Several Types of Irrevocable Trusts
By Cowles Liipfert
There are several different types of irrevocable trusts––mostly known by four-letter words––which we will describe very briefly (and superficially) below, and if you need to know more information about any of them, you will need to consult further with an estate planning professional.
1. Irrevocable Life Insurance Trust (ILIT)
If a life insurance policy is owned by the insured and is payable to named beneficiaries at death, the full death benefit is included in the taxable estate of the insured.
If a life insurance policy is owned from its inception by someone other than the insured, such as a trust, it will not be included in the taxable estate of the insured at the time of death.
If an existing policy is transferred to an irrevocable trust by the insured, instead of a brand-new policy owned from its inception by the trust, then the transferred policy will be taxable as part of the grantor’s taxable estate if the Grantor dies in less than three years after the transfer, but after three years, the policy will not be considered part of the grantor’s taxable estate.
Because the estate tax exemption for US citizens and residents is so high at the current time ($11.4 million in 2019, indexed for inflation), these trusts are not used as frequently as they have been in the past, when the estate tax exemption was much lower, but many irrevocable trusts which own life insurance policies remain in existence. They can still be useful tools for avoiding unnecessary estate tax when an insured has a large estate, and if the estate tax exemption is reduced in the future, they could become more important to many insureds.
If a contribution is made to an ILIT to pay premiums on a life insurance policy, certain procedures must be followed to qualify the contribution for the donor’s gift tax annual exclusion.
2. Qualified Personal Residence Trust (QPRT)
These trusts are not used as frequently as in the past because of the high estate tax exemption and also because the prevailing interest rates have been historically low for a number of years, but QPRTs have been used for many years to leverage taxpayers’ gift and estate tax exemptions, for both primary residences and vacation homes.
With a QPRT, a grantor gives away a residence, subject to the grantor’s right to continue using the residence for a term of years, after which the trust will terminate, and the residence will be turned over to the “remainder beneficiaries.”
For example, the trust grantor could give a vacation home to his or her children, subject to a 15-year retained possessory interest and subject to a reversionary interest in the grantor’s estate if the grantor dies before the end of the trust term. Depending on the applicable federal rate (AFR) of interest at the time of the transfer to the trust, and also depending the grantor’s actuarial life expectancy at that time, the gift of the “remainder” interest for a $500,000 vacation home might be $150,000 and the value of the grantor’s retained interests might be $350,000, for example.
In that case, if the grantor outlives the term of his or her retained possessory interest, he or she would have given away a $500,000 house for a taxable transfer valued at $150,000. Better yet, if the house appreciates in value to $650,000 after the gift, the grantor also would have avoided that $150,000 in future appreciation, without gift or estate tax consequences. The retained term should be shorter than the grantor’s life expectancy to obtain the anticipated gift and estate tax benefits.
An option, which appeals to some, is to name the spouse as a life beneficiary at the end of the grantor’s retained possessory term, but this must be done with caution.
Under most QPRT’s, if the grantor dies before the end of the trust term, the house will revert to the grantor at that time, so the owner, when he or she creates the QPRT, is essentially betting that he or she will outlive the term of the retained interest in the house.
If the grantor dies before the end of the trust term and the house reverts to his or her estate, the grantor’s estate would recover the $150,000 portion of his or her applicable gift tax exclusion used at the original transfer, so “losing the bet” would not be any worse that not having created the trust in the first place. One might look at it as “Heads you win, tails you do not lose.”
3. Charitable Remainder Unitrust (CRUT)
Not unlike the QPRT discussed above, this trust is a split-interest trust which is used to obtain some tax benefits for the trust’s grantor by a temporary interest retained by the grantor, followed by a “remainder” interest in a charity or charities selected by the grantor.
Suppose that the grantor owns $1,000,000 of stock in a company which is likely to be bought out by another company, and further suppose that the grantor has a very low cost-basis in the stock.
By creating a CRUT and transferring the stock to the CRUT prior to the buy-out, the grantor could avoid having to pay capital gains tax when the buy-out occurred. Since the CRUT would be a charitable trust, it would be exempt from capital gains taxes which could perhaps total as much as $200,000 on a $1 million sale of stock, as compared to the alternative of having immediate tax.
The trust would receive the proceeds of the stock sale when it occurred and would distribute a fixed percentage of the trust’s value to the grantor for life, based on the value of the trust assets, as recalculated annually.
If the investments went up in value during the year, the distributions would be increased accordingly, and if the trust assets went down in value, the distributions would go down by a similar percentage.
The actuarial value of the charitable payout on termination of the trust would be calculated up-front, at the time of the original stock transfer to the CRUT, which calculated amount would qualify for the income tax charitable deduction on the grantor’s personal income tax return, and also would not be subject to gift tax.
The grantor (and the grantor’s spouse, if applicable) would in effect receive taxable life distributions from the trust each year, but the capital gains would not be subject to capital gains tax so long as the trust continued to hold the undistributed gain.
Upon the death or deaths of the life beneficiaries of the trust, the trust would be terminated, and the remaining assets would be distributed to the charitable remainder beneficiary.
The trust would enable the grantor to retain a higher flow of distributions during the grantor’s lifetime than if the grantor had retained the assets and paid capital gains tax from the proceeds when the stock was sold, and the grantor would receive an income tax charitable deduction at the time of the initial gift to the trust.
The grantor’s spouse could be a life beneficiary of the trust, if the spouse survived the grantor. If both spouses were grantors of the original trust, the distributions could continue to the surviving grantor.
Drawbacks of a CRUT could include (1) lack of access to the trust assets if needed, as the grantor would receive only the prescribed distributions, (2) the cost of the trust’s administration would be higher than if there were no trust; and (3) since the trust assets would go to charity at the end of the trust term, those assets would not be available to go to the family at that time.
(Some families prefer to buy life insurance, using part of the extra cash flow resulting from tax savings at the creation of the trust, to pay insurance premiums, for a policy to replace the family wealth lost by the large charitable gift. That is, the life insurance death benefit could replace the family wealth which will go to charity on termination of the trust).
For someone with a big charitable inclination, however, a CRUT could be a good option.
4. Charitable Remainder Annuity (CRAT)
A CRAT would work in much the same manner as a CRUT, except that the distributions would be fixed during the trust term, instead of being adjusted each year to reflect appreciation or depreciation.
The distributions would remain fixed during the trust term.
5. Grantor Retained Annuity Trust (GRAT)
A GRAT is a trust whereby the grantor retains a fixed payout for a term of years, after which the trust would terminate and the assets would be distributed to non-charitable remainder beneficiaries, such as family members.
The grantor’s taxable gift would be reduced by the actuarial value of the annuity interest for the term of years retained by the trust’s grantor.
6. Grantor Retained Unitrust (GRUT)
A GRUT is similar to a GRAT, except that the distributions are adjusted annually, to reflect capital appreciation or depreciation from year to year, instead of fixed payments for the entire trust term.
Like a GRAT, the grantor’s taxable gift would be reduced by the actuarial value of the annuity interest for the term of years retained by the trust’s grantor.
For generation-skipping trusts (to grandchildren instead of children, etc.), a GRUT is a better tax vehicle than a GRAT.
7. Qualified Domestic Trust (QDOT)
A QDOT is used to qualify a gift to a non-citizen spouse for the estate of gift tax marital deduction.
8. Intentionally “Defective” Income Trust (IDIT)
A IDIT is a trust to which a grantor transfers assets but retains powers over the trust which, under the Internal Revenue Code requires the income of the trust to be taxable to the grantor because of too much retained control – hence called “defective.”
The so-called “defect” can be used to the advantage of the grantor, if the grantor gives assets (usually shares of stock) to originally fund the trust, then later sells a larger number of shares to the trust in exchange for a promissory note.
The sale is not deemed taxable because of the “defect.”
If the stock later increases in market value, appreciated shares can be transferred back to the grantor at their appreciated value, in payment for the promissory note. The remaining shares could be retained by the trust and/or distributed to the beneficiaries, without income tax or gift tax consequences.
In other words, future appreciation in the value of the stock could be transferred to the beneficiaries – without gift tax or income tax consequences.
9. “Bypass” Trust
A Bypass Trust is commonly used by one spouse to leave assets to his or her surviving spouse in a manner in which the surviving spouse can get the benefit of the trust assets, but the assets do not become part of the surviving spouse’s taxable estate – hence bypassing estate taxes upon the death of the survivor.
10. “Dynasty” Trust or GST Trust
This is a trust which can be created on behalf of more than one generation of beneficiaries, which can give each succeeding generation the benefit of distributions of income, etc., but which does not become subject to estate tax at the level of each generation.
If the assets grow steadily over several generations without being periodically subject to estate taxes, the trusts can grow to very large value – hence sometimes called “Dynasty” trusts.
Rather than holding everything in one big trust for several generations, the trust could authorize the trustee to split the trust periodically into smaller trusts, especially if individual members of succeeding generations have different needs and objectives. Also, the trust agreement could allow for principal distributions in addition to income distributions based on need, especially from smaller trusts after a split, if necessary.
All of the above are very technical and should be studied in detail with your professional tax advisor.