2012 Estate Planning Techniques Self-Settled Trusts/SLATs/Other Donor Beneficiary Techniques

Bailey, Moore, Glazer, Schaefer & Proto, LLP16 Lunar Drive

Woodbridge, Ct 06525Tel: (203) 397-7700 Fax: (203) 397-7717

2012 Estate Planning TechniquesSelf-Settled Trusts/SLATs/OtherDonor Beneficiary Techniques

By: Michael D’Addio, JD

Bailey, Moore, Glazer, Schaefer & Proto, LLP

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2012 Gift & Estate Tax PlanningBackground

• The 2012 year presents a unique opportunity:– Take advantage of the $5,125,000 gift and

estate tax unified credit amount (scheduled to be reduced to $1,000,000 in 2013, unless Congress acts); and

– Take advantage of the maximum 35% gift tax rate (scheduled to increase up to 55% in 2013, unless Congress acts).


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2012 Gift & Estate Tax PlanningSuper Wealthy

• For the super wealthy (i.e., single person or couples with estates of $10 million or more):– There is a risk that $8,250,000 of their estates will be

subject to tax after 2012 (if Congress does not increase the unified credit exemption equivalent to more than the $1 million per person scheduled for 2013), at a 50% or greater rate.

– 2012 may be the last year they can take advantage of estate reduction techniques.

• NOTE: Even if Congress acts, it is not clear that it will maintain the $5 million exemption. Democratic proposals set the exemption level at $2 million or $3.5 million.

• NOTE: Prior to 2011, the gift tax exemption was set at only $1 million. It is unclear that any legislative increase to the estate exemption level will also increase the gift tax exemption amount.


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2012 Gift & Estate Tax PlanningModerate Estate Problem

• Utilization of the high exemption by the end of 2012 applies even to those with moderately high estates (not only the super rich).– Ex: H and W have an estate worth $4,000,000.

• Under 2012 law (and for the past many years) they have no estate tax problem. The unified credit equivalent more than covers their combined estates and they can pass assets with zero federal tax.

• If they pass away in 2013, with only a combined $2,000,000 unified credit exemption, they will have a taxable estate of $2,000,000 and a tax of about $800,000.

• These persons can find their estates having a substantial tax problem under scheduled law.

• Anyone with an estate over $1 million or couple with a combined estate over $2 million face a significant estate tax problem in 2013 and later.


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2012 Gift & Estate Tax PlanningModerate Estate Problem

• Those with moderate estates will be less inclined to make substantial gifts.– They will need to use assets for their living

needs.– They will be concerned with transferring

control over the assets which constitute their wealth.

• Even the superwealthy may look for mechanisms to get access to transferred assets.


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2012 Gift & Estate Tax Planning“Have Your Cake and Eat It” Plans

• Possible solutions for estate reduction techniques providing donors with some access to transferred assets:– Self-Settled Trusts;– Spouse Lifetime Access Trusts (SLATs);– Transfers with Power of Appointment in Trust;– Formula Gifts

• Trusts provide “safety valves” for unexpected circumstances.

• NOTE: It is not tax efficient to make a completed gift of assets to a trust and then bring assets back into the estate at a later date. – This essentially causes a wasting of the exemption.– However if the returned assets are consumed, there is no estate

tax harm.


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2012 Gift & Estate Tax PlanningRisk Analysis

• Structuring of a gift tax plan for 2012 involves an analysis of the technical risks associated with each plan.– Each technique carries a different risk of IRS attack.

• Careful drafting is required to minimize these risks.• Facts and circumstances must also be considered as to how

they color the potential tax results.

• The issue of a gift “clawback” or “recapture” must be considered before a transfer is made.


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2012 Gift & Estate Tax PlanningPotential Clawback/Recapture

• One concern involves the impact of a reduction of the gift/estate tax exclusion when the donor dies at the time when there is a lower exclusion.– This concern is caused by the way the Form 706 deals

with prior taxable gifts.• They are added to the taxable estate to produce a cumulative

taxable amount under the estate and gift tax systems.• Once a tax is computed on this combined amount, this tax is

reduced by the unified credit (which is the tax calculated on the unified credit exemption amount)

– If in 2013 this amount is the tax on a $1,000,000 exemption, then the deceased will pay tax on the previously nontaxable gifts.


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• If there is a clawback, this may only equal the tax that would apply if no transfer had been made.– There is no estate tax harm (unless the asset

transferred has decreased in value). However, the recipient takes an income tax basis under the gift tax rules (generally the same tax basis as the donor’s) instead of a fair market value basis.

– Since the assets transferred by gift are not part of the estate, the estate tax will generally be borne by the heirs of the remaining estate assets.

• NOTE: It is possible that one could have gifted a large enough portion of the estate so that the estate taxes exceed the remaining estate assets.


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• Approach #1 – There is no clawback– Under old IRC section 2001(b)(2) [scheduled to be revived in

2013], the tentative tax calculated on the taxable estate and prior taxable gifts is reduced by “the aggregate amount of tax which would have been payable under chapter 12 [gift tax] …if the provisions of subsection (c) (as in effect at the decedent’s death) had been applicable at the time of such gifts.”

– One interpretation treats the tax as what would have been paid under the law in effect in the year of death (2013 or later).This eliminates the clawback issue as applying to the credit amount.

• This positive interpretation is based on a return to the old tax law. If Congress changes the law, this argument will not apply unless the clawback issue is directly addressed in the law.

• The ABA, AICPA and other tax organizations are aware of this issue and it is believed that it will be addressed.

– Others interpret this language to apply only to adjust the rates used to compute the deemed tax on the gifts – but not to account for the reduced exemption amount. This produces a clawback.


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• Approach #2: Provide for an apportionment of any increased estate tax due to prior gifts among the beneficiaries of the estate and gift donees.– There are questions as to the effectiveness of

such a provision. There is some authority on both sides.


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• Approach #3: Structure the transfer as a net gift – so that the donee assumes the legal responsibility to pay any estate taxes attributable to the inclusion of the gift in the estate tax computation.– Typical net gift obligates donee to pay the gift tax on the transfer,

which normally is readily determinable (though subject to valuation adjustment).

– Related estate taxes could take years to determine, making the net gift computation difficult.

• In McCord v Com’r, 461 F3d 614 (5th Cir, 2006), court held that net gift is reduced by donee obligation to pay additional estate taxes caused by estate inclusion within 3 years of payment of the gift taxes under IRC section 2035(b).

• Similar argument can be made her – though a court could conclude that difficulty of computation makes it impossible to reduce the gift value.

– Obligation to pay the transfer taxes is deemed consideration to the donor and can produce income tax consequences.


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2012 Gift & Estate Tax PlanningSLATs

• Spousal Lifetime Access Trust (SLAT)– Donor can create a family trust for the benefit of the

donor’s spouse and children.• This is a completed gift into a credit shelter trust.• Though Donor does not retain any powers over the trust and

is not a permissible distributee, the donor can benefit through distributions made to the spouse.

– Distributions can be made to the children, who can loan or gift assets back to the donor.

– The distributions can be subject to trustee discretion or can be the subject to an ascertainable standard (e.g., for health, education, maintenance or support).


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• Spousal Lifetime Access Trust (SLAT)• Spouse can be given a non-cumulative withdrawal power of

the greater of $5,000 or 5% of annual trust value (a limited or special power of appointment).

– This provides the spouse additional access to the trust assets which can potentially benefit the donor.

– The limited power will not cause inclusion of trust assets into the spouse’s estate.

» If spouse dies at time when the 5-and-5 power is available, the value of trust assets that can be withdrawn will be included.

» Trust can provide a limited window (e.g., 30 days) to exercise or else the power lapses.


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• Each spouse can create SLATs for the other:– While both spouses are alive, they potentially, through

exercise of trustee discretion, have access to all of the assets held by the trusts if the trustee determines they need it.

– If one spouse dies, then the trust of which they are the beneficiary will now be held for the other family members/beneficiaries.

• However the surviving spouse is still the beneficiary of the trust created for his/her benefit.

• 50% of the assets remain for the benefit of the surviving spouse.


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2012 Gift & Estate PlanningSLATs

• Drafter of Dual SLATs must avoid the Reciprocal Trust doctrine.– If IRS determines that both trusts are reciprocal, then

each spouse will be deemed to be the donor of the trust created for his/her benefit. IRS will argue that the trust assets should be included in his/her estate under IRC sec 2036 or 2038.

• This doctrine applies where trust have interrelated, reciprocal and substantially identical property interests created by two persons for the benefit of the other.

• US Supreme Court first enunciated this doctrine in US v Estate of Grace, 395 US 316 (1969).

– It is not a requirement that each trust be created as a quid pro quo for the other or that there be evidence of a tax avoidance motive. The key issues are whether the trusts are interrelated and leave the transferors in essentially the same economic position as if the trusts were not created.


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2012 Gift & Estate PlanningSLATs

• In Estate of Levy v Com,r, TC Memo 1983-453: Trust were considered not to be interrelated where one trust provided for a power of appointment which was not present in the other trust.

• PLR 2004-26-008: IRS rules that two nearly identical trusts were not reciprocal trusts where:– One trust provided a withdrawal right to a spouse and a limited power of

appointment, both contingent on a son predeceasing the power holder (which did not occur).

• IRS held the existence of the power was sufficient to avoid reciprocal trusts – even though the contingency which triggered the powers was unlikely to occur.

• Commentators believe that other differences:– Payouts to beneficiaries at different ages;– Payouts to one spouse under an ascertainable standard while payout to

other at trustee discretioncan avoid Reciprocal Trust status.


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2012 Gift & Estate Tax PlanningPower of Appointment to Donor

• As Part of a SLAT or other trust, a power of appointment can be included to allow the spouse or another person to redirect trust assets to the original donor.– Donee spouse cannot be allowed to appoint the trust assets to

his/her estate, his/her creditors, or the creditors of his/her estate.– Testamentary power to appoint back to the donor-spouse can be

used where the beneficiary-spouse predeceases the donor-spouse, who has a need for additional resources.

– HOWEVER there cannot be a pre-arrangement. If there would, there would be inclusion.

• NOTE: State law issue to be considered is whether such an exercise could be considered to be a “self-settled trust” which can permit creditors of the donor access to the trust assets. This could cause inclusion under IRC sections 2036 or 2041.


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2012 Gift & Estate Tax PlanningPower of Appointment to Donor

• The transaction becomes riskier from a tax perspective if additional powers (like this appointive power is included).– It raises the specter of an arrangement

between the donor and the power holder.– The tax advisor must compare the risks to the

ultimate needs of the client.


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2012 Gift & Estate PlanningSelf-Settled Trust

• Another possible solution is use of a “self-settled trust” created in certain jurisdictions [Domestic Asset Protection Trusts (DAPTs)]– A trust created by the donor of the property,– Where the Donor is a potential beneficiary of the trust, at the

discretion of the Trustee,– There is no Mandatory right to distributions to the Donor,– Trust contains a spendthrift provision –preventing the trustee

from using trust assets to satisfy the Donor’s creditors.• This trust can be:

– Created as an off-shore trust (in several foreign jurisdictions with friendly trust laws); or

– One of seven jurisdictions in the United States which limit the rights of creditors of a donor.


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2012 Gift & Estate PlanningSelf-Settled Trust

• Twelve states have statutes which permit Domestic Asset Protection Trusts if statutory requirements are met:– Alaska South Dakota– Delaware Wyoming– Nevada Tennessee– Rhode Island New Hampshire– Utah Oklahoma– Missouri Hawaii


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Self-Settled TrustBackground

• Historically, US courts have not permitted a person to create a spendthrift trust where the person is a beneficiary and to use such trust to protect him/herself from his/her creditors.– In part, this plan was seen as an attempt to

defraud potential creditors.– This follows the rule of the Restatement of

Trusts.


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Self-Settled TrustsGift & Estate Tax Consequences

• PLR 2009-44-002 (10/30/09) – IRS addressed gift and estate tax issue.– Trustee had power, in sole and absolute discretion, to distribute income

and principal “for the benefit of one or more members of the class” including the grantor, grantor’s spouse and grantor’s issue.

– State statute permitted creditor protection in a self-settled trust if certain conditions were satisfied unless:

• The trust was revocable;• Donor intended to defraud a creditor;• Donor was in default of child support obligation; or• Trust mandates all or part of income or principal be distributed to grantor.

– IRS ruled a transfer to the trust was a completed gift.– IRS ruled that since none of the 4 factors allowing creditor satisfaction

existed, the trust was not included in grantor’s estate.– IRS did not rule on whether trustee discretion in combination with other

factors (e.g., pre-existing arrangement or understanding between trustee and Grantor) would cause inclusion under IRC sec 2036.


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Self-Settled TrustsGift & Estate Tax Consequences

• IRC sec 2036 will cause inclusion in the grantor’s estate where his/her creditors can look to the trust assets to satisfy claims.

• Mortensen v Battley is an Alaska bankruptcy case in which a bankruptcy court held that an Alaska self-settled trust did not protect assets from creditors under federal bankruptcy law.– The court found that Mortensen intended to defraud his creditors

since he did not retain sufficient assets after the transfer to trust to support current and future debts.

– Mortensen filed bankruptcy after the four year state of limitations look-back under Alaska but within the 10 year federal look-back statute.


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Self-Settled TrustsMortensen v Battley

• Mortensen:» Used a template, had it reviewed by an attorney who suggested

minor changes.» Named brother and a personal friend as trustees» Named his mother as a protector» Stated purpose of trust was “to maximize the protection of the trust

estate or estates from creditor claims of grantor or any beneficiary and to minimize all wealth transfer taxes.”

» Transferred Alaska real estate with value of $60,000 and $80,000 of $100,000 received from his mother

» Had other assets of about $73,000.» Had $49,711 of credit card debt at time of transfer.» Post transfer, credit card debt increased significantly.» In August 2009, he filed a petition for bankruptcy having over

$250,000 in credit card debt and $8,140 in medical bills.• Bankruptcy trustee filed an adversary proceeding to set aside the

trust as a fraudulent conveyance.


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• Bankruptcy Court» (After first denying summary judgment cross motions) held

for Trustee holding assets available for claims of grantor’s creditors for ten years under federal bankrupcty law.

» Sec 11 USC 548(e)(1) provides that trustee may avoid any transfer of an interest of debtor in property made on or within 10 years before the date of filing of the petition of bankruptcy, if

a) such transfer is made to a self-settled trust or similar device;

b) such transfer was made by the debtor; c) the debtor is a beneficiary of such trust or similar device;

and d) the debtor made such transfer with actual intent to

hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.

» This section was added in 2005 to close the “self-settled trust loophole”.


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• Ruling:» The trust clearly met the first 3 statutory tests.» Question was whether there was actual intent to

hinder, delay, or defraud any entity.» While Mortensen said the purposes of the trust was

to protect and preserve property for his children, the stated purpose of the trust was to frustrate the claims of future creditors.

» Court said he created trust after years of below average income, high credit card debt and financial troubles from a divorce.

» He did not use the money received from his mother to pay off debts but to speculate on stock for the trust.


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• Reaction to Mortensen– The bankruptcy court case was fact specific in finding

intent to defraud and should not negate estate tax benefit of all self-settled trusts in DAPT jurisdictions;

• Even DAPT jurisdictions will protect creditor rights if there is a fraudulent conveyance or intent to defraud.

– If state law has a look back period during which creditors may make claims against trust assets, some practitioners question if there may be an estate inclusion issue during this period.


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• Reaction to Mortensen– How does a DAPT established in one

jurisdiction apply to a grantor living in a non-DAPT jurisdiction.

• If a judgment is received against the grantor in the non-DAPT jurisdiction, the full faith and credit provisions of the US constitution provide that it must be recognized in the DAPT jurisdiction.

– Some argue that this applies only to the judgment as against the grantor, who is a different from the trust.


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Self-Settled TrustsConflicts of Laws

• Reaction to Mortensen– It may be better to establish a self-settled trust

offshore, in a jurisdiction not subject to bankruptcy control.

• Grantor may still be subject. However the assets may not be directly reachable.

• NOTE: A bankruptcy court may direct grantor-bankrupt to direct payment of assets or else hold grantor in contempt.


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• Commerce Bank v Bolander, 239 Ped 83 (Kan Ct App, 2007)

– Facts:» T created a trust in Kansas with self as potential

beneficiary. Kansas was designated as governing law, named a Kansas successor trustee, and was funded with a pourover from T’s estate.

» Kansas law follows normal rule that self-settled trust assets are subject to creditor claims. Additionally, Kansas law provides that creditor rights are not cut off once the settlor dies (more controversial rule).

» T’s IRA was payable to the trust. IRA benefits are statutorily exempt from creditor claims which could not be reached during T’s life. [If T had named specific beneficiaries of the IRA, the assets would continue to be exempt.]

» T spent the last 6 weeks of life in a Texas health-care facility and received Medicaid from Texas.


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• Commerce Bank v Bolander, 239 Ped 83 (Kan Ct App, 2007)

– Facts (cont):» Debt arose in Kansas and was secured with T’s real

and personal property.– Conclusion:

» Since Kansas law did not violate the law of any jurisdiction having the most significant relation to the matter at issue (typical conflict of laws test), court applied Kansas law.


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2012 Gift & Estate PlanningTrustee Removal

• Rev Rul 95-58, 1995-2 CB 191: – IRS held that grantor’s retention of unqualified power

to remove the trustee and replace with a new trustee (not the grantor) was not a retained power to distribute and did not cause inclusion under IRC sec 2036 or 2038, where the trustee power was limited by an ascertainable standard (health, education, maintenance, support)

• Some trusts will use a “Protector” to oversee the trustee and have the power to remove and replace.

• Combination of these powers can be used in a self-settled trust or SLAT to assure its proper operation.


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2012 Gift & Estate Tax PlanningDefined Formula Gifts

• A series of cases have given taxpayer victories with formula gifts.– Petter v Com’r, 653 F 3d 1012 (9th Cir, 2011),

aff’g TC Memo 2009-280 [using a charitable trust for the excess]

– Hendrix v Com’r, TC Memo 2011-133 [excess going to a donor advised fund]

– Wandry v Com’r, TC Memo 2012-88 [excess going to a marital trust]


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• Petter v Com’r, 653 F3d 1012 (9th Cir, 2011), aff’g TC Memo 2009-280

– Facts:» T inherited stock in UPS from her uncle sufficiently large

that she was restricted from selling during a lock-up period related to an IPO.

» T created Petter Family LLC (disregarded entity) and contributed the UPS stock.

» T created two grantor trusts for children and gave them LLC interests by a formula referring to the “dollar value that can pass free of federal gift tax”.

» She assigned under sale documents an amount equal to $4,085,190 of value as finally determined for federal gift tax purposes (9 times amount of gift) for 20-year note.

» In both assignments, any excess would pass to two charitable community foundations.


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• Petter v Com’r, 653 F3d 1012 (9th Cir, 2011), aff’g TC Memo 2009-280 (cont)

– IRS argued:» Cases like Com’r v Proctor, 142 F2d 824 (4th Cir), revg & remg 2

TCM 429 (1943) held that formula adjustment clauses were not valid as:

a) against public policy (discourage tax collection); b) relied on a condition subsequent

– Court:» Public policy argument is undermined by Com’r v Tellier, 383 US

687 (1966), Supreme Court warned against invoking public policy exceptions too freely.

» Later audit did not change what donor had given but triggered a final allocation of the shares donees received.

» Donor who gives away a fixed set of rights with uncertain value [formula clause] is different from donor who tries to take property back (savings clause, found in Proctor).

» Did not accept IRS condition subsequent argument – that gift to charity was subject to IRS audit. The transfers were effective immediately.


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• Hendrix v Com’r, TC Memo 2011-133– Facts:

» H and W wanted to make S corp stock gifts to family members (nonvoting shares) and to a donor advised fund at Greater Houston Community Foundation.

» H & W transferred $20,000 to establish donor-advised fund.» Independent appraisal firm valued shares, in part based on values used in

a prior year corporate redemption.» H & W transferred 287,919 shares (each) of nonvoting stock pursuant to a

formula where shares equal to $10,519,136 to benefit of family and remaining portion to Foundation.

» Assignments required the trusts pay any gift taxes imposed as a result of transfer and trusts signed promissory notes to H & W of $9,090,000 to each petitioner.

» 2d set of assignments transferred 115,622 nonvoting shares with share to family portion of $4,213,710 with note back of $3,641,233.

» Assignments did not allocate the shares. This was left to the transferees with a dispute resolution and buy-sell agreement. Arbitration was required if agreement could not be reached.

» Estate attorney represented the trusts and advised trustees to get new appraisal. They hired same valuation company and sent the new appraisal to the Foundation.


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• Hendrix v Com’r, TC Memo 2011-133 (cont)– Holding:

» Court accepted the Defined Formula gift to establish the transferred amounts since the assets were hard to value and the parties acted at arm’s length.

» Court noted that the case would be appealable to the 5th Circuit and guided by that court’s decision in McCord v Com’r, 461 F3d 614 (5th Cir, 2006), reg 120 TC 358 (2003), which has sustained the use of defined value clauses, generally.

» Court found there was no collusion, side deal or understanding which would support the public policy argument. The mere fact that parties are “close” and that taxpayer’s estate plan is benefitted does not necessarily negate existence of arm’s-length deal.


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• Wandry v Com’r, TC Memo 2012-88– Facts:

» In 2001, H & W forms investment LLC with children holding cash & marketable securities.

» In 2004, H & W made gifts of their interests. Their attorney said it would difficult to value the interests until a valuation was completed. He suggested they gift based upon a specific dollar amount instead of a specific number of shares.

» H & W gave $261,000 of interest to each of their children and $11,000 to each of their grandchildren.

» Independent appraisal of shares was anticipated – though not completed until after the transfer.

» Assignment stated that a good faith estimate was being made of value but could be subject to good faith IRS adjustment. If the value were adjusted, then the amount transferred would be adjusted in a manner similar to a marital deduction formula clause adjustment.

» Gift tax return reflected the dollar amount transferred – but also showed a percentage interest transferred. The partnership tax return also reflected such transfers.


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• Wandry v Com’r, TC Memo 2012-88 (cont)– IRS argued:

» Form 709 showed percentages transferred and this was an admission that these units were transferred [since this information was included on a signed return]

» The capital accounts of the entity control what was transferred.

» Transfer documents transfer fixed percentages since the formula gift was void as against public policy.

– Tax Court:» While 709 did show percentages, it also showed the

amounts transferred, per the assignment documents.» The facts and circumstances impact the capital accounts

(not the reverse). IRS had also relied on stock transfer cases where the amount reflected on the transfer books evidenced the gift. Those cases dealt with whether there was a completed gift – not an issue here.

» Formula gift is not void (per McCord, Petter, Hexler cases) and are distinguishable from formula adjustment clauses.


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• Wandry – important case– Clear taxpayer victory.– Establishes validity of Defined Formula Gifts.– There was no residual beneficiary in this case

• Many practitioners believed it was necessary to have a residual tax-favored entity (e.g.,charity, charitable trust, marital trust) to pick up an excess value.

– This may still be best practice.

• The case dealt with a naked power.


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• Wandry case:– This case was appealed by IRS to the 10th Circuit.

• A pro-taxpayer result would be a significant loss to IRS.– Per the Tax Court website, the IRS has withdrawn its appeal of this

case decision.• No reason has been provided yet for this change.

• Implications of Wandry could be the elimination of all gift tax valuation issues.– It may foster a “swing for the fences” mentality, which may cause courts

to modify the results.– Remember “bad facts make bad law”.

• Possible statute of limitation question on issue of amount transferred.– Since gift is not defined by units, it is possible that IRS will state that

even with adequate disclosure, they can question whether additional assets are held by the transferor or marital trust.

Documents

2012 Estate Planning Techniques Self-Settled Trusts/SLATs/Other Donor Beneficiary Techniques