Category: Exemption Capture Planning

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Estate Planning Exemption Capture Planning Generation-Skipping Transfer (“GST”) Tax

Proposed Resurrection of the Common Law Rule against Perpetuities—At Least for GST Tax Purposes

Kyle G. Durante —

There is one common law rule that haunts most law students, and many legal practitioners: “no interest is good unless it must vest, if at all, not later than twenty-one years after some life in being at the creation of the interest.” This rule, known as the rule against perpetuities, has many applications, but, most importantly, it limits the duration that an irrevocable trust may remain in existence. This rule was initially adopted in an effort to limit dead-hand control over property by requiring property to vest in a beneficiary within a certain period of time.

Generally, at common law, an irrevocable trust could remain in existence for a period of time not exceeding 21 years after the death of all members of a particular class of persons who were alive at the time the perpetuities period began. For an irrevocable trust, generally, the perpetuities period will begin on the date the trust was created. While some states, such as New York,[1] continue to follow the common law rule, a number of states, such as New Jersey, Pennsylvania, Delaware, and South Dakota,[2] have completely abrogated the rule, while others have extended the period of time that an irrevocable trust may remain in existence, such as Connecticut (which applies an 800 year period in gross) and Florida (which applies a 1,000 year period in gross).

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Estate Planning Estate Tax Exemption Capture Planning Gift Tax

IRC Section 2701 and Gifts of Carried Interests

James R. O’Neill —

James O'Neill's headshot photo

The transfer in the course of estate planning of a fund manager’s carried interest early in the life of a fund (when the carried interest has a modest value) can be an attractive way in which to remove anticipated future appreciation from the manager’s estate at a nominal gift tax cost. However, any transfer of a carried interest could be subject to the special valuation rules of Internal Revenue Code (“IRC”) Section 2701 and result in an unexpected deemed gift and substantial gift tax liability. If the entire carried interest is transferred, the capital interest in the fund retained by the manager may be valued at zero for gift tax purposes under Section 2701, and the manager may be deemed to have made a gift of his entire interest in the fund, including his capital interest, rather than just the carried interest.

One way to achieve the desired estate planning result and avoid the applicability of Section 2701 is the sale of a derivative, based on the performance of the manager’s carried interest, rather than a transfer of the carried interest itself. Typically, the sale would be made to an intentionally defective grantor trust (also simply known as a “grantor trust”) for the benefit of family members. The use of a derivative contract to transfer the value of the carried interest does not require the actual transfer of the carried interest itself, thereby avoiding the applicability of Section 2701. Under this approach, the manager enters into a derivative contract with the trust agreeing to pay the trust at a future settlement date, usually set near the end of the fund’s life, the fair market value of the carried interest on the settlement date. For more aggressive planning, the payment may be set in the derivative contract as a multiple of the value of the carried interest on the settlement date. The derivative contract also can be structured so that the payment is required only after the carried interest has exceeded a certain total return, using a hurdle amount. For its part, the trust pays to the manager upon execution of the derivative contract the present value of the trust’s right to receive the future payment on the settlement date. That present value is determined by an appraisal of the trust’s future right (at current fair market value) upon execution of the derivative contract, which is generally significantly less than what the trust will actually receive upon the settlement date.

For example, if the present value of the trust’s right to receive the future payment based on the carried interest is appraised currently at $500,000, the trust pays the manager that amount upon execution of the derivative contract. If the value of that carried interest is five million dollars at the future settlement date, the manager pays to the trust that five million dollars on the settlement date at conclusion of the term of the derivative contract. A gift tax return is filed to report the sale to the trust (and a zero-dollar gift) of the appraised value of the derivative based on the carried interest to start the running of the statute of limitations for the Internal Revenue Service to audit the gift tax return. Given that the derivative was sold to the trust and there is no reportable gift value, there are no gift tax consequences associated with the sale.

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Estate Planning Estate Tax Exemption Capture Planning Gift Tax Income Tax

Irrevocable Trusts: Who Is the Taxpayer?

Kyle G. Durante —

In establishing and funding an irrevocable trust, a common question is who is responsible for the income tax liabilities associated with the trust? Many individuals assume that the trust is a separate and independent taxpayer, requiring the trustees to file income tax returns for the trust. However, that is not always the case.

Irrevocable trusts are either classified as “grantor trusts” or “non-grantor trusts.” When an irrevocable trust is classified as a grantor trust, the trust is treated as identical to the settlor or the donor, requiring the settlor to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns. When an irrevocable trust is classified as a non-grantor trust, the trust is deemed to be a separate taxpayer, requiring the trustees to file annual income tax returns for the trust (known as fiduciary income tax returns) reporting all matters of income and deduction with respect to the trust.

Generally, whether an irrevocable trust will be classified as a grantor or non-grantor trust depends on certain powers that may have been retained by the settlor with respect to the trust, who are the beneficiaries of the trust, and certain provisions in the trust. For instance, if the settlor retained the power of substitution (also known as a swap power), if the trustees have the power to use trust income to pay premiums on a life insurance policy insuring the life of the settlor or if the settlor’s spouse is a permissible beneficiary of the income of the trust, the irrevocable trust will be deemed to be a grantor trust. As a general rule, although not always the case, an irrevocable life insurance trust (holding a life insurance policy insuring the life of the settlor) or a spousal lifetime access trust (“SLAT”) will almost always be deemed a grantor trust during the settlor’s lifetime.

At first blush, a grantor trust may be seen as a harmful result given that the settlor is transferring property to an irrevocable trust (of which the settlor is generally not a beneficiary and no longer has access to the property) but the settlor remains liable for the income tax bill. However, establishing an irrevocable trust as a grantor trust can have significant transfer tax benefits. By establishing a grantor trust, each year the settlor will report and pay any associated income tax liabilities with respect to the trust. Under current law, the payment of tax liabilities that would otherwise be paid by the trust is, in essence, a tax-free gift to the trust each year. As such, the payment of the trust’s tax liabilities by the settlor will permit the settlor to further deplete the assets in his or her own name (that will be subject to estate tax at his or her death) without using any of the settlor’s gift/estate tax exemption.

With respect to grantor trusts, of course, once the settlor dies, the trust will generally cease to be a grantor trust and convert to a non-grantor trust. It may also, however, be possible to convert the trust from a grantor trust to a non-grantor trust, and vice versa, during the settlor’s lifetime, if that would be desirable.

Irrevocable trusts are further subclassified under the Internal Revenue Code as either foreign or domestic trusts. As a general rule, domestic trusts are subject to U.S. income tax on their world-wide income, while foreign trusts are subject to U.S. income tax on only their U.S.-sourced income. The implications of each such classification and the tests to determine such classifications will be addressed in an upcoming cross-border estate planning series.