At a time when trusts are under attack and being taxed out of existence in other countries, they are alive and well in the US. Various types of trusts are created by Americans of moderate, as well as great, wealth, and a complex series of laws governs their use.
The legal concept of the trust was carried over from the English common law, which all US states adopted. A trust can only be created under the substantive laws of a particular state; it is not possible to create a trust under ‘US law’. On the other hand, the US has a complex series of laws and regulation concerning the federal estate and income taxation of trusts. Initially, most trusts were testamentary, created by the wills of decedents primarily to provide governance and management of funds for minors and spouses, and secondarily to provide for charities. Today, many trusts are created by inter vivos agreement, and they address tax- and creditor-protection issues as well.
The use of the revocable trust as a will substitute became popular in states such as California and Florida, where probate proceedings are rather cumbersome. Revocable trusts are now standard in terms of estate planning for larger estates in every state (although New York practitioners have been the slowest to adopt revocable trusts). No tax- or asset- protection benefit is achieved by the revocable trust, but it is valid for passing assets, outright or in further trust, at the death of the settlor, avoiding the cost and delay of probating a will.
From around 2000, certain states introduced a number of laws intended to make them more attractive as trust jurisdictions, even for persons who do not reside there.
A will or revocable trust agreement can create ongoing trusts after the death of the testator or settlor. A compliant trust for the sole benefit of a spouse (a ‘qualified terminable interest property’ or ‘QTIP’ trust) will qualify for the federal estate tax marital deduction in the same way as an outright bequest to the spouse. A similar trust, the qualified domestic trust (QDOT), will qualify for the marital deduction when the surviving spouse is not a US citizen (in which case an outright bequest would not so qualify).
Ongoing trusts for children may terminate at a certain age, or in fractions, such as one-third when the child reaches 25, one-half at 30 and the balance at 35. The better plan for larger estates is for the property to remain in trust for the life of the child and then pass to the next generation (a ‘generation-skipping trust’). This provides protection from creditors and matrimonial claims, and allows the trust property to pass to grandchildren free of a second estate tax (although this tax benefit is limited by the imposition of the generation-skipping transfer tax). A trust beneficiary can be given the power to direct where the trust property passes at their death (a ‘limited power of appointment’) without being treated as the owner of the trust assets for estate tax purposes.
Settlors (or ‘grantors’) can also create irrevocable trusts in order to achieve tax advantages. The settlor normally will transfer assets to the irrevocable trust, making a ‘completed gift’ that is subject to US gift tax if it exceeds the applicable exemptions. Thereafter, on the death of the settlor, the assets will normally not be included in their estate for estate tax purposes. All appreciation in the assets after the transfer passes free of transfer tax.
An important subset of the irrevocable trust described above is the insurance trust. The settlor creates an irrevocable trust for their family and makes modest annual gifts to it. The trustee uses the gifts to pay annual premiums on an insurance policy on the life of the settlor owned by the trust. On the death of the settlor, the insurance is not subject to estate tax because the settlor does not own it. The trustee collects the proceeds and disposes of them in accordance with the ongoing trust provisions, usually in trust for the surviving spouse and descendants.
A number of more complex inter vivos irrevocable trusts have been developed for specific tax purposes. These include: the qualified personal residence trust (QPRT), the grantor retained annuity trust (GRAT) and the charitable remainder unitrust (CRUT), explained below.
Qualified personal residence trust
The settlor transfers a residence to this trust and reserves the right to reside in it for a period of time, such as 15 years. This reservation of an interest reduces the value of the taxable gift to the trust. If the settlor lives beyond the initial term, the property passes to their descendants free of any further gift or estate tax.
Grantor retained annuity trust
The grantor transfers assets to this trust and retains an annuity, such as the right to receive 10 per cent of the value of the trust per year for the next five years, after which the trust passes to their descendants. This annuity reduces the value of the gift, and also fixes the value of the asset, so that future appreciation is not taxed. By retaining a large enough annuity, the grantor can create a ‘zeroed-out GRAT’, which results in no taxable gift at the time of the transfer, but with all appreciation passing free of tax to the remaindermen.
Charitable remainder unitrust
The grantor transfers property to this trust and retains an annuity equal to a percentage of the trust asset value annually for their lifetime. The remainder at the grantor’s death passes to charity. The grantor receives an income-tax charitable deduction for the transfer to the trust and the trust itself does not pay any income tax (although the annuity payments to the grantor are subject to income tax). So, for instance, highly appreciated stock might be transferred to the trust and then sold, and no immediate capital gains tax will be payable.
In general, trusts are separate taxpayers for income tax purposes. If the trust does not make any distributions, it will file a tax return and be taxed on income earned each year. If distributions are made, they carry out ordinary income such as dividends and interest, which will then be taxed to the beneficiary instead of the trust. (This is true even if the distribution is designated as a distribution of capital for accounting purposes.) Capital gains taxes are normally paid by the trust and do not pass out to beneficiaries of distributions.
However, some inter vivos trusts are classified as ‘grantor trusts’ because the grantor has retained a degree of interest or control over the trust. All income of a grantor trust, both ordinary income and capital gains, is taxed to the grantor personally, even if the income is accumulated in the trust or paid out to other beneficiaries. As an example, all revocable trusts and most insurance trusts are grantor trusts. A trust ceases to be a grantor trust on the death of the grantor.
Trust law among the various states differs in many respects. From around 2000, certain states, such as Alaska, Delaware, South Dakota and Nevada, introduced a number of laws intended to make them more attractive as trust jurisdictions, even for persons who do not reside there. These innovations include:
•Abolishing the rule against perpetuities;
•Restricting the ability of a creditor of the settlor to reach trust assets, even if the settlor remains among the permissible beneficiaries of the trust; and
•Allowing designation of a separate investment advisor with full investment authority, thereby relieving the trustee of any power over investments and any potential liability for investment performance.
For US income tax purposes, a trust is categorised as either foreign or domestic. A foreign trust is not subject to US income tax except on US-source income (although US beneficiaries will be taxed on distributions to them unless it is a grantor trust). A domestic trust is subject to US income tax on its worldwide income. Trusts created under the laws of a foreign jurisdiction with a foreign trustee will almost certainly be foreign trusts. However, trusts created under the laws of a US state with a US trustee will be domestic trusts only if US persons control all substantial distributions. For instance, if a non-US protector can remove and replace the trustee, the trust is a foreign-tax trust free of US income tax, even though it is governed by New York law and has a New York trustee.
In short, trusts have broad and varied uses in the US. The state and federal laws governing the administration and taxation of trusts are complex, but those able to navigate them can achieve many benefits.
The opinions expressed do not constitute investment advice and specialist advice should be sought about your specific circumstances.
Published on our website on Sep.18, 2014