frequently called the Grantor), is treated as the owner of the trust for income tax purposes. This makes the trust a “defective” grantor trust. It is defective in the sense that the grantor is treated as the owner of the trust for income tax purposes only and is not treated as the owner for any other reason, including determining federal estate taxes. It is an anomaly in the Internal Revenue Code that allows this to happen.
A second choice is for the beneficiary of the trust to be treated as the owner of the trust for income tax purposes while the trust remains the owner for all other purposes such as for asset protection planning, exclusion from the taxable estate of the beneficiary and other valuable reasons. Distributions of income and capital gains are not required to cause them to be taxable to the beneficiary, although funds can be distributed if the beneficiary needs them to pay the taxes. We call this a defective beneficiary trust.
WHY WOULD THESE OPTIONS FOR TAXING TRUST INCOME BE CONSIDERED?
As to treating the grantor of the trust as the owner for income tax purposes, it means that more assets are building up in the trust for the beneficiaries because the trust principal is not reduced by the payment of income taxes. Where estate tax planning is an issue for the Donor, dollars spent by the Donor paying the income taxes of the trust are from assets that would otherwise be includible in his taxable estate.
There are different reasons for setting up the trust to be a defective beneficiary trust. Usually, the beneficiary is in a lower tax bracket than the Donor or the trust so this manages income tax rates. However, the beneficiary is not required to take out the income which eliminates the need to manage tax issues by distributing income and gains to the beneficiary to avoid the high tax rates of trusts and triggering the Net Investment Income tax on gains. This feature allows the beneficiary to leave more assets in the trust that are subject to the asset protection features that trust ownership provides.
IS IT RECOMMENDED THAT THE TRUSTEE USE AN INVESTMENT ADVISOR?
Yes. The person used should be familiar with the tax issues and opportunities that are presented when investing assets in a FGT and with the fact that the FGT is only one component of a sophisticated estate plan. This is because investment strategy is impacted by the fact that the investments are held in a trust, which is subject to the highest income tax rates at a low threshold. In 2014, income over $12,100 is taxed at the highest federal income taxes. Also, the new Net Investment Income tax kicks in at $12,100 instead of the substantially higher amounts for individuals. It is also affected by estate planning factors.
We recommend consulting with an investment advisor who is familiar with these issues. It is particularly helpful to use the Donor’s investment advisor as he has been involved in the overall estate plan and can integrate the investment planning for the FGT into his overall investment strategy.
The trust agreement explicitly allows the Trustee to use the services of an investment expert. If a recommendation is needed for a financial advisor who is familiar with investing assets in FGTs, we can provide the Trustee with names of skilled advisors he can interview.
SHOULD AN ACCOUNTANT BE INVOLVED?
Engaging a qualified accountant familiar with tax planning matters and fiduciary returns is advisable. This person can help insure that the greatest income tax advantages are being accomplished. If you need the name of a qualified person, please discuss this with us, John Tullio or Lindsey Smith. We also suggest that you give this person a copy of this memorandum and advise him that he should contact us if he has any questions.
The tax accountant can prepare the income tax return for each trust. This is not a complex return for a skilled professional and it is important that this be done each year and correctly.
DOES THE TRUSTEE NEED TO SPEAK WITH CAVITCH?We understand that reading this memorandum is, in many cases, not enough. It is advisable that we have at least a telephone conversation with the Trustee after he or she has reviewed this memorandum. If the Trustee wants to meet with us in person, they should call to set up an appointment. This service is part of the agreement that we have with the Donor and is covered in our fees.
We expect that there will be periodic reviews of the estate plan by the Donor at which time we will also review the operation and performance of any Family Gift Trusts and make suggestions and recommendations. At any time, Trustees of Family Gift Trusts may contact us with questions or concerns that they may have. Just use these links to find contact information for John Tullio or Lindsey Smith.
SOME FINAL THOUGHTS
This memorandum focuses on the important questions and considerations concerning FGTs. Our development of this planning technique is part of our continuing efforts to bring to our clients and their families advanced planning strategies designed to maximize and protect family wealth.
Cavitch, Familo & Durkin Co., L.P.A.
Attorneys at Law