BENEFICIARY DEFECTIVE INHERITOR TRUSTS

1. BENEFICIARY DEFECTIVE INHERITOR TRUSTS Presented by: Julius H. Giarmarco, Esq. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver, Tenth Floor Troy, MI 48084 jhg@disinherit-irs.com www.disinherit-irs.com

3. Inheritors’ Goals • Control. • The right to manage the property. • The right to remove and replace the independent trustee. • Tax savings. • Trust is estate, gift and GST tax exempt. • Estate depletion (“tax burn”) as a result of grantor trust status as to the inheritor.

4. Inheritors’ Goals • Use and enjoyment. • The right to income. • The right to withdraw principal for health, education, maintenance and support (ascertainable standard). • The right for independent trustee to make distributions without a standard (e.g. best interests). • The right to use trust property for any purpose.

5. Inheritors’ Goals • Flexibility. • The broadest inter vivos and testamentary limited power of appointment to “rewrite” the trust in favor of anyone other than the inheritor, his/her estate or the creditors of either. • Creditor protection. • Because the trust is settled by a third party and is regarded as a spendthrift trust rather than as a self-settled trust as to the inheritor. • Simplicity.

6. BDITs $5,000* Dynasty Trust Grantor No transfer tax paid. Discretionary Distributions to Inheritor for Life No transfer tax paid. • Advantages • Creditor protection • Divorce protection • Estate tax protection Discretionary Distributions to Future Generations for Life * Gift should take advantage of grantor’s lifetime GST exemption The trust creator is the grantor for transfer tax purposes and creditor rights purposes, but not income tax purposes For income tax purposes, the inheritor is treated as the grantor of the trust

7. Avoiding the String Provisions of IRC Sections 2036 and 2038 • Someone (usually a parent or grandparent) funds the trust with no reimbursement from inheritor. • The inheritor does not make (directly or indirectly) a gift to the trust. • The inheritor only enters into a sale to the trust “for an adequate and full consideration in money’s worth”. IRC Sec. 2036(a).

8. Avoiding the String Provisions of IRC Sections 2036 and 2038 • Potential inclusion in the inheritor’s gross estate for estate tax purposes should be governed solely by IRC Section 2041. • Section 2041 should not apply to a properly structured BDIT sale because the inheritor would not have any ability to direct principal distributions: • To or for himself other than for his health, education, maintenance or support; or • To or for his estate, his creditors or his estate’s creditors. See Treas. Regs. Section 20.2041-1(c)(1).

9. Why an Installment Sale to a BDIT works No capital gains tax on sale between inheritor and trust. Rev. Rul. 85-13. Arbitrage; freezes value of appreciation on assets sold at the interest rate used. Interest payments not taxable to inheritor. Tax burn; payment of BDIT’s income taxes by inheritor leaves more assets in the trust – gift tax free. Rev. Rul. 2004-64.

10. Why an Installment Sale to a BDIT works • Back end-loading (i.e., interest only with a balloon payment). • Valuation discounts increase effectiveness of technique. • Possible discount for value of note in inheritor’s estate. • BDIT is an eligible Subchapter S shareholder. • A BDIT can purchase (for FMV) an existing life insurance policy on the life of the inheritor without subjecting the policy to taxation under the transfer-for-value rule. Rev. Rul. 2007-13.

11. Grantor Trust vs Non-Grantor Trust

12. Step One – Establishing the BDIT • Parent or grandparent establishes a Crummey trust and funds it with $5,000, and allocates $5,000 of his/her GST exemption to the trust. • The inheritor is the managementtrustee: • except over life insurance [IRC Sec. 2042] and controlled stock [IRC Sec. 2036(b)]; and • may also be able to make distributions for HEMS (depending on state law). • An independent trustee is the distributiontrustee for distributions beyond HEMS.

13. Step One – Establishing the BDIT • Inheritor has right to remove and replace the independent trustee with someone who is not related or subordinate. IRC Sec. 672(c) and Rev. Rul. 95-58. • Inheritor is granted the broadest limited power of appointment to “rewrite” the trust (IRC Sec. 2041(b)) - except over: • life insurance on the inheritor’s life [IRC Sec. 2042]: and/or • at least 20% of voting stock [IRC Sec. 2036(b)]. • The trust contains a formula clause which “shifts” unintended gifts to a non-exempt trust (for GST purposes).

14. Step Two – Sale to the BDIT • The business interest (usually non-voting) to be sold by the inheritor to the trust is valued by a qualified appraiser (considering valuation discounts for lack of control and lack of marketability if still available). • The independent trustee represents the trust in the purchase of hard-to-value assets, and has separate counsel. • Typical sale terms: Interest only (at current market rates, as opposed to AFR), with a balloon payment in 5-10 years.

15. Step Two – Sale to the BDIT • No gain on the sale, and interest payments are not taxable to inheritor. Rev. Rul. 85-13. Trust likely takes inheritor’s basis in the assets sold. • A third party guarantees 20% of the note amount and is paid an annual guarantee fee. • The sale is structured to be a defined value sale to avoid any unintended gift being made. • Inheritor’s payment of trust’s income taxes is not a gift. Rev. Rul. 2004-64.

16. Step Three – File a Gift Tax Return • Disclose the sale on the inheritor’s Form 709 to start the running of the three-year statute of limitations. Treas. Reg. Sec. 301.6501(c)-(f)(4). • The inheritor’s limited power of appointment (LPA) avoids any gift tax, because it is an incomplete gift. Treas. Reg. Secs. 25.2511-2(b), 25.2512 and 25.2701-2704. • If the IRS successfully challenges the valuation, the excess “gift” is allocated to the non-exempt trust. The non-exempt trust can be depleted with the LPA during the inheritor’s lifetime to minimize the estate tax exposure at the inheritor’s death.

17. Obtaining Beneficiary Defective Status • A Crummey withdrawal power causes the inheritor to be treated as the trust’s owner for income tax purposes (IRC Sec. 678) – provided the settlor (nor anyone else) is treated as the owner of the trust under IRC Sections 673, 674, 676, 677 or 679. • If the inheritor releases the power, he/she will be deemed to have made a “gift back” to the trust. • However, IRC Secs. 2514(e) and 2041(b)(2) provide that if the power lapses, it is not a gift unless the power lapses in excess of the greater of $5,000 or 5% of the value of the trust property.

18. Obtaining Beneficiary Defective Status • Does the lapse of the power of withdrawal also result in the inheritor no longer being treated as the owner of the trust for income tax purposes? • IRC Sec. 678(a)(2) provides that the beneficiary remains the owner where (1) the power is “partially released” by the beneficiary and (2) the trust would be a grantor trust if the beneficiary had been the true grantor (e.g., the beneficiary is eligible to receive trust distributions). • This begs the question of whether a “lapse” is a “release”? If not, the trust does not remain “defective” for income tax purposes with respect to the beneficiary.

19. Obtaining Beneficiary Defective Status – PLR 200949012 • In PLR 200949012, a non-grantor trust (with respect to the Settlor) was created wherein the beneficiary had (1) a $5,000/5% power to withdraw all contributions made to the trust (a general power of appointment); (2) a power to make distributions for HEMS (an ascertainable standard); and (3) a testamentary limited power of appointment. • In the PLR, the unilateral power to withdraw lapsed each calendar year in an amount equal to the greater of $5,000 or 5% of the value of the trust; but the power to withdraw under the HEMS standard did not lapse.

20. Obtaining Beneficiary Defective Status – PLR 200949012 • PLR 200949012 concluded that the beneficiary will be treated as the owner of the trust for federal income tax purposes under IRC Secs. 671 and 678 before and after the lapse. • This suggests that “lapse” equals “release”; and the lapse of the unilateral power (thereby avoiding IRC Sec. 2041) to a non-lapsing HEMS power results in a “partial release” under IRC Sec. 678(a)(2).

21. Obtaining Beneficiary Defective Status – PLR 201216034 • In PLR 201216034 (April 20, 2012), a trust was established for a beneficiary who was also the sole trustee. The trust was a non-grantor trust with respect to the settlor. • The beneficiary had a cumulative power to withdraw contributions to the trust.  Each year the beneficiary’s power lapsed to the extent of the greater of $5,000 or 5 percent of the value of the trust’s principal.

22. Obtaining Beneficiary Defective Status – PLR 201216034 • In addition, the beneficiary, as trustee, could make distributions to himself of income or principal in accordance with an ascertainable standard (HEMS). • The beneficiary also had a non-fiduciary power to acquire trust property by substituting assets of an equivalent value, such value to be determined by an independent appraiser (a swap power). IRC Sec. 675(4)(C). 

23. Obtaining Beneficiary Defective Status – PLR 201216034 • The IRS concluded that the trust would be treated as owned by the beneficiary (for income tax purposes) with regard to the portion of the trust that the beneficiary had a presently exercisable right of withdrawal. IRC Section 678(a)(1). • The beneficiary’s power of withdrawal, therefore, triggered grantor trust status with respect to the beneficiary for so long as (and to the extent) such power of withdrawal was exercisable. 

24. Obtaining Beneficiary Defective Status – PLR 201216034 • The IRS stated that the beneficiary could potentially be considered the owner of the trust for income tax purposes under Section 678(a)(2) after his power of withdrawal lapsed if, thereafter, he held another power that would result in grantor trust status under IRC Sections 671 to 677. • The other power in this case was the beneficiary’s right to acquire trust property by substituting assets of an equivalent value in a non-fiduciary capacity. IRC Sec 675(4)(C).   

25. Obtaining Beneficiary Defective Status – PLR 201216034 • The IRS stated that whether the swap power was exercised in a non-fiduciary capacity is a factual determination and, therefore, would not render a definitive ruling on whether the interplay between Section 678(a)(2) and Section 675(4)(C) conferred grantor status on the beneficiary. • Although the IRS didn’t so state in either PLR 200949012 or PLR 201216034, it appears the IRS treated the lapse of the beneficiary’s power of withdrawal in each case as a release and further treated such lapse as a partial release within the meaning of Section 678(a)(2).

26. Obtaining Beneficiary Defective Status – PLR 201216034 • As between the BDIT designs outlined in PLR 201216034 and PLR 200949012, the PLR 200949012 approach may be preferable because its success doesn’t depend on whether the IRS later determines the IRC Section 675(4)(C) power of substitution is exercisable in a non-fiduciary capacity.

27. Creditor Rights and Withdrawal Powers • If a beneficiary can appoint trust assets to his/her creditors, that creates a general power of appointment under IRC Sec. 2041(b)(1) and, therefore, results in estate tax inclusion. • To the extent that the beneficiary allows the withdrawal power to lapse, the beneficiary may be treated under state law as creating a self-settled trust taxable in the beneficiary’s estate (because the beneficiary’s creditors can attach the trust’s assets).

28. Creditor Rights and Withdrawal Powers • Under ORC 5805.06(B)(2), if the powerholder allows the withdrawal power to lapse, releases it, or waives it, the powerholder will not be treated as the settlor of the trust, provided the amount subject to withdrawal is limited to the greater of: • The federal gift tax annual exclusion amount (doubled if the donor was married at the time of the transfer to the trust); or • $5,000 or 5% of the trust principal.

29. BDIT vs Ohio Legacy Trust

30. Best Practices – Initial Gift • When the withdrawal right lapses in accordance with the $5,000 and 5% exception to IRC Secs. 2041(b)(2) and 2514(e), the inheritor becomes the sole owner of the trust for income tax purposes. • The original grantor should just contribute $5,000 cash to the trust (cash is used to avoid fluctuations in value during the withdrawal period). • Gifting additional sums may bifurcate the trust and create uncertainty as to whether the inheritor is the income tax owner of only a portion of the trust. Treas. Reg. Sec. 1.671-3(a)(3).

31. Best Practices – Proper Valuation • If the sale is recast as a partial gift (because the sale price was too low), the LPA avoids any gift tax, but the trust assets could still be taxed in the inheritor’s estate under IRC Sections 2036 – 2038. • The inheritor can then exercise the LPA in favor of permitted appointees to reduce his/her estate tax liability. • To avoid an unintended gift, a qualified appraiser should be hired to determine the sales price. • The sale should be reported on the inheritor’s gift tax return (Form 709).

32. Best Practices – Use Independent Co-Trustee • The inheritor can act as the family trustee to (1) make distributions for HEMS; (2) control trust investments; (3) make management decisions; (4) and remove and replace the independent trustee (with someone not related or subordinate). • The independent trustee will (1) make all distributions beyond HEMS; (2) represent the trust in purchasing hard-to-value assets; and (3) have all incidents of ownership over any life insurance policies owned by the trust on the inheritor’s life and all powers over controlled corporation stock.

33. Best Practices – Use Independent Co-Trustee • The independent trustee can use the cash values on a policy insuring the inheritor’s life for the inheritor’s benefit.

34. Best Practices – Seed Guaranty • To provide a sale transaction with economic substance, a rule of thumb is that there should be no more than an 8:1 debt-to-equity ratio. • To avoid an unintended gift, the inheritor should not act as the guarantor. • The guarantor must have sufficient net worth to make good on the guarantee. • The guarantor must be paid an annual guarantee fee by the trust (at prevailing market rates) to avoid becoming a “grantor” of the trust.

35. Best Practices – Seed Guaranty • The guarantee fee should be determined by an independent appraiser. • The guarantor should be represented by separate counsel. • If the guarantor is the inheritor’s spouse, the guaranty fee is not taxable. IRC Sec. 1014.

36. Best Practices – Defined Value Clause • The inheritor’s limited power of appointment (LPA) avoids any gift tax on the sale because it results in an incomplete gift. • The inheritor can then use the LPA to appoint the non-exempt share to non-skip persons. • In addition, a defined value clause can be used as additional protection to avoid an unintended gift. McCord, Christiansen, Petter, Hendrix and Wandry.

37. Defined Value Clauses Wandry v Comm’r (Tax Court 2012) (IRS Non-acq.) Gift of LLC units equal to $1 million exemption is split 4 children $1.044 million Mr. and Mrs. Wandry among children and grandchildren 5 grandchildren $11,000 each *Formula stated “I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation redetermination by the IRS and/or a court of law.

38. Best Practices – Interest Rate • Using the AFR for the installment sale will avoid a gift tax issue. • But, using an interest rate that is less than current market rates risks exposure under creditor rights laws, which could cause estate tax inclusion as a general power of appointment. IRC Sec. 2041.

39. Best Practices – Avoiding a Step Transaction • The Binding Commitment Test: Did the parties “commit” themselves to reach a specific result from the outset? • The Result Test: Did the steps to the transaction exclude all other results? • The Mutual Interdependence Test: Were the different steps so interdependent that they would have been fruitless without the completion of all of the steps?

40. Best Practices – Avoiding a Step Transaction • The leading cases are Linton, 107 AFTR 2011-375 (9th Cir. 2011); Heckerman, W.D. Washington Cause No. C08-0211-JCC (July 27, 2009); and Pierre, 99.T.C.M. (CCH) 1436 (2010). • In all three cases, the steps occurred on the same day. With a BDIT, at least 30 days have passed from the funding of the trust until the inheritor’s withdrawal right lapses.

41. Best Practices – Avoiding a Step Transaction • Arguably, the IRS cannot aggregate the gift, the seed guaranty and the sale, because they involve three separate parties. • And, even if the IRS is successful with the step-transaction argument, the BDIT should be protected by the “full and adequate consideration” provision to IRC Sec. 2036(a).

42. Planning Opportunities • Asset protection. • Installment sales of discountable assets to take advantage of the low interest rates (arbitrage) and estate depletion by virtue of the inheritor’s tax burn. • Opportunity shifting where inheritor is about to enter into a new start-up with great potential. • BDIT can use excess cash flow to purchase life insurance on the life of the inheritor to leverage the GST exemption allocated to the BDIT. In other words, BDITs are good ILITs. • Hedge against FET repeal and subsequent re-enactment of FET.

43. Parent/Grantor Funds BDIT with $5,000 BDITfbo Child Diagram – Creation of BDIT Grantor makes cash gift to BDIT; has separate counsel; and retains no grantor trust powers. Grantor allocates his/her GST exemption to the gift, assuming BDIT is a dynasty trust. Inheritor has a Crummey withdrawal power which makes the inheritor the owner of the Trust for income tax purposes. IRC Sec. 678(a). Neither the inheritor – nor anyone else – can make a gift to the trust after the initial funding.

44. Parent/Grantor Funds BDIT with $5,000 BDITfbo Child Diagram – Creation of BDIT Inheritor is co-trustee with an independent trustee and has the right to remove and replace the independent trustee with someone who is not related or subordinate. IRC Sec. 672(c) and Rev. Rul. 95-58. Inheritor can distribute trust income and principal for his/her health, education, maintenance and support. Independent trustee can distribute income and principal for inheritor’s best interests. Inheritor has a limited power of appointment (LPA) - except over any life insurance on the inheritor’s life and over controlled stock - to “rewrite” the trust.

45. Diagram – Installment Sale Business Interests IRS Child BDITfbo Child Promissory Note Pays Income Taxes Business Interest Initial Gift After the withdrawal right lapses, child sells non-voting interests of a start-up business to BDIT. Annual interest payments (at prevailing rates) with balloon payment. Child continues to control the business entity. Possible valuation discounts. Sale will be of a defined value. No gain on the sale. Rev. Rul. 85-13. Child’s payment of BDIT’s income taxes is a tax-free gift to the BDIT. Rev. Rul. 2004-64. Child reports the sale on Form 709 as a non-gift. Child’s LPA avoids any unintended gift; and any excess is allocated under a formula clause in the trust to a non-GST exempt share.

46. Diagram – Installment Sale Guarantor Partial Guarantee Guarantee Fee Installment Sale IRS Child BDITfbo Child Promissory Note Pays Income Taxes Since child cannot make a gift to the Trust, a third party (e.g., the grantor, the child’s spouse, the remainder beneficiaries, an existing irrevocable trust, etc.), should guarantee 20% of the loan. Guarantee fee should be determined by an independent appraiser. Guarantor should have separate counsel and must have sufficient assets to make good on the guarantee. The guarantee is the “seed” money so that the sale is not treated as a disguised gift. IRC Secs. 2036 and 2702. If child’s spouse is guarantor, fee is not subject to income taxes. IRC Sec. 1014.

47. Diagram – Life Insurance Application Guarantor Partial Guarantee Guarantee Fee Installment Sale IRS Child BDITfbo Child Promissory Note Pays Income Taxes Life Ins. Co. Excess Cash Flowcan pay Premiums Death Proceeds are Income, Estate and GST Tax Free Trust funds in excess of the interest payment and guarantee fee can be used to fund the balloon payment under the note. Excess funds may also be used to purchase life insurance so as to “leverage” the GST exemption. All incidents of ownership over the policy must rest with the independent co-trustee.

48. Diagram – Tax Authority Guarantor Partial Guarantee Guarantee Fee Installment Sale IRS Child BDITfbo Child Promissory Note Life Ins. Co. Excess Cash Flow can pay Premiums Pays Income Taxes Death Proceeds are Income, Estate and GST Tax Free BDITs are relatively untested and based upon PLRs 200949012, 201039010, 201216034 and 129745-11, which dealt with grantor trust status and did not address whether the trust assets would be included in the inheritor’s estate after the withdrawal period lapsed. Possible step-transaction challenge by the IRS that the inheritor is the true settlor of the trust. The IRS added the “sale to a BDIT” transaction to its “no ruling” list in Section 4.01(39) of Rev. Proc. 2015-3.

49. THE END THANK YOU