Take-Away: Many wealthy individuals grudgingly acknowledge that they should take advantage of today’s $11.85 million federal transfer tax exemption. However, they are reluctant to do so out of a fear that they may need access to those transferred assets sometime in the future. Estate planning strategies exist that can reassure those individuals that they can continue to have indirect access to the assets that they previously transferred to a trust.

Background: The current estate planning environment is an excellent time to make large lifetime transfers of wealth. A short list of those reasons to make lifetime transfers include: (i) low market valuations for some assets, e.g. commercial real estate, that arise from the COVID-19 pandemic; (ii) historically low interest rates that favor loans to family members and transfers to grantor retained annuity trusts (GRATs); (iii) federal spending in the trillions in response to the pandemic, which strongly suggest a future increase in both income and estate taxes to address that growing federal deficit; (iv) a Presidential election, where one candidate, currently leading in the polls, supports a reduction in the federal estate tax exemption to $3.5 million, a $1.0 million exemption for lifetime gifts, and a limit of $20,000 a year on annual exclusion gifts; and (v) a concern about asset protection in light of the recession and anticipated increase in the number of pandemic-induced bankruptcies. Yet, despite all of these reasons, individuals are reluctant to make large lifetime gifts due to an honest anxiety that they may need access to those transferred assets later in life. This is where advisors can assure their clients that they can continue to have reasonable access through creative estate planning and the effective use of flexible trusts.

Taxation of Retained Rights: An individual can make lifetime transfers of wealth and reserve certain rights in, or control over, the transferred assets. The problem is that with those retained rights or powers, the fair market value of the transferred assets will be included in the transferor’s taxable estate at his or her death, thus defeating one of the principal purposes for making the lifetime transfer.

  • IRC 2036: The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth) by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death-

(a)(1) the possession or enjoyment of, or the right to the income from, the property, or

(a)(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

  • IRC 2038(a): The value of the gross estate shall include the value of all property-
  • To the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power is) to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3 year period ending on the date of the decedent’s death. 

Access to Irrevocable Trust Assets: As a result of these two Tax Code sections, aka string provisions, many of the following strategies intentionally avoid the settlor holding a retained right to receive income, use trust assets, or power to control who else might benefit from the trust or its assets.

  1. Spousal Lifetime Access Trust (SLAT): [Uses the large federal gift tax exemptions while it still exists.] Each spouse uses his or her own available federal gift tax exemption to shelter assets transferred to an irrevocable trust for the benefit of their spouse. The martial deduction is not claimed for the transfer, thus causing each settlor-spouse to use their then-available gift tax exemption, up to $11.58 million. It is important that the terms of these trusts are not similar, in order to avoid the IRS applying the reciprocal trust doctrine to include the value of the transferred assets in the transferring-spouse’s taxable estate. One beneficiary-spouse might have the right to receive all of the income from the trust created for him or her, while the other beneficiary- spouse may have a unitrust withdrawal right, limited to December of each calendar year of 5% from the trust created for him or her. Or, each of  the trusts might giver the beneficiary-spouse different limited powers of appointment, e.g. one is lifetime, the other is testamentary. If these separate trusts have different provisions like these, different assets, different trustees, and are created at different times, there is a good chance that the reciprocal trust doctrine. It is best, too, to create these marital trusts  in different tax years when the gift is being reported on the donor spouse’s federal gift tax return. The benefit of a SLAT is that each spouse uses their then available federal applicable exemption amount while it still exists, and between the two spouses, they will continue to have access to all of the income generated by the two SLATs.
  2. Michigan Qualified Dispositions in Trust (DAPT): [Protects assets from creditor claims or bankruptcy caused by the pandemic.] This trust is available for a single person who is a Michigan resident. It is Michigan’s version of a self-settled domestic asset protection trust, or DAPT. The settlor can be a discretionary beneficiary of this trust, and also retain other rights, like a testamentary power of appointment over the trust corpus, or the right to have the trustee reimburse the settlor’s estate for any federal estate tax liability. This type of trust is not focused on saving federal gift or estate taxes as it is in the protection of the irrevocable trust’s assets from the settlor’s creditor claims. If more than just the settlor are DAPT beneficiaries, the trustee can spray income to those beneficiaries in a lower marginal income tax bracket than the settlor. While a self-settled trust can become part of the settlor’s bankruptcy estate, due to the Bankruptcy Code’s 10-year look-back rule, the DAPT can be structured so that the settlor was not a discretionary beneficiary of the DAPT until at least 10 years and one month, in order to keep its assets from inclusion in the bankruptcy estate, but still permit the settlor access to the DAPT’s assets later in life.
  3. Grantor Retained Annuity Trust (GRAT): [Exploits low interest rates and creates a GRAT with an annuity stream of payments back to the settlor before GRATs are ‘outlawed’.] This type of trust is designed to shift appreciating assets to the next generation at a low, or no, gift tax cost. The taxable gift is the value of the remainder interest in the GRAT. A GRAT can be zeroed-out, however, so no present gift of the remainder interest occurs. A GRAT could be funded using valuation discounts, which might soon disappear with a change in Administrations. Currently GRATs can be funded using a ‘zeroed-out’ annuity formula, which results in no value assigned to the gifted remainder interest in the GRAT, but  this opportunity could also disappear with a change in Administrations. In addition, with the historically low interest rates, the value of the GRAT remainder interest will be very low, if a gift tax is to be incurred on the GRAT’s formation. The settlor of the GRAT has access to the stream of annuity payments for the duration of the GRAT; if there is any value in the GRAT remaining at the end of the annuity payment period, the excess assets pass to the GRAT remainder gift-tax free. With the extremely low current interest rates, there is a very good chance that wealth will be passed on to the remainder beneficiaries of the GRAT gift tax-free.
  4. Special Power of Appointment Trust (SPAT): [Gives the settlor later indirect access to trust assets if needed.] The settlor could fund a conventional irrevocable trust using his or her currently available federal gift tax exemption to shelter the transfer from gift taxation. If the settlor was anxious about transferring too much to the trust, the trust instrument could grant an individual a power of appointment to direct the trustee to distribute assets to the settlor. Instead of expressly naming the settlor as a potential appointee, instead a class of individuals are described as the potential group of appointees. Example: George W. Bush creates and funds an irrevocable trust for his daughters. The trust instrument gives Jeb Bush the power to direct (a naked power of appointment) the trustee to make a distribution to any lineal descendant of George H. Bush. Jeb exercises the power and directs the trustee to make a distribution directly to his brother, George W. Bush, since George W. is within the class of appointees described in the trust instrument, i.e. he is a direct lineal descendant of George H. This power of appointment approach to direct distributions could be a feature included in a SLAT or a DAPT, should the settlor later desire to have access to and benefit from the trust that he or she previously created. With this approach, the settlor should never be named as a beneficiary of the trust that he/she created, nor should the trustee make discretionary distributions to the settlor. With a SPAT the trust will not be treated as a self-settled trust and the settlor’s creditors should not be able to access trust assets.
  5. Power to Loan Trust Assets:  [Gives the settlor indirect access to trust assets if needed.] A trust instrument could give a person who does not have fiduciary duties the power to loan trust assets to third parties, including the settlor. This power to loan is just another form of a power of appointment. While normally a retained power to exchange assets or receive loans from a trust will cause the trust to be classified as a grantor trust for income tax classification purposes, the power to make loans can also be used with a non-grantor trust if the settlor has made a large lifetime gift to that trust and later would like to access those trust assets. This power to loan, or the SPAT, might be an occasion to establish the trust’s situs in Delaware. Michigan’s Trust Code makes it clear that a trust director serves in a fiduciary capacity. Under Delaware’s trust  law, the settlor can choose to make a trust protector/trust director a fiduciary, or not.
  6. Grantor Trusts: [Gives the settlor the ability to retrieve assets previously transferred to the trust.] We know that a common way in which to cause an irrevocable trust to be classified as a grantor trust for income tax reporting purpose is for the settlor to retain a power to substitute assets of equivalent value with trust property. As has been previously reported, (last year) there are a couple of reported decisions that approved the settlor giving to the trustee a promissory note in exchange for trust assets. Consequently, if a settlor needs access to the trust’s income producing assets, the settlor can exchange a promissory note, or other high-basis assets, for the trust’s asset.

Conclusion: These are just some examples of how a settlor can continue to have access to assets previously transferred to a trust. If a closely held business is transferred to the trust, the settlor can continue to be employed by that business and exercise some managerial authority over the business. Similarly, the settlor could be named as a trust director with regard to the management of specific assets held in the irrevocable trust. The point of this exercise is that an individual’s reluctance to engage in estate planning during these uncertain times is understandable, yet with creative advice and the thoughtful drafting of trusts with some backdoor provisions, that individual’s reluctance to make large lifetime gifts can be overcome.