intentionally defective grantor trusts: asset transfer...

Intentionally Defective Grantor Trusts: Asset Transfer Planning Strategies and Form 1041 and 1099 Reporting Compliance

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JUNE 25, 2014

Presenting a live 110-minute teleconference with interactive Q&A

Lawrence M. Lipoff, Consultant, Friedman LLP, New York, N.Y.

Donna J. Jackson, Attorney, Donna J. Jackson, Attorney at Law, Oklahoma City, Okla.

Eido M. Walny, Founder, Walny Legal Group, Milwaukee, Wis.

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IDGT ADVANTAGES AND APPLICATIONS

Donna J. Jackson, Attorney at Law

What Is IDGT?

A grantor trust is a trust in which the grantor, sometimes called a settlor or trustor, retains an interest. One particular type of grantor trust, called an intentionally defective grantor trust (IDGT), leverages disparities in the federal income and estate taxes to provide opportunities for tax, Medicaid and asset protection planning.

*Irrevocable

*Not included in Estate

*Subject to income tax in Grantor’s return

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What Is IDGT? (Cont.)

• An IDGT can allow a grantor to freeze his/her federal estate and/or gift tax obligations associated with an appreciating asset and allow the IDGT to receive the income from the asset free of federal income tax. An IDGT can also enable a grantor to become eligible for Medicaid coverage while permitting the grantor to claim some federal income tax exclusions and/or deductions.

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The federal estate and gift taxes are distinct taxes, but they are both concerned with the same thing: the taxation of wealth transfers

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The law associated with both taxes effectively creates a lifetime unified credit against which a person can transfer assets without incurring federal estate or gift tax obligations, either while alive or at death. The credit is currently $5.34 million per person or $10.68 million per married couple.

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The reason an IDGT is often called “intentionally defective” stems from the federal income tax laws that disregard the existence of the trust for federal income tax purposes, thereby imposing the federal income tax obligations associated with the asset upon the grantor as opposed to the trust. Although this may seem undesirable, it can actually enable the asset owner to transfer significant wealth to beneficiaries, tax-free.

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• The interests that cause a trust to be defective are set forth in sections 671 through 677 of the Internal Revenue Code (IRC).

• The following is a list of some interests that can cause a trust to be defective, that are often considered significant interests, and that often do not result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts:

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– Power to revoke (IRC § 676)

– Power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC §674)

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– Power to control the investment of the trust funds, either by directing investments or reinvestments or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC §675)

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• The following is a list of some interest that can cause a trust to be defective, that are often considered less significant interests, and that often do result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts:

– Power to alter beneficial enjoyment (IRC §674)

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– Power to deal for less than adequate and full consideration (IRC §675)

– Power to borrow without adequate interest or security (IRC §675)

– Power to reacquire the trust corpus by substituting other property of an equivalent value (IRC §675)

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Lifetime Gifting

• A major incentive for making lifetime gifts is the ability to avoid including future appreciation of, and income from, the transferred property in the donor's estate. After the transfer, the recipient of the gift is generally responsible for paying taxes on the income and appreciation attributable to the transferred property.

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Lifetime Gifting (Cont.)

• It may be possible, however, to structure the gift so that the donor rather than the donee is responsible for paying the income taxes. Why would the donor want to pay taxes on income from property he or she no longer owns? Because, by relieving the donee of this responsibility, the donor in effect makes an additional gift, free of any gift tax. The use of an intentionally defective grantor trust (IDGT) as the recipient of the transfer is a way to structure this transaction.

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• The use of IDGT provides for substantial saving. A transfer to a properly structured IDGT is considered a completed transfer for estate and gift tax purposes, but incomplete for income tax purposes. Therefore, an IDGT would not be included in the donor's estate upon his or her death, yet it would be considered a grantor trust for income tax purposes. As a grantor trust, the donor is taxed currently on the trust income. By paying the income taxes attributable to the income earned by the trust, the donor in effect is making additional transfers to the trust beneficiaries without being subject to gift tax.

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• One of issues in establishing an IDGT is ensuring that the trust is not included in the grantor's estate. The Trust must be properly drafted so that the transfer does not run afoul of the estate tax inclusion rules on prior transfers (IRC Secs. 2036-2038). The trust must, at the same time, fall under the grantor trust income tax rules (IRC Secs. 671679). Therefore, the grantor needs to retain enough control for grantor trust status, but not enough to cause the trust assets to be included in the grantor's estate. There are various ways that the drafter of the trust instrument can accomplish this.

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• Another issue is that the IRS will not treat the income taxes paid by the grantor as a taxable gift. Practitioners feel that since the income taxes are the obligation of the grantor under IRC Sect. 671, no gift tax will be imposed. By satisfying his own liability to pay taxes, the grantor should not be treated as making taxable gifts to those who have no legal obligation to pay such taxes.

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Slide Intentionally Left Blank

Common Uses Of IDGT: Medicaid Planning

• Individuals can also leverage the same disparities between the federal income and federal estate tax laws during Medicaid planning, i.e. structuring ownership of assets to enable eligibility for coverage through Medicaid.

• If a man transfers his house to trust and meets the lookback requirements and other requirements of his state, e.g. not retaining a significant interest in the trust, in addition to the requirements of Sect. 121 of the IRC, he may be able to claim the capital gain exclusion on the sale of the residence as set forth in IRC §121.

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Asset Protection

• If structured correctly, an IDGT can also shield a person’s assets from liabilities associated with the asset, thereby providing significant asset protection. Principally, this is because IDGTs are irrevocable trusts, and the trust assets generally cannot be attached to satisfy judgments against a grantor if the assets were not illegally transferred to the trust.

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VA & Medicaid Trust

• Veterans Asset Protection Trusts (VAPTs) and Medicaid Asset Protection Trusts (MAPTs) are generally drafted as irrevocable trusts with non-grantor trust provisions. Often times, estate planning clients who need an irrevocable trust for Veterans' or Medicaid asset protection purposes also have a separate revocable trust drafted to hold "non-countable" assets. Traditional "pure" irrevocable trusts include non-grantor trust provisions while revocable trusts include grantor trust provisions. However, it is possible, and it's becoming more common, to draft a single irrevocable trust that has both non-grantor trust provisions and grantor trust provisions.

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Va Trusts

• Grantor trusts are classified as disregarded entities for tax purposes; therefore, any taxable income or deduction earned by the trust will be taxed on the grantor's personal tax return. For Veterans' asset protection planning and Medicaid asset protection planning purposes, many estate planning professionals will draft irrevocable trusts with dual provisions. In order to draft a trust with dual provisions, careful attention must be paid by the drafter to ensure that the grantor isn't treated as the owner of any portion of the non-grantor sub-trust in accordance with IRC §671. As CPAs, how do we know what those provisions look like and how do we identify them?

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Following the Internal Revenue Code and

the Regulations provide a great deal of

guidance on this issue when the trust

agreements aren't ambiguous.

Unfortunately, more often than not, drafters

inadvertently include provisions in their

trust agreements that confuse the grantor

or non-grantor status of the trust.

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How do CPAs determine grantor and

non-grantor trust status?

If you've been dealing with trust tax returns

for any amount of time, I don't have to tell

you that there is a vast difference between

drafting styles with each trust. A "good

trust" will include a detailed table of

contents, introduction, or provisions that

will provide you some indication as to

whether or not the trust is intended to be a

grantor trust, non-grantor trust, or will have

both types of sub-trusts. Unfortunately,

more commonly we are faced with trusts

whose grantor/non-grantor status isn't so

apparent. Furthermore, even when the

drafter does us the favor of making the

trust's intended status apparent, the

language used by the drafter can often

undermine those objectives.

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As CPAs, how can we tell which type of

trust we're dealing with? Generally, in

order for a trust to maintain non-grantor

status, the provisions of the trust

agreement must avoid granting the grantor

or any other person one or more of the

powers described in Sections 671-679 of

the Internal Revenue Code. More

specifically, non-grantor trusts (or sub-

trusts) should include four general

provisions:

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Excluding transactions for less than

adequate consideration;

Excluding any powers to borrow money

from the trust without adequate interest or

security;

Allowing only independent trustees to vote

or direct the voting of any corporate shares

or other securities of any trust created by

said trust agreement;

Allowing only independent trustees to

control the investments or reinvestments of

the trust by direction or by veto;

Forbidding anyone from compelling the

trustee to exchange trust property by

substituting other property of equivalent

value; and

Excluding the trustee from using trust

income to pay the premiums on any life

insurance policies insuring the grantor's life

or the life of the grantor's spouse.

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What’s the point of having an

irrevocable trust with dual provisions?

You may be wondering why people go

through the trouble of drafting "irrevocable"

trusts with grantor, also commonly referred

to as residence, sub-trust provisions. From

a practical standpoint, it makes

homeowners nervous when you tell them

they have to hand over control of their

assets to the trustee of an irrevocable trust,

particularly when one of their assets is their

home. Plus, transferring the principal

residence isn't really necessary.

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The purpose of transferring most assets to

an irrevocable trust with non-grantor status

is so that those assets will not be

countable for the purpose of calculating

income and assets for public benefits.

However, the principal residence isn't

typically a countable asset for public

benefits calculations. Additionally, from a

tax standpoint, transferring the principal

residence can mean the loss of property

tax exemptions for Veterans and their

spouses. Accordingly, it has become a

popular method of estate planning for

drafters to draft irrevocable trusts with a

non-grantor sub-trust and a

grantor/residence sub-trust. The non-

grantor sub-trust holds all of the grantor's

assets except for the principal residence,

which is held in the grantor/residence sub-

trust.

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Tax Issues Surrounding MAPTs and VAPTs

with Sub-Trusts

Here are a couple of tax issues I believe

you should be aware of when preparing tax

returns for irrevocable trusts with non-

grantor and grantor/residence sub-trusts:

1. Does a Residence/Grantor Trust Qualify

for Exemptions under IRC §121? Just last

week I had a trustee of one my VAPTs call

in a panic because her parents' (the

grantors') CPA had told her that her

parents wouldn't qualify for any exclusions

under section 121, which is FALSE!

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If a residence is owned by a grantor trust

or sub-trust, for the period that a taxpayer

is treated under section 671 through 679

as the owner of the trust or the portion of

the trust that includes the residence, the

taxpayer will be treated as owning the

residence for purposes of satisfying the 2-

year ownership requirement of section 121,

and the sale or exchange by the trust will

be treated as if made by the taxpayer!

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Net Investment Income Tax (NIIT) of 3.8

Percent. The "new" NIIT applies to certain

income retained by trusts and estates if

taxable income exceeds $11,950. Net

investment income includes interest and

dividend income and capital gains, but also

includes passive income from rental and

business activities, and from pass-through

entities such as partnerships, limited

liability companies (LLCs), and S

Corporations. As a result, many trusts and

estates will be taxed in 2013 and future

years at 43.4 percent (39.6 + 3.8) on

ordinary income and 23.8 percent (20 +

3.8) on qualified dividends and long-term

capital gains, plus state income taxes.

Sample Provision

• While I am alive, I intend that this trust be a grantor trust for federal income tax purposes. A grantor trust means the income of my trust will be taxed to me under IRC §§672 – 677. To carry out this intent, the following provisions shall apply in the administration of my trust.

• 1. Power of substitution: During my lifetime, the Trust Protector has the right to direct that the Trustee transfer trust property to me in exchange for property of equivalent value.

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Sample Provision (Cont.)

• 2. Power to add charities as beneficiaries: During my lifetime, the Trust Protector shall have the power to add charitable organizations described in IRC §170 as an additional beneficiary of the net income of the trust. My Trustee may, but is not required to, distribute the net income to the additional charitable beneficiary, in such amounts and proportions as my Trustee may determine.

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• 3. Power to enable grantor to borrow: During my lifetime, the Trust Protector shall have the power to grant me the power to borrow income or principal of my trust without adequate interest and/or without adequate security.

• The power to borrow shall be granted me by the Trust Protector in writing which will also specify the terms under and the amount that I may borrow.

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• 4. Powers granted herein are exercisable solely in a non-fiduciary capacity without approval of any person acting in a fiduciary capacity. No claim for breach of fiduciary duty may be imposed upon my Trust Protector, my Trustee or any other person as a result of the exercise or non-exercise of the powers granted herein.

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• The powers described in this Section shall not be exercisable to the extent that their exercise would reasonably be expected to cause the assets of the trust or any portion thereof to be included in my gross estate for federal estate tax purposes or subject to my creditors for asset protection purposes.

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• Thank you!

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Transactions with Grantor Defective Trusts

Eido M. Walny, Esq.

Walny Legal Group LLC 751 N. Jefferson Street

Milwaukee, WI 53217

Phone: 414-751-7531

Fax: 414-455-4419

Website: www.walnylegal.com

Email: [email protected]

Copyright © 2014. All rights reserved.

IDGT Transactions

Transactions:

1. Gift

2. Sales

3. Sales to a Beneficiary Defective Inheritor’s Trust (BDIT)

For internal use only. Not for distribution. 42

IDGT Transactions

• Objectives to consider:

– Remove any future asset appreciation from the grantor’s estate (“estate freeze”);

– Sell assets at a discount (“estate squeeze”);

– Have the Grantor pay income taxes (“estate burn”);


Gifts • Transfer to a trust is treated as a transfer of

property by gift, unless the trust is treated as wholly owned by the donor or the donor’s spouse

• Transfer is considered a completed gift for gift tax purposes

– Only subject to gift tax if over annual exclusion amount or lifetime exemption amount

• $14,000

• $5,340,000


Gifts

• Only present interest gifts qualify for the annual exclusion

• Crummey Powers


Crummey Powers

• Allows gifts to irrevocable trusts (including IDGTs) to qualify for annual exclusion

– Beneficiary has right to withdraw gifts to trusts for a specified period (30 days)

– After that time period, the right lapses and the gift is completed and vests in the trust


Crummey Powers • 5 x 5 Rule

– Beneficiary’s lapse could result in taxable consequences

• Release of power of appointment is considered a transfer of property

• Taxable to the extent lapse exceeds the greater of $5,000 or 5% of the aggregate trust assets


Crummey Powers

• Solution

– Consider using Lifetime exemption

– Contribute $5,000 or 5%

– Hanging Crummey powers

• Right to withdraw all of the contribution up to the annual exclusion amount – Withdrawal power lapse at the 5 x 5 rule limitations


Sales to IDGT • Steps:

– Establish an IDGT

– Fund

– Sale

• Options: – Promissory Note

– Self-cancelling Installment Note (SCIN)


Establishing an IDGT • Drafting

– Structure as a defective grantor trust

• Funding

– Grantor makes an initial gift to the trust (i.e. seed

money)

• 10% equity funding

• Reduces the risk that the sale will be treated as a transfer with a retained interest under Section 2036

– Cash or marketable securities

• Avoids valuation issue

For internal use only. Not for distribution.

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IDGT Sales Overview

• Sale

– Grantor sells an asset with potential for appreciation to the IDGT at FMV in exchange for a note at a low interest rate

• IDGT can also distribute in-kind asset to make note payments

• Income and appreciation accumulate inside the trust gift and GST tax free

• Plan to repay the note during the seller’s lifetime


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IDGT Sales Overview

KEY ISSUE: STEP TRANSACTION PROBLEM

The key to avoid step transaction argument is to be patient and wait.


Promissory Notes

• How it works?

– The asset is sold to the IDGT in exchange for the promissory note secured by the IDGT assets

– Note provides for periodic payments

– Income generated by the asset sold or other IDGT assets utilized to make note payments


Promissory Notes Terms

• Payments

– Annual with a balloon payment at the end of the term

– Prepayment permitted

• Interest Rate

– Section 7872 (AFR)


Guarantee

• Personal guarantee

• Can be made by the beneficiaries to substantiate it as an arm’s length transaction

– May be treated as a contribution to the IDGT by the beneficiary and affect grantor trust status

» To avoid, consider having the IDGT pay annual fee to the beneficiary or use a 3d party.


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SCINs

• Self-Cancelling Installment Note

– An installment note that contains a provision under which the buyer’s obligation to pay automatically ceases upon the death of a specified person

• Compared to Promissory Note

– Will not be included in the transferor’s estate


SCINs • Risk Premium

– Grantor must pay an increased premium to avoid making a gift on the sale

• The older the transferor, the greater the premium – Increase purchase price

– Higher interest rate


SCINs

• Valuation

–Purchase price

• Independent written appraisal

–Adjustment Clause

• Typically drafted into the IDGT and not the sales agreement


Beneficiary Defective Inheritor’s

Trusts (BDITs)

• Established and funded by a third party for the benefit of the inheritor

– Inheritor’s descendants and spouse included as permissible discretionary distributees

• Dynastic Trust

• Special Power of Appointment (SPOA)

• Include grantor trust provisions to make it defective to a beneficiary under Section 678(a).


BDITS and SPOA

• Broad special POA given to inheritor to “rewrite” the trust based on changed circumstances in future and to avoid transfer tax issues

– Usually given to trust descendants at the time they become primary beneficiaries

– Protect inheritor against interference in administration by subordinate beneficiaries

– Eliminate significant gift tax issues

• SPA prevents IRS from determining a completed

gift has been made


BDITS and Trustees

• Family Trustee – Control trust investment and management decisions

– Also control who holds the office of independent trustee

• Independent Trustee – One or more third party trustees

– Makes all tax sensitive decisions, represents the trust in arms length transactions, exercises powers which would otherwise cause tax and/or creditor issues


BDITs & Sales

• How it works?

– Transactions between the BDIT and inheritor are income tax free

• Inheritor can engage in sales of discountable, income-producing assets to the trust

– Funding

• By a third party

• May require a guarantee – Guarantors should receive reasonable payment in order to

avoid gift tax issues


Arms-Length Transactions

• Inheritor should not act as both the buyer (as Trustee) and the seller (Individually)

• Valuation and interest rates should be well-documented by qualified appraisers and other experts

– Current market interest rate as opposed to AFR


BDIT Benefits

• Combines the benefits of IDGTs with the enhanced wealth, transfer tax and asset protection advantages of a third party settled trust

– IDGT “enhanced” with asset protection and transfer tax avoidance qualities

– Enjoyment and control/flexibility

• Upon inheritor’s death, passes to beneficiaries subject to POA


Intentionally Defective Grantor Trusts on behalf of Strafford Publications

Foreign Trust Compliance Section July 25, 2014

Managing Director

Lipoff Global Advisors

46 Powder Horn Drive

Suffern, New York 10901-2428

[email protected]

Lawrence M. Lipoff 914.262.6812

Consultant

Friedman LLP

1700 Broadway

New York, New York 10019-5826

[email protected]

mailto:[email protected]

mailto:[email protected]

Illustrative Cases

• Grantor Trust Ceases to be Grantor Trust (§684)

• Pre-immigration Planning - §679 Five Year Rule

• Foreign Trusts Often Have Foreign Business Company Holding Assets – CFC & PFIC Rules

• United States Filing Information Not Available

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Defining Foreign Trust

All trusts are deemed to be foreign unless both the “Court Test” and “Control Test” met

• Court Test: Court in United States able to exercise primary supervision over trust administration

• Control Test: One of more United States persons have authority to control all substantial decisions of the trust

Accidental tripping of Control Test rules to become foreign trust does have twelve month opportunity to correct

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Foreign Grantor Trust Compliance

• New FBAR – FinCEN Form 114 – Report of Foreign Bank and Financial Accounts

• Form 3520 – Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts

• Form 3520-A – Annual Information Return of Foreign Trust With a U.S. Owner

• Form 4970 – Tax on Accumulation Distribution of Trusts

• Form 8832- Entity Classification Election 69

Section 684

Direct or deemed transfers by a United States person to a foreign trust are taxable under §684 as a sale or exchange for the amount of the property’s fair market value

Gains but not losses are recognized

Death of grantor creates an exception

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§679 & Pre-Immigration Planning (1/2)

To avoid future United States gift and estate tax exposure, non-United States person might place assets in trust before becoming United States resident alien

There is a difference in being a United States person for income (objective) and transfer (subjective) tax purposes – can be RA for one and NRA for the other

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§679 & Pre-Immigration Planning (2/2)

If a nonresident alien transfers property to a foreign trust within five years of making a transfer to a foreign trust, §679(a)(4) makes trust a grantor trust from the residency starting date

An intermediary’s transfer to foreign trust will also toll §679(a)(4)

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Foreign Trusts & Foreign Business Company

Controlled Foreign Corporation (CFC) – generally include proportionate

share of investment and other Subpart F income – 50% of vote or value owned by “US shareholders” with 10% of voting stock

Passive Foreign Investment Company (PFIC) – US shareholders taxed on direct and indirect dispositions of stock and “excess distributions” - 75% of gross income is passive or 50% average passive assets

CFC trumps PFIC classification Planning often involves checking-the-box – either up to 12 months

prospective or 75 days retroactively (or 3 years and 75 days retroactively with IRS permission)

Various elections to potentially mitigate anti-deferral provisions

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United States Filing Information

For Foreign Trusts

September 19, 1995 was end of former grantor trust rules are grandfathered if compliant

Current rules, effective after August 20, 1996, basically (i) revocable or (ii) during lifetime distributable only to grantor and/or spouse

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