Estate Defective Trusts Offer A Wealth Of Planning Opportunities

Many clients have depreciated their assets to a nominal income tax value. The sale of the asset may create depreciation recapture. If the asset is gifted, the donee may be responsible for the income tax payment associated with the depreciation recapture. If the asset is retained in the clients taxable estate until death, the depreciation recapture disappears when the basis steps up to fair market value. Not only does the depreciation recapture disappear, but the inheritors also have a new basis and can start depreciating the asset again using a new higher basis.

Future Appreciation. The EDT also provides the ability to grow the value of the assets after the creation of the trust and receive a step-up in basis at the donors later death.

Planning: Assume a client has an asset that is currently worth $200,000 with a $10,000 basis. The asset is expected to grow at a rate of 5% per year while generating an annual income stream of $30,000 per year. The client places the $200,000 asset in an EDT and dies 20 years later. Over the term of the trust prior to his death, $600,000 in income has been moved to the children who pay the related income tax at a potentially lower rate than the grantor. Second, in 20 years the value of the assets placed in the EDT is over $677,000. When the EDT assets step-up to a fair market value (assuming a 25% state and federal capital gain bracket), the post-death sale of the assets would save almost $170,000.

Non-Tax Opportunities. Many client estate planning decisions have been dictated by the requirements of the avoidance of a federal estate tax. For example, a grantor to a trust could not retain a power of appointment to reconfigure the trust at some later date without the trust assets remaining in the grantors taxable estate. However, because the vast majority of estates will no longer be taxable, the dictation of trust terms to avoid the federal estate tax will no longer apply to a majority of estates. Instead planners should examine the income tax implications of trusts and draft language to minimize the income tax exposes, not the estate tax exposures.

Planning: Assume a client creates an irrevocable trust, naming his three children as beneficiaries. The clients children have not shown themselves to be financially responsible and the client wants to retain some ability to reconfigure the assets among the beneficiaries or give the assets to charity in the future. A retained testamentary power of appointment over the EDT will result in the inclusion of the trust assets in the grantors estate. However, a testamentary power of appointment does not result in the trust being treated as a grantor trust for income tax purposes if the trust income cannot accumulate without the consent of an adverse party. Therefore, the income of the trust would be taxable to the recipient beneficiaries, the EDT assets would be includable in the grantors estate at the time of his death permitting a step-up in basis, and the grantor retains a power over the EDT to satisfy his personal concerns about his children.

Secrecy. In many cases a client wants to make sure that his or her disposition decisions are not reflected in public records. By placing assets in the EDT, the client effectively can remove how assets are being passed from the scrutiny of other parties.

Planning: Assume a client does not want his new wife to know what he does for the benefit of estranged family members or ex-wives. Assuming the estate is not taxable, the use of an EDT could provide a mechanism for transferring low basis assets to "unacceptable" family members without disclosure to all of the family members. If a federal estate tax return is not due, there may be no documents which disclose the existence of the trust and unless the trustee or the beneficiary makes this disclosure, the veil of secrecy remains.

Risks of EDTs. The Estate Defective Trust does carry significant risks. First, an EDT is normally created on the assumption that the grantor will not have a federal taxable estate. Inheritances, unexpected growth in the estate or other factors could increase the size of the estate. Moreover, the transfer tax exclusions which are currently available could be decreased by a future Congress.

Second, without careful planning, the transfer to the EDT could be treated as a completed gift for federal gift tax purposes (i.e., using portions of the clients available unified credit applicable exclusion) while remaining taxable in the grantors estate. Because of the differences between the estate and gift tax rules, double taxation is possible. For example, assume a grantor retains the right to change the time or manner of a beneficiarys interest in the EDT but cannot take away the beneficial interest. Such a transfer would be complete for gift tax purposes, but the retained power would result in the grantor including the EDT assets in his taxable estate.

Third, if the estate is below the unified credit applicable exclusion amount, a federal estate tax return is generally not due. However, clients still need to document properly the value of the assets in the EDT as of the date of death of the grantor. It is an absolute necessity that any unmarketable EDT assets which are included in the grantors taxable estate be appraised properly at the time of the death of the grantor. The trust should probably include language requiring the trustees to obtain such an appraisal.

Fourth, even though there will be substantial reductions in federal transfer taxes, state death taxes will offset at least part of the reduction. As a part of EGTRRA, Congress replaced the state death tax credit with a federal estate tax deduction. Thirty-eight states used the federal credit as their state estate tax. Most of these states now are revising their statutes to impose new state inheritance taxes. Some states will ignore the higher federal exemption amounts, creating a state death tax when no federal estate tax is due.

The Estate Defective Trust adds one more tool to the arsenal of planning tools. Like the Income Defective Trust, the EDT will not work for every client, but for those clients who fit its criteria, it can be an excellent part of their plan.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga., and author of "The Family Incentive Trust," published by The National Underwriter Company. He can be reached via e-mail at [email protected].

Reproduced from National Underwriter Edition, December 30, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.