If you are considering making large gifts in 2012, you may be concerned about whether you can have access to money you gift to a trust should you need it. While ultra-high net worth taxpayers may not worry about a $5 to $10 million transfer, many people who can benefit from 2012 gift transfers simply don’t have the kind of wealth to make even a $1 million gift. This is one of the key planning ideas to address. You will want to understand the various ways you may be able to access value inside such a trust. The checklist that follows lists various ways you may benefit from assets transferred to a domestic asset protection trust (DAPT), including transferring flow-through entity interest into such sophisticated irrevocable trusts in 2012 to use your $5 million gift tax exemption.
1. If you transfer entity interests by gift (or even sale) to a DAPT or other irrevocable trust in 2012, any entity distributions made after the transfer should be paid to the then record owner that will be the trust (or proportionate to the interests the trust holds). Prior to transfer of a flow-through entity to the trust, all distributions should be paid to the then owner of record, you, in your personal capacity. Thus, to assure continued distributions from interests in a family business, a family limited partnership (FLP) that holds investment assets, or other entity, you should evaluate retaining a portion of the equity interests in order to continue receiving at least some distributions.
2. Because most dynasty trusts, DAPTs, and beneficiary defective irrevocable trusts (BDITs) are designed as grantor trusts, all of the trust’s income will be reported on your personal income tax return. You should file a Form 1041 tax return for the trust including a statement that the trust is a grantor trust and that all items of income, gain deduction, and other items of the trust will be reported on your personal tax return, Form 1040. This is actually a negative cash flow each year that you must factor into your analysis. In the event that your payment of tax on the trust’s income and gains becomes a real financial burden, it can be dealt with in a number of ways:
3. The trust could include a provision authorizing an independent trustee to reimburse you as the grantor for the income tax you had to pay on income retained in the trust. While this can be a valuable cash flow safety valve not all estate planners are comfortable using this technique because of a concern that the distribution reduces the assets protected in the trust thus defeating a portion of the plan. Some are concerned that in some instances the reimbursement might cause the trust to be included back in your taxable estate if it is deemed by the IRS to evidence an understanding you had with the trustee.
4. The trust can loan money to you to pay income tax, or to use for living expenses, or anything else. In fact, many of these sophisticated trusts expressly include a provision authorizing a named person to make loans to you without requiring adequate security, as this is one of the mechanisms used to create grantor trust status.
5. If you transfer interests in a family business entity to the trust and you remain active in that business, the business entity can pay (or continue to pay) a reasonable compensation to you.
6. Many entity governing instruments (e.g., operating agreements for an LLC) mandate minimum annual distributions to fund income tax payments by the equity holders. For example, a family S corporation distributes 40% of its annual income so shareholders will have enough cash to pay the income taxes on their distributable share of S corporation income. The estate plan of transferring interests to a trust will complicate this mechanism. Once the flow-through entity interests have been transferred to the grantor trust, all distributions attributable to the transferred interests must be directed to the trust as the record owner (member, partner, S shareholder). Unfortunately, that won’t infuse funds into your bank account for you to pay income tax on the earnings of the flow-through entity that will remain taxable to you due to grantor trust status. However, such a mandatory distribution provision will infuse cash into the trust which can then be loaned or distributed by the trustee to you.
7. The optimal means of handling this situation from a tax and asset protection perspective is to not make any distribution from the trust to fund your expenses or taxes because the payments you make will reduce the size of your taxable estate. This is one of the key leveraging benefits of structuring trusts to be treated as grantor trusts. The greater the unreimbursed tax burden, the smaller the taxable estate and the lower the estate tax.
8. So, like the old Wendy’s commercial, “Where’s the beef?” Well Clara, here it is:
- Salary and compensation may still be paid from the entities when appropriate.
- Distributions may be able to be made to your spouse from your trust (i.e., if you’re married and your spouse is a beneficiary of the trust).
- Distributions may be able to be made from your spouse’s trust to you and perhaps your spouse (if it’s a DAPT) (i.e., assuming each spouse creates a similar but non-reciprocal trust).
- The trust could make a loan for adequate interest to you or perhaps your spouse.
9. If any of these possible distributions follow a regular pattern or appear to correlate with your tax or other expenditures, the IRS may argue that there was an implied understanding between the trustee and you as to these distributions. This could be used by the IRS as a means to disregard the trust and pull all trust assets back into your taxable estate.
10. The valuation of the entity interests to be transferred to the trust may have to consider forthcoming distributions, and if there is a pattern of making distributions so members can pay income tax on their pro-rata share of income, that pattern of payments may be viewed as reducing available discounts.
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