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Thursday, March 29, 2007

Animal/Pet Trusts

New Jersey passed legislation a short while ago permitting the creation of a Pet Trust under: N.J. Stat. Ann. § 3B:11-38.

1. The new law states:

a. A trust for the care of a domesticated animal is valid. The intended use of the principal or income may be enforced by a person designated for that purpose in the trust instrument, a person appointed by the court, or a trustee. The trust shall terminate when no living animal is covered by the trust, or at the end of 21 years, whichever occurs earlier.

b. Except as expressly provided otherwise in the trust instrument, no portion of the trust's principal or income may be converted to the use of the trustee or to any use other than for the benefit of the animal designated in the trust.

c. Upon termination of the trust, the trustee shall transfer the unexpended trust property as directed in the trust instrument. If no directions for such transfer exist, the property shall pass to the estate of the creator of the trust.

d. The court may reduce the amount of the property transferred if it determines that the amount substantially exceeds the amount required for the intended use. The amount of any reduction shall be transferred as directed in the trust instrument or, if no such directions are contained in the trust instrument, to the estate of the creator of the trust.

e. If no trustee is designated or if no designated trustee is willing or able to serve, a court shall appoint a trustee and may make such other orders and determinations as are advisable to carry out the intent of the creator of the trust and the purpose of this act.

2. Prior Law - Previously, an animal trust existed as an honorary trust (i.e. there was no judicial enforcement).

3. Planning Points

a. Unlike most other trusts, the beneficiaries of an animal trust literally cannot talk for themselves, so the Grantor/Pet Owner must clearly indicate what level of care should be given to the surviving pet. The document should also clarify what payments may be made to the pet’s caretaker.

b. A remainder beneficiary should always be considered (and it is usually inadvisable to make the caretaker the remainderman).

c. Many animals live longer than 21 years, so a truly trusted caretaker and trustee should be considered. Any animal trust that is in excess of 21 years likely continues as an honorary trust.

d. The animal should be clearly identified to prevent fraud.

4. Tax Aspects

a. A Pet Trust is taxed as a complex trust that has not made any distributions. Revenue Ruling 76-4876.

b. In general, a trust's income is subject to graduated income taxation at the same rates as individuals with the highest marginal rate of 35% taking effect after only $10,050 (for 2006) of income, a significant detrimental income tax effect. Some commentators have reported that the IRS will tax these trusts at a marginal rate that is lower than that of the average trust.

Wednesday, March 21, 2007


Qualified Domestic Trust (QDOT) – A QDOT is a statutorily created trust designed to allow a non-citizen widow or widower qualify for the unlimited marital deduction. See I.R.C. §2056A.

1. Other than the citizenship requirements:
a. A QDOT must qualify for the marital deduction as provided for in §2056.
1) Although I.R.C. §2056A does not expressly mandate the distribution of trust income to the spouse, the IRS has stated in letter rulings that a QDOT must also meet the general marital deduction requirements of Sec. 2056. Accordingly, a QDOT should provide that all income is distributable to the surviving non-citizen spouse.
b. The trustee of the QDOT must be a citizen of the United States and possibly even a corporate trustee depending upon the size and types of assets involved.
1) A “large QDOT” is a QDOT with assets in excess of $2,000,000.
i At least one of the trustees must be a U.S. bank or a trust company; or
ii The U.S. trustee (an individual trustee) must furnish a bond or letter of credit equal to 65 percent of the fair market value of the assets in the trust.
2) A “small QDOT” is a QDOT with assets less than $2,000,000.
i There must be either a U.S. bank or a trust company as the trustee; or
ii No more than 35 percent of the trust assets can be real property located outside the United States.
c. As funds are paid out from the trust, the estate tax must be paid on each distribution and the trustee must have the right to withhold the taxable amount.
1) Income distributions from a QDOT are not subject to the estate tax;
2) A surviving non-citizen spouse may also be eligible for a hardship exemption.

2. Planning Considerations
a. To avoid the difficulties associated with QDOTs, it is advisable for clients to make use of the $100,000 gift tax exemption (indexed for inflation, making it over $134,000 in 2010) available for transfers to a non-citizen spouse. Other planning tools such as ILITs should be considered.
b. A QDOT need not be created in the decedent’s Will (or in a revocable living trust); it may be created by the surviving non-citizen spouse provided it is funded prior to the due date for the federal estate tax return.
c. Citizenship – It is imperative to learn of the client’s citizenship and status to accurately plan and determine if any treaties apply.
1) If the surviving non-citizen spouse becomes a citizen prior to the filing of the estate tax return, there will be no need for a QDOT.
2) If the surviving spouse becomes a citizen after the assets are transferred to the QDOT, distribution of property from the QDOT will not be taxed if:
i the surviving spouse either was a U.S. resident from the date of death of the decedent or no taxable distributions were made from the QDOT prior to the surviving spouse becoming a citizen; and
ii the United States trustee notifies the IRS that the surviving spouse has become a U.S. citizen.
iii Note: Special rules apply if the QDOT had already made taxable distributions. See Treas. Reg. § 20.2056A-10
d. A QDOT Rollover IRA should be considered for the decedent’s IRA and 401(k) assets to avoid an immediate income tax and estate tax. See also Treas. Reg. §20.2056A-4(c) for alternatives on handling non-assignable annuities and other such assets.
e. Joint property owned by the decedent and the non-citizen spouse will follow the rules established under I.R.C. §2040(a), which basically states that the asset will be includible in the gross estate of the person who paid for the asset. I.R.C. §2040(b), which provides an exception to married couples, does not apply.
f. The QDOT should only be funded with assets in excess of the federal estate tax limit, not in excess of the New Jersey estate tax limit (unless the spouse decides to become a citizen before any distributions are made from the trust).

3. Tax Consequences
a. The QDOT should be taxed as a simple trust for income tax purposes.
b. The assets transferred into the QDOT are eligible for the unlimited marital deduction.
c. Each distribution from the QDOT triggers the federal estate tax.
d. Form 706-QDT must be filed annually to report the amount in the trust as well as the distributions made from the trust.
e. A non-citizen spouse cannot use the applicable exclusion amount to shelter any distributions of principal from a QDOT, because QDOT assets are never considered part of the non-citizen spouse's gross estate; they are part of the deceased spouse's estate for estate tax purposes.
f. A non-citizen spouse cannot use the applicable exclusion amount to shelter assets in a QDOT from estate taxes upon his or her death. However, the surviving non-citizen spouse may use the applicable exclusion amount ($2 million in 2006) to shelter his or her own assets from federal estate taxes.
f. The 2001 tax act (known as "EGTRRA") now provides that even though the Federal Estate Tax may be abolished, if assets pass to a QDOT as a result of a death before the phase-out is complete, the assets in the QDOT will be taxable upon withdrawal until December 31, 2020.

Minor updates made on December 14, 2010.

Friday, March 9, 2007

Contribution Notice - Who Signs for a Minor?

Many people create irrevocable life insurance trusts (ILIT) for the benefit of minor children. The common scenario is that the grantor will create an ILIT and his or her spouse will act as trustee of such trust.

Because ILITs are established as Crummey trusts, a contribution notice should be sent out to the beneficiaries whenever a contribution is made to the trust. When the children are minors - who signs off on the notice, the Grantor or the Trustee?

General consensus amongst practitioners is that the Trustee parent should sign the notice under the theory that if the Grantor parent acts as if he or she has a withdrawal power, then he or she is maintaining an impermissible incident of ownership in the trust. Such retention of power might cause the trust to be includible in the Grantor's estate for estate tax purpose, thereby nullifying the reason the trust was probably created in the first place.

For second to die life insurance trusts, neither parent should act as signer for a minor child. Accordingly, to be very safe, a guardian ad litem should be appointed, in a limited capacity, to sign the contribution notices. Practitioners should try to avoid creating second to die life insurance trusts until the designated beneficiaries of the trust have reached the age of majority.

Nuts and Bolts of Life Insurance Trusts

Life Insurance Trusts – The most common form of inter vivos irrevocable trust is the Life Insurance Trust (ILIT). Since the grantor of the trust has no desire to use the proceeds of this trust during his life, and because the value of the insurance at the time of the grantor’s death can be quite high, it is a very popular mechanism for reducing or avoiding a grantor’s estate tax liability.

a. When creating a life insurance trust, it is important to know whether the client will be buying the insurance through the insurance trust or if they will be transferring in an existing insurance policy.

1) If at all possible, the client should always have the trust buy the insurance because:

i It avoids I.R.C. §2035 which states that a person’s gross estate for estate tax purposes includes certain assets that have been transferred out of the person’s estate within three years of death. Accordingly, if a person transfers an insurance policy to an insurance trust and dies within three years of when the gift to the trust was made, the full amount of the proceeds will be subject to both the Federal and New Jersey Estate Taxes.

ii It avoids having to determine the value of the existing policy at the time of the transfer. This value is known as the interpolated terminal reserve.

iii We are sure the insurance actually gets into the trust. All too often a planner creates the insurance trust and then it never gets funded, exposing the practitioner to unnecessary liability.

2) If the client will be contributing existing insurance to a trust:

i The value of the insurance at the time of the transfer is a gift to the Crummey beneficiaries of the trust.

ii Care must be taken when selecting the beneficiaries of the trust to ensure that there are enough beneficiaries to shelter the value of the gift.

iii The trust must be funded with enough liquid assets in the event someone does wish to exercise their withdrawal rights.

b. The trust should be established as a Crummey Trust.

1) A Crummey Trust is named after Clifford Crummey, the first taxpayer to use this type of trust successfully.

2) A Crummey trust is designed to provided a limited withdrawal right to certain beneficiaries in an irrevocable trust so that transfers to the trust are eligible for the annual gift tax exclusion.

3) The more Crummey beneficiaries there are, the greater the gift that may be made to the trust without having to pay a gift tax. Crummey beneficiaries may not just be named at random, because they do have a real right to withdraw the money that is put into the trust.

4) Generally, a 30 day withdrawal right is considered adequate, but there is no clear minimum.

5) Particular care must be taken when drafting the Crummey power to ensure that the power lapses only the extent of the greater of $5000 or 5%. Any greater lapse will be considered a gift by that withdrawal beneficiary to the other beneficiaries of the trust.

6) The trustee should have broad powers to satisfy any withdrawal rights. All Crummey withdrawal rights should be satisfied either against the contribution or the property of the trust, including any insurance policy or fractional interests in the insurance policy. This will provide substance to a Crummey withdrawal right.

c. Tax aspects

1) The trust should generally be created as an Intentionally Defective Grantor trust, I.R.C. §677, so that although the assets of the trust are out of the grantor’s estate, during the life of the Grantor any income received by the trust is taxed to the Grantor rather than being taxed to the trust. This avoids having to file a Form 1041 income tax return for the trust and it provides an additional gift to the beneficiaries in an amount equal to the income taxes actually paid. Frequently this is done with a power to substitute trust assets, other than the insurance, with assets of an equivalent value to the trust in a non fiduciary manner I.R.C. § 675(4).

2) Upon the death of the grantor, the trust will either be taxed as a simple or complex trust depending upon the terms of the trust.

3) The practitioner must consider whether the Grantor’s Generation Skipping Tax Exemption should be allocated to the ILIT. The Code was revised under EGTRRA to provide an automatic allocation of the Grantor’s GST exemption in many cases and this is not always the most desirable result. A grantor may opt in or opt out of having the automatic allocation on a timely filed gift tax return.

d. Planning Considerations

1) The Grantor should NEVER be trustee of his or her own ILIT.

2) It may sound obvious, but it is important to counsel clients that once money goes into an irrevocable trust, the money no longer belongs to them and they will have difficulty getting the money back.

3) If the Trustee is the Grantor’s spouse, care must be taken when making contributions to the trust to ensure that the Trustee spouse is not making any contributions. (i.e. Never contribute joint or community property to the trust or write a check to the trust from a joint account or a business account).

4) ILITs are somewhat expense to establish and maintain for many clients, particularly those who have large estates due strictly to the amount of insurance they buy. Consideration should be given to naming a child as the owner and beneficiary of the policy as a means to save money for the client while receiving many of the same tax benefits.

5) The client should make sure that the insurance premiums are paid on an annual basis to minimize the maintenance fees. If multiple insurance policies are in one trust, try to convince the insurance carriers to have the same due date for the premiums.

6) The life insurance trusts is a particularly useful planning tool for same sex couples and unmarried couples because it provides a means to give the decedent’s significant other a large sum of money tax free, yet control the money’s ultimate destination.

e. Types of Life Insurance - Regardless of whether a client owns a term, whole life, or variable life insurance policy, if the value of the policy and the client’s other assets are in excess of the New Jersey Estate Tax threshold, it is advisable to discuss the benefits of the ILIT.

1) Term Life Insurance – These policies by their nature are designed to last for short period of time to cover a particular type of risk. The premiums on these policies are typically low, and a contribution of an existing policy to an insurance trust is relatively easy because of the low value of the policy.

2) Whole Life Insurance – These policies are designed to build up a cash value to produce a guaranteed return that will ultimately pay for the insurance premium. The premiums can be quite substantial, which is important to know when calculating the number of Crummey beneficiaries that must be named. A contribution of a large whole life policy to an ILIT may result in a gift tax no matter how comprehensive the planning because of the size of the insurance.

3) Variable Life Insurance – This type of policy is similar to the whole life insurance except that instead of having a guaranteed return, the rate is variable. Since most people are not good investors, be wary of advising this product.

4) Second to Die Insurance - A Second to Die Insurance Trust is different from a typical ILIT in one substantial and obvious way - the insurance benefits are not paid until the second to die.

i Practitioners should ensure that neither spouse is ever eligible to serve as trustee nor made a Crummey beneficiary.

ii Since this trust is not for the benefit of the surviving spouse, the clients should be sure that the surviving spouse has enough funds to live on absent the trust funds.

iii These trusts are particularly beneficial for clients interested in dynasty trusts as more insurance can purchased for a lower premium amount.

f. Insurance Trusts Established Pursuant to Divorce or Separation– Frequently Divorce attorneys draft provisions in a separation agreement or a divorce decree that call for an insurance trust to be created for the benefit of the children of the marriage. Terms of the trust are rarely spelled out with any specificity.

1) In the event that the person who is required to be insured passes prior to the creation of an ILIT, the courts can impose a constructive trust for the benefit of the children. (A constructive trust is an implied trust established by operation of law.) The terms of the trust are in the judge’s discretion, rather than in either the form that the decedent, or surviving parent, would want.

2) Planning Considerations

i Frequently a divorce or separation agreement will say what amount of insurance a person should have without any consideration for who should be trustee, the tax consequences or the ages at which the children should have access to the money. Occasionally, inappropriate provisions are included. Thought must be given how to address these concerns, particularly in light of the fact that these two individuals may not be on good terms.

ii Payment for the trust. I have yet to see a divorce decree or separation agreement that contemplates who will actually pay for the insurance trust. This is often a sticking point for many clients.

iii Compliance. Working with an unfriendly trustee or grantor can severely complicate compliance with both the tax laws and properly funding the trust.

g. Management of Insurance Trusts

1) The management of an insurance trust from an investment standpoint is quite simple. Most insurance trusts do not have assets other than the insurance itself.

2) The complexity comes when trying to explain the maintenance and funding requirements of the trust to clients. Further complicating matters, often clients will try to manage the trust completely on their own to save on costs. The practitioner must take extreme care when allowing this to happen because the practitioner will still be potentially liable.

3) Funding the Trust

i Checking accounts must be created in the name of the trust (and if the Grantor does not have an individual checking account, the Grantor may also have to create a checking account to fund the trust). Many practitioners like to get a separate tax identification number for the ILIT. If the trust is an Intentionally Defective Grantor Trust (IDGT), it is not necessary, but it is still a good idea in the event a creditor does an asset search using the Grantor’s Social Security Number.

ii Insurance must either be purchased by the trust or transferred into the trust. This requires completing insurance forms that designate the trust as the owner and beneficiary of the policy.

4) Sending the annual Crummey letter. As soon as practical after the trust is funded, a letter must be sent to the designated Crummey beneficiaries to advise them of their withdrawal rights. These letters should be acknowledged by the beneficiaries (or their guardians) and maintained by the attorney (or trustee).

i After 30 days (or whatever the relevant Crummey time period is) the Trustee may use the gift from the Grantor to pay the insurance proceeds.

5) To avoid problems with I.R.C. §2035 and §2036 (which would bring the insurance back into the gross estate of the Grantor), it is important that the Grantor contains no impermissible control over the trust and should never be the trustee. The Grantor may be given limited ability to hire and fire Trustees.