A testamentary trust can enhance a comprehensive estate plan. Including a trust in a will permits the testator a modicum of control over the distribution of estate assets, which an outright bequest cannot provide. Married couples rely on certain types of testamentary trusts to preserve assets in the estate. Transfers to trusts that qualify for the marital deduction are important because the deduction is unlimited and the deduction can ensure estate assets are protected from taxation.

A testamentary trust can enhance a comprehensive estate plan. Including a trust in a will permits the testator a modicum of control over the distribution of estate assets, which an outright bequest cannot provide. Married couples rely on certain types of testamentary trusts to preserve assets in the estate. Transfers to trusts that qualify for the marital deduction are important because the deduction is unlimited and the deduction can ensure estate assets are protected from taxation.

A second type of unlimited estate tax deduction is for transfers to a qualified charity. This deduction can also be used to the testator’s advantage. There are occasions and opportunities for matching the marital and charitable deductions in an estate plan that can provide for the surviving spouse and promote philanthropy.

Testamentary Trust Basics

A trust requires five basic elements:

• Grantor – The individual who sets up the trust by transferring his assets to a third party.
• Trustee – An individual, corporation or a bank who keeps legal title, possession and control over the trust property.
• Trust property – The trust property (or “corpus”) may include almost anything capable of being legally owned, such as real or personal property, or a contract right such as a life insurance policy.
• Beneficiaries – The recipients of the trust income and corpus.
• Trust terms – A trust must include instructions directing the trustee as to his duties and distribution requirements.

The trustee holds legal title to the trust property; the beneficiaries own equitable title. As legal titleholder, the trustee can exercise property rights over the trust assets: invest or sell assets, enter into contracts, or pay taxes on trust income.

A testamentary trust is created through the execution of a will. The testator includes language in the will to create and fund the trust upon his or her death. A testamentary trust exists to carry out some purpose of the decedent’s estate plan that cannot be achieved by a bequest alone. There are many reasons for including a testamentary trust within an estate plan:

• Maximizing the estate tax applicable credit amount.
• Protecting trust assets from creditors.
• Providing a regular income to the surviving spouse.
• Preserving assets for children of a first marriage (after providing an income to a surviving spouse).
• Giving to favorite charities as well as family members.

Comparing Testamentary Trusts and Revocable Living Trusts

A revocable living trust is a trust created during the grantor’s lifetime that the grantor may alter, amend or revoke. And, depending on the terms of the trust, the revocable living trust could become irrevocable upon the grantor’s death. The assets inside such a trust are part of the estate. However, the trust will not be subject to probate. This privacy aspect is an advantage over the testamentary trust because testamentary trust property must proceed through the probate system with its added costs and delays.

Credit Shelter Trust

The credit shelter trust (also known as a bypass trust) is an estate planning device used to minimize the combined estate taxes by fully utilizing each spouse’s applicable credit shelter amount at death.

Here is how a credit shelter trust works: At the first spouse’s death, the estate transfers assets equal to the applicable credit amount for federal estate tax purposes into a trust. No estate taxes will be assessed on that property because of the “shelter” of the exemption equivalent to the credit. And though the credit shelter trust property remains outside the surviving spouse’s estate, the spouse can receive benefits from the trust during his or her lifetime, including income and (some) corpus distributions.

The second portion of the estate (in excess of the applicable credit amount) will either be given directly to the spouse or placed in a marital trust for the benefit of the spouse. This property will not be subject to estate taxes because the transfer of this property to a spouse (who is a U.S. citizen) qualifies for the unlimited marital deduction.

Note that the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 included a provision that permits a surviving spouse to use the deceased spouse’s unused exclusion amount (DSUEA) [IRC Section 2010(c)(4)]. This means the applicable exclusion amount not used by a deceased spouse would not go wasted—possibly meaning a credit shelter trust would not be as useful for estate planning in 2011 and 2012.

However, a credit shelter trust may still be useful in planning because the DSUEA transferred at the time of the first spouse’s death may not suffice to protect an estate that continues to grow from the estate tax when the surviving spouse dies. For example, a husband dies in 2011 with an estate of $9 million. He leaves all his property to his wife so he uses none of his estate tax applicable exclusion amount. The unused $5 million amount will (eventually) be added to the wife’s applicable exclusion amount. But it is possible that after the husband’s death the assets will continue to grow. The applicable exclusion amount of $5 million is adjusted for inflation every year, but the growth of the assets may grow faster. And the $5 million unused spousal applicable exclusion amount the husband left behind in 2011 remains fixed because the DSUEA is not indexed for inflation. In such a case, the wife’s estate could outgrow the combined exclusion amounts and be subject to the estate tax.

Furthermore, the portability provision is temporary. The federal estate tax in 2013 may or may not include portability depending how Congress does or does not act.

So if a credit shelter trust is part of an estate plan, one way to avoid estate tax being applied to the second spouse’s estate would be for the surviving spouse to select a charity as the remainder beneficiary of the marital trust, or make an outright bequest. If an estate plan has previously left assets to children, grandchildren or other family members via the credit shelter trust, philanthropic goals can be met by leaving the remaining assets of a marital trust to charity.

Qualified Terminal Interest Property Trust

Under IRC Sec. 2056, there is an unlimited marital deduction for transfers to a spouse under the federal estate tax. However, the marital deduction may not apply for certain transfers. A transfer of a terminable interest—an interest that terminates upon the death of the holder or on the occurrence or nonoccurrence of a certain event—will not qualify for the marital deduction [IRC Sec. 2056(b)(1)].

But there is an exception to this general rule. A qualified terminable interest property (QTIP) trust is property in a decedent’s estate that, even though subject to certain restrictions, can still qualify for the estate tax marital deduction [IRC Sec. 2056(b)(7)]. A QTIP is property placed in trust that must pass directly from the decedent to give the surviving spouse a lifetime income interest (paid at least annually) [IRC Sec. 2056(b)(7)(B)(ii)]. And, the executor must elect the QTIP [IRC Sec. 2056(b)(7)(B)(v)].

The primary goal of a QTIP trust is to provide a lifetime income to a spouse. A secondary goal of a QTIP trust can be to benefit a worthwhile charity. The grantor can name a charity as the remainder beneficiary of the trust: when the spouse dies, the remaining assets in the QTIP trust go to charity.

As mentioned earlier, a QTIP qualifies for the marital deduction for estate tax purposes. Upon the death of the spouse, the QTIP trust that has provided the spouse a lifetime income is included in his or her estate. If a charity is named as the remainder beneficiary, the spouse’s estate may claim a charitable deduction for the value of the property that goes to charity [IRC Sec. 2055(a)]. Thus, the property the grantor originally directed into the QTIP trust avoids estate taxation: the first time by the marital deduction, and the second time by the charitable deduction.

It is important to note that the initial decedent spouse is the one to direct the charitable remainder in the QTIP controlling document. Otherwise, if no charity is selected as the remainderman, the surviving spouse would not have the right under the trust to change the remainder beneficiary to the charity.

Qualified Domestic Trust

The estate tax marital deduction generally does not apply when the surviving spouse is not a United States citizen [IRC Sec. 2056(d)(1)]. However, there is a special exception for property placed in a qualified domestic trust [IRC Sec. 2056(d)(2)(A)]. The use of a qualified domestic trust (QDOT) ensures that, the assets in the trust avoid federal estate taxation at the first death, though the tax will eventually be imposed on these assets upon the death of the surviving noncitizen spouse.*

Any distribution of principal from the trust to the surviving noncitizen spouse during his or her lifetime will result in the immediate imposition of estate taxes on the amount of principal distributed, unless the distribution is made because of hardship [IRC Sec. 2056A(b)(1); Reg. Sec. 20.2056A-5(c)(1)]. Income-only distributions to the surviving noncitizen spouse do not trigger the tax [ibid.]. At the surviving spouse’s death, the value of the assets remaining in the QDOT will become subject to estate tax [IRC Sec. 2056A(b)(1)(B)]. The tax is also levied if the trust fails at any time to meet the qualified domestic trust requirements described in Reg. Sec. 20.2056A-2.

Since the executor of the estate must make an election on the estate tax return, this provides some flexibility in planning. The executor can take into account the precise situation existing at death in determining whether to make such an election. The executor must balance the elimination of appreciation from the estate tax base at the second death (i.e., no election) against the opportunity to defer estate tax until the second death (i.e., make the election). Of course, the executor must also respect the decedent’s wishes with respect to the security of the surviving spouse, even if there is a financial price to pay.

Jointly held property that passes outright to the surviving spouse by right of survivorship will not qualify for the estate tax marital deduction. For this reason, the spouses might consider placing the property in tenancy in common, with the deceased’s interest passing to the QDOT.

A charitable remainder trust that also satisfies the requirements for a QDOT (including a U.S. trustee) can qualify the transfer in trust for the unlimited marital deduction [Reg. Sec. 20.2056A-2(b)(1); Reg. Sec. 20.2056A-6(b)(3)]. The income interest belonging to the noncitizen spouse qualifies for the marital deduction. The remainder interest distributed to the charity qualifies for the charitable deduction. Thus, none of the assets placed in the trust will be subject to the estate tax.

*The regular estate tax marital deduction is available if the surviving spouse becomes a U.S. citizen before the estate tax return is filed. However, the spouse must have been residing in the U.S. at the decedent’s death and continuously thereafter until he or she becomes a U.S. citizen [IRC Sec. 2056(d)(4)].

Charitable Remainder Trusts

A charitable remainder trust (CRT) is an irrevocable trust in which a noncharitable beneficiary designated by the grantor receives distributions from the trust for a life or joint lives, or for a period of up to 20 years, after which the trust terminates and the trust corpus is distributed to the charitable remainderman [IRC Sec. 664 (d)(1)(A), 664(d)(2)(A)]. Plus, the income payout must be at least 5% but not more than 50% of either the value of the assets initially transferred to the trust (a charitable remainder annuity trust) or the value of the trust assets as valued every year (a charitable remainder unitrust) [ibid.]. The value of the charitable remainder must be 10% or more of the initial value of the property transferred to the trust [IRC Sec. 664 (d)(1)(D), 664(d)(2)(D)].

The advantage of including a testamentary CRT in a will is the estate tax deduction for the value of the remainder interest as calculated at the time of the trust formation (i.e., the death of the grantor). If the grantor names the surviving spouse as the sole noncharitable beneficiary of the CRT, there is a double advantage: both the value of the spouse’s income interest (marital) and the value of the remainder interest (charitable) are deductible so that the property placed in this particular testamentary CRT is not subject to estate taxation. Note that the marital deduction would not be available if there were another noncharitable beneficiary in addition to the spouse (though the charitable deduction for the charitable remainder would remain intact).

The testamentary CRT document should not instruct that the trust should pay estate taxes or inheritance taxes on its share. Any distribution made from the CRT to pay these taxes would disqualify the trust [IRC Sec. 664(d)(1)(B), 664(d)(2)(B)]. Such taxes should be paid from the estate itself before the CRT is created and funded [IRC Reg. Sec. 1.664-1(a)(6)].

In 2003, the IRS published a series of sample charitable remainder annuity trust forms, including forms for testamentary trusts [Rev. Proc. 2003-57 through Rev. Proc. 2003-60]. In 2005, the IRS gave the same sample form treatment to charitable remainder unitrusts [Rev. Proc. 2005-56 through Rev. Proc. 2005-59]. The sample forms contain basic provisions, alternate provisions, and annotations.

It is important to remember that things may change between the time a testamentary CRT is drafted and when it comes into existence at the death of the grantor. If the income payout period is long due to the (relative) youth of the spouse beneficiary, the value of the charity’s remainder interest may fall below the 10% threshold, potentially jeopardizing the tax qualification of the trust. Also, consider that a testamentary charitable remainder annuity trust (CRAT) could come into existence at a time of low applicable federal rates. Even with fairly elderly income beneficiaries, the CRAT might fail to qualify and lose the estate tax charitable deduction without a formula or other precaution written into the trust language. Furthermore, the trust should specify a contingent charitable remainderman in case the primary charitable remainderman ceases to exist or ceases to be a qualified charitable organization.

If the testator chooses, the CRT may grant the income recipient a power of appointment to designate the charitable remainderman [Rev. Rul. 76-7, 1976-1 C.B. 179].

Comparing Testamentary Charitable Remainder Trusts and QTIP Trusts

Consider whether a QTIP trust with the remainder going to charity might be preferable to a testamentary CRT. Both a QTIP trust and a CRT provide a lifetime income to a surviving spouse. Both a QTIP trust and a CRT transfer the remaining assets to a qualified charity upon the death of the surviving spouse. However, there are significant differences as well:

• A QTIP trust corpus can be invaded for the spouse’s benefit. But, the rules regarding CRT distributions are set and cannot be disregarded even if the surviving spouse is in some distress.
• A CRT is (unless unrelated business taxable income is involved) a nontaxable entity. But if a QTIP trust sells assets, the capital gains are taxable to the trust.
• A QTIP trust cannot include a provision that would terminate the trust upon the remarriage of the surviving spouse. But a CRT can include such a remarriage clause and still retain the marital deduction.

The type of testamentary trust appropriate for an estate plan must take these differences into account.

Charitable Lead Trusts

The charitable lead trust (CLT) is a trust arrangement under which an annual income from the trust is paid to a qualified charitable organization for a specified period of years, with the principal of the trust passing to the grantor or, instead, noncharitable beneficiaries (often the children or grandchildren of the donor) when the trust terminates [Reg. Sec. 20.2055-2(e)(2)(vi)(a), 20.2055-2(e)(2)(vii)(b)].

The CLT agreement must provide for the annual payment to a charity of either a specified fixed dollar annuity payment (a CLAT) or a specified percentage of the value of the trust each year (a CLUT) [ibid.]. Generally, there must be no payments other than these income payments to charity until the trust terminates.

Thus, the CLT is a technique for making a “temporary gift” of income to a charitable institution and eventually passing the property to individual beneficiaries. Because the value of the income interest is tax deductible for federal estate tax purposes, the CLT is often used to reduce taxes while ultimately passing ownership to family members or other beneficiaries [IRC Sec. 2055(e)(2)(B)]. Plus, any appreciation in the value of the property that exceeds the value of the property at the time it was included in the decedent’s estate will pass to the heirs without an additional transfer tax when the CLT term expires. Thus, funding the CLT with assets expected to increase in value would be a plus.

A CLT must be irrevocable. Thus, the family members will not have access to or benefit from the property until the term of the trust expires. Thus, the income needs of the noncharitable beneficiaries should always be considered before setting up a testamentary lead trust. Most lead trusts are created for a specified period of years, but the term of the trust can also be measured by the life or lives of designated individual(s).

Remember that, unlike an intervivos CLT for which the donor is considered the owner, the estate is not considered the owner of a testamentary CLT and is not taxed on its income.

One goal of individuals who use testamentary CLTs is to “zero out” the federal estate tax. The preferred form to use is the charitable lead annuity trust (CLAT) because an annuity interest can equalize the value of the charitable income interest and the fair market value of the assets transferred to the trust. In order to reach this equilibrium, a formula must be included in the trust terms based on the number of years for payout as determined by the prevailing applicable federal rate (Sec. 7520 rate) at the time of death.

Planning with a CLT must include a consideration of the generation skipping transfer (GST) tax (e.g., naming a grandchild as a noncharitable beneficiary). A testamentary CLUT can include a formula to control the value of the remainder interest so that it equals the decedent’s available GST tax exemption at death. However, the rules are different for allocating GST tax exemption for a testamentary CLAT which allocates the GST tax exemption at the time the trust expires, not at the time it is funded. And, the transfer to a testamentary CLAT does not qualify for the charitable deduction for GST tax purposes.

In 2007, the IRS published a series of sample charitable lead annuity trust forms, including forms for testamentary trusts [Rev. Proc. 2007-46]. In 2008, the IRS gave the same sample form treatment to charitable lead unitrusts. The sample forms contain basic provisions, alternate provisions, and annotations [Rev. Proc. 2008-46].

As noted in the discussion of CRTs, the professional who drafts a testamentary CLT must be mindful of the potential for change and a contingent charity should be named in the document.

Closing

Leaving a legacy through charitable giving is a goal of estate planning for many people. Because of the uncertainty of the estate tax law (in 2013, the current law is scheduled to revert to what existed in 2001) your clients will likely need an estate plan that addresses changes in the law. Keep in mind that a philanthropically inclined client might be interested in possibility of the options afforded by leaving property to a charity through a testamentary trust.