Trust Planning

Editor's Note: As discussed last month, modern trusts are, in general, more protective than trusts created even in the recent past. Whether a trust's funds may be reachable in a divorce proceeding will depend on several factors, such as whether it is a “support” trust or a “discretionary” trust, or whether the trustee has the power to change or add beneficiaries. Now, the author explains how an existing trust may be made more “divorce-proof,” offers some hypothetical examples of the treatment trust funds may be given in divorce, and describes some lesser-known trust-related problems to be avoided.

Improving Old Irrevocable Trusts: Decanting

Many existing trusts were designed in less than optimally protective manners. What can be done? While the presumption has historically been that if a trust is irrevocable, it cannot be changed, decanting can improve even old trusts that do not incorporate the flexibility of modern trust drafting discussed in last month's issue. Decanting is the process of merging, or pouring over, an old trust into a new and improved trust. This technique has grown significantly in popularity and use in recent years, and may provide a vital method for practitioners to guide clients to improve trusts before a matrimonial challenge. This might raise the issue of pre-divorce planning, an issue with which practitioners are familiar. Therefore, the brief discussion below will focus only on the decanting. Trust decanting may provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:

1. Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
2. Under state statute. A growing number of states permit decanting pursuant to state statute. Alaska has a very robust statute and if the old trust is not presently located in Alaska, it may be feasible to move the situs of the old trust to that state and then take advantage of the Alaska decanting statute.
3. Under state common law. For example, New Jersey common law has provided a basis to merge an old trust into a new trust.

Decanting may enable a trustee to:

• Extend the term of an existing trust, although generation-skipping transfer tax issues must be addressed. If a client is a beneficiary of a trust that is set to distribute all principal at age 40, and the client is 37, decanting the trust into one that is perpetual may insulate trust assets from a future claim that may have had a greater chance of success if the assets were owned directly.
• Change trustee provisions to incorporate some of the more modern clauses discussed above.
• Change governing law and situs to a state that is more favorable to achieving trust objectives, such as Nevada, which does not provide for exception creditors.

Types of Trust and Trust Transactions

There are hosts of ways trusts can be structured to take advantage of modern trust planning and provide matrimonial protection in a range of circumstances. Some of these are noted below with specific explanation as to how matrimonial practitioners can apply the following techniques.

BDIT

A person creates a trust for a beneficiary, e.g., a child, and funds the trust with a one-time gift of $5,000. The terms of this trust, called a Beneficiary Defective Irrevocable Trust (BDIT) instrument, grants to the child a $5,000/5% power to withdraw. When the power lapses, the trust is treated as if the child withdrew $5,000 and contributed the cash to the trust, and that transforms the child as the grantor and deemed owner of the trust for income tax purposes. IRC Sec. 678. Then the child sells a highly appreciated asset to the trust. This can be a useful tool when, for example, a child has married but already owns an interest in a family business outright. If the parent sets up a BDIT, the child could sell its interest in the family business to the BDIT for a note. While this may not diminish the marital estate, since the note is equal to the value of the business that would be included in the estate, it may provide an important protection for a family business.

Two Generations CRUT

Approximately five million baby boomers a year are retiring. A substantially greater proportion of them are in second and later marriages than their parents' generation. For many, retirement assets comprise a significant portion of their net worth. How can these boomers provide on death for their spouse and children from a prior marriage? One answer may be to use a Charitable Remainder Unitrust (CRUT) as beneficiary for IRA assets. If the surviving spouse is named as beneficiary, he or she would be required to withdraw the IRA account over a proxy for life expectancy, using the number of years specified in IRS tables. This would leave little for the surviving spouse in later years, and perhaps nothing for the children from the prior marriage, barring premature death of the second spouse.

If instead a CRUT is named as beneficiary, the IRA could be distributed on the client's death to the charitable trust, with no income tax due. PLRs 199901023 and 9820021. The surviving spouse could receive 5% per year of the value of the account for as long as he or she lives. On the surviving spouse's death, the children from the prior marriage could receive 5% per year until they die, at which time the balance would go to charity. This technique can provide tax advantage, a more assured cash flow, and avoid issues of a second spouse cutting out the children.

New Trust Problems

Late Funding of Bypass Trust

For many years, bypass trusts have been a standard part of estate planning. If assets were not put into this trust on the death of the first spouse, a valuable estate tax exemption would have been lost. Now, with portability, the surviving spouse can preserve the deceased spouse exemption without a bypass trust. No doubt what will occur is that many clients will simply not fund bypass trusts provided for in wills. This will prove devastating over time for children of prior marriages seeking to receive the inheritance intended for them. Practitioners should know, when they identify such situations, that there may be a position to argue for the retroactive funding of the bypass trust and thus protect those intended heirs.

Courts have recognized the existence of a bypass trust funded long after the death of the first spouse. Est. of Richard v. Comm'r, 103 TCM 1924 (2012). It may be feasible, depending on the facts and state law, to argue that a “constructive” trust, or perhaps a “resulting” trust be imposed over the assets improperly transferred to the surviving spouse instead of the bypass trust. Stansbury v. United States, 543 F. Supp. 154, 50 AFTR 2d 82-6134 (N.D. Ill. 1982), aff'd 735 F.2d 1367 (7th Cir. 1984). Another approach some commentators have suggested is to argue that the deceased spouse died owing a “debt” to the bypass trust, measured by the amount that would now be held by the trust if the funding amount had not been wrongfully withheld.

General Power Trap

There is another growing trust land mine of which matrimonial practitioners should be aware. In simple terms, when a taxpayer dies, any assets owned by that taxpayer get a step-up in income tax basis. This means unrealized capital gains are eliminated. If the taxpayer had paid $10 for an asset worth $100,000, the new tax basis on death becomes $100,000. To help clients capture as much basis step-up elixir as possible, tax practitioners have begun to use general powers of appointment. If a taxpayer did not own an asset on death, but had the power to appoint that asset to his or her estate, creditors or the creditors of his or her estate, that power alone will suffice to pull the assets into that taxpayer's estate and generate the sought-after basis step-up.

With the assured growth in these powers, matrimonial practitioners will need to be alert to who may hold a power to redirect assets, whether such powers are themselves reachable in a matrimonial action as a marital asset, and whether prenuptial agreements should address the exercise or non-exercise of these powers. Perhaps all prenuptial agreements should acknowledge that the spouse not holding a power of appointment has no claims or rights, or ability to mandate an exercise of a power held by the other spouse.

Conclusion

The continued evolution of trust planning and drafting, and the ramifications of the dramatic recent changes in the tax law, are reverberating through every area of matrimonial planning ' creating new planning opportunities, and potentially worrisome traps.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, is an attorney in private practice in Paramus, NJ, and New York City. Mr. Shenkman concentrates on estate and closely held business planning, tax planning, and estate administration, and is the author of more than 40 books and 800 articles.

Editor's Note: As discussed last month, modern trusts are, in general, more protective than trusts created even in the recent past. Whether a trust's funds may be reachable in a divorce proceeding will depend on several factors, such as whether it is a “support” trust or a “discretionary” trust, or whether the trustee has the power to change or add beneficiaries. Now, the author explains how an existing trust may be made more “divorce-proof,” offers some hypothetical examples of the treatment trust funds may be given in divorce, and describes some lesser-known trust-related problems to be avoided.

Improving Old Irrevocable Trusts: Decanting

Many existing trusts were designed in less than optimally protective manners. What can be done? While the presumption has historically been that if a trust is irrevocable, it cannot be changed, decanting can improve even old trusts that do not incorporate the flexibility of modern trust drafting discussed in last month's issue. Decanting is the process of merging, or pouring over, an old trust into a new and improved trust. This technique has grown significantly in popularity and use in recent years, and may provide a vital method for practitioners to guide clients to improve trusts before a matrimonial challenge. This might raise the issue of pre-divorce planning, an issue with which practitioners are familiar. Therefore, the brief discussion below will focus only on the decanting. Trust decanting may provide an efficient mechanism to salvage the trust purpose. Decanting can be accomplished in one of three ways:

1. Pursuant to the terms of the trust, if the governing instrument permits a transfer of trust assets to the new trust.
2. Under state statute. A growing number of states permit decanting pursuant to state statute. Alaska has a very robust statute and if the old trust is not presently located in Alaska, it may be feasible to move the situs of the old trust to that state and then take advantage of the Alaska decanting statute.
3. Under state common law. For example, New Jersey common law has provided a basis to merge an old trust into a new trust.

Decanting may enable a trustee to:

• Extend the term of an existing trust, although generation-skipping transfer tax issues must be addressed. If a client is a beneficiary of a trust that is set to distribute all principal at age 40, and the client is 37, decanting the trust into one that is perpetual may insulate trust assets from a future claim that may have had a greater chance of success if the assets were owned directly.
• Change trustee provisions to incorporate some of the more modern clauses discussed above.
• Change governing law and situs to a state that is more favorable to achieving trust objectives, such as Nevada, which does not provide for exception creditors.

Types of Trust and Trust Transactions

There are hosts of ways trusts can be structured to take advantage of modern trust planning and provide matrimonial protection in a range of circumstances. Some of these are noted below with specific explanation as to how matrimonial practitioners can apply the following techniques.

BDIT

A person creates a trust for a beneficiary, e.g., a child, and funds the trust with a one-time gift of $5,000. The terms of this trust, called a Beneficiary Defective Irrevocable Trust (BDIT) instrument, grants to the child a $5,000/5% power to withdraw. When the power lapses, the trust is treated as if the child withdrew $5,000 and contributed the cash to the trust, and that transforms the child as the grantor and deemed owner of the trust for income tax purposes. IRC Sec. 678. Then the child sells a highly appreciated asset to the trust. This can be a useful tool when, for example, a child has married but already owns an interest in a family business outright. If the parent sets up a BDIT, the child could sell its interest in the family business to the BDIT for a note. While this may not diminish the marital estate, since the note is equal to the value of the business that would be included in the estate, it may provide an important protection for a family business.

Two Generations CRUT

Approximately five million baby boomers a year are retiring. A substantially greater proportion of them are in second and later marriages than their parents' generation. For many, retirement assets comprise a significant portion of their net worth. How can these boomers provide on death for their spouse and children from a prior marriage? One answer may be to use a Charitable Remainder Unitrust (CRUT) as beneficiary for IRA assets. If the surviving spouse is named as beneficiary, he or she would be required to withdraw the IRA account over a proxy for life expectancy, using the number of years specified in IRS tables. This would leave little for the surviving spouse in later years, and perhaps nothing for the children from the prior marriage, barring premature death of the second spouse.

If instead a CRUT is named as beneficiary, the IRA could be distributed on the client's death to the charitable trust, with no income tax due. PLRs 199901023 and 9820021. The surviving spouse could receive 5% per year of the value of the account for as long as he or she lives. On the surviving spouse's death, the children from the prior marriage could receive 5% per year until they die, at which time the balance would go to charity. This technique can provide tax advantage, a more assured cash flow, and avoid issues of a second spouse cutting out the children.

New Trust Problems

Late Funding of Bypass Trust

For many years, bypass trusts have been a standard part of estate planning. If assets were not put into this trust on the death of the first spouse, a valuable estate tax exemption would have been lost. Now, with portability, the surviving spouse can preserve the deceased spouse exemption without a bypass trust. No doubt what will occur is that many clients will simply not fund bypass trusts provided for in wills. This will prove devastating over time for children of prior marriages seeking to receive the inheritance intended for them. Practitioners should know, when they identify such situations, that there may be a position to argue for the retroactive funding of the bypass trust and thus protect those intended heirs.

Courts have recognized the existence of a bypass trust funded long after the death of the first spouse. Est. of Richard v. Comm'r , 103 TCM 1924 (2012). It may be feasible, depending on the facts and state law, to argue that a “constructive” trust, or perhaps a “resulting” trust be imposed over the assets improperly transferred to the surviving spouse instead of the bypass trust. Stansbury v. United States , 543 F. Supp. 154, 50 AFTR 2d 82-6134 (N.D. Ill. 1982), aff'd 735 F.2d 1367 (7th Cir. 1984). Another approach some commentators have suggested is to argue that the deceased spouse died owing a “debt” to the bypass trust, measured by the amount that would now be held by the trust if the funding amount had not been wrongfully withheld.

General Power Trap

There is another growing trust land mine of which matrimonial practitioners should be aware. In simple terms, when a taxpayer dies, any assets owned by that taxpayer get a step-up in income tax basis. This means unrealized capital gains are eliminated. If the taxpayer had paid $10 for an asset worth $100,000, the new tax basis on death becomes $100,000. To help clients capture as much basis step-up elixir as possible, tax practitioners have begun to use general powers of appointment. If a taxpayer did not own an asset on death, but had the power to appoint that asset to his or her estate, creditors or the creditors of his or her estate, that power alone will suffice to pull the assets into that taxpayer's estate and generate the sought-after basis step-up.

With the assured growth in these powers, matrimonial practitioners will need to be alert to who may hold a power to redirect assets, whether such powers are themselves reachable in a matrimonial action as a marital asset, and whether prenuptial agreements should address the exercise or non-exercise of these powers. Perhaps all prenuptial agreements should acknowledge that the spouse not holding a power of appointment has no claims or rights, or ability to mandate an exercise of a power held by the other spouse.

Conclusion

The continued evolution of trust planning and drafting, and the ramifications of the dramatic recent changes in the tax law, are reverberating through every area of matrimonial planning ' creating new planning opportunities, and potentially worrisome traps.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, is an attorney in private practice in Paramus, NJ, and New York City. Mr. Shenkman concentrates on estate and closely held business planning, tax planning, and estate administration, and is the author of more than 40 books and 800 articles.