Editor’s note: This is part 16 — and the final article — of a series about the fundamental principles of using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
When facing estate planning decisions, it can be tempting to search for one product — perhaps a trust or LLC package — to address all of the needs. However, this product based approach to fails to balance the multiple variables that stand in trade-off with one another such as income tax vs transfer tax or control and flexibility vs asset protection.
Rather than looking for a pre-packaged trust or LLC solution, it is more effective to take a first-principles approach to planning, by first asking questions that elicit the parameters, needs, constraints and tradeoffs that must be balanced and addressed now and in the future.
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In balancing the asset protection tradeoffs in using trusts and LLCs, if a trust maker retains more powers and controls over a trust or LLC, the trust maker might be afforded less asset protection. So, too, in planning for estate and gift tax, if the trust maker retains more control and powers over a trust or LLC, that will likely cause the assets to be included in the trust maker’s gross estate — and including assets in the gross estate (subject to potential taxation) can be a very good thing for capital gains tax reduction if the estate will owe no estate taxes.
Sometimes a person owning volatile assets that could appreciate quickly thinks that they should transfer the asset into a trust so that the assets are out of their potentially taxable gross estate. However, before transferring the asset out of their gross estate, the person should carefully consider the capital gains tax consequences of such a transfer. They should also consider that by transferring assets to a trust that is out of their potentially taxable estate, they must give up control and rights over the trust and the trust assets. This loss of control can stymie the investment objective and thwart asset growth. More important, if a trust maker makes a completed gift to a trust to avoid estate taxes, they will lock in the trust’s basis in the property, ensuring that capital gains taxes must be paid when the trust assets are later sold.
Example. A digital assets investor is concerned about asset protection and tax planning, so they set up an asset protection trust that can be used to later bridge into more comprehensive tax planning through later termination of trust rights and powers. The digital assets investor is aware that even though the digital assets were transferred into an asset protection trust, if the trust maker retains management control, the value of the assets will be included in the investor’s gross estate. The digital assets investor decided it was best to keep management control and beneficiary rights over their digital assets after they considered the tradeoff between estate taxes and capital gains taxes.
Rustin advises clients on tax, business and estate planning matters. He serves as an adjunct professor, frequent speaker and is current or former chair of professional associations. A prolific author, he has published many technical and popular articles on estate and business issues, as well as drafting and advising legislators in developing numerous statutes pertaining to trust and estate and business planning, creditor exemption planning and digital asset (blockchain) trusts and blockchain entities known as decentralized autonomous organizations.
The digital assets investor forms a Wyoming-based DAPT (domestic asset protection trust) in which the trust maker retains grantor powers because the general rule for income earned from digital assets is that in any year where digital assets owned by a trust (or owned by a trust-owned LLC) are sold, traded or earn any dividends, airdrops, staking rewards or other DeFi awards, the LLC or trust will need to report the income on either the trust tax return (usually taxed at higher rates) or on the trust maker’s tax return (usually taxed at lower tax rates).
Next, the Wyoming DAPT forms an LLC that is fully owned by the DAPT. The digital assets investor chooses that trust-LLC structure because they are aware that LLCs holding digital assets can raise many tax issues and must be approached with caution because of diverse investment company tax consequences that can result from transferring digital assets into LLCs taxed as partnerships, including immediate capital gain recognition for contribution into certain LLCs with multiple members, taxed as investment partnerships.
The digital assets investor then transfers $100,000 of their digital assets into that LLC, which is 100% owned by the Wyoming DAPT. Not too long after the transfer, the digital assets held in the DAPT experience a flash appreciation event, and their value increases by 1,000 times, from $100,000 to $100 million.
The digital assets investor is shocked by the sudden increase in value and calls their tax attorney in a panic because they now have a gross estate that is subject to the 40% estate tax. The digital assets investor is equally surprised that the attorney laughs and says, “Now we have some very exciting tax planning to do, but we have hundreds of possible techniques that we can use to solve this excellent problem together.”
Many estate and tax planning techniques
Tax planning attorneys have nearly limitless estate and tax planning techniques that can help minimize estate tax and achieve capital gains tax efficiency. Irrevocable trusts can be drafted with endless features that reduce or increase beneficiary rights, finetune trustee powers and controls, implement checks and balances, shift income taxes from the trust to a “grantor,” affect capital gains taxes or avoid gift, estate and generation-skipping transfer taxes. Just like flour, oil and water can be combined with other ingredients to make countless entrees, so too can these basic trust ingredients create nearly endless trusts. Attorneys and marketing companies will sometimes brand a trust to create a little buzz, but the trust is almost always a different permutation of the basic tax planning and asset protection ingredients.
Nearly all transfer tax planning techniques function to reduce taxes by “Freeze, Squeeze and Burn”:
- They “freeze” future appreciation of assets out of the estate through completed gifts
- They “squeeze,” or compress, the value of assets being transferred out of the estate by gifting minority interests in assets to create discounts for lack of control and lack of marketability
- They “burn” down the value of the assets remaining in the trust maker’s gross estate (assets subject to the estate tax) by having the trust maker pay the income tax on the trust.
Examples of common trusts and trust powers
Here’s a short list (with overly simplified summaries) of some of the most common trusts and trust powers that can be used to enhance asset protection and implement powerful tax planning strategies:
DAPTs. These trusts, permitted in just under 20 U.S. jurisdictions, allow a trust maker to set up a trust to protect assets for the trust maker as the beneficiary — known as a “self-settled” trust. DAPTs are also called dynasty trusts if the DAPT is structured to be exempt from estate tax and generation-skipping transfer taxes (GSTTs). The top four most popular jurisdictions for DAPTs or dynasty trusts are South Dakota, Nevada, Wyoming and Alaska.
Grantor retained annuity trusts. GRATs are estate planning trusts in which the trust maker forms a trust, contributes some cash into the trust and then sells an income-producing asset to the trust in exchange for an annuity payment from the trust. The annuity must last for at least two years. GRATs are specifically allowed under the Internal Revenue Code, but GRATS are subject to the risk that the trust property will be included in the estate of the trust maker, a significant estate tax inclusion period (ETIP) rule.
Intentionally defective grantor trusts. IDGTs have an unfortunate name because of the word “defective,” but IDGTs are very effective at removing value from the taxable estate by using installment sales and trusts. IDGTs are close cousins to the statutorily authorized GRAT, and although IDGTs lack the statutory safeguards of GRATs, IDGTs don’t face quite the same all-or-nothing ETIP issues as GRATs.
Qualified personal residence trusts. QPRTs are another cousin to GRATs and IDGTs, statutorily authorized and involving the gift of a personal residence into a trust, again with an all-or-nothing potential ETIP.
Charitable remainder trusts. CRTs are a popular technique for trust makers who have charitable intentions. As with a GRAT, the CRT trust maker will give property to a trust that will ultimately terminate to a charity, but not until after the trust maker (and/or possibly other beneficiaries) are paid back for an annuity from the trust. The IRS requires that at least 5% of the assets end up with the charity.
CRTs can be effective tools to plan for gift and estate tax, income tax and capital gains taxes. Depending on the trust assets, interest rates and the trust maker’s objectives, some variations to a CRT include annuities (CRAT) or unitrusts (CRUT). Reverse charitable lead trust structures (CLAT or CLUT) are also available with some variance in the rules.
Irrevocable life insurance trusts. ILITs hold life insurance policies, because life insurance has tremendous tax advantages by virtue of growing tax-free and paying out tax-free. When an ILIT is coupled with efficient funding such as annual exclusion gift waivers (“Crummey waivers”) and/or split dollar funding, an ILIT can be an extremely tax-efficient way to not only create an asset outside of the taxable estate, but also to magnify the size of the estate and create liquidity that can be used or borrowed to pay estate taxes.
LLC and partnership discount planning. Once people form a partnership, the partnership assets can no longer be controlled as easily and are less marketable. Even if a partnership holds only marketable securities, the value of the securities is discounted because of the lack of marketability and lack of control. Impairing the control over partnership assets by gifting some ownership in the partnership to family members, a powerful technique often known as a family limited partnership (FLP) can reduce the value of assets transferred out of a taxable estate.
Spousal lifetime access trusts. Using about half of the total marital property, a married trust maker forms a SLAT for the benefit of their spouse and possibly children as beneficiaries. The other spouse later forms a second SLAT trust for the children and the trust maker with the other half of the marital property, being careful that the terms of the second SLAT differ from the first SLAT.
SLATs are popular estate tax planning trusts, with many variations, including SPLATs, SLANTs and SPLANTs.
Trust protector powers are very potent powers that add flexibility to an irrevocable trust so that the trust can be modified (reconfigured) or even “decanted” (transferred) into a new jurisdiction with trust rules and options that can reduce taxes. The question of whether a trust protector who can be appointed by the trust maker has fiduciary powers, making the trust protector subordinate to the trust maker, is also important in determining whether the trust protector powers will cause the trust assets to be included in the taxable estate of the trust maker.
Powers of appointment can be used to reset basis in trusts to save on capital gains taxes through gross estate inclusion. The power to appoint is the power to disappoint, and powers of appointment are either broad or limited when it comes to adding or removing beneficiaries. Powers of appointment can create gifts or estate tax inclusion for purposes of stepping up basis in trust assets, though the exercise of a power must be made with caution, especially when there is a potential GST collateral effect.
No trust can do everything
Keep in mind that these trusts and powers are only a taste test of a much larger array of techniques available — a veritable Swiss army knife of techniques that can be combined to achieve dual tax planning and asset protection benefits. There is no magic trust that will do everything, because all trusts entail tradeoffs, and most trust makers with wealth and unique risks will need multiple trusts.
Some trust types and techniques are unique to specific jurisdictions. Trusts (and LLCs) always name a situs or jurisdiction whose laws will apply to the trust in the trust’s formation document. Even if the trust maker lives in a different state, they can still pick their jurisdiction of choice for a trust or LLC. There are many good jurisdictions for trusts and LLCs. Alaska, Delaware, Nevada, South Dakota and Wyoming are currently the top U.S. jurisdictions for trusts and LLCs.
It is also important to keep in mind that if a trust has beneficiaries who are not U.S. citizens, the trust can become subject to foreign trust rules. If any of the trustees or beneficiaries of a trust change to a foreign person, the trust-reporting requirements, income tax features and capital gains tax features will change. One of the most significant consequences of a foreign trust is the possibility of “throwback tax” on accumulated distributions of trust income under IRC Section 666 — an aptly numbered section. If a trust maker wants to make gifts to individuals or to a trust, foundation or business entity with beneficiaries or owners overseas, additional FinCEN, IRS and KYC compliance will be needed, and reporting will first be required before making gifts.
Advanced trust tax and asset protection planning is less about “magically” choosing a special trust that will “do it all” and more about balancing the tradeoffs between very specific powers and techniques. Advanced tax and asset protection planning is the product of deep and recondite knowledge of federal tax laws, state laws and common law principles, applied to the very specific needs of a trust maker.
Best results in tax and asset protection planning are achieved by working with an experienced team of attorneys, CPAs and other advisers to work through the multivariable calculus of tradeoffs in benefits and burdens that exist between all planning choices.
The Other Articles in This Series
- Part one: To Avoid Probate, Use Trusts for Estate Planning
- Part two: How Quitclaim Deeds Can Cause Estate Planning Catastrophes
- Part three: Revocable Trusts: The Most Common Trusts in Estate Planning
- Part four: With Irrevocable Trusts, It’s All About Who Has Control
- Part five: Ins and Outs of Domestic Asset Protection Trusts (DAPTs)
- Part six: Irrevocable Trusts: Less Control Equals More Asset Protection
- Part seven: Should You or the Trust Pay a Trust’s Income Taxes?
- Part eight: How to Handle Irrevocable Trust Assets Tax-Efficiently
- Part nine: Repeal the Death Tax? These Are the Taxing Trade-Offs
- Part 10: Gift and Estate Tax vs Capital Gains Tax: Which Is Less?
- Part 11: This Double-Dip Trust Benefit Really Is Too Good to Be True
- Part 12: This Trust Strategy Can Reduce Your Taxes Big-Time
- Part 13: Limited Liability Companies (LLCs): How Assets Are Protected
- Part 14: How Trusts Can Be Used to Protect LLCs From Creditors
- Part 15: LLCs: Power Tools That Can Create Big Problems
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