The Advantages of Beneficiary-Favored Trusts

Protecting Assets and Preventing Taxation While Retaining Control and Use

A last will and testament, which directs an individual's affairs after death, can include trust provisions that become effective at death. But a trust created during one's lifetimethat is, an intervivos trust-might be more appealing to some individuals; in fact, trusts have been widely used to achieve certain advantages that a last will and testament cannot accomplish. Depending upon how it is designed, an intervivos trust typically presents two benefits: 1) asset protection for the individual and subsequent heirs, and 2) an estate tax reduction, by removing appreciating assets from the individual's otherwise taxable estate. But these benefits could come at a price: the individual generally loses control over the assets placed in the trust and the use of the assets themselves, as well as the future income or gains associated with them.

These two tradeoffs make an intervivos trust less attractive, especially given that the estate tax reduction benefit became less of a motivator with the "permanent" higher gift, generation-skipping transfer (GST), and estate tax exemption amounts of $5.34 million (per individual) and $10.68 million (per married couple), indexed for inflation. The portability of the estate tax exemption might make the intervivos trust even less appealing for certain individuals.

But what if an intervivos trust could be designed so that the asset protection and estate tax reduction aspects could be achieved while maintaining the control and use of the trust assets? Such a trust's wide latitude of variables might lead an individual to choose to be its primary beneficiary. In addition, even if an individual is no longer concerned with estate tax risks, the use of trusts to reduce the estate tax exposure of moderate-wealth individuals can still be valuable if Congress later decides to return the exemption amounts to lower levels.

The beneficiary-favored trust (BFT) can accomplish the desired goals of asset protection, estate tax reduction, control over assets, and the potential use and enjoyment of trust assets and income. The ability to retain use of the BFT property is especially attractive to individuals who want future retirement funds to remain safely tucked away as a nest egg. An additional unique aspect of the BFT is the application of Internal Revenue Code (IRC) section 678, which causes the BFT to be a grantor trust to the primary beneficiarythat is, that individual's taxable estate and number of creditor-exposed assets are reduced, because IRC section 678 requires the individual to pay the BFT's income tax liability. IRC section 678 also allows assets to be sold to the BFT income tax free.

Financial advisors should review the ensuing details about setting up a BFT, using the BFT assets, controlling those assets, and enjoying both asset protection and estate tax reduction benefits.

Setting Up the BFT

The BFT is an irrevocable trust created by an individual termed the "settlor" or "donor." The settlor is neither a trustee nor a beneficiary of the BFT, does not retain any benefits, and has no rights to alter others' enjoyment of the trust assets.

The BFT agreement is designed to give the primary beneficiary maximum control, protection, and access to the trust assets in a tax-favorable environment. The BFT should be created in a jurisdiction that has beneficial laws, such as an extended perpetuities law or no perpetuities law at all, as well as favorable asset protection laws with respect to trust beneficiaries. For example, jurisdictions that provide asset protection for "self-settled" trusts can become crucial in the event the primary beneficiary were to ever mistakenly make a gift to the BFT, which could inadvertently cause the BFT to become self-settled; this would subject the BFT assets to possible estate taxation and creditor exposure if the trust had been created in the wrong jurisdiction.

The longer the jurisdiction allows the BFT to remain in existence, the more distant future generational beneficiaries can enjoy the trust benefits. Furthermore, the longer the trust period, the longer the trust assets can remain free of any GST taxes.

The primary beneficiary is designated as a purely discretionary beneficiary of the BFT and, thus, can enjoy economic benefits from the BFT (through distributions of income or corpus) through the exercise of discretion by an independent trustee. This independent trustee holds the power to make distributions, and loans to the primary beneficiary or any other beneficiary at any time. The BFT could also be designed to require the primary beneficiary, as a co-trustee (sometimes referred to as the "family trustee"), to make distributions to herself, as needed, for health, education, and support needs (Private Letter Ruling [PLR] 200949012).

The independent trustee cannot be subordinate or related to the primary beneficiary. (Generally, a "subordinate or related" person is defined as a family member or employee of the primary beneficiary under IRC section 672 [c] and Revenue Ruling 95-58.) Even though this definition is based on an income tax provision, having an independent trustee is important in order to ensure that the trust assets will not be included as part of the primary beneficiary's taxable estate. If the primary beneficiary or one of her family members or employees holds trustee powers that can benefit the primary beneficiary too broadly, there exists greater risk that the trust assets would be included in her taxable estate or become subject to her creditors under some agency or de facto control argument.

Under the terms of a BFT agreement, the independent trustee is also authorized to negotiate any sales transactions between the trust and the primary beneficiary. In essence, the independent trustee holds all the tax-sensitive powers. In the design of the BFT, the primary beneficiary is granted the authority to replace the independent trustee with a new independent trustee at any time; this power is intended to allow the replacement of independent trustees who fail to fulfill their fiduciary duty.

Although the primary beneficiary does not need to be the only beneficiary, the primary beneficiary is the only one who holds the "Crummey" powers (discussed below) and who serves as the family trustee. A family trustee holds trustee powers over the management and investment of the trust assets. A family trustee's powers in a BFT are limited to the extent necessary to avoid having the BFT assets included in that trustee's taxable estate; this entails ensuring that IRC sections 2041 and 2042 will not apply.

IRC section 2041 generally includes assets in one's estate, if such person has the ability to direct the assets to oneself, one's creditors, or for the benefit of either. For example, the family trustee cannot hold any power to appoint the BFT assets to herself (unless limited to an ascertainable standard as described in IRC section 2041 [b][l][A]), her creditors, or to creditors of her estate without causing the BFT assets to be included in her taxable estate. IRC section 2042 includes life insurance policies in the insured's estate, if such person can exercise powers over the policies, such as changing the beneficiaries or borrowing from the policies. In some very limited circumstances, however, the insured may retain a right to the policy dividends (Chief Counsel Advice [CCA] 201328030).

As mentioned, the BFT grants the primary beneficiary Crummey withdrawal powersthat is, the power to withdraw all contributions made to the BFT, but only for a limited period of time. The BFT provides that if the primary beneficiary does not withdraw the contributions during that window, the withdrawal power lapses.

The settlor will usually initially contribute $5,000 to the BFT from the settlor's own funds; this is typically the maximum annual amount. Incidentally, this contribution will also not be subject to any gift tax or use any of the settlor's lifetime gift tax exemption, because the Crummey provision qualifies the contribution for the annual gift tax exclusion. A larger gift could result in a deemed taxable gift by the primary beneficiary to the BFT.

The lapsing Crummey withdrawal power, to the extent it does not exceed $5,000 or 5% of the relevant trust corpus in any one calendar year, will not be treated as a taxable gift by the primary beneficiary because it falls within the IRC sections 2041(b)(2) and 2514(e) allowance rules. This is key-if the primary beneficiary were deemed to have made a gift to file BFT, it would render the BFT vulnerable to the self-settled tmst mies (if the BFT were not created in the proper jurisdiction), as well as to IRC section 2036 (discussed later).

The Crummey withdrawal power provision will usually state that the primary beneficiary has a 30-day window to withdraw up to $5,000 of any contributions made to the BFT in that calendar year. If file primary beneficiary does not exercise the power within the 30-day period, it is designed to lapse, per the BFT agreement. This power not only allows the contribution to qualify for the annual gift tax exclusion available to the settlor; it also allows the BFT to be entirely treated as a grantor tmst with respect to the primary beneficiary. This grantor tmst treatment causes the primary beneficiary to be deemed the direct owner of all the BFT assets for income tax purposes. As a result, the BFT taxable income is entirely taxable to the primary beneficiary (see IRC sections 678[a][l] and 678[a][2]). Furthermore, a sale of assets by the primary beneficiary to the BFT would avoid any capital gains tax.

The settlor will always be treated as the tmst creator for state law and transfer tax purposes. As to the settlor, the BFT is a nongrantor tmst-in this case, a tmst with income that is not taxable to the settlor. This is accomplished by not granting the settlor any powers under IRC sections 671 through 677. For example, the settlor cannot be allowed to receive distributions as a beneficiary from an independent trustee, or be an insured on a life insurance policy owned by the BFT. In addition, the BFT generally cannot own life insurance on the settlor's spouse's life (IRC section 677[a][3]). If the BFT were a grantor trust with respect to the settlor (i.e., treating the settlor as the owner of the trust assets), this would trump file ability to have the BFT be a grantor trust with respect to the primary beneficiary, under IRC section 678(b).

Use of Trust Assets

A primary beneficiary holds a beneficial interest in the BFT, which allows that individual to receive trust distributions without compromising the asset protection and estate tax reduction goals. The primary beneficiary typically holds a discretionary beneficial interest in a BFT, meaning that the independent trustee has the virtually unrestrained authority to make distributions to file primary beneficiary at any time, subject to any applicable state law fiduciary duties. Furthermore, the independent trustee can allow the primary beneficiary broad access to use trust assets, such as living in a vacation home owned by the BFT.

As previously mentioned, the primary beneficiary must not make any gifts to file BFT. Such gifts would cause the BFT to be a self-settled tmst because the primary beneficiary is eligible to receive distributions from the tmst. Under most state laws, a self-settled tmst is fully exposed to the settlor's current and future creditors. Under IRC section 2036, if the settlor's creditors have access to the tmst assets, then the trust assets are part of the settlor's taxable estate; therefore, in states with no creditor-protected self-settled trust law, gifts to the BFT by the primary beneficiary will be included in that beneficiary's taxable estate. Avoiding such gifts allows the BFT to avoid such exposure. (Note that the BFT's classification as a grantor trust to the primary beneficiary does not cause such exposure.) But even in states that protect self-settled tmst assets from the transferor's creditors, if the primary beneficiary holds a power of appointment over the tmst to which the beneficiary made any gifts, this power alone pulls the gifted assets back into the primary beneficiary's estate. The BFT can, however, be designed to automatically redirect any such gifted assets into a subtrust over which the primary beneficiary has no power of appointment.

A self-settled trust could mn a higher risk of losing the desired asset protection and estate tax reduction capacity of the BFT. (Some financial advisors mistakenly believe that the grantor trust mies under IRC sections 671-679 subject a trust to the settlor's creditors or to estate taxes at the client's death, but this is not the case; the grantor trust mies are an income tax concept, distinct from how the self-settled tmst rules interact with the estate inclusion rules under IRC sections 2036 and 2038.) The BFT's primary beneficiary can transfer assets to that BFT without increasing the risk of lost asset protection or of having inclusion of transferred assets in that beneficiary's taxable estate; however, this applies only if the transfer is for full consideration. IRC sections 2036 through 2038 provide that the assets will not be pulled back into the transferor's estate if the transfer involves a sale of assets for full consideration, such as an installment note issued by the BFT. The primary beneficiary then receives payments through the installment note.

Under IRC sections 2036 and 2038, the taxpayer's ability to alter or revoke a tmst will cause the tmst assets to be included in the taxpayer's taxable estate if the taxpayer initially transferred assets to the trust for less than full consideration. These sections generally apply when one makes a transfer to a tmst while retaining either file right to the income from those transferred assets or a right to alter others' enjoyment of the transferred assets. This is why, in a typical tmst transfer, the individual transferor is not a tmst beneficiary (so there are no retained benefits) and does not serve as a trustee of the trust (so there is no power to affect others with regard to their allowed enjoyment of the trust assets).

Control of Trust Assets

The primary beneficiary has the power-in a number of ways and in several different capacities-to decide how assets are managed and to whom tmst assets are to be distributed. With a BFT, the primary beneficiary can hold powers over asset distribution and management as the family trustee. The primary beneficiary, individually, can also have the ability to "rewrite" the tmst by way of a "special power of appointment." Generally, filis is a power, held by the primary ben- eficiary and exercisable during life or at death, to appoint BFT assets (other than a life insurance policy on the primary beneficiary's life, because of the estate tax consequences under IRC section 2042) to anyone other than to himself, his creditors, his estate, or creditors of his estate. In essence, this allows the beneficiary to modify the trust's dispositive provisions.

This special power of appointment will not cause the BFT assets to be included in the primary beneficiary's taxable estate, because it does not rise to the level of a general power of appointment; IRC section 2041 includes only property subject to a general power of appointment as part of the power-holder's taxable estate.

Other controls can be held by the primary beneficiary, such as the ability to change trustees. (See Estate of Wall v. Comm V, 101 T.C. 300 [1993] and Revenue Ruling 95-98, which set forth certain restrictions on the primary beneficiary's change of trustee powers in order to avoid adverse tax results.) The BFT typically grants the authority to replace the currently serving independent trustee with a new trustee who is not subordinate or related to the settlor or to the primary beneficiary. Furthermore, the primary beneficiary can replace trust assets with the primary beneficiary's personal assets by selling those personal assets to the BFT (which would be income tax-free in accordance with IRC section 678 [PLR 200949012; PLR 201216034]) in exchange for BFT assets of equal value or an installment note. Alternatively, the primary beneficiary can be granted a power in the BFT agreement to simply substitute his assets in exchange for BFT assets of equal value. (See PLR 201216034 and Revenue Ruling 2011-28; even though this power will also cause the trust to be a grantor trust, the focus in the above discussion is on powers that allow control.)

Asset Protection and Estate Tax Reduction

As with many other types of trusts, a BFT still provides the possibility for asset protection and estate tax reduction, notwithstanding the control and use or receipt of trust assets.

Asset protection. The BFT's asset protection is in place against creditors of the beneficiaries and any future unexpected creditors of the settlor. This is achieved for the beneficiaries largely due to a BFT's inclusion of a "spendthrift" clause, coupled with the fact that a BFT is not settled by any beneficiary. In most states, when a settlor creates a trust in which the settlor is a beneficiary (a self-settled trust), the settlor's creditors can access the trust's assets. Such a trust's spendthrift provisions can adequately protect the trust assets from the other trust beneficiaries' creditors. In a BFT, the primary beneficiary is one of these "other beneficiaries," because the BFT is created by someone other than the primary beneficiary.

Such a spendthrift clause could read as follows:

No beneficiary of the trust estate shall have any right, power, or authority to sell, assign, pledge, mortgage or in any other manner to encumber, alienate, or impair all or any part of his or her interest in the trust estate or in the principal or income thereof. The beneficial and legal interest in, and the principal and income of, the trust estate and every part of it shall be free from interference or control of any creditor of any beneficiary of the trust and shall not be subject to the claims of any such creditor, including claims for the payment of alimony, nor liable to attachment, execution, bankruptcy, or any other legal or equitable process. The income and principal of the trust estate shall be paid over to the beneficiary directly, or, in the event of the minority or incompetency of any beneficiary, to the legal representative of that beneficiary, or in any form allowed by law for gifts to minors, or to or for the benefit of that beneficiary, in such manner as the Trustee in the Trustee's sole discretion deems advisable, at the time and in the manner provided by the terms of the trust, and not upon any written or oral order nor upon any assignment or transfer by the beneficiary nor by operation of law.

Furthermore, as the primary beneficiary incurs income taxes on the BFT's earnings (as discussed below regarding IRC section 678), the primary beneficiaiy's personal assets that would otherwise be attachable by a creditor are further depleted, while allowing the creditor-protected BFT assets to grow without any income tax burden.

In addition, the primary beneficiary can sell personal assets to the BFT. If the assets sold are in the form of a limited partnership or LLC in exchange for a promissory note from the BFT, the note can reflect valuation minority and marketability discounts that were ascertained at the time of the sale of assets to the BFT. This is often the case when an interest in an LLC that was properly structured to avoid any IRC section 2036 exposures is sold to the BFT. The discounted valuation of the LLC, which is reflected in the face value of the installment note, provides some immediate asset protection and taxable estate reduction following the sale.

For example, consider a primary beneficiary who sells a 49% interest in an LLC to the BFT. The LLC owns $1 million in real estate. With a 20% discount, the 49% interest is sold for $392,000, rather than the underlying value of $490,000. In return, the primary beneficiary receives a promissory note, secured by the LLC interest, for $392,000. The promissory note reflects an interest rate of 5% (for purposes of this example, assume that 5% is the prevailing rate that local banks would charge for a similar secured loan).

The installment note may reflect a discounted sales price, but without further action, it would still be subject to the primary beneficiary's creditors, as well as includible in the primary beneficiary's taxable estate. Thus, further estate planning is necessary if the note is also to be protected from estate taxes and creditors. If this is desired, the primary beneficiary can contribute the note to a separate trust that is more narrowly designed to accomplish just those two goals (i.e., asset protection and estate tax reduction). For example, the note could be contributed to an intentionally defective grantor trust (IDGT) or a self-settled asset protection trust designed as a "completed gift" trust, utilizing the primary beneficiary's available lifetime gift tax exemption. (Further discussion of this strategy expands beyond the scope of this article.)

Estate tax reduction. The BFT allows opportunities to minimize the gift and estate tax exposures at the federal level or state level. (For example, New Jersey allows only a $675,000 estate tax exemption; New York</location> allows $1 million.) When a person makes gratuitous transfers to a trust, the trust assets could be included in that transferor's taxable estate if that beneficiary retains any of the powers listed under IRC sections 2036-2038. Minimizing estate taxes is achieved under a BFT because its design allows the primary beneficiary to transfer assets (that are expected to appreciate significantly) via a sale (thus avoiding IRC sections 2036-2038) to the trust, while continuing to be both a beneficiary and a trustee, all without having the BFT's assets includible in that beneficiary's taxable estate.

In addition, the primary beneficiary can sell assets that qualify for minority discounting to the BFT. Lastly, the BFT is designed as a grantor trust with respect to file primary beneficiary, which results in a further reduction to that beneficiary's taxable estate due to the income tax burden required by IRC section 678. This personal income tax responsibility of the primaiy beneficiary further reduces the primary beneficiary's taxable estate.

Note that an income tax burden on the primary beneficiary's taxable estate refers to the fact that the primary beneficiary must continue to pay out of a personal estate the income taxes owed on the BFT's taxable income and gains, while the BFT assets, income, and gains are allowed to continue to grow and accumulate, free of any income tax burden, inside the BFT's estate tax-free environment. IRC section 678 treats the primary beneficiary as the owner of the trust assets for income tax purposes; thus, the primary beneficiary is personally responsible for paying the income taxes on the BFT's taxable income and gains. This assumes that the trust is not a foreign trust for income tax purposes; it also assumes that the beneficiary's spouse is not the settlor. In either of these two cases, the settlor would be deemed the owner of the trust assets for income tax purposes under IRC sections 679 and 672[e], respectively, as opposed to the primary beneficiary.

The installment note payments received by the primary beneficiary should help with any cash flow concerns. The estate tax reduction becomes especially evident once any installment note that the primary beneficiary might receive in a sale of assets to the BFT has been fully repaid, resulting in a cessation of further installment payments to the primary beneficiary.

IRC section 678. This section treats the primary beneficiary as the owner of the BFT assets, but only for income tax purposes. IRC section 678 grantor trust treatment opens up some estate tax planning strategies for the primary beneficiary. One such strategy involves the primary beneficiary selling assets that are expected to appreciate or generate a healthy cash flow. Such assets can be sold to the BFT for an installment note. (If the assets sold are difficult to value, the independent trustee should be the trustee who is solely authorized to negotiate the sale/purchase with the primary beneficiary.) This represents an effective "estate freeze" for the primary beneficiary. The sold assets grow in value inside the BFT, which is not includible in the primary beneficiary's taxable estate. In today's low interest rate environment, there may be an opportunity to arbitrage the sold assets into capital growth for the BFT. Furthermore, no gain is recognized from the sale to the BFT, because the primary beneficiary is treated as the owner for income tax purposes. Likewise, the primary beneficiary is not taxed on the interest-income portion of the installment note payments.

For example, the independent trustee and the primary beneficiary can enter into a sale transaction for which a qualified appraisal has established or supported the sale price. Assuming the price will be paid through an installment note, the note should reflect an adequate interest rate, reflecting its term. If a 10-year note is used, then the prevailing rates that a local bank would charge in connection with a similar note should act as a guide. In addition, the note should be secured by the sold assets.

Concurrently, the primary beneficiary's remaining taxable estate is also reduced by the payment of tax on the BFT income. Hie payment of this tax reduces the primary beneficiary's taxable estate, while allowing the BFT's value to grow free of income and estate taxes. This not only reduces any estate tax exposure for the primary beneficiary; it also reduces creditor liability for the primary beneficiary, because the assets that are nonprotected (e.g., assets personally owned by the primary beneficiary) are diminished, while the creditor-protected nest egg in the BFT is allowed to grow unencumbered by any income tax burdens.

The BFT can even provide income tax benefits. As of 2014, a nongrantor trust's income is taxed at the highest tax rate at income levels above $12,150. Capital gains are taxed at 20%. An added 3.8% surtax is then applied against the trust's investment income, including the capital gains. Most trusts created by a settlor (also known as the grantor) are nongrantor trusts after the death of the settlor/grantor, at which point these top income tax brackets apply. The BFT, on the other hand, remains a grantor trust after the settlor's death. Thus, the 3.8% surtax, for example, is not assessed until income reaches $250,000 (for a married primary beneficiary), as opposed to $12,150. In addition, the 20% capital gains tax rate is not assessed until income reaches $457,600 (for a married primary beneficiary), again as opposed to $12,150.

Additional Considerations

Life insurance. If a BFT were to own life insurance on the primary beneficiary's life, he cannot hold any incidents of ownership in the policies without causing those policies to be included in his taxable estate (IRC section 2042). As this concept applies to a BFT, the primary beneficiary cannot hold any power of appointment or any trustee powers over any of the life insurance policies, or the policies will be included in that beneficiary's estate. "Incidents of ownership" encompasses any authority held by the insured to, for example, change the beneficiaries of the policy, borrow from the policy, or terminate the policy. Thus, a BFT typically provides that only the independent trustee holds such powers over the policy. Simply being a discretionary beneficiary of a trust that holds life insurance on that beneficiary's life is not, in and of itself, an incident of ownership (PLR 9451053).

GST tax exemption allocation. The BFT can be wholly exempt from any federal GST taxes, in that the settlor can allocate the available GST tax exemption to any contribution made to the BFT.

Statute of limitations. A gift tax return should be filed to start the statute of limitations running, in case the 1RS later decides the sales price was less than the value of the sold asset (Treasury Regulations sections 301.6501[c]-l[f][4] and [5]). This will start the statute of limitations with respect to the fact that no gift occurred. The primary beneficiary files file gift tax return to report the transfer as a nongift transaction.

Installment note tips. As mentioned above, the primary beneficiary can sell, but not gift, assets to the BFT. If the primary beneficiary decides to enter into such a sale, some portion of the repayment of file installment note should be guaranteed. Hie use of a guaranty is advised in order to avoid the BFT assets being the sole allowable source for repayment for the installment note. If the BFT assets are the sole financial backing for the installment note, it can be argued that the note is simply a retained right by the primary beneficiary to the income of the sold asset. Such a retained right to income could thereby invoke IRC section 2036, which draws the BFT's assets back into the primary beneficiary/seller's estate.

The guarantor can be anyone other than the primary beneficiary, such as the primary beneficiary's spouse, certain separate trusts aeated by the primary beneficiary, or a third party; however, the guarantor must be someone who has the financial wherewithal to honor the terms of the guarantee. The guarantor should be represented by separate counsel and should be paid an arm's-length guaranty fee by the BFT. Determining the proper market rate for the fee may necessitate an appraisal.

Proper Planning

Although a settlor can have independent reasons for setting up a BFT for family members (e.g., a primary beneficiary/child and grandchildren), the BFT clearly provides many benefits to the primary beneficiary. (It is, of course, advisable that a settlor engage an independent advisor to ensure that the settlor's goals are being accomplished, rather than creating a structure that satisfies only the primary beneficiary's interests.) The BFT provides a safer environment in which the primary beneficiary can carry on business ventures and other endeavors geared for financial success and eventual retirement.

With proper planning and motivation, the BFT can be a highly effective trust in a variety of situations-regardless of whether the settlor or the primary beneficiary is married or single-because it can achieve four goals of strategic estate planning: 1) prevention of taxes (i.e., reduces the income, estate, and generation-skipping transfer tax burden); 2) protection of assets; 3) retention of powers held by the beneficiary to control, manage, and direct the disposition of trust assets; and 4) the ability for the beneficiary to receive the profits due to her efforts as the managing family trustee of the trust. ?

Other controls can be held by the primary beneficiary, such as the ability to change trustees.

Edward D. Brown, JD, is a principal at Engel & Reiman PC, Denver, Colo.