Third-Party Trusts Integrate Estate and Asset-Protection Planning — footnotes

¹ The term “settlor” means the person who creates (i.e., settles) and funds the trust via gifts.

² A “self-settled” trust, as used herein, is a trust created by its primary beneficiary and funded by his or her gifts (i.e., not transfers for full consideration).

³ If the initial contribution exceeds $5,000, and the TPT uses a hanging Crummey power provision to qualify the contribution as a present-interest gift (a discussion of which is beyond this article’s scope), the client may continue to hold a general power of appointment over the hanging power at a time when a creditor might attempt to force the client to exercise the latter for the creditor’s benefit.

For purpose of this article, a hanging Crummey power generally means a beneficiary’s power to withdraw amounts contributed to the trust, within a certain time period described in the instrument. Typically, the beneficiary does not exercise this withdrawal right and it lapses. To the extent the lapse does not exceed the greater of 5% of the trust corpus or $5,000, it will not be deemed a gift back to the trust by the beneficiary; to the extent it exceeds the greater of 5% or $5,000 (the excess), it is deemed such a gift. To avoid the deemed gift, the trust can provide that the beneficiary will continue to have the right (a hanging power) to withdraw the excess; however, the power cannot hang forever. If the trust value increases such that the $5,000 or 5% amount exceeds the amount contributed to the trust that year, the hanging power amounts from prior years will lapse (per the beneficiary who holds a withdrawal power) to the extent of the greater of $5,000 or 5%; see D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968).

A hanging Crummey power is typically used in a TPT because, to be treated as the grantor of a grantor trust under Sec. 678(a), the client must hold such a general power of appointment or have previously held such a power and subsequently released it. Having the TPT qualify as a grantor trust to the client allows the latter to sell appreciated assets to the trust without recognizing gain; see Rev. Rul. 85-13, 1985-1 CB 184.

⁴ See Rev. Rul. 95-58, 1995-2 CB 191 (trust assets were not includible in an estate, even though the decedent could replace the trustee).

⁵ This veto power is not a Sec. 2036 or 2038 power, because the client sold the assets to the trust for full consideration.

⁶ An independent trustee may be granted the power to amend the TPT to a limited degree to allow the trust to continue to carry out the settlor’s estate planning goals, as affected by tax law changes.

⁷ For instance, a TPT might grant a foreign independent trustee the power to remove all domestic trustees (including the family trustee) if he or she believes such action is needed to uphold the fiduciary obligation to protect TPT assets. The client/family trustee’s veto of the foreign trustee’s decision to remove the family trustee would most likely, under the TPT’s terms, be nullified if the family trustee’s exercise of his or her veto power resulted from duress or compulsion.

⁸ Care in drafting the TPT agreement should be exercised, to avoid allowing distributions to beneficiaries who could be deemed agents of the family trustee.

⁹ However, the TPT document may provide the client the power to appoint trust assets to anyone other than himself or herself, his or her creditors, estate or the creditors of his or her estate, allowing the client to further control such assets without causing them to be included in his or her estate.

¹⁰ Even though the appreciating assets are beyond the reach of the client’s creditors, the installment obligation is not (unless steps are taken to protect it).

¹¹ If an active business is sold, the trustee’s authority to hold and operate it should be clearly stated in the TPT agreement, as well as the trustee’s other powers. For example, the trustee’s authority to serve on the business’s board should be expressed. This, of course, raises other issues, such as how to resolve conflicts-of-interest when the trustee’s actions benefit the business, but not the beneficiaries. For example, the trustee’s actions may allow the business to grow, but may also interfere with the TPT’s (1) beneficiaries’ ability to receive liquid distributions or (2) ability to meet its payment obligations under an installment note. Also, if the TPT’s business activities are a potential source of liability, the client should become a primary beneficiary of two separate TPTs, one holding only the business assets and the other holding the passive assets, so that the liability stemming from the business TPT will not taint the passive TPT.

¹² Of course, if it appears that the negotiated provisions could serve as an impediment to an existing or anticipated creditor, then a full fraudulent-transfer analysis should be conducted first, to ensure that the client is not making the transfer with an intent to hinder, delay or defraud anticipated or existing creditors.

¹³ See Sec. 7872 and Regs. Secs. 20.2031-4 and 25.2512-4; see also Edwin H. Frazee, 98 TC 554 (1992).

¹⁴ For example, if X contributed the 1% SMLLC interest, along with the management powers over the SMLLC, to an intentionally defective irrevocable trust, this interest would also be excluded from X’s estate. This may be advisable if X is concerned about a few recent cases that treated partnerships and LLCs formed by a taxpayer as completely includible in the estate if the taxpayer died while retaining general partner or manager powers over the entity (although this new trend of cases has shown some signs of reversal; see, e.g., David A. Kimbell, 371 F3d 257 (5th Cir. 2004)). For a discussion, see Eyberg and Raasch, “FLP Planning after Strangi, Kimbell and Thompson,” 34 The Tax Adviser 750 (December 2004).

¹⁵ See Rev. Rul. 85-13, note 3 supra, which states that a sale by a grantor to his or her grantor trust will not be treated as a sale for income tax purposes.

¹⁶ This is due to the grantor trust provisions that attribute the powers held by a spouse-beneficiary to the settlor-spouse. Because a TPT grants grantor trust powers to the client, if his or her spouse is the settlor, the settlor will be deemed to hold such powers and will be treated as the grantor.

¹⁷ The TPT would need to be carefully drafted for it to be deemed a trust for the benefit of the client’s spouse under Sec. 1041. Also, if the property sold is subject to debt in excess of the client’s tax basis, other rules apply; compare Sec. 1041(e) with Sec. 671 et seq.

¹⁸ The settlor should consider allocating his or her generation-skipping transfer (GST) tax exemptions to contributions to the TPT, to avoid the possibility of GST tax.

¹⁹ See Nevada Revised Statute 166.010 et seq.

²⁰ See Sec. 2056(b)(7).

²¹ See the Nevis Limited Liability Company Ordinance (1985).

²² See AZ Rev. Stat. 29-341.

²³ The fact that the client could have withdrawn the assets, but instead lets them remain in the TPT, causes concern for those who question whether this is an effective contribution/gift of those assets to the TPT by the client. Provisions under the estate tax, gift tax and trust laws, however, suggest that allowing a client’s withdrawal powers to lapse is not a contribution to the trust by the client of an amount not exceeding the greater of $5,000, or 5% of the trust corpus; see Secs. 2514(e) and 2041(b)(2) and Uniform Trust Code 505(b)(2). The terms “lapse” and “release” differ for purposes of Sec. 2514. The distinction can be critical in this context, but a discussion is beyond this article’s scope.

²⁴ This can trigger a “form-over-substance” argument from the IRS, however.

²⁵ A private annuity involves the purchaser making a series of payments, the present value of which will equal the value of the assets sold. The payments are computed by referring to mortality-based annuity tables based on the seller’s life expectancy; see IRS Pub. 1457, Actuarial Values, Book Aleph, Table 90CM. For example, the older the seller, the larger the payments, because the older seller is predicted to have a shorter period to receive payments.

Private annuities have been used as tools whose value disappears at death. Thus, they can provide a potential estate tax reduction strategy. This is somewhat risky, in that the sale may be reclassified as a transfer with a retained interest.

²⁶ See 212 Corp., 70 TC 788 (1978).