Trusts are among the major weapons in the arsenal of estate planners, as we strive to assist clients accomplish their goals of minimizing income, estate, and gift taxes, while also passing assets to individuals on a schedule and subject to the conditions that are important to the clients. Many of these types of trusts, because their technical names are rather long, have come to be known using acronyms, including “CST,” “GST Trust,” “GRAT,” “ILIT,” “QDOT,” “QPRT,” and “QTIP.” This article discusses the basic features and purposes of several of these trusts. Some of the trusts can be established during life or upon death, either by means of a trust agreement or through a will.
There are other types of trusts, designed to benefit charitable organizations or persons with physical or mental disabilities having special needs. Such trusts will be the focus of future articles.
Credit Shelter Trust ("CST")
Under federal tax law, every individual is entitled to an exemption from the estate tax. This exemption, often called the unified credit because of the way it is calculated, completely avoids the estate tax for all time. The unified credit should be distinguished from the marital deduction, which provides that the estate tax on assets passing to the surviving spouse is merely postponed until after the surviving spouse has died.
Under current federal law, the maximum amount that can be sheltered from estate tax (hence the name, “credit shelter”) is $2,000,000 for 2007 and 2008. In 2009, it will be $3,500,000. After that, the federal estate tax is repealed in its entirety for 2010, but returns with a vengeance in 2011 and later years, when the credit shelter will be only $1,000,000. To confuse matters further, many states are not as generous as the federal government in their credit shelter amounts: for example, New York excludes only the first $1,000,000 from its estate tax, and New Jersey only the first $675,000.
A credit shelter trust (“CST”) is a popular way for a married couple to utilize each member’s unified credit. The trust is typically funded at death with the maximum amount that can be sheltered from federal estate tax. Its terms can be very flexible, and the client’s spouse can be the sole beneficiary, or the spouse and others, or only others. The trustee can be required to pay the income on a current basis, or can be given the discretion to accumulate the income. Upon the death of the surviving spouse, the trust typically terminates and its assets are paid over to the client’s children or others (or even to charities), or held in further trust, all without being taxed in either the client’s estate or the estate of the client’s spouse. Sometimes, because of the lack of coordination between the exemption allowed under federal law and that allowed by the state in which the client resides, some flexibility must be sacrificed, or the client’s estate must pay some state estate tax on the CST.
Qualified Terminable Interest Trust (“QTIP Trust”)
A qualified terminable interest trust (“QTIP Trust”) is a trust created for the benefit of the spouse. Because of the unlimited marital deduction for both gift and estate tax purposes, it can be created either during the client’s life or upon death. The QTIP Trust must be for the exclusive benefit of the spouse during the spouse’s lifetime, and the spouse must be entitled to the net income of the trust for his or her life. Because the marital deduction postpones estate tax, but does not avoid it, there is no gift or estate tax payable when the trust is created and funded, but estate tax may be payable when the QTIP Trust is included in the surviving spouse’s estate if that estate is greater than the exemption in effect in the year of the surviving spouse’s death.
The attractiveness of the QTIP Trust, as opposed to an outright gift or bequest to the spouse, not in trust, is that the client can make sure that the assets after the surviving spouse has died will pass to the persons designated by the client, instead of to the surviving spouse’s children from a prior marriage, or to the next person whom the surviving spouse marries or lives with, or to the surviving spouse’s creditors.
Qualified Domestic Trust (“QDOT”)
A QTIP Trust qualifies for the marital deduction only if the surviving spouse is a U.S. citizen. If the surviving spouse is not a U.S. citizen, the assets must pass in the form of a qualified domestic trust (“QDOT”). The terms of the QDOT are similar to those of a QTIP Trust, but have a number of additional requirements. For example, at least one trustee must be either a U.S. citizen or a domestic banking corporation, and withholding may be required if principal is distributed to the non-citizen spouse. Upon the death of the noncitizen spouse, the federal estate tax that is due may be higher than if the surviving spouse had been a U.S. citizen.
Grantor Retained Annuity Trust (“GRAT”)
A grantor retained annuity trust (“GRAT”) can only be created during life. The grantor-client transfers assets to the GRAT and retains the right to receive, at least annually, payment from the trust of a fixed dollar amount, for a specified number of years. At the end of the GRAT term, assets remaining in the GRAT pass to designated beneficiaries. If the grantor-client dies before the end of the term, the remaining assets are returned to his or her estate.
The GRAT is attractive because of the way in which the gift to the GRAT is valued. Under applicable Internal Revenue Service rules and tables, an actuarial computation is made and only the amount that is expected to remain in the GRAT at the end of the term is subject to gift tax. If the actual rate of return exceeds the IRS assumptions, not only has a gift been made at less than full value, but appreciation has escaped gift taxation as well.