Unique Assets: Purpose Trusts

While most trusts are established to make distributions to either individuals who are the named trust beneficiaries or to a charity, a purpose trust normally exists to hold or to dispose of specific assets, meaning the trust exists to carry out a specific purpose rather than to provide a benefit to particular individuals. Purpose trusts seem to be gaining a lot of attention in the press these days, especially with the proponents of gun trusts which are intended to avoid federal regulations on permissible ownership and registration and transfer fees.

Historic examples of a purpose trust are trusts that are established to care for a pet on the pet owner’s death; to preserve the family cottage; or to maintain the decedent’s cemetery lot (but the trust cannot be used to maintain or preserve human remains!) A purpose trust can also hold other unique assets, often when ownership of the asset is highly regulated like firearms or a registered aircraft. A purpose trust can also be used to hold valuable collectibles that require a high level of expertise and experience for their preservation, protection, and valuation (like artwork or a wine collection) before the asset is liquidated or distributed to trust beneficiaries.

Common Law: At common law these trusts were labeled honorary trusts, which were strictly speaking legally unenforceable if the designated trustee failed to carry out the specified purpose. In addition, the residuary beneficiaries of the honorary trust could petition a probate court to terminate the trust at any time.

Michigan Statute: With the advent of statutory purpose trusts comes more regulation. For example, Michigan’s Trust Code recognizes that a trust may be created for a non-charitable purpose. MCL 700.7402(1)(c)(ii) As a generalization, however, that non-charitable purpose trust can legally exist for only 21 years if there is no ascertainable beneficiary who is designated in the trust instrument. MCL 700.2722(1)

Transfer Taxation: A purpose trust can be created and funded during the owner’s lifetime or more commonly a purpose trust is created upon the owner’s death as part of a more comprehensive estate planning trust that contains express provisions that address a specific asset or collection.

• Gift Taxation: The lifetime transfer of valuable assets into an irrevocable purpose trust will be completed gifts for federal gift tax reporting purposes. But the nature of the trust can cause some confusion. If the purpose trust is a grantor trust for income tax reporting purposes, the taxation is simple, in that all incidents of taxation pass through to the grantor of the trust. But if the gift to the grantor trust is incomplete at the time of the transfer of assets to the trust, then as funds are distributed from the trust, the grantor will be deemed to have made taxable gifts that are not eligible for the federal gift tax annual exclusion. Reg. 25.2511-1(h)(1)
• Estate Taxation: The transfer of assets to a purpose trust on the owner’s death will be subject to the federal estate taxation; generally with a corresponding step-up in the income tax basis of the decedent’s transferred assets. IRC 2031; 1014
• Charitable Deduction: Despite the statutory recognition of purpose trusts, the IRS continues to refuse to recognize the validity of a pet trust. The IRS will disallow any federal estate tax charitable deduction under IRC Sections 170, 664, 2055(a) and 2055(e) (2) for the bequest of a remainder interest in a purpose trust to a charity, e.g. the Humane Society, where the present interest in the trust is reserved for the care of the companion animal during its lifetime. Rev. Rul. 78-105, 1978-1 C.B. 295

Income Taxation: The income taxation of a purpose trust can be tricky, however, because the trust lacks an individual beneficiary, which can lead to some surprising income tax results. Generally, as with most conventional trusts, there is normally a deduction for trust distributions to individual beneficiaries, which carry out income and which require the beneficiary to pay income taxes on that distributions. IRC 651 and 661 But an animal, or other item of property, is not a person, cannot be a trust beneficiary. In short, a pure purpose trust without an individual beneficiary is considered to lack a beneficiary and thus is invalid and unenforceable in the eyes of the IRS. But the IRS is willing to recognize that a purpose trust which ‘should nonetheless be classified as a trust for tax purposes under IRC 641 whenever such a trust is not invalid under applicable state law.’ Rev Rul. 76-486, 1976-2 CB 192

Since a purpose trust does not have a beneficiary as defined in IRC Sections 643(c) and 7701(a) (1) with a social security number, the trust cannot claim an income tax distribution deduction. Thus, unlike a typical complex trust for income tax reporting purposes, a restricted purpose trust must pay all income taxes at the trust level. IRC Sections 641 and I (e)

But if the purpose trust holds a pet, cottage or cemetery lot with a designated caregiver, then different income tax rules apply. If the beneficiary of the trust is not a person as defined in the tax code and thus there is no designated taxpayer-beneficiary but there is a designated caretaker or caregiver, (e.g. the assets are used by the caretaker to maintain the family cottage; disbursements are made to the caretaker to protect the family cemetery lots and monuments; trust income is directed to be used by the caregiver to feed and provide veterinary care for the companion animal), then the tax imposed on the income distributed by the purpose trust will be payable by those “U.S. persons who are connected with or who benefit from the object or the purpose of the trust.” Thus, the IRS has formally held that a trust with a pet as a direct beneficiary is taxed under IRC 641(e) which causes the pet’s caretaker to pay tax on the distributions made by the purpose trust for the pet’s care. Rev. Ruling 76-486

Consequently, if there is an individual named in the trust, e.g. a caretaker for the family cottage, then those human indirect beneficiaries of the purpose trust will be taxed as with any other complex trust. If a pet trust directs that the caregiver of the companion animal is to receive distributions from the trust to be used to pay for the animal’s food, board, and veterinary services, then that caregiver will be deemed to have received taxable income to the extent that the purpose trust’s assets generated income. In short, if a trust directs distributions to be used exclusively for the care of the decedent’s companion animal or to maintain the family cottage, the caregiver/caretaker will have reportable taxable income on which he or she must pay income taxes.

Closing Thoughts: Due to the unusual tax treatment associated with a purpose trust, the trust instrument when drafted should: (i) consider how estate taxes will be allocated and paid that are attributable to the purpose trust assets; (ii) direct the trustee to ‘gross up’ any trust distributions to the caregiver/caretaker in order to defray that individual’s increased income tax liability caused by the trust distributions that are made; (iii) authorize the trustee to invest the purpose trust’s assets in a manner intended to reduce taxable income in order to avoid the compressed federal income tax brackets that irrevocable trusts normally face, e.g. 39.6% federal tax on accumulated income in excess of $12,400; and (iv) if a charitable estate tax (or income tax if a lifetime transfer) is intended, name the intended caregiver person as the lifetime beneficiary of the trust, with the charity named as the remainder trust beneficiary so that the a charitable deduction can be claimed under IRC 664 and Reg. 1.664-1(a)(3).

Care of Collectibles: With collectible values rapidly escalating these days, it is not uncommon for a trustee to come into possession of a valuable art collection or wine collection on the collector’s death that will require special attention. When these unique assets are held in trust more likely there will be individual beneficiaries of the purpose trust. But even with beneficiaries who will have a keen interest in the distribution or disposition of those assets, the assets will require intensive care by a trustee who possesses special knowledge so that the value of the assets can be preserved and orderly disposed of consistent with the trust settlor’s directions. Consider some of the unique responsibilities and decisions that fall to a trustee upon the trust settlor’s death when the trust estate consists of valuable and sophisticated collections of assets like artwork or wine that are a primary focus of the trust:

• (i) locate all of the items that comprise the collection. Are all the items of the collection in the decedent’s home? In storage? Is some of the artwork loaned to third-parties?
  Are there outstanding orders for future distributions of wine not yet delivered? Are any items of artwork on consignment for sale? Are all purchase and/or consignment records readily available?
• (ii) identify that title is correctly in the decedent’s name, or in the name of the decedent’s trust. What is the provenance of the artwork in the decedent’s name, since that will determine, to a large extent, the value of the work of art? Are all the records that document provenance and the decedent’s title to the asset readily available to the trustee?
• (iii) document ownership of each valuable item in the collection. Is the collection, or items that comprise the collection, solely owned by the decedent? Are items or artwork or wine fractionally owned with other family members or shared with museums?
• (iv) controlled storage of valuable items while in the fiduciary’s care is critical to preserve their value. Is the correct temperature with proper heating and cooling systems in place where the collection maintained, e.g. a constant 55 degree temperature for a wine collection? Does the trustee need to incur the additional expense to provide controlled storage for the collectible?
• (v) security of valuable items is critical to avoid theft or damage. Is there adequate security to protect the decedent’s collection prior to it being appraised? Will the collection have to consolidate into one location to facilitate insurance and estate tax appraisals? Who selects the appraiser? Who negotiates the appraiser’s fee? How does the trustee protect the wine collection from the decedent’s heirs who only wish to ‘visit Dad’s wine cellar’ with the intent to use a few bottles from his wine collection at the wake following his funeral?
• (vi) inventorying or marshalling the collection will be required, not only to appraise the collection for federal estate tax reporting purposes and to establish the income tax basis ‘step-up’ basis purposes, but also to obtain the correct amount of insurance while the trust is administered. Is the existing insurance adequate? Should competing insurance bids be obtained?
• (vii) liquidation of the items or the collection may be directed by the trust instrument. Planning for the trust’s liquidity will be critical since the unique collection could cause federal estate tax liability, yet there is no ready market either for the items or the collection. If the collection is to be sold as a part of the trust estate’s administration, will the valuable items or be liquidated over an extended period of time to preserve its aggregate value and in order to avoid the possibility of a valuation blockage discount if the entire the collection is placed on the market at one time? Can a wine collection be quickly liquidated when the trustee must comply with federal and state alcohol distribution regulations? Who will pay the estate tax on the unique assets or collection while it is liquidated to assure that the highest price is obtained upon sale?
• (ix) expenses prior to distribution of the assets or the collection will be dependent upon the directions provided by the decedent in the purpose While the collection is held in trust there will be on-going expenses of storage and insurance, not to mention to cost of appraisals. The trust instrument may, or may not, provide directions for how the items or collection are to be distributed. Are the items to be placed with an auction house for future sale? Are portions of the collection to be placed on consignment? Are items simply to be distributed to the trust’s individual beneficiaries, but perhaps with the directive that these items are to be distributed to several beneficiaries ‘in shares of equal value’ which will require the trustee to identify each item’s value to carry out that equalization directive. Any losses or damage that occurs to the items while under the trustee’s control will be at the trustee’s expense, so the quicker the items are appraised and distributed from the trust, the happier both the trustee and the trust beneficiaries will be, but until they are no longer under the control of the trustee, these expenses will continue as part of the estate’s general administration. Will the trust instrument authorize the trustee to treat the distribution or disposition of the collection as a priority and to expeditiously distribute these items from the trust?

The owner of these assets held in trust can address all of these responsibilities with regard to collectibles held in a purpose trust. The owner can assist the trustee by keeping good records of the each item in the collection, with documents of title, provenance, and with a complete paper trail particularly if some of the items are out of the owner’s possession on loan, consignment, or are in the process of being purchased. The owner should also consider naming an experienced co-trustee who is charged with the responsibility to marshal, value, and protect the valuable items, thus relieving the other co-trustee of any legal responsibility to assure the correct storage, valuation, insurance, and sale, tasks that require a high level of knowledge. Or, instead of naming a person as co-trustee under the trust, the owner could name a trust protector under the trust instrument who directs or vetoes decisions made by the trustee with regard to the handling and disposition of these unique assets. The co-trustee or the trust protector will possess a high level of knowledge not only to protect the collection, but also possess the necessary experience as to how it should be appraised, by whom it should be appraised, and if the collection is to be liquidated, the best way to maximize the price paid for the collection or how to negotiate the most remunerative consignment contract with an auction house.