Jaconetta, Burnham & Wimer, LLC

This document was last revised on July 1, 2002 and does not reflect changes in the law that have occurred since that date. The purpose of this outline is to provide an overview of concepts germane to the subject. None of the information contained herein should be relied upon without careful analysis of the changes to the applicable laws and regulations since the revision date.

I. The Irrevocable Life Insurance Trust (“ILIT”).

A. Ownership of the Policy. Life Insurance policy is obtained through an irrevocable trust; that is, the trust is the owner and beneficiary of the insurance policy.

1. When the insured dies, the Trustee of the Trust collects the death benefit and distributes the death benefit to the insured’s beneficiaries who take the proceeds free from income and estate taxes.

NOTE: Regardless of how a life insurance policy is owned, the beneficiary of the policy generally receives the death benefit income tax free. However, the full amount of the death benefit is included in the estate of the owner/insured of the policy upon his or her death for estate tax purposes. The main benefit of the ILIT is that the Trust is the owner of the policy, and therefore, the death benefit is not included in the estate of the insured upon death. In other words, the death benefit can pass to the insured’s intended beneficiaries entirely free of income and estate taxes.

2. Traditionally a life insurance policy insuring one life has been used with an ILIT. An ILIT can also be the owner of an insurance policy on two lives; a joint-and-survivor policy that pays a death benefit only when the surviving insured dies. For estate planning purposes, a joint and survivor policy insuring the lives of a husband and wife offers several benefits:

(a) It pays a death benefit upon the death of the surviving spouse (when estate taxes generally must be paid) thereby providing a vehicle for funding a married couple’s estate tax liability.

(b) Since the policy only pays a death benefit on the death of the surviving spouse, the premiums are generally less.

3. If an existing policy of life insurance on the life of a person is transferred by that person into an ILIT, the person must live for three (3) years from the date of transfer to successfully exclude the policy proceeds from his or her estate.

B. Payment of Premiums

1. Each year the insured transfers cash into the ILIT, and the Trustee uses the cash to pay the policy premiums.

2. The transfer of cash into the ILIT is treated as a gift to the beneficiaries of the trust. The insured can transfer up to $11,000 per beneficiary per year into the trust ($22,000 if the insured is married). If each beneficiary is given a withdrawal or crummy power over the funds placed into the trust for his or her benefit, the annual gift exclusion applies so that the gift is not taxable.

3. The ILIT can build a substantial cash value entirely income tax free.

4. The ILIT allows parents to make non-taxable gifts to their children by using their annual gift exclusions, and, at the same time, postpone the actual transfer of funds (by retaining assets in trust) until some preselected point of time in the future.

5. Contributions to the ILIT decrease the portion of an individual’s estate which is subject to estate tax.

6. Assets in the ILIT are not subject to the claims of creditors of the beneficiaries of the ILIT.

C. Distributions During Lifetime of Insured

1. THE ILIT IS IRREVOCABLE; THAT IS, THE PERSON WHO SETS UP THE TRUST CANNOT REVOKE THE TRUST OR EVER TAKE BACK PROPERTY CONVEYED INTO THE TRUST.

2. The ILIT is typically structured so that distributions can be made to the beneficiaries of the Trust during the insured’s lifetime.

3. Beneficiaries of the ILIT have no legal obligation to return trust property which has been distributed to them to the persons who set up the trust and made the gifts. ILITs are often structured, however, on the premise that the persons who set up the trust have trust that the beneficiaries would return the trust property to them following a distribution if and when the need arises.

D. Distributions After Death of Insured

1. In situations where an estate is illiquid or does not have enough cash to pay estate taxes, an ILIT can purchase illiquid assets from the estate, thereby providing the cash needed to pay the estate taxes.

2. The possibilities are endless with respect to how the ILIT can be structured to make distributions to beneficiaries after the death of the insured:

(a) The Trustee may simply be required to distribute the death benefit outright to each beneficiary in equal shares.

(b) The Trustee may be required to hold the trust property until each beneficiary attains a certain age, goes to college or retires.

(c) The ILIT can be structured as a generation skipping trust which avoids ever being taxed in the beneficiaries’ estates. This is typically done by limiting distributions to income distributions and discretionary principal distributions. Beneficiaries can even be given a special power of appointment without the property in the trust being included in their estates. When the beneficiary dies, his or her share of the trust property would then pass according to the special power of appointment if exercised, or if not, to the beneficiary’s heirs.

II. Qualified Personal Residence Trust (QPRT). QPRT’s allow a person to transfer his or her personal residence to heirs and retain the right to continue living in the residence for a certain number of years, while paying reduced gift taxes on the transfer and removing the value of the residence from his or her estate.

A. The Mechanics

1. An individual; i.e. grantor, transfers ownership of his or her personal residence into an irrevocable trust. Personal residence is defined as:

(a) The principal residence of the grantor within the meaning of Code Section 1034; or

(b) A dwelling unit used by the term holder as a personal residence for a number of days that exceeds the greater of 14 days or 10% of the number of days during the year for which the unit is rented at a fair market rental in accordance with Code Section 280A(d).

2. The grantor retains the right to live in the residence for a period of years defined in the QPRT. Usually the term of the retained use is between five and fifteen years.

3. At the end of the period of years, the residence passes to the beneficiaries of the trust (usually family members of the grantor). The grantor may continue to occupy and enjoy the residence after the term has expired by using one of the following strategies:

(a) The grantor may continue to live in the residence and pay the new owners fair market rent.

(b) The personal residence continues to be held in trust during the life of the grantor’s spouse or the grantor’s descendants.

4. If the grantor dies during the term of retained use, the residence passes to the grantor’s estate or according to a power of appointment exercised by the grantor.

B. Tax Consequences

1. Gift Tax. The amount subject to gift tax is less than the entire value of the residence, since the grantor is retaining the right to live in the residence for a term of years. The fair market value of the residence at the time of the gift is reduced by the actuarial value of the retained interest to determine the amount of the gift. Thus, a grantor can reduce the size of the gift by increasing the duration of the retained interest. Additionally, any appreciation in the value of the house during the term of retained use passes to the beneficiaries gift tax free.

(a) Federal Gift Taxes. Grantor can use his or her federal gift tax exemption to avoid federal gift taxes on the transfer.

(b) State of Connecticut Gift Taxes. The State of Connecticut gift tax structure does not recognize the federal gift tax exemption. Therefore, Connecticut gift tax is due on the total value of the gift.

NOTE: Since the transfer of a residence to a QPRT is not a gift of a present interest in property to the beneficiaries, the transfer does not qualify for the annual gift tax exclusions of the grantor.

2. Estate Tax. The irrevocable nature of the QPRT removes the value of the residence from the grantor’s estate if the grantor survives the term of retained use. If the grantor dies during the term of retained use, the value of the residence is included in the grantor’s gross taxable estate and a credit in the amount of the gift taxes paid on the transfer into the QPRT is applied to the estate taxes due. As a result, no estate tax savings are achieved unless the grantor survives the term of retained use.

3. Example: Felix, age 50, transferred a personal residence worth $1 million to a personal residence trust for a 10-year term during a month in which the Section 7520 rate was 8.4%. Felix’s retained interest was worth approximately $591,650, resulting in a taxable gift to the remainder beneficiaries (Felix’s children) of $480,350. At the end of the 10-year term, the residence, now worth $1.5 million, passes to the remainder beneficiaries. In effect, Felix removed an asset worth $1.5 million from his gross taxable estate while only using $480,350 of his unified credit. Bear in mind that if the property is located in Connecticut, Felix must pay Connecticut gift tax of $21,517.50 by April 15th of the year following the calendar year of the gift.

C. Other Requirements Applicable to QPRTs. A QPRT is a trust that meets all the requirements of Treas. Regs. Section 25.2702-5(c).

1. Use As Personal Residence. The trust ceases to be a QPRT if the residence ceases to be used as a personal residence by the grantor during the term of retained use.

2. Distribution of Income to Grantor. The QPRT must require all income of the trust to be distributed to the grantor during the term of retained use no less frequently than annually.

3. No Distributions to Beneficiaries During Term. The QPRT must prohibit principal distributions to any one other than the grantor prior to expiration of the term of retained use.

4. Prohibition On Ownership of Other Assets. A QPRT cannot own any assets other than a personal residence except for the following:

(a) Cash for payment of expenses “reasonably expected to be paid” within six (6) months of the date of contribution and certain improvements to be paid within six months of contribution.

(b) Cash for initial purchase of residence or purchase of replacement residence.

(d) Cash proceeds from sale of residence.

NOTE: Direct payment of expenses chargeable to income or cash contributions to the QPRT to pay for such items do not constitute additional gifts of property for gift tax purposes. Note, however, that cash contributions for improvements, principal payments on a mortgage or a replacement residence will result in additional taxable gifts.

5. Sale of Personal Residence. Although a QPRT does allow for the sale of a personal residence during the term of retained use, the following restrictions apply:

(a) The proceeds from the sale of the residence must be held in a separate account.

(b) The sales proceeds must be reinvested in a new residence within two years or, if sooner, the date of termination of the term of retained use.

NOTE: Treasury Regulations prohibit the QPRT from selling the residence to the grantor at any time during the term of retained use and at any time thereafter.

6. Disposition of Trust Assets Upon Failure to Qualify as QPRT. If the trust ceases to qualify as a QPRT, it must require the distribution of trust assets to the grantor or the conversion of the trust into a grantor retained annuity trust (GRAT).

7. Limitation on Rights of Grantor After Expiration of Term of Retained Use. The grantor should not retain the right, upon expiration of the term of retained use, to distributions of trust income or principal or to change the trust beneficiaries.

D. Advantages

1. Gift and Estate Tax Savings. Reduced gift taxes paid on transfer of home and elimination of estate taxes if grantor survives the term of retained use.

2. Avoid Probate. Transfer of residence to the trust removes it from the grantor’s probate estate.

3. Succession. The grantor can ensure that the residence passes to his or her desired beneficiaries.

4. Income Tax Deductions Retained. QPRT’s are considered grantor trusts, resulting in the grantor being entitled to deductions for mortgage interest, property taxes and other applicable costs incurred during the term of retained use.

5. Capital Gains Exclusion Retained. If the residence is sold to a third party during the term of the trust, the grantor retains the ability to exclude up to $250,000 of capital gain on the sale ($500,000 if the grantor is married), if all requirements of Code Section 121 are met.

E. Disadvantages

1. Irrevocable Nature of Trust. The transfer of the residence to the QPRT is

irrevocable; that is, the grantor has no right to revoke the trust or withdraw the residence from the trust once it has been transferred.

2. Loss of Control. Since title to the residence is transferred to the trust and then the beneficiaries, the grantor loses control of decisions concerning the residence.

3. Loss of Step-up in Basis. Since the QPRT removes the residence from the grantor’s estate if the grantor survives the term of retained use, the step-up in basis is lost and the beneficiaries’ basis in the residence equals the basis of the property in the hands of the grantor prior to the transfer into the QPRT. Note that if the grantor does die during the term, the beneficiaries receive a step-up in basis, so that their basis in the personal residence is equal to its fair market value at the grantor’s death.

4. Displacement at End of Trust. Many grantors are concerned about being forced out of the residence if he or she outlives the term of the retained use.

5. Annual Gift Exclusions Not Available. Since the transfer of a residence to a QPRT is a gift of a future interest to the beneficiaries, the gift does not qualify for the annual gift exclusion of $11,000.00 per person per year.

6. Connecticut Gift Tax. The transfer of a personal residence located in Connecticut to a QPRT is subject to Connecticut gift tax.

7. Mortgage. If the residence is encumbered by a mortgage, the continued payment of principal by the grantor is subject to gift taxes.

VII. Grantor Retained Annuity Trust (GRAT). A GRAT allows the grantor to transfer assets into an irrevocable trust and retain the right to receive fixed payments for a certain number of years, while paying reduced gift taxes on the transfer and removing the assets from the grantor’s estate. A GRAT is a qualified interest under Chapter 14 of the Internal Revenue Code and therefore the zero value (of retained interests) rule is not applicable.

A. The Mechanics

1. An individual, i.e. the grantor, transfers ownership of assets into an irrevocable trust.

(a) A GRAT usually makes sense when highly appreciating assets are transferred into the GRAT.

(b) Using stock of a family-owned corporation to fund a GRAT has become popular, where discounts can be used to determine the value of the stock transferred into the GRAT, and the amount of the taxable gift can be zeroed out (reduced to zero) by increasing the amount of the retained annuity payments and therefore the value of the retained interest in the GRAT.

2. The grantor retains the right to payment of a fixed amount each year for a period of time (the “Term”) as defined in the GRAT.

(a) The Term is usually between 5 and 20 years, but must be

a minimum of 2 years.

(b) The payments are usually made in monthly, quarterly or annual installments.

(i) A specific dollar amount payable periodically but not less frequently than annually.

(ii) A stated percentage of the fair market value of the property transferred into the GRAT determined on the date of transfer into trust.

Note: The annuity amount can increase each year by up to 120% of the annuity amount paid for the preceding year.

3. At the end of the Term, the trust assets pass to the beneficiaries of the trust (usually children or grandchildren of the grantor).

4. If the grantor dies before the end of the Term, the trust assets pass to the grantor’s estate or according to a power of appointment exercised by the grantor.

B. Tax Consequences

1. Gift Tax. The amount subject to gift tax is less than the entire value of the property transferred into the GRAT, since the grantor is retaining the right to payments of the fixed amount each year during the Term. The fair market value of the assets at the time of the gift is reduced by the actuarial value of the retained interest to determine the amount of the gift. Thus, a grantor can reduce the size of the gift (potentially to zero) by increasing the length of the Term or the amount of each annuity payment. Additionally, any appreciation in the value of the assets during the Term passes to the beneficiaries gift tax free.

(a) Federal Gift Taxes. Grantor can use his or her federal gift tax exemption to avoid federal gift taxes on the transfer but decreasing the amount of the credit available at death.

NOTE: Since the transfer of property to a GRAT is not a gift of a present interest in property to the beneficiaries, the transfer does not qualify for the annual gift tax exclusions of the grantor.

2 Estate Tax. The irrevocable nature of the GRAT removes the value of the assets from the grantor’s estate, if the grantor survives the Term of the trust. If the grantor dies during the Term, the value of the assets is included in the grantor’s estate and a credit in the amount of the gift taxes paid on the transfer into the GRAT is applied to the estate taxes due. As a result, no estate tax savings are achieved unless the grantor survives the Term.

C. Specific Requirements Applicable to GRATs. A GRAT must comply with the following requirements of Code Sections 25.2702-3(b) and (d):

1. Exclusive Distributions to Grantor. The trust must provide that

distributions can not be made to anyone other than the grantor during the Term.

2. Establishment of Fixed Term. The trust must establish a fixed Term of years for the payment of the annuity amount. The grantor can not change the Term after it has been established.

3. Prohibition on Commutation. The trust must prohibit the acceleration or prepayment of the annuity amount to the grantor.

4. Mandatory Payment of Annuity Amount. The annuity amount must be paid to the grantor each year during the Term, even where trust income or cash on hand is not sufficient.

(a) Where cash is not available for distributions, trust assets can be

distributed in kind.

(b) The annuity amount can be paid after the close of the taxable year, provided that it is made no later than the date that the trust’s tax returns are due (without regard to extensions).

5. Additional Contributions Not Allowed. Once the GRAT is established, the grantor can not add additional property to the trust.

D. Advantages

1. Estate and Gift Tax Savings. Reduction or elimination of gift taxes paid on transfer of assets into the GRAT and elimination of estate taxes if the grantor survives the Term of the trust.

(a) Post transfer appreciation in value of assets passes to trust beneficiaries estate tax free.

(b) Lack of marketability and control discounts can be used to determine value of closely held business interests transferred into the GRAT.

2. Avoid Probate. Transfer of assets to the trust removes it from your probate estate.

3. Succession. The grantor can ensure that the trust assets pass to his or her desired beneficiaries.

4. Grantor Trust Status. Since the grantor retains an annuity interest in the GRAT and the trust provides that the trust assets revert to the grantor’s estate if the grantor dies during the Term, the GRAT is usually treated as a grantor trust for income tax purposes. Grantor trust status offers the following advantages:

(a) No gain or loss is recognized on the transfer of assets to and from the trust.

(b) The grantor is taxed on all trust income during the Term allowing trust assets to appreciate tax free for the beneficiaries.

E. Disadvantages

1. Estate Tax Savings Not Guaranteed. If the grantor dies during the Term of the trust, the assets are included in the grantor’s estate and there is no estate tax savings realized.

2. Risk of Lack of Future Appreciation. If the assets in the GRAT appreciate at a rate which is less than the applicable federal discount rate under Code Section 7520, estate tax savings will not be realized.

3. Irrevocable Nature of Trust. The transfer of assets to a GRAT is irrevocable; that is, the grantor has no right to revoke the trust or withdraw trust assets from the trust once it is funded.

4. Loss of Control. Since title to the assets pass to the trust and then the beneficiaries, the grantor loses control of decisions concerning the assets.

5. Loss of Step-up in Basis. Since the GRAT removes the trust assets from the grantors estate if the grantor survives the Term, a step-up in basis in the trust assets upon the death of the grantor is lost and the beneficiaries’ basis in the trust assets equals the basis of the assets in the hands of the grantor prior to the date of transfer into the GRAT.

6. Annual Gift Exclusions Not Available. Since the transfer of assets to a GRAT is a gift of a future interest in property to the trust beneficiaries, the transfer does not qualify for the grantor’s annual gift exclusions.

7. Connecticut Gift Tax. The transfer of assets into the GRAT is subject to Connecticut gift tax.

VIII. Installment Sales to Intentionally Defective Irrevocable Trusts. Intentionally defective irrevocable trusts (IDITs) are trusts designed to afford their creators the best of both worlds from an estate and income taxation point of view. From an estate tax perspective, the IDIT is an irrevocable trust, and therefore, the assets of the IDIT, if properly structured, are excluded from the estate of the grantor at death. From an income tax perspective, the IDIT is a grantor trust. Thus, otherwise taxable sale transactions between the grantor and the IDIT are ignored for income tax purposes, and the income of the IDIT is taxed to the grantor.

A. The Mechanics

1. The grantor creates the IDIT.

(a) The IDIT is an irrevocable trust that is designed (very similar to the irrevocable life insurance trust) to exclude any assets transferred to it from the grantor’s gross taxable estate for estate tax purposes.

(b) The IDIT can benefit the grantor’s spouse during his or her lifetime and then pass to the grantor’s children without being included in either of the grantor’s or the grantor’s spouse’s estate. The IDIT can be structured with generation skipping provisions so that the assets stay in trust for the entire lives of the grantor’s children and then pass to the grandchildren without ever being subject to estate taxes in the children’s’ estates.

(c) The IDIT will contain one or more “defective” provisions which will cause the trust to be treated as a grantor trust for income tax purposes only.

2. Grantor transfers seed money to the IDIT, usually an amount equal to 10% of the value of the assets being sold to IDIT.

3. The grantor sells assets to the IDIT for an amount equal to the fair market value of the interests being sold.

(a) The Trustee of the IDIT executes and delivers to the grantor a promissory note with a face amount equal to the value of the assets being purchased.

(b) The promissory note bears interest at the applicable Section 1274 rate. With a note over nine years, the federal long-term rate applies.

B. Tax Consequences

1. Estate Taxes.

(a) The value of the assets owned by the IDIT is excluded from the grantor’s estate even if the grantor dies before the promissory note is paid off.

(b) The appreciation in value of the assets following the sale to the IDIT escapes estate tax. As long as the assets appreciate at a rate which is higher than the applicable Section 1274 rate, the IDIT is a successful estate planning tool.

(c) If the grantor dies before the promissory note is paid in full, the value of the promissory note is included in the grantor’s estate for estate tax purposes.

2. Gift Taxes.

(a) The transfer of the seed money to the IDIT is a transfer subject to gift taxes. If the IDIT contains Crummey powers and the grantor is married, $22,000.00 per beneficiary can be transferred to the IDIT gift tax free. Beyond that, up to the grantor’s (and grantor’s spouse’s) gift tax exemption can be transferred to the IDIT as seed money federal estate tax free.

(b) The sale of the assets in return for a promissory note with the same value is not treated as a taxable gift.

• care must be taken to determine the value of the assets by a certified appraiser.

• most tax practitioners agree that Chapter 14 of the Code applicable to transfers of retained interests does not apply to IDITs.

3. Income Taxes. For income tax purposes, the IDIT is treated as a grantor trust.

(a) IRS rulings have held that a sale of assets between a grantor and a grantor trust is not treated as taxable event. Thus, no gain or loss is recognized to the grantor on a sale of the assets to the IDIT.

(b) The grantor is not taxed on the interest payments on the note.

(c) All income of the IDIT is treated as income of the grantor and therefore is taxed to the grantor at the grantor’s personal income tax rates.

• Most practitioners agree that payment of the income taxes by the grantor on the income of the IDIT is not a taxable gift by the grantor to the IDIT.

• If the assets are subsequently sold by the IDIT, the gain or loss is recognized by the grantor.

C. Powers Which Cause a Trust to be Treated as a Grantor Trust. The following is a list of powers which can be included in an irrevocable trust in order to render the trust a defective grantor trust for income tax purposes.

1. Premium Payment Power. Under Code Section 677(a)(3), the grantor is taxable as the owner of any trust or trust portion as to which any nonadverse trustee may apply trust income to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse.

2. Spouse as Beneficiary. The grantor’s spouse’s status as a beneficiary eligible to receive distributions of income in the discretion of a nonadverse trustee causes the trust to be a grantor trust under Code Section 677(a).

3. Power to Borrow. The power of the grantor or the grantor’s spouse to borrow income or principal of the trust without regard to adequate interest or security will cause the trust to be a grantor trust under Code Section 675(3)

4. Power to Add Beneficiaries. A grantor is treated as the owner of the entire trust if a nonadverse person has the power to add persons (other than after-born or after-adopted children) to the class of trust beneficiaries, in addition to having discretion to distribute trust income and principal.

5. Right to Substitute Assets. The grantor’s retention or grant to another person (such as a spouse) of the right, exercisable in a nonfiduciary capacity, to reacquire trust assets by substituting assets of equivalent value, will create a grantor trust under Code Section 675(4).