“Having Your Cake and Eating It Too” Using Trusts to Remove Assets From Your Taxable Estate While Retaining Access to Them for Your Financial Support

June 23, 2011 | Stuart B. Dorsett

Special Bulletin

The 2010 Tax Act ("Act") unified the federal gift, estate, and generation-skipping transfer ("GST") tax exemptions for the first time in history and increased the amount of these exemptions to $5 million (contrasted with the $1 million gift tax exemption and the $3.5 million estate tax and GST tax exemptions applicable in 2009). Accordingly, the Act provides high net worth individuals with a unique opportunity to make significant lifetime gifts to their children, grandchildren, or other beneficiaries. With appropriate use of trusts and the allocation of the GST tax exemption, these gifted assets may be removed from the federal transfer tax system for several generations – perhaps even in perpetuity – while providing access to them if needed.

Advantages of Lifetime Gifts

Because the gift tax and estate tax exemptions are now the same, many people may believe it is irrelevant whether the assets are transferred during lifetime or at death. In fact, because assets transferred at death receive an adjusted (or so-called "stepped up") basis for capital gains tax purposes, there may be a bias in favor of transfers at death in order to eliminate unrealized capital gains on appreciated assets. However, for high net worth individuals, using the $5 million exemption ($10 million for a married couple) now, rather than waiting to apply it at the time of death, is advantageous for several reasons:

There is a risk that the $5 million exemption will be reduced significantly in the future. In fact, the Act has a lifespan of only two years, with a $1 million gift tax and estate tax exemption scheduled for 2013 and beyond. Although many commentators believe that Congress will extend the current exemptions after 2012, such an extension cannot be guaranteed, particularly if significant federal budget shortfalls continue. Accordingly, if you do not use the $5 million exemption before the end of 2012, you may lose as much as $4 million of the exemption in 2013.
Lifetime gifts frequently can be structured in a way to generate valuation discounts (for example, through the use of family limited partnerships and family limited liability companies). Such discounts effectively "leverage" your $5 million gift tax exemption by enabling you to transfer more than $5 million worth of underlying assets. Consequently, it is possible that more of your assets may be sheltered from tax with a lifetime gift than with a transfer at your death.
A lifetime gift also would have the effect of removing from your taxable estate all of the post-gift appreciation and earnings. This point reflects the time value of money – that is, a $5 million exemption is simply worth more today than it would be at some unknown point in the future.

Thus, giving away up to $5 million now may be a wise move from an estate planning standpoint. However, you may be hesitant to give up to $5 million because, generally speaking, lifetime gifts require you to sacrifice continued access to those assets. Accordingly, you may be reluctant to make large lifetime gifts even if such gifts may significantly reduce your estate taxes in the future. Nevertheless, there is a solution to this dilemma.

Use of Trusts to Retain Access to Gifted Assets

Fortunately, it is possible to "have your cake and eat it too." By using special trust arrangements, you, or you and your spouse, may give away assets, thereby removing those assets from your taxable estate(s), while nonetheless retaining control over, and access to, those transferred assets.

Spousal Access Trusts

For married couples who have a trusting and stable relationship, this "holy grail" of estate planning is relatively easy to achieve through a so-called "spousal access trust." One spouse creates an irrevocable trust for the benefit of the other spouse, children, grandchildren, and even more remote generations. The beneficiary-spouse will have access to the gifted assets because the trustee may make distributions from the trust to that spouse, who may then use the distributions to support the married couple.

Moreover, the trustee who is making decisions about trust distributions may be the beneficiary-spouse. So long as the trustee's discretion to make distributions is based on the beneficiary's need for health, education, support, and maintenance (known as an "ascertainable standard"), the trustee-spouse's decision to make distributions to himself or herself should not cause inclusion of the trust assets in that spouse's taxable estate at death. It seems of little practical consequence that the trustee's discretion to distribute funds to himself or herself is limited by the "ascertainable standard," given the breadth of the needs and desires which fall under the standards of "support" and "maintenance."

A spousal access trust also allows you and your spouse to retain testamentary control over the gifted assets. Although the trust will be "irrevocable," the beneficiary-spouse may be given a testamentary power of appointment, which is the power to change the way in which the assets will pass to your descendants. This power allows you and your spouse to respond appropriately to changing circumstances within your family.

In fact, you and your spouse may retain even more expansive indirect control over your trust through the appointment of a "Trust Protector." A Trust Protector is an independent party (often a close friend or a trusted professional advisor) who has the power to make significant changes in the terms of your trust. The Trust Protector may effectively rewrite your trust if circumstances so dictate.

It is self-evident that the above arrangement works only if you and your spouse have a solid relationship. Moreover, a spousal access trust is appropriate only if the donor-spouse is willing to assume the risk that the beneficiary-spouse might die prematurely, thereby robbing the donor-spouse of access to the trust assets. If the beneficiary-spouse dies before the donor-spouse, then the donor-spouse loses the ability to tap into the trust for support, because only the beneficiary-spouse may receive trust distributions.

Grantor Access Trusts

What if you or your spouse is unable or unwilling to assume this risk or you are a single parent? The answer may be a so-called "grantor access trust." Such a trust is an irrevocable trust created and funded by you, of which you are also a permissible beneficiary. In most states (including North Carolina), the assets of such a "self-settled" trust will be subject to the claims of your creditors and, therefore, are considered to be "owned" by you for estate tax purposes. However, special rules in certain states (notably, Alaska and Delaware) prohibit creditor access to such a trust (if it meets certain guidelines), with the result that the trust assets will be excluded from your taxable estate. Accordingly, you still can "have your cake and eat it too" by giving away your assets while nonetheless retaining indirect access to those assets for your support.

Grantor access trusts have other advantages as well. Not only have Alaska and Delaware provided enhanced protection from creditors, both states also have repealed the "Rule Against Perpetuities," meaning that a trust can run indefinitely for the benefit of successive generations of beneficiaries. Accordingly, once the assets are given to the trust, those trust assets (as well as post-gift earnings and appreciation) may never be subject to federal estate tax.

There are certain disadvantages to such a grantor access trust. The costs of creating the trust are likely to be higher than with a more traditional irrevocable trust. Moreover, unlike a spousal access trust, a grantor access trust must have an independent trustee located in the state where the trust is situated, and that independent trustee will charge commissions to the trust. Furthermore, while the beneficiary-spouse may be the trustee of a spousal access trust, thereby giving the married couple direct managerial control over the trust assets, managerial control of a grantor access trust will be held by a corporate trustee (although you may maintain indirect influence over the administration of the trust through the power to remove and replace the corporate trustee).

Conclusion

The 2010 Tax Act presents a unique (and possibly short-lived) opportunity for you to make substantial gifts and remove assets from your taxable estate. With proper planning, you not only may achieve significant gift and estate tax savings, but you also may retain the ability to control and access the gifted assets. Contrary to the old saying, it is truly possible to "have your cake and eat it too."

For further information regarding the issues described above, please contact Stuart B. Dorsett.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.