Beneficiary-controlled Trusts

Estate planners use trusts to protect beneficiaries from their inability, their disability, their creditors and their predators. Included under “creditors” are the IRS and divorced spouses. Most traditional trusts distribute the assets when the beneficiary reaches a certain age or ages, with the last distribution terminating the trust.

More sophisticated estate planners generally create multi-generational dynasty trusts for their clients’ descendants that are (1) estate tax protected, (2) creditor protected and (3) divorce protected – while at the same time allowing the primary beneficiary to control the trust as a co-trustee. In essence, the primary beneficiary has nearly all the rights, benefits and control over the trust property that a person would have with outright ownership – in addition to tax, creditor and divorce protection not available with outright ownership. Such trusts are sometimes referred to as “beneficiary-controlled” trusts. Following are the design features of the typical beneficiary-controlled trust:

* The donor (i.e., parent or grandparent) is the grantor of the Trust.

* The child and his/her descendants are the beneficiaries of the Trust. However, the child is the “primary” beneficiary of the Trust during his/her lifetime and, therefore, the child’s needs take priority over the needs of his/her descendants.

* The Trust has two trustees – the primary beneficiary (upon attaining the age of projected maturity) and an independent trustee. The independent trustee can be the primary beneficiary’s friend, trusted advisor or a bank.

* The primary beneficiary has the power to remove and replace the independent trustee from time to time, thereby maintaining the beneficiary controlled feature of this trust design, so long as the replacement trustee is not a “related or subordinate party” as defined in Internal Revenue Code Section 672(c).

* The trustees can distribute to the primary beneficiary (and his/her descendants) income and principal as needed for health, education, maintenance and support.

* The trust agreement also allows the trustees to acquire assets for the primary beneficiary’s use and enjoyment (without remuneration) such as vacation homes, art work, jewelry, etc. The trustee could also invest in a business that the beneficiaries can be employed by.

* The primary beneficiary can be given a broad non-general power to appoint the trust property during life and/or at death in favor of anyone other than the primary beneficiary, his/her creditors, his/her estate, or the creditors of his/her estate. Thus, the primary beneficiary can “re-write” the trust for future generations.

* At the primary beneficiary’s death, the assets remaining in trust pass to his/her children (i.e., the grantor’s grandchildren), in equal shares, but in further trust. At that time, the grandchild becomes the primary beneficiary of his/her separate trust, which now benefits the grandchild and the grandchild’s descendants. To the extent of the grantor’s generation skipping tax exemption (which is the same as the estate tax exemption) plus the future appreciation thereon, there would be no estate taxes due.

Many beneficiary-controlled trusts are designed as generation-skipping trusts. In 1986, Congress (recognizing that the IRS was losing billions in estate taxes) attempted to thwart generation-skipping trusts by creating the “generation -skipping transfer tax” (GSTT). The GSTT is imposed on the transfer of assets to individuals who are more than one generation younger than the transferor (i.e., grandchildren and great grandchildren). This includes the transfer of assets that are given outright or in trust. The GSTT is in addition to the Federal estate and gift tax, and is equal to the maximum estate tax rate. Fortunately, Congress did include a significant exemption to the GSTT. The GSTT exemption is equal to the estate tax exemption. While there is a present lapse in the estate and generation-skipping transfer taxes, it’s likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%.

Although the GSTT exemption is the same as the estate tax exemption, tax-free gifts to a generation-skipping trust are still limited to the $13,000 annual gift tax exclusion ($26,000 for a married couple); and the $1 million lifetime gift tax exemption ($2 million for a married couple). If the GSTT exemption is allocated to a generation-skipping trust, the trust, including all appreciation, is entirely exempt from the GSTT for its entire term. Lifetime transfers to most generation-skipping trusts result in the automatic allocation of the grantor’s remaining GSTT exemption, unless a gift tax return (Form 709) is timely filed to elect out of the allocation.

As a general rule, the earlier the trust is created in the life cycle of an asset or investment, the greater the benefits in tax savings. Creating a beneficiary-controlled trust early on also enables the donor to place the initial seed money for funding a favorable business or investment opportunity into a trust rather than have the donee own it. Nowhere is this opportunity shifting more productive than with new ventures or startup businesses.

The beneficiary-controlled trust is gaining popularity among estate planners. Beneficiary-controlled trusts can be created at the grantor’s death as part of the donor’s living trust, or can be used in irrevocable trusts, including irrevocable life insurance trusts. But the benefits of creditor protection and estate tax savings are only available if someone else, such as a parent or grandparent, sets up the trust. In short, a beneficiary-controlled trust should be considered whenever it is worthwhile to protect beneficiaries from creditors, divorcing spouses and estate taxes.


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