By Jacqueline L. Messler
When estate planners meet with clients to review their estate plan, it is very common to run across clients who created irrevocable trusts in the 1980s, 90s, or early 2000s. The goal in creating these irrevocable trusts was often to reduce the size of the client’s estate to avoid estate tax. Now that fewer people are subject to estate tax, these trusts are often no longer necessary to avoid estate tax. Under recent changes to the state statutes, we now have more flexibility to modify or terminate unwanted and unnecessary irrevocable trusts.
Common Irrevocable Trusts
Over the last 20 years, the unified gift and estate tax exemption – the amount of taxable gifts that can be made during lifetime or amount passed at death without being subject to estate taxes – has risen dramatically. In 1997, the exemption amount was $600,000, and the top estate tax rate was 55%. In 2007, the exemption amount was $2,000,000, and the top estate tax rate was 45%. In 2017, the exemption amount was $5,490,000, and the top estate tax rate was 40%.
Looking back at 1997 when the exemption was $600,000 and when we consider all of the assets included in an estate for estate tax purposes – including your house, bank accounts, retirement accounts, and the death benefit of your life insurance – it is easy to see how many people would have exceeded an exemption amount of $600,000.
Therefore, when the exemption was much lower, estate planners were much more concerned with reducing or eliminating estate tax. One technique to reduce or eliminate a possible estate tax was to transfer assets to children or grandchildren during your lifetime.
This could be done with outright gifts, such as taking advantage of the annual gift tax exclusion. The annual gift tax exclusion is the amount that any person can give to any other person without having to file a gift tax return and without having to use any exemption. In 2018, the annual exclusion amount will be $15,000.
Alternatively, gifting could be done through an irrevocable trust. A few of the most common irrevocable trusts are summarized below:
- Irrevocable Life Insurance Trust (“ILIT”). A person (the “Settlor”) creates an irrevocable trust with someone other than the Settlor as the Trustee. The trust purchases a life insurance policy. The beneficiaries of the trust are often the Settlor’s spouse and/or children. The life insurance policy typically has high premiums. When the premiums are paid (which reduces the size of the Settlor’s estate), that is a gift to the trust beneficiaries. The trust beneficiaries will often have a power to withdraw gifts made to the trust, which allows the gift to qualify for the annual gift tax exclusion (meaning no exemption is used up by making the gifts). It is not expected that the beneficiaries will exercise that power of withdrawal, rather, the amount of the gift goes to pay the insurance premiums. When the Settlor dies, the death benefit is paid to the trust. If done correctly, the amount of the death benefit is not included in the Settlor’s estate because the trust, not the Settlor, was the owner of the life insurance policy. The life insurance proceeds pass to the beneficiaries tax free. This technique was very common where the Settlor owned a business or farm, and the Settlor’s estate needed liquidity to pay estate taxes upon the Settlor’s death.
- Qualified Personal Residence Trust (“QPRT”). The Settlor creates a QPRT and transfers a residence to the trust. The Settlor is a beneficiary of the trust for a number of years. During that term of years, the Settlor lives in the residence owned by the Trust rent-free. Then if the Settlor survives the term of years, the residence will pass to the remainder beneficiaries (usually the Settlor’s children). The Settlor and the remainder beneficiaries both have a valuable interest in the trust. When the Settlor transfers the residence into the trust, the Settlor is making a gift. But since the Settlor still retains an interest in the trust, the amount of the gift is less than the full value of the house. So let’s say the Settlor’s interest is 40% of the total value of the residence, and the remainder beneficiaries’ interest is 60% of the total value. When the residence is transferred into the trust, the gift is only 60% of the value of the house, rather than 100%. If the Settlor survives the term of years and the residence transfers to the remainder beneficiaries, the Settlor has now transferred 100% of the value of the residence, but has made a taxable gift of only 60% of the value, meaning 40% of the value has transferred to the children but escaped taxation.
- Credit Shelter Trust. One other very common irrevocable trust is a trust created at the death of the first spouse. The deceased spouse’s assets are funded into an irrevocable trust for the benefit of the surviving spouse. When the exemption amount was lower, this planning was done to avoid estate taxes upon the second spouse’s death. This trust is often called a “Marital Trust” or a “Family Trust.”
The common theme with all of these irrevocable trusts is that they seek to reduce the size of a person’s estate. Now that the estate tax exemption is much higher, often reducing the size of a person’s estate is no longer necessary or desirable.
There is an important income tax reason why we actually want to include assets in an estate as long as it does not result in estate tax being paid. When assets are included in an estate, the asset receives a new income tax basis equal to the date of death value. So let’s say dad died 10 years ago, and a brokerage account worth $500,000 at the time of dad’s death was funded into a Family Trust which will not be included in mom’s estate upon her death. The brokerage account is now worth $1,000,000. If that account was included in mom’s estate, mom and dad’s heirs would inherit that account with a new income tax basis of $1,000,000. That means the heirs could turn around and sell that account without having to pay capital gains on the $500,000 of gain. This rule does not apply to retirement accounts, annuities, and some other assets.
So let’s say you have a life insurance trust that was created in the 1990s. As you are getting older, the premiums are becoming dramatically higher. The original reason you created the life insurance trust is no longer relevant. Or, under a different example, mom is the beneficiary of a Family Trust with assets that have substantially appreciated, and income taxes can be avoided if we can include the assets in mom’s estate. What can be done to unwind the irrevocable trust?
Modifying or Terminating Irrevocable Trusts & Tax Consequences
There are a few ways to modify or terminate an irrevocable trust. First and foremost, you may be able to modify or terminate the trust under the provisions of the trust itself. The trust may allow the Trustee to modify or terminate the trust if circumstances have changed, if the Trustee determines it is in the best interests of the beneficiaries, or if the trust assets are under a certain dollar amount set forth in the trust.
The second option is to look at the state statutes. If the trust does not provide an option to terminate the trust if the assets are under a certain dollar amount, the Wisconsin Statutes do provide that opportunity. The Statutes provide that a Trustee can terminate a trust with assets less than $100,000 (that number is indexed for inflation).
If neither of the options set forth above are permitted, under the state statutes (commonly known as the “Wisconsin Trust Code,” which was completely updated in 2014), an irrevocable trust can be modified or terminated using a Nonjudicial Settlement Agreement (“NJSA”). If the Settlor is still alive, an irrevocable trust may be modified or terminated without court involvement upon consent of the Settlor and all of the beneficiaries. If the Settlor is not alive, or if the Settlor does not agree, an irrevocable trust may be modified or terminated without court involvement upon consent of all of the beneficiaries if “continuance of the trust is not necessary to achieve any material purpose of the trust.” One point to consider, “all beneficiaries” means all beneficiaries, which sounds rather obvious. But if the trust provides that if the Settlor and all of the Settlor’s descendants die together in an accident, the trust assets pass to great Aunt Edna, then great Aunt Edna must sign the NJSA.
Another point to consider is what happens to the trust assets when the trust is terminated. If the remainder beneficiaries are agreeing to give the trust assets back to the Settlor, they are actually making a gift to the Settlor. So the gift tax consequences of terminating a trust through an NJSA must be carefully considered.
Additionally, it may not always be appropriate to terminate an irrevocable trust and distribute the assets outright. Keeping assets in a trust may provide protection from a beneficiary’s creditors (including divorce), and distributing the assets to the beneficiary may expose them to the beneficiary’s creditors.
In summary, the Wisconsin Trust Code gives us more options to modify and terminate irrevocable trusts. If you have an irrevocable trust as part of your estate plan, it might be worth revisiting the original purpose and the continuing effectiveness of that trust with your estate planner.
If you have any questions regarding this article, please contact your Davis & Kuelthau attorney, the author noted above or our Trusts, Estates and Succession Planning practice co-chairs linked here.