CHAPTER 17
Managing Other Types of Irrevocable Trusts

The discussion, thus far, has centered primarily on the management of the marital and credit shelter type trusts. The same duties, responsibilities, and principles of trust administration also apply to other types of irrevocable trusts. Some types of irrevocable trusts have unique rules that apply to their administration. These requirements are primarily tax related and will either be described under the terms of the trust or under the Internal Revenue Code.

Children’s Gift Trusts

These are trusts established by a parent to make gifts to a child and qualify for the annual gift tax exclusion. The trustee controls when and under what circumstances the child receives the funds. Children’s gift trusts, which are described under Sections 2503(b) and 2503(c) of the Internal Revenue Code, have the following administration characteristics:

The trust must terminate when the child reaches age twenty-one and the trustee must distribute all of the income and principal to the child at that time.
In a 2503(c) type of trust, distributions can be made in the discretion of the trustee. However, in the 2503(b) type of trust, income must be distributed to the beneficiary.
Distributions from the trust are taxed at the parent’s marginal tax rate until the child attains the age of fourteen. This is referred to as the kiddie tax. After the child reaches age fourteen, the tax is paid at the child’s individual income tax rate.

It is important that the trustee obtain a copy of the beneficiary’s birth certificate, and make a record of the key dates.

Irrevocable Life Insurance Trusts

The purpose of an irrevocable life insurance trust is to remove the ownership of life insurance from the settlor and avoid taxation of the face amount of the policy at the settlor’s death. When the trust is created, the settlor will either transfer an existing insurance policy to the trust or have the trustee purchase a new policy on the settlor’s life. The settlor deposits funds to the trust periodically to cover the payment of premiums and any administration costs. In administering this type of trust, the trustee needs to be aware of certain requirements:

If an insurance policy is transferred or added to the trust, the settlor must survive three years in order to avoid having the proceeds taxed in the settlor’s estate. If the settlor dies within three years, the trustee must so notify the settlor’s executor and provide the executor with Form 712, which is provided by the insurance company and reports the amount of the insurance and interest paid on the policy.
As deposits are made to the trust to cover premiums and administration costs, the trustee must notify the beneficiaries that they have the right—referred to as Crummey power—to withdraw those funds. This right lapses after a period of time stated in the trust document. The Crummey power is required to qualify the deposit for the annual gift tax exclusion. Failure of the trustee to give proper notice will subject the deposits to gift taxes.
The trustee should periodically review the policies with an insurance agent to assure that they are performing as expected and that the insurance company is viable. If a problem exists, the trustee is required to take appropriate action to safeguard the interests of the beneficiaries.
Often the irrevocable life insurance trust is established to provide cash to pay estate taxes. To the extent that this cash is used directly to pay the estate tax, that amount will be included in the decedent’s taxable estate. A well-drafted trust will allow the trustee to purchase assets from the estate to provide the needed cash, thereby avoiding this problem. The trustee needs to coordinate the purchase of assets with the executor.

GRITs, GRATs, and GRUTs

The grantor-retained income trust, or GRIT, grantor-retained annuity trust, or GRAT, and grantor-retained unitrust, or GRUT, serve primarily to shelter future appreciation of the property transferred to the trust from federal estate tax. As previously mentioned, Congress has significantly curtailed the advantages of these devices in recent years. However, they still have application in some circumstances, and many of these trusts that were established in earlier years still exist. A trustee’s responsibilities in managing these types of trusts include:

In the case of a GRIT, paying all of the net income of the trust to the grantor. In the case of a GRAT, this calls for computing the fixed annuity amount required by the trust and paying the grantor each year. In the case of a GRUT, determining the amount of the payout each year, based on the percentage stated in the trust document and the fair market value of the trust assets at the beginning of each tax year.
For GRATs and GRUTs, this calls for managing the trust’s portfolio to efficiently produce the returns necessary to meet the payout requirement in the trust document.
If the grantor dies before the end of the stated term of the trust, the trust assets will be taxed in the grantor’s estate and the trustee must value the assets as of the grantor’s date of death for federal estate tax purposes.
If the grantor survives the term of the trust, the trust must be terminated and the assets distributed to the named remainder beneficiaries.

Charitable Trusts

Charitable remainder trusts are one of the last tax-advantaged trust arrangements that have remained virtually untouched by Congress. For those individuals who have a charitable intent, the charitable remainder trust offers significant advantages, including an income tax deduction based on the amount transferred to the trust, an estate tax deduction, avoidance of capital gains taxes if the property in the trust is sold, and the retention of an income stream for life. There are several types of charitable remainder trusts.

The most common are the charitable remainder annuity trust, or CRAT, and the charitable remainder unitrust, or CRUT. The CRAT pays a fixed annuity to the grantor and/or the grantor’s spouse or other beneficiary for life. The CRUT pays an amount based on a stated percentage of the trust assets to the grantor and/or the grantor’s spouse or other beneficiary for life. Another type of charitable trust is the Charitable Lead Trust, or CLT. It pays a specific dollar amount or fixed percentage of the value of the trust to a charity each year for a specified term. At the end of the term, the trust property is either distributed to or retained in trust for the benefit of noncharitable beneficiaries (children, grandchildren, etc.). The purpose of the CLT is to remove the income from the grantor, having the same effect as a charitable income tax deduction, and also to make a gift to the remainder beneficiaries.

Some of the administrative duties that apply to a charitable remainder trust include:

In the case of a CRAT, computing the fixed annuity amount and paying it to the grantor each year. For a CRUT, determining the amount of the payout each year, based on the percentage stated in the trust document and the fair market value of the trust assets at the beginning of each tax year.
Managing the investments efficiently to meet the payout requirement of the trust. If the trust allows the use of principal to supplement income, and the payout percentage is high, a total return strategy should be used to manage the portfolio. With a high payout percentage such as 9% or 10%, the portfolio should be weighted toward equities (stocks) in order to achieve the return needed to meet the payout requirement.
Some trusts provide that only the net income can be distributed. These trusts are referred to as net income trusts or NIMCRUTS. If the payout requirement is 9% and the current income (dividends, interest, rents, etc.) is only 4%, that is all that can be paid out. These types of trusts usually have a “make up” provision that will require the trustee to maintain records of the years in which there is a shortfall. If the net income in future years exceeds the stated percentage payout, the trustee can pay the excess to make up for the shortfalls in prior years.
The trustee must adhere to some specific rules that apply to these trusts under the Internal Revenue Code. Under these rules the trustee: shall not engage in any act of self-dealing, as defined in Section 4941(d) of the Internal Revenue Service Code (Code); shall not make any taxable expenditure as defined in Section 4945(d) of the Code; shall not make any investments that jeopardize the charitable purpose of the trust, within the meaning of Section 4943 of the Code; is prohibited from incurring unrelated business taxable income within the meaning of Section 512 of the Code; is prohibited from incurring debt-financed income within the meaning of Section 514 of the Code.

Other Types of Trusts

Other types of irrevocable trusts are established for a variety of purposes. Again, the important thing to remember is that the standards of conduct and principles of trust administration discussed in this book apply to all irrevocable trusts. It is important that the trustee understand the basic purpose and intent of these trusts in order to manage them properly:

Qualified Personal Residence Trust (QPRT)—A QPRT is a trust that holds the grantor’s residence for a specified period of years while allowing the grantor to retain the right to use the property. If the grantor dies before the term ends, the property will be included in the grantor’s estate. However, if the grantor survives the term, it will be excluded from the grantor’s estate because title will have passed at that point, typically to the settlor’s children. The trust can provide for the payment of fair market rent to allow the grantor to continue to live in the house beyond the term of the trust. The trust document must prohibit the trustee from selling or transferring the property to the grantor or the grantor’s spouse.
Special Needs Trust—A special needs trust is designed to put funds aside for a beneficiary without those funds disqualifying the beneficiary from receiving public assistance. The trust provides that the trustee is to use his or her discretion in making distributions to the beneficiary and only to supplement the funds available through public assistance programs, such as Medicaid.
Wealth Replacement Trust—A wealth replacement trust is nothing more than a separate irrevocable life insurance trust, or ILIT, whose purpose is to replace the inheritance that was lost as a result of property transferred to a charitable remainder trust (CRT). A life insurance policy equal to the value of the property transferred to the CRT is purchased in the wealth replacement trust. It is subject to the same rules that apply to an ILIT, and should be managed accordingly.
Spendthrift Trust—Although most family or credit shelter trusts contain a spendthrift provision, a separate irrevocable trust is sometimes created specifically to protect a beneficiary from his creditors and divorce. The spendthrift trust precludes the beneficiary from having access to principal, either by prohibiting principal distributions or by giving the trustee sole discretion to make payments from principal. This restriction prevents the creditors of the beneficiary from reaching the trust assets. The trustee must evaluate every principal distribution and be assured that the funds are being used for the purpose for which they were disbursed.

As is the case with almost any arrangement that attempts to avoid taxes and creditor claims, some will stay within the spirit of the law and others will try to push the limits. The Internal Revenue Service has recently given notice that they consider the following trust arrangements abusive:

The Business Trust—The owner of a business transfers the business to a trust in exchange for units or certificates of beneficial interest. The business trust makes payments to the trust unit holders or to other trusts created by the owner that purport to reduce the taxable income of the business trust to the point where little or no tax is due from the business trust. Most states do not recognize business trusts.
Equipment or Service Trust—An equipment trust is formed to hold equipment that is rented or leased to the business trust, often at inflated rates. The service trust is formed to provide services to the business trust, often for inflated fees.
Family Residence Trust—The owner (grantor) of the family residence transfers the residence, including its furnishings, to a trust, which is leased back to the grantor. The trustee takes depreciation and other expenses to reduce or eliminate the taxable income from lease rent. The trust claims the exchange results in a stepped-up basis for the property, and the owner reports no gain.
Charitable Trust—The owner transfers assets to a purported charitable trust and claims either that the payments to the trust are deductible or that payments made by the trust are deductible charitable contributions. However, in fact, the payments are principally for the personal educational, living, or recreational expenses of the owner or the owner’s family.
Final Trust—In some multitrust arrangements, the U.S. owner of one or more abusive trusts establishes a trust that holds trust units of the owner’s other trusts and is the final distributee of the income. A final trust often is formed in a foreign country that will impose little or no tax on the trust.

For obvious reasons, it would be prudent for an individual not to serve as a trustee for any of these types of trusts. The IRS has advised that taxpayers and/or the promoters of these trust arrangements may be subject to civil and/or criminal penalties.

Checklist

Identify the specific rules that apply to the trust you are managing.
Read the trust document and identify any special provisions that apply to the administration of the trust.
Identify, by consulting with the attorney for the trust or other qualified professional, any special legal requirements that apply to the administration of the trust.
Develop an investment strategy that meets the specific current payout requirements of the trust and protects the interests of remaindermen.