Utilizing the Estate and Gift Tax Exemption Before It’s Too Late
Absent action from Congress, the federal estate and gift tax exemption will revert back to $1 million in 2013. Given this looming uncertainty, individuals should take advantage of the current $5.12 million exemption before the end of 2012 by making gifts. In addition, New York State does not currently impose a gift tax, making this an opportune time for New Yorkers to consider gifting strategies.
High-net-worth married couples often hesitate to make outright gifts for fear of losing income and control over assets. One technique couples can use to help alleviate these concerns is to create mutual lifetime credit shelter trusts for the benefit of each spouse. A lifetime transfer to a credit shelter trust would ordinarily be considered a taxable gift to the trust beneficiary, but because the gift is less than or equal to the exemption amount, the gift is a tax-free transfer. The ability to customize the trust instrument according to each spouse’s unique needs and desires, while also providing each spouse with some degree of control, is an attractive feature of the credit shelter trust.
For example, consider Jack and Jill, a husband and wife with a net worth of $20 million and two adult children. Theyare concerned about the possible loss of the current exemption, and would like to reduce the amount of estate taxes that their children will have to pay. Jack and Jill also wish to maintain their cash flow and control over their assets. This dual concern for financial security and control prevents them from currently making gifts to their children.
Lifetime credit shelter trusts might be the ideal instrument for such a couple. Credit shelter trusts allow for creativity and flexibility; the trust can be drafted in a way that ensures each spouse income during life, while still allowing the couple to take advantage of the current exemption. For example, Jack could fund a lifetime credit shelter trust for Jill’s benefit with $5 million of assets, a transfer that would be tax-free under the current exemption. All income would be paid to Jill for her life, with principal distributed according to an “ascertainable standard.” Upon Jill’s death, the trust funds would be available to their children and might be either distributed or held in further trust. In addition, assuming that Jack (the settlor) has not retained any prohibited powers over the trust, its value would not be included in his estate. The trust would also be drafted to avoid inclusion in Jill’s estate. Similarly, Jill could use her $5 million exemption to fund a lifetime credit shelter trust for Jack’s benefit.
Acting as Beneficiary and Trustee
One common question that arises when a couple wishes to retain control of their assets is whether a spouse can act as both beneficiary and trustee without incurring adverse tax consequences, such as inclusion of the trust assets in her estate. For example, perhaps Jill, as beneficiary, would like to retain a higher degree of control over the trust assets by participating as trustee. In Revenue Ruling 78-398, the IRS determined that a trust beneficiary who was also named as the sole trustee could have some discretion to make distributions of principal to herself. In that case, the trust assets were not included in her estate because her powers as trustee were limited by an ascertainable standard—namely, only as necessary for her “maintenance and medical care.” As described below, the Treasury Regulations are even more permissive.
This ruling was recently confirmed by Estate of Chancellor v. Comm’r (T.C. Memo 2011-172). In Chancellor, the surviving spouse acted as both beneficiary and trustee of a credit shelter trust created by her husband. The trust instrument provided that the trustee could distribute trust principal to the beneficiary-spouse for her “maintenance, education, health care, sustenance, welfare or other appropriate expenditures.” The Tax Court ruled that the spouse, as both beneficiary and trustee, could exercise her power to make distributions to herself without the trust being included in her estate because her power was limited by an ascertainable standard.
Traditionally, “ascertainable standard” has been defined by Internal Revenue Code (IRC) section 2041 and Treasury Regulations section 20.2041-1 as relating to the beneficiary’s “health, education, sup- port, or maintenance.” These are broad standards, and the Treasury Regulations also permit the trustee to exercise discretion to support the beneficiary’s “accustomed manner of living.” Use of these specific terms is not required, but caution is advised when using alternative terms.
For example, in Chancellor, the IRS asserted that the trustee-beneficiary’s estate should have included the trust because the standard did not relate solely to her health, education, support, or maintenance, but also considered the spouse’s “welfare and other appropriate expenditures.” After examining the settlor’s intent and the applicable state law, the Tax Court ultimately ruled that the power to invade was limited by an ascertainable standard and did not include the trust in the decedent’s estate. This case highlights the importance of careful drafting by illustrating that the IRS may take action if the trust instrument strays from using the exact language contained in the regulation.
An alternative to using an ascertainable standard is to appoint an independent trustee. The independent trustee could act as the sole trustee, or, if the couple wishes to retain more control, the independent trustee could instead act as a co-trustee with the beneficiary. As a co-trustee, the independent trustee could be empowered to make those discretionary distributions that beneficiaries might not be able to make without risking inclusion of the trust in their estates.
Returning to the example above, perhaps Jill feels constrained by a standard limiting her to distributions only for her health, education, maintenance, or support. She could instead, or in addition, appoint a trusted friend to act as an independent trustee. This friend could make those distributions that Jill feels she needs but would otherwise not be necessary for her health, maintenance, education, or support. By using an independent trustee, Jill would not be exercising a power that would risk inclusion of the trust in her estate. IRC section 674(c) generally describes independent trustees as persons who are not immediate family or subordinates or employees of the settlor or trustee. Consideration should be given to appropriate trustee appointment and removal powers.
A third consideration is to include a “five-by-five power.” Under a five-by-five power, as defined by IRC section 2041(b)(2), beneficiaries can retain limited withdrawal powers over principal without the entire trust being taxed in their estates. This ability to withdraw principal must be limited to an annual amount that does not exceed the greater of either $5,000 or 5% of the trust principal.
Reciprocal Trust Doctrine
Mutual lifetime credit shelter trusts do have a hidden danger: the IRS’s reciprocal trust doctrine. This danger can be avoided through careful drafting. Reciprocal trusts are those created by two individuals for the benefit of each other. Application of the reciprocal trust doctrine allows the IRS to “uncross” the trusts and to treat each as a self-settled trust, or one created solely for the settlor’s benefit. As such, the trust is included in the settlor’s estate, obviating one purpose for which the trust was initially created.
For example, if Jack funds a trust with $5 million for the benefit of Jill, and Jill funds an identical trust with $5 million for the benefit of Jack, such trusts would be reciprocal. The IRS could then use the reciprocal trust doctrine to uncross the trusts, deeming Jack to be the beneficiary of the trust that he created and Jill to be the beneficiary of the trust that she created, thereby resulting in estate inclusion.
According to the U.S. Supreme Court in U.S. v. Grace (395 U.S. 316, 324–25 ), the reciprocal trust doctrine applies when two trusts are interrelated and the settlors are left “in approximately the same economic position” as before the creation of the trusts. For example, in Grace, trusts created by a husband and wife for the other’s benefit were deemed to be reciprocal because each settlor was in the same basic economic position and because the trusts were “substantially identical in terms and were created at approximately the same time.”
The doctrine has also been applied when spouses held crossed trustee powers over identical trusts, but did not have an economic interest. In Estate of Bischoff v. Comm’r (69 T.C. 32 ), the couple executed identical trusts for the benefit of their grandchildren and named the other spouse as trustee. Distributions of principal and income were made in the sole discretion of the trustee. If such a power had been held by the settlor, the value of the trust would have been included in the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). Here, the Tax Court ruled that the trustee powers were reciprocal and uncrossed the powers, deeming the spouses to be the trustees of the trusts they created. Thus, each trust was deemed to be part of the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). In its decision, the Tax Court stated that it was not necessary for the settlor to have an economic interest in the property transferred in order for the reciprocal trust doctrine to apply; it was enough for the settlors to have crossed trustee powers.
To avoid the reciprocal trust doctrine, each trust must be materially different. The IRS does not define material differences, and careful drafting is essential. Although certainty is impossible, the following non-exhaustive list of examples of material differences might provide assistance:
- Different times of execution
- Different distribution schemes
- Different trustees
- Appointment of an independent trustee in one trust
- Different or additional beneficiaries
- Inclusion of a five-by-five power in one trust
- Inclusion of a limited power of appoint- ment in one trust
- Different remainder interests
- Different times of termination.
Each family situation is different and presents opportunities for innovation and creative drafting. For example, in an appropriate situation, one trust might appoint the spouse and children as trustees, whereas the other trust names only the spouse as trustee. Perhaps Jack’s trust allows Jill to invade principal for her health, maintenance, education, and support, whereas Jill’s trust grants Jack a more limited withdrawal power over principal. Alternatively, Jack’s trust might grant the remainder to the children outright, whereas Jill’s trust might hold the remainder in trust for their children and grandchildren, thereby utilizing her generation-skipping transfer tax exemption.
Case law indicates that material difference is not a particularly stringent standard, but prudence is always recommended. In Estate of Levy v. Comm’r (T.C. Memo 1983-453), the reciprocal trust doctrine did not apply to two trusts simultaneously created by a husband and wife because the trust terms were not identical; the trust instrument for the wife’s benefit granted her a special power of appointment, whereas the trust for the husband’s benefit granted him no such power. The wife’s special power of appointment was found to have “objective value” that resulted in the trusts having “very different legal consequences.”
Similarly, in Private Letter Ruling 200426008, the IRS chose not to apply the reciprocal trust doctrine to trusts executed by a husband and wife for the benefit of the other spouse and their child (June 25, 2004, http://www.irs.gov/pub/irswd/0426008.pdf). Each trust contained a life insurance policy on the settlor’s life and named the other spouse as trustee. The trusts were similar in many respects, but also had several important differences. Under his trust, the husband could only receive distributions three years after his wife’s death and only when his net worth and income fell below specified levels. Under her trust, the wife could only receive distributions after the death of their child and only up to $5,000 or 5% of the trust principal. Furthermore, the wife was given a limited power of appointment that could only be exercised after their child’s death. Of course, like all private letter rulings, this decision was limited to the parties at issue and cannot be cited as precedent. The ruling does, however, highlight the types of differences that the IRS will examine in determining whether the reciprocal trust doctrine applies.
In the case of mutual lifetime credit shelter trusts, the parties should strive to avoid the reciprocal trust doctrine by including significant material differences between the trust instruments. These differences need not be arbitrary. Given the general flexibility of the credit shelter trust, material differences can be incorporated by tailoring each trust to the respective beneficiary’s needs. For example, if Jack is elderly or in poor health, Jill’s trust for his benefit might be funded with fewer assets or have a more restrictive distribution scheme. This technique likely has the dual benefits of adapting the trust to accommodate the couple’s unique situation and avoiding the reciprocal trust doctrine. Couples might also consider including a limited power of appointment in the trust that names the spouse and children as trustees. This will help protect the spouse and ensure that the children exercise discretion in their parents’ best interests. The key is to avoid estate inclusion and application of the reciprocal trust doctrine. Careful drafting will achieve both goals, while also protecting each spouse and providing a degree of control.
Another consideration might include drafting the trusts to utilize the generation-skipping transfer tax exemption. The trust may provide that the trust corpus remain in further trust for the benefit of the settlor’s children and grandchildren. The settlor might then allocate his generationskipping transfer tax exemption to the trust. This will allow the trust assets and any future appreciation to ultimately pass to his grandchildren without imposition of the generation-skipping transfer tax. It is important to note that the current generation-skipping transfer tax exemption, which is equal to the estate tax exemption, is similarly scheduled to revert back to $1 million on January 1, 2013.
Lifetime credit shelter trusts are ideal ways to take advantage of the current estate and gift tax exemption. Their use allows married couples to make gifts while retaining some financial control and a source of income. Credit shelter trusts also allow for flexible and creative drafting, a characteristic that can help avoid inclusion of the trust in the beneficiary’s estate and avoid application of the reciprocal trust doctrine. Because the fate of the $5.12 million estate tax exemption hangs in the balance, couples should act before the end of the year.