by John M. Goralka
Sacramento, CA
We help successful families, business owners, and real estate owners minimize income tax, estate tax, and property tax. We help our clients to better protect their assets and to transfer their legacy and family values to the next generation.
Sophisticated planning involves using trusts and entities to better protect assets and to minimize estate tax, income tax, and taxes on capital gains. This planning often involves the use of irrevocable trusts.
Irrevocable trusts are widely used for other types of planning such as special needs trusts or seeking to qualify for Medical, Medicaid, or veteran’s benefits. While that planning is also important, the laws and trust provisions for those legal areas are more specialized. This article focuses on planning to minimize taxes on capital gains, ordinary income, estate tax, and property tax.
The term “irrevocable trust” can be troubling for successful clients who are accustomed to maintaining control over their business and financial lives. The term “irrevocable” alone creates concerns. None of us knows for sure what the future will bring, what our financial needs will be, or even what the tax and other laws will be in the future. However, careful drafting of the irrevocable trust permits you, the client, to retain significant influence or indirect control over the assets, income, and business. Careful drafting can also provide significant flexibility and the ability to make changes in your planning to respond to changed circumstances or needs.
Assets Not Directly Transferred to the Trust so You Retain Control
First, the assets are typically not transferred directly to the irrevocable trust. Typically, the assets would be transferred to an entity such as a limited liability company (LLC), S corporation, or family limited partnership (FLP) that the client controls. Then, an interest in that entity is transferred to the irrevocable trust so you, the client, retain control of the entity and the assets. This can be done by transferring nonvoting interests in the entity to the irrevocable trust.
Selecting the Trustee
The trustee oversees the trust transactions and activities. You can designate the initial trustee of the irrevocable trust. This is the second way you can retain influence or indirect control. Of the different ways to retain influence or indirect control, this is probably the least important.
While alive, most clients initially seek to appoint themselves as trustee. However, you actually have more control if you are not the initial trustee. If you are the initial trustee of an irrevocable trust for your child or children, then the distribution provisions limit the trustee in making distributions to your child or children to those amounts needed for health, education, maintenance, and support (HEMS) if the assets are to be excluded from your estate for estate tax purposes.
HEMS distribution provisions can also impede the beneficiary’s protection from creditor attack. A creditor could assert that the beneficiary has a right to the HEMS distribution. The creditor could then seek to take that amount for the trust.
On the other hand, if you are not the trustee, the trustee may have complete discretion to make distributions. There is no limitation to the HEMS standards. This provides better asset protection for your beneficiaries or children. The key is having a trustee who will act according to your wishes.
In selecting a trustee, clients typically have two (2) goals. During the client’s lifetime, he or she wants a trustee who will do whatever the client wants – absolute loyalty. After death, then you, the client, want a trustee whose judgment they trust.
You may designate your trusted, adult child to act as trustee. If the child does not do as you wish, then you can disinherit the adult child. Will that adult child have the appropriate judgment after your death? Care should be taken including consideration of family dynamics in designating one sibling overseeing his or her brother or sister. Will emotional baggage or prior history cause that trustee to treat that beneficiary unfairly?
You Can Remove and Replace the Trustee
More importantly, you retain the right to remove the trustee and designate a new trustee. This right to remove can be without any cause whatsoever. If any trustee fails to act properly or you simply change your mind, then you can remove that person and designate a new trustee. This is a far stronger means of maintaining control than designation of the initial trustee.
When selecting the new or successor trustee, you cannot select someone who is related or subordinate to you. The term “related” means a lineal descendant or sibling of your parents. The term “subordinate” refers to an employee of any business in which you own a significant business. Note that we do have a way around this restriction, using a trust protector which is discussed below.
Note that then you can include a related or subordinate person in the trustee succession provision listed in the trust document. You cannot go outside the trust agreement or succession provision to designate a related person or a subordinate.
Trust Protectors – How to Create a Flexible Irrevocable Trust
Trustees have a fiduciary duty to not only the beneficiaries, but also possibly to potential or actual creditors including the tax authorities. The trustee must follow the provisions of the Declaration of Trust.
A trust protector is a position defined in the Declaration of Trust or Trust Agreement. The trust protector is given the power to take designated actions including those that may harm the beneficiaries. To be effective, the trust protector should be specifically identified as not being a fiduciary or holding a fiduciary relation to beneficiaries or other interested parties. I sometimes describe the trust protector as being the Lone Ranger. He does not wear a badge, but rides in to save the day and then rides off into the sunset.
The choice of powers that can be taken by the trust protector is up to you and are set forth in the trust. Those powers include the following:
To remove and replace the trustee
To appoint a trustee who is related to or subordinate
To remove a beneficiary including changing the allocation among beneficiaries
To add a beneficiary
To change the timing and method of distributions to beneficiaries
However, if the irrevocable trust is being used to minimize income tax, including the tax on capital gains, the only power that may be given to the trust protector is the power to remove and replace the trustee.
Planning to avoid tax means the irrevocable trust must be a separate independent taxpayer. If the trust protector holds any of the powers other than terminating and replacing the trustee, then the irrevocable trust would be characterized as a Grantor Trust for income tax purposes.
This means that the trust essentially did not exist for income tax purposes. All trust income is reported on your individual tax return as the “grantor” or creator of the trust. While this does not work as a tool to minimize income tax, this can be a substantial advantage when planning to minimize estate tax. Income producing assets are held in a trust and outside of your estate for estate tax purposes, you still pay the income tax on the income generated from those assets. The payment of that tax does not trigger gift tax and is essentially a tax-free gift to the beneficiaries. Note that private annuities or promissory notes can be used to get income back to you on a tax-free basis when the assets are transferred to the irrevocable trust on a tax-free basis. This can be done because the trust is characterized as a Grantor Trust.
Method of Appointing the Trust Protector
Due to the long-term nature of irrevocable trusts, we do not name a trust protector when the trust is drafted. In fact, many people have a difficult time finding a person to act as the trustee or successor trustee. Instead, the trust instrument provides a process to appoint a trust protector in and when that is needed or appropriate. We often list our law firm, or your then acting CPA to appoint the trust protector. The trust protector is typically appointed to take a specific action. The trust protector typically resigns immediately after completing that action.
Decanting
Decanting is another process that can be used to modify an irrevocable trust. Be sure to check your state law on decanting, which varies greatly. Some states, such as California, have a restrictive decanting statute that allows very limited change to an irrevocable trust. Others, including Nevada, have a very broad decanting statute permitting a wide range of modification. However, all decanting statutes require the consent of all the beneficiaries. The requirement for consent does not provide the control or influence desired by most clients at the outset of the plan.
The Flexible Irrevocable Trust is the Best Alternative
An irrevocable trust in an uncertain world can be very worrisome over time. We don’t know your financial needs, income, asset values, or even the tax rates in the future. However, careful drafting as described above can provide the needed flexibility and control. Instead, a “Flexible Irrevocable Trust” is what is needed in today’s uncertainty.
