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Irrevocable Trust Flexibility: Is Anything Really Irrevocable Anymore?

Irrevocable Trust Flexibility: Is Anything Really Irrevocable Anymore?

Contributing Authors: Robert G. Dwyer and Frances A. McCormick

Originally published in October 2015

Fundamentals of Current Tax Law in this Area

IRC §2036(a)(1) – Transfers with Retained Life Estates

This section will be invoked if each of the following requirements are satisfied:

The transferor made a lifetime transfer of property after March 3, 1931;
The transferor retained the possession or enjoyment of, or the right to the income from, the transferred property; and
The possession or enjoyment of income was retained for:
The transferor’s life;
Any period not ascertainable without reference to the transferor’s death; or
Any period that does not actually end before the transferor’s death.

“Possession or enjoyment” refers to “situations in which the owner of property divested himself of title but retained an income interest or, in the case of real property, the lifetime use of the property.” Although most common with real property, this can also occur with personal property, like artwork, where the transferor transfers ownership, but retains the right to possession.

The most common example of “right to income” is where Mr. Smith transfers income producing property in trust, retaining the right to income for his life, with the remainder going to the children of Mr. Smith upon his death. If Mr. Smith only retains 30% of the income from the property during his life, only 30% of the property held in trust is included in Mr. Smith’s gross estate.

If the income from transferred property is to be distributed to the transferor at the exclusive discretion of an independent trustee, the property generally will not be included in the transferor’s gross estate under this section because no right has been retained.

There are four exceptions to this general rule:

If the facts give rise to the inference that there was an agreement or understanding to the effect that either (i) the trustee would pay all (or a fixed portion) of the income to the settlor; or (ii) the trustee would pay any or all of the income to the settlor upon the latter’s demand;
If, under applicable state law, the transferor’s creditors can reach the income of the trust;
If an independent person is designated as trustee, but the settlor possesses at death the power to remove the independent person and name the settlor as successor trustee; or
If the income from the property transferred in trust is to be distributed to the transferor according to an ascertainable standard that can be enforced by the transferor-beneficiary, the property will be included in the gross estate of the transferor-beneficiary under this section to the extent of the amount of property necessary to generate income sufficient to make the required distributions. If the income from the transferred property is to be distributed to the transferor as required for the transferor’s happiness or comfort, neither of which is an ascertainable standard, the entire property will be included in the gross estate.

Exceptions to application of §2036(a)(1):

Transfers that are bona fide sales for an adequate and full consideration in money or money’s worth; and
Pre-death termination of retained possession or enjoyment of, or income from, the transferred property.

General rules for amount of inclusion:

If the transferor retains all of the income from the entirety of the property or the possession or enjoyment of the entirety of the property, §2036(a)(1) includes not the present value of the retained income interest or retained right at the moment of death, but rather the estate tax value of the entirety of the property.
If the transferor retains an interest in only a portion of the transferred property, the estate tax value of only that portion of the property is included in the gross estate.

IRC §2036(a)(2) – Transfers with Retained Powers

This section will be invoked if each of the following requirements are satisfied:

The transferor made a lifetime transfer of property after March 3, 1931;
The transferor retained the right, either alone or in conjunction with any person, to designate the persons who will possess or enjoy the property or the income therefrom; and
The right was retained for: The transferor’s life; Any period not ascertainable without reference to the transferor’s death; or Any period that does not actually end before the transferor’s death.

The fundamental difference between §2036(a)(1) and §2036(a)(2) is that §2036(a)(1) applies to the transferor’s possession or enjoyment of transferred property, whereas §2036(a)(2) applies to the transferor’s retained right to designate who will possess or enjoy the property.

The powers referred to in this Section can be narrow – such as the retained right to choose between two beneficiaries – or broad – such as the retained right to choose among a prescribed class of persons.

The following powers retained by the transferor cause inclusion of the entire property in the estate of the transferor:

To accumulate all income.
To distribute trust income or corpus to a person other than the person prescribed in the document of initial transfer. However, if the transferor’s power to distribute corpus is limited to distributions to the income beneficiary, §2036(a)(2) does not apply as a power that effects only the remainder interest in the property is excluded from the reach of this section.
A contingent power to designate the persons to possess or enjoy the property or the income therefrom is subject to §2036(a)(2), even though the contingency activating the power failed to occur before death.

The phrase “in conjunction with another person” means that even though a decedent may be constrained by a co-holder of the power, §2036(a)(2) still applies. A right of the transferor to veto the action of another person is sufficient to invoke §2036(a)(2).

Exceptions to application of §2036(a)(2):

Transfers that are bona fide sales for an adequate and full consideration in money or money’s worth;
Power that does not affect enjoyment of income during transferor’s life;
Powers subject to an ascertainable standard; and
Pre-death termination of retained power over the transferred property.

General rules for amount of inclusion:

If the transferor retains a power over the income from the entirety of the property or a power over the entirety of the remainder interest, §2036(a)(2) includes not the present value of the retained income interest or retained right at the moment of death, but rather the estate tax value of the entirety of the property.
If the transferor retains a §2036(a)(2) power in only a portion of the transferred property, the estate tax value of only that portion of the property is included in the gross estate.

IRC §2037 – Transfers Taking Effect at Death

The value of a decedent’s gross estate includes the value of property to the extent of any interest therein of which the decedent made a lifetime transfer after September 7, 1916 if:

Possession or enjoyment of the property can, through ownership of such interest, be obtained only by surviving the decedent; and
The decedent has retained a reversionary interest in the property the value of which immediately before the death of the decedent exceeds 5% of the value of the property.

Section 2037 applies because the transfer is sufficiently incomplete in that:

During the decedent’s life, the decedent did not fully dispose of all of the decedent’s interest in the property due to the retained interest; and
The successor owner receives the property only by surviving the decedent.

The question of survivorship is not focused on whether possession or enjoyment of the interest is actually obtained before the decedent’s death, the inquiry is whether possession or enjoyment of the interest could be obtained only by surviving the transferor. For purposes of §2037, a reversionary interest refers to any possibility that corpus (but not income) may return to the transferor or his or her estate. This concept encompasses interests subject to conditions precedent and conditions subsequent, although the interest need not have matured into possession or enjoyment.

The §2037 reversionary interest requirement is commonly satisfied in the following situations:

Trustee is required to pay corpus to the settlor in a fixed amount or on a periodic basis;
Settlor-beneficiary can demand a fixed amount of trust corpus;
Trustee is required to pay corpus to the settlor under an ascertainable standard relating to health, education, maintenance, or support; or
Trustee is required to pay corpus to the settlor’s minor children for their support or maintenance, and if such payments discharge the settlor’s support obligations, then the settlor would be deemed to be the beneficiary and accordingly, to have retained a reversionary interest.

Reversionary interest does not include the possibility that the decedent will receive an interest in previously transferred property in the form of an inheritance from the person it was transferred to. The reversionary interest must actually exist at the death of the transferor. It can either be created by the express terms of an instrument or by operation of law.

An example of a reversion that arises by operation of law is where Mr. Smith transfers all of his property to an irrevocable trust, with the income to be accumulated until Mr. Smith’s death and the remainder to be distributed to his then-living children. If Mr. Smith is not survived by any of his children, the property passes to Mr. Smith’s estate.

Immediately before the death of the transferor, the value of the transferor’s reversionary interest must exceed 5% of the value of the transferred property. This value is determined by consulting §7520 actuarial tables, providing present values of the remainder interests being analyzed.

Exceptions to application of §2037:

Transfers that are bona fide sales for an adequate and full consideration in money or money’s worth;
Transfers prior to September 7, 1916;
Possession or enjoyment of the property could have been obtained by any beneficiary through the exercise of a power of appointment exercisable immediately before the decedent’s death.

If the requirements of §2037 are met and none of the exceptions apply, the entire value (as of the date of death) of any interests transferred, the possession or enjoyment of which is contingent upon surviving the decedent, is included in the decedent’s gross estate.

IRC §2038 – Revocable Transfers

Section 2038(a)(1) will be invoked if each of the following requirements is satisfied:

The transferor made a lifetime transfer of property after June 22, 1936; and
The transferor possessed at death a power to alter, amend, revoke, or terminate the enjoyment of the transferred property (or any such power was relinquished during the three year period ending on the date of the transferor’s death).

The power to “alter or amend” has been broadly construed and does not need to be for the benefit of the transferor. Each of the following constitutes a power to alter or amend:

The discretionary power to sprinkle income or corpus among a prescribed class of beneficiaries;
The power to change proportionate interests among persons within a class; and
The power to name new beneficiaries.

Section 2038(a)(1) explicitly states that a power to terminate triggers §2038, even though termination may cause the property to go to persons other than the transferor.

The power to revoke may be explicitly retained in the document of transfer or state law may provide an implicit power of revocation that is not expressed in the instrument of transfer. For example, if under state law, the settlor’s creditors can reach the corpus because the trustee may make discretionary distributions for the benefit of the settlor, the settlor has retained an implicit power to revoke.

Exceptions to application of §2038:

Transfers that are bona fide sales for an adequate and full consideration in money or money’s worth;
Decedent’s power could only be exercised with the consent of all parties having an interest in the transferred property and the power adds nothing to the rights of the parties under local law;
Contingent power not effective at death;
Power subject to an ascertainable standard;
Pre-death termination or relinquishment of power over transferred property.

Under §2038, the amount includible in the estate of the decedent is the estate tax value of the interest or interests subject to the §2038 power, rather than the estate tax value of the entirety of the property to which the interest relates, as is generally the case under §2036. However, if more than one provision causes inclusion in the gross estate, the applicable provision is whichever causes the greatest inclusion in the gross estate.

IRC §2039 – Annuities

Section 2039 stipulates that the gross estate includes the value of an annuity or other payment receivable by any beneficiary by reason of surviving the decedent under any form of contract or agreement (other than insurance on the decedent’s life) if, under such contract or agreement, an annuity or other payment was payable to the decedent for any period not ascertainable without reference to his or her death or for a period that does not end before his or her death.

Inclusion under §2039 requires the following conditions:

The existence of some kind of contract or agreement;
The contract or agreement must provide than an amount or amounts are receivable by a beneficiary;
The amount or amounts are receivable by a beneficiary by reason of his or her surviving the decedent; and
Under the same contract or agreement, the decedent, while alive, was either entitled to receive, or was actually receiving, payments that could not or, in fact, did not end before his or her death.

Private annuities that expire upon the transferor’s death escape inclusion in the transferor’s gross estate under §2039, as death extinguishes the transferor’s right to any further payments with no amount being payable to a beneficiary.

IRC §2040 – Joint Interests

Non-Spousal Tenancies – §2040(a)

The presumption is that the entire jointly owned estate is includible in the deceased joint tenant’s gross estate. To overcome this presumption, the personal representative of the estate has the burden of showing the surviving co-tenant either originally owned the asset, or contributed to its acquisition.

In addition, §2040(a) provides that jointly owned property acquired by the owners by gift, bequest, devise, or inheritance from another is included in a deceased joint tenant’s estate only to the extent of that joint tenant’s interest, determined by dividing the value of the property by the number of joint tenants.

Spousal Tenancies – §2040(b)

Effective for estates of decedents dying after 1981, §2040(b) establishes a special estate tax inclusion rule for “qualified joint interests.” A “qualified joint interest” is any interest in property held by the decedent’s surviving spouse as tenants by the entirety, or joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants. Also, the surviving spouse must be a U.S. citizen.

One-half of the value of a qualified joint interest is includible in the estate of the first spouse to die. This rule applies regardless of which spouse furnished consideration in acquiring the property or whether a gift occurred upon formation of the joint tenancy. The portion includible in the deceased spouse’s estate qualifies for the estate tax marital deduction. The survivor’s basis in the one-half interest is, in most cases, entitled to a step-up in basis to fair market value with respect to that one-half of the property.

IRC §2041 – Powers of Appointment

Property subject to a general power of appointment held by a powerholder at his or her death is includible in his or her gross estate under §2041. A general power of appointment is commonly defined as “a power exercisable in favor of the powerholder, his or her estate, his or her creditors, or the creditors of his or her estate.” A power of appointment may be created by Will, deed, trust or other instrument.

Regulation § 20.2041-1(b)(1) identifies the following rights as powers of appointment:

The power held by a trust beneficiary to “appropriate or consume the principal of the trust”;
The power to “affect the beneficial enjoyment of trust property or its income by altering, amending, or revoking the trust instrument or terminating the trust.”

Conversely, the following powers will not be deemed to be powers of appointment:

The power to amend only the administrative provisions of a trust instrument, that cannot substantially affect the beneficial enjoyment of trust property or income;
The mere power of asset management, investment, custody, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity.

A power vested in a donee to consume, invade, or appropriate property, even though for his or her own benefit, is not deemed a general power of appointment if it is limited by an “ascertainable standard” relating to the health, education, maintenance, or support. If a decedent holds a general power under §2041, the decedent’s estate must report the value of the property (at the date of death value) subject to the power.

IRC §2042 and Irrevocable Life Insurance Trust (“ILIT”)

Section 2042 provides that the value of the gross estate shall include the value of all property:

To the extent received by the executor as insurance under policies on the life of the decedent; and
To the extent received by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with another person.

Generally, when a trust is modified under state law (See III(B) below) the life insurance proceeds are not included in the settlor’s estate under §§2036-2038. However, the mere ability to amend an ILIT would appear to qualify as an incident of ownership exercisable by the decedent in conjunction with another person which could cause insurance proceeds, thought to be outside the decedent’s estate, to instead be included. In fact, the Internal Revenue Service (“IRS”) could take the position that the settlor would not even need to consent to the modification to reach this result, as the power itself may suffice.

Note: The IRS has not ruled on this specific issue, but it should be brought to clients’ attention, especially when considering modification of a valuable ILIT. A safer option would be to sell the policy from one trust to another trust in order to avoid the issue altogether. The purchase price is the interpolated terminal reserve value plus any unused portion of the paid premium.

Strategies to Lessen the Power of the Current Tax Laws

Pennsylvania Probate, Estate, and Fiduciary Code Sections

§7740.1 – Modification or Termination of Noncharitable Irrevocable Trust by Consent

Consent by settlor and beneficiaries: A noncharitable irrevocable trust may be modified or terminated upon consent of the settlor and all beneficiaries even if the modification or termination is inconsistent with a material purpose of the trust. A settlor’s power to consent to a trust’s modification or termination may be exercised by a guardian, an agent under a settlor’s general power of attorney, or an agent under the settlor’s limited power of attorney that specifically authorizes that action.

Consent by beneficiaries with court approval: A noncharitable irrevocable trust may be modified upon the consent of all the beneficiaries only if the court concludes that the modification is not inconsistent with a material purpose of the trust. A noncharitable irrevocable trust may be terminated upon consent of all the beneficiaries only if the court concludes that continuance of the trust is not necessary to achieve any material purpose of the trust. A spendthrift provision in a trust instrument is presumed to constitute a material purpose of the trust.

Upon termination, the trustee shall distribute the trust property as agreed by the beneficiaries. If not all of the beneficiaries consent to a proposed modification or termination of a trust, the modification or termination may be approved by the court only if the court is satisfied that:

If all the beneficiaries had consented, the trust could have been modified or terminated pursuant to this section; and
The interests of a beneficiary who does not consent will be adequately protected.

§7740.2 – Modification or Termination of Noncharitable Irrevocable Trust by Court

The court may modify the administrative or dispositive provisions of a noncharitable irrevocable trust, make an allowance from the principal of the trust or terminate the trust, if, because of circumstances that apparently were not anticipated by the settlor, modification, allowance or termination will further the purposes of the trust. To the extent practicable, the modification or allowance shall approximate the settlor’s probable intention.

The court may modify the administrative provisions of a noncharitable irrevocable trust if adherence to the existing provisions would be impracticable, wasteful, or impair the trust’s administration.

Upon termination of a trust under this section, the trustee shall distribute the trust property in a manner consistent with the purposes of the trust.

§7740.4 – Modification or Termination of Noncharitable Trust – UTC 414

A trustee of a noncharitable trust may terminate the trust if the trustee concludes that the value of the trust property is insufficient to justify the cost of administration, the trustee has given written notice to the qualified beneficiaries at least 60 days before the proposed termination, and no qualified beneficiary provides the trustee with a written objection to the proposed termination on or before the date specified in the notice. The court may modify or terminate a noncharitable trust, or remove the trustee and appoint a different trustee, if it determines that the value of the trust property is insufficient to justify the cost of administration.

Upon termination of a trust under this section, the trustee shall distribute the trust property in a manner consistent with the purposes of the trust.

§7740.5 – Reformations to Correct Mistakes

The court may reform a trust instrument, even if unambiguous, to conform to the settlor’s probable intention if it is proved by clear and convincing evidence that the settlor’s intent, as expressed in the trust instrument, was affected by a mistake of fact or law, whether in expression or inducement. The court may provide that the modification have retroactive effect.

§7740.6 – Modifications to Achieve Settlor’s Tax Objectives

The court may modify a trust instrument in a manner that is not contrary to the settlor’s probable intention in order to achieve the settlor’s tax objective. The court may provide that the modification have retroactive effect.

Trust Protector Provisions Ensure Maximum Flexibility

Trust Protectors are a very simple way to create flexibility in an irrevocable trust document. The scope of the Trust Protector depends on the instrument of appointment. The Trust Protector needs to be an independent person. The role can be a very narrow one, such as simply overseeing the trustee and being given the power to fire the trustee in certain circumstances.

The role can, however, be much broader, and encompass some or all of the following powers:

Modify or revise the administrative provisions contained in trust instruments;
Modify the financial powers of the trustee contained in trust instruments; and
Modify distribution provisions set forth in trust instruments.

Great care should be taken while drafting the powers of the Trust Protector to ensure that the powers do not include:

The ability to modify or have any power over any trust or gift that would otherwise qualify for the marital deduction;
The ability to exercise any power that would violate any applicable rule against perpetuities;
The ability to exercise any power if it would nullify, reduce, limit, or otherwise adversely affect provisions requiring the accrued or undistributed income of a Qualified Subchapter S Trust (QSST) or other trust holding S corporation shares.
The ability to act in anything other than a fiduciary capacity or in any way that would cause any portion of the trust to be included in the Trust Protector’s gross estate.

Other State Statutes

The states with the most aggressive asset protection laws, while giving the settlor some level of control over assets irrevocably transferred in trust include Alaska, Delaware, Nevada, New Hampshire, South Dakota, and Tennessee. These states generally require the trustee to be local to the state, so a corporate trustee is typically utilized.

Before certain asset protection attributes are guaranteed, there may be a waiting period of several years where the trust assets must be held in trust. These trusts often don’t guard against creditors such as current tort lawsuits or divorcing spouses. Another benefit is that their liberal state laws often grant a trustee the unilateral power to amend an irrevocable trust agreement by giving notice to the beneficiaries – sometimes consent is not required.

Current Thinking & Planning vs. IRS Aggressively Combating These Strategies

Recent Tax Court Cases, Revenue Procedures, and Private Letter Rulings that support the trend of the IRS attacking schemes whereby grantors attempt to control assets that they want to keep out of their estates (i.e. “plugging loopholes”) include:

In Revenue Procedure 2015-37, 2015-26 IRB, the IRS ruled that it will no longer provide a ruling letter that assets in a grantor trust will receive a Code Sec. 1014 basis adjustment on the death of the owner where those assets aren't included in the owner's estate. Practitioners have speculated that this no-rule guidance may be targeted at the overly aggressive use of intentionally defective grantor trusts as an estate planning tool.

In Balsam Mountain Investments, LLC v. Comm'r, TC Memo 2015-43 (March 12, 2015), the Tax Court denied an income tax deduction for a gift of a conservation easement over a 22-acre parcel of land, where the donor retained the right to make minor modifications of the boundaries of the restricted area. The Tax Court, relying on Belk v. Comm'r, 140 TC 1 (2013), supp'd by TC Memo. 2013-154, aff'd, 774 F3d 221 (4th Cir. 2014), stated that an interest in real property is a deductible “qualified real property interest” only if it is an interest in an identifiable, specific piece of real property, and that the property is not identifiable if the donor can change the boundaries.

In PLR 201507008 (Feb. 13, 2015), the IRS stated that an irrevocable trust for the benefit of the grantor and her issue was a grantor trust for income tax purposes, an incomplete gift for gift tax purposes, and includible in the grantor's gross estate for estate tax purposes. The trust allowed an independent distribution adviser to direct the independent trustee as to distributions of principal and allowed the grantor to veto distributions to her issue. It also gave the grantor a lifetime and testamentary power to appoint the trust assets among the issue of her father, excluding the grantor, her estate, her creditors, and the creditors of her estate. The grantor was allowed to borrow trust assets with independent interest, but not necessarily with security.

In PLR 201440008 – PLR 201440012 (Oct. 3, 2014), the IRS stated that transfers to an irrevocable trust were not completed transfers for gift tax purposes, and that the trust was not a grantor trust. The trusts were directed trusts for the benefit of the grantor, her stepchildren, her children, and their issue. During the grantor's lifetime, the trustee must distribute net income and principal to and among the beneficiaries as follows: (a) pursuant to the direction of a majority of the distribution committee, with the grantor's written consent; (b) pursuant to the direction of the unanimous distribution committee members, other than the grantor; and (c) pursuant to the grantor's sole decision, to beneficiaries other than the grantor, for their health, maintenance, support, and education.

The IRS stated that, as long as there was a distribution committee, the trust was not a grantor trust, contributions of property to the trust were not completed gifts by the grantor, distributions of property by the distribution committee from the trust to the grantor were not completed gifts by any member of the distribution committee, and distributions of property by the distribution committee from the trust to any beneficiary, other than the grantor, were not completed gifts by any member of the distribution committee, other than the grantor.

In PLR 201326011 (June 28, 2013), the IRS stated that a grantor who was the income beneficiary of an irrevocable trust and who held a testamentary limited power to appoint the remainder of the trust was deemed to own both income and principal under the grantor trust rules. The IRS stated that the grantor owned the ordinary income of the trust, because it must be distributed to her, and she owned the income allocable to principal (gains and losses, depreciation, depletion, and other principal items), because the grantor has a testamentary power to appoint the corpus (and any accumulated income allocable to corpus), and capital gains are added to corpus.

Glossary of Terms

Independent Trustee

The phrase “Independent Trustee” generally means a person who has no beneficial interest, present or future, vested or contingent, direct or indirect, in the trust. The Independent Trustee also cannot be any of the following:

(a) a contributor to the trust;
(b) a beneficiary;
(c) a spouse, former spouse, ancestor, descendant, sibling or employee of a contributor or beneficiary (or of a spouse or former spouse of a contributor or beneficiary);
(d) a corporation or other entity, or an employee of a corporation or other entity, in which the stock or other holdings of a contributor (or beneficiary, or a spouse or former spouse of a contributor or beneficiary) and the trust are significant from the viewpoint of voting or other control;
(e) a subordinate employee of a corporation or other entity in which a contributor or beneficiary (or a spouse or former spouse of a contributor or beneficiary) is an executive; or
(f) any party, not described in (a) through (e) of this clause (iii), that is, or, if nonadverse (within the meaning of Section 672(b) of the Code), would be, a “related or subordinate party,” with respect to a contributor or a beneficiary (as if the beneficiary were a contributor), within the meaning of Section 672(c) (after application of Section 672(e)) of the Code (iv), is not controlled, directly or indirectly, within the contemplation of income or any transfer tax, by any person or other entity that, according to the portion of this sentence preceding this clause (iv), is ineligible to be an Independent Entity and (v) under the United States internal revenue laws in effect at such time can alone (as though the only trustee), to such extent as some person or other entity (described in the portion of this sentence preceding this clause (v)) could alone (as though the only trustee), possess and exercise each power given a trustee by this instrument or by law (a) without causing any attribution of the trust estate of the trust to any person (whether personally or as deemed transferor or otherwise) for purposes of income or any transfer (including without limitation gift, estate and generation-skipping) tax before the person becomes entitled to receive it outright (or, because of a power granted in or according to this instrument to the person as a beneficiary, the person becomes entitled to pay it to the person or the estate, creditors or creditors of the estate of the person) or it is paid to, or for the benefit of, the person, (b) without otherwise causing any generation-skipping transfer, and (c) without causing any deemed sale or exchange, or transfer to a foreign trust, of any of the trust estate.

Intentionally Defective Grantor Trust

A grantor trust is a trust that runs afoul of the rules contained in IRC§§671-679. Traditionally, violating these rules was viewed negatively, because the grantor of the trust was, for income tax purposes, the owner of the trust assets, and therefore responsible for all income tax associated therewith. This income tax responsibility rested with the grantor whether the income and/or principal was distributed to the grantor or not.

Modern thinking is that violating these rules produces a positive result in many instances, as the grantor’s payment of the income tax generated on the trust’s assets is not considered a gift to the trust beneficiaries. Although the grantor is treated as the owner for federal income tax purposes, the grantor is not necessarily treated as the owner for federal estate tax purposes. The estate tax inclusion rules are applied separately to make this determination.

An Intentionally Defective Grantor Trust (“IDGT”) is a term used for a trust that is purposely drafted to invoke the grantor trust rules. The grantor typically utilizes an IDGT by irrevocably transferring assets to the trust for the benefit of others, typically children or grandchildren. Those assets are removed from the grantor’s estate for estate tax purposes.

The grantor continues to pay the income tax on those assets which provides three substantial benefits:

The grantor continues to decrease the value of his or her estate through the payment of income taxes on trust assets;
The assets in the trust grow income tax free (and if structured properly, estate and inheritance tax free) for the benefit of the beneficiaries; and
The payment of income taxes by the grantor is not considered a gift to the trust beneficiaries.

Decanting

The basic premise is that if the trustee has the ability to invade corpus for a beneficiary under the terms of a trust agreement, the trustee may, in the exercise of its principal invasion power, appoint the principal to a new trust for the benefit of some or all of the beneficiaries of the first trust.

The various state statutes permit a trustee to exercise a decanting power to varying degrees. Decanting statutes can be used to update the terms of a governing instrument by pouring over all of the assets from a trust governed by an outdated instrument to a new trust that contains modern administrative provisions that will afford more flexibility to the trustee and beneficiaries. The decanting statute can also be used in certain situations to alter the beneficial interest in a trust.

There are at least 17 states that have enacted decanting statutes: Alaska, Arizona, Delaware, Florida, Illinois, Indiana, Kentucky, Missouri, Nevada, New Hampshire, New York, North Carolina, Ohio, Rhode Island, South Dakota, Tennessee and Virginia.

Trust Protector

An independent person or entity who holds one or more powers capable of affecting what the trustees are able to do with the trust property.

Investment and Distribution Committees

Increasingly popular strategies to remove the trustee of investment and/or distribution decisions by assigning investment decisions to appropriate experts and distribution decisions to family advisors.