Grantor trusts in South Dakota: preserving a planning tool to maintain the state's trust friendly status.
The world of grantor trusts gives rise to a wide variety of options for the estate planner, including those grantor trusts labeled GRITs, GRATs, GRUTs, QPRTs, ILITs, and IDGTs.' Despite this vast array of acronyms grantor trusts can generally--and more simply--be defined as trusts wherein the grantor, rather than the trust itself, is taxed on the trust's income. (2) These trusts have evolved with changes in the common law, regulations, and legislation, but the purpose of grantor trusts has always been reducing the tax burden on either the grantor, the beneficiaries, or both. (3)
While there is a split of opinions on the usefulness and future viability of grantor trusts, (4) they are, nonetheless, important tools for estate planners to help clients because grantor trusts may reduce or eliminate estate taxes upon the client's death by diminishing the amount of a client's taxable property. (5) Additionally, attainment of grantor trust status--given the current compressed marginal tax rates for trusts--has the effect of reducing the income tax paid on the assets placed in trust because the grantor, rather than the trust, will pay the income taxes. (6)
South Dakota has taken advantage of these benefits by passing legislation that creates a favorable atmosphere for those clients who situs their trusts in the state. (7) However, subsequent to an inversion of the income tax rates in 1986, (8) many commentators argue that grantor trusts have outlived their usefulness and should therefore be eliminated or drastically reformed. (9) The idea for reform has percolated through in recent years as Treasury Department proposals aimed at limiting or destroying the effectiveness of certain grantor trusts. (10) Therefore,
Irrevocable Life Insurance Trust ("ILIT") takes advantage of specific code provisions to remove from one's estate the value of that person's life insurance policy. Steinkamp, supra, at 78. Finally, an Intentionally Defective Grantor Trust ("IDGT") exploits the differences in estate and income tax through a grantor's sale of property to the trust in exchange for payments on a note. Mark S. Poker, Sales to Intentionally Defective Grantor Trusts: Here is How Defects Can Be Positives, Prac. Tax Law., Fall 2010, at 15, 15-16, 18. See infra Part II for a more nuanced discussion on each of these trusts in turn. South Dakota legal practitioners and estate planners must understand the advantages and disadvantages of grantor trusts and be prepared to advocate for the preservation of these estate planning tools in order to maintain their availability, and to promote South Dakota's flourishing trust industry. (11)
As such, this comment will first explain why South Dakota is regarded as one of the best places to situs a trust, due in large part to its (1) repeal of the Rule Against Perpetuities ("RAP"), (2) lack of income or capital gains tax for individuals or trusts, and (3) favorable trust decanting, directed trust, and asset protection statutes for trustors and trustees of South Dakota trusts. (12) Next, this comment will review the legislative history of the creation of grantor trusts and provide an overview of the current rules that govern grantor trusts. (13) This comment will then clarify the operation of the grantor trust rules and provide a primer on some of the trusts those rules allow, including GRITs, GRATs, GRUTs, QPRTs, ILITs, and IDGTs. (14) Lastly, this comment will analyze scholarly opposition to grantor trusts, including some proposals that could be detrimental for grantor trusts and trusts in South Dakota, while arguing that South Dakota estate planners and their clients should advocate for the status quo to maintain the state's current "trust friendly" status. (15)
A. SOUTH DAKOTA: THE TRUST FRIENDLY STATE
South Dakota consistently makes it onto Best Trust States lists. (16) One reason is that South Dakota was one of the first states to repeal the RAP. (17) Without the RAP, a trustor technically can create a dynasty trust that would allow consecutive life interests to be passed perpetually. (18) This means that "a properly structured trust can continue growing ... indefinitely[.]... free of estate, gift and generation-skipping taxes, which can consume about half a trust's assets." (19) By allowing wealthy families to defer taxes indefinitely, South Dakota has set itself up as an attractive place for those families to situs their trusts. (20)
A second reason South Dakota is trust friendly is because of its tax laws. South Dakota does not impose any state tax "on the assets that comprise a trust located there[,]" including income, capital gains, dividends, interest, or intangibles. (22) For trusts this is a boon, because paying income taxes, or capital gains on trust assets, erodes the res in trust. (23) It also slows asset growth and diminishes the beneficiaries' shares. (24)
South Dakota is also a trust friendly place because of its trust decanting, and trust modification statutes. (*5) Decanting is the process whereby a trustee "mak[es] a distribution to a new trust with different terms from the original trust." (26) Decanting essentially allows a trustee to change the terms of an irrevocable trust. (27) There are many reasons a trustee would want to do this, but a few of the more common are: for better federal or state tax advantages, for better administrative provisions, or to add asset protection. (28) But decanting is not the only option to modify an irrevocable trust. (29) South Dakota has taken a permissive stance on modifying irrevocable trusts even before the 2007 enactment of the decanting statutes by allowing judicial and non-judicial reformation or even termination, among other means. (30) An attractive prospect for South Dakota trust clients is that "Tijrrevocable'--more and more in the trust world--does not mean immutable." (31)
Another reason South Dakota is a trust friendly environment is because of its directed trusts statutory scheme. (32) A directed trust is one where the trust instrument appoints persons to act as trust advisors to direct the trustee with regards to certain areas of trust administration. (33) Directed trust provisions serve two purposes, encouraging better trust administration, and enabling liability mitigation for trustees. (34) Prior to enactment of the directed trust provisions, when the trust or transferred assets to the trust, the trustee was solely responsible for administering those assets. (35) However, given the complexity of modern trusts, a single person may not be the best manager of all of the administrative functions a trust requires. (36) Therefore, in a directed trust, one advisor may serve to administer in the best interest of the investments, while another might be better suited to administer discretionary distributions. This arrangement might allow family members to maintain more control of the trust rather than relying solely on the discretion of a single trustee. (38) Additionally, the South Dakota directed trust provisions provide a higher level of liability protection for directed trustees. (39) With benefits for both the trustor's and trustee's interests, "directed trusts are an obvious win for everyone." (40)
South Dakota also excels in the area of asset protection, especially for third party beneficiaries and for self-settled trusts. (41) South Dakota codified third party discretionary support that offers protection for beneficiaries from creditors. (42) The 2007 law "states that discretionary interests in a third party trust, limited power[s] of appointment^], and remainder interests are not considered property interests." (43) Additionally, because they are not property interests, "no creditor may attach such interest." (44) South Dakota also has "excellent" self settled trust statutes to further provide asset protection. (45) Through a legislative commitment to "maintain South Dakota as 'a highly desirable jurisdiction in which to locate trusts[,]'" South Dakota has set itself up as a trust friendly place. (46)
B. History of Grantor Trusts
Estate planners, for over a half century, have attempted to exploit new legislation to reduce the grantor's estate and income tax liability by creating a separate taxable entity, the trust. (47) Additionally, trusts became popular because of the assignment of income doctrine developed in Lucas v. Earl (48) and because of the differential rates that existed at that time for estate and gift taxes. (49) It became apparent that trusts would be used in all manner of tax avoidance schemes; therefore, in a trilogy of cases, the United States Supreme Court began evoking language that would result in the grantor trust rules. (50)
The first of these cases was Corliss v. Bowers, (51) in which a husband set up a revocable trust in 1922 with the benefit to his wife and children. When the trust paid its net income to the wife in 1924, the husband was taxed for this income even though he and his wife filed separately. (53) Justice Holmes wrote, "[t]he income that is subject to a man's unfettered command and that he is free to enjoy at his own opinion may be taxed to him as income, whether he sees fit to enjoy it or not." (54) This holding established that the test of ownership is proved by substantial control rather than mere title to property. (55)
In the second case, Burnet v. Wells, (56) Wells, the petitioner and taxpayer, set up several trusts that were funded by an assignment of stocks to purchase life insurance policies on him, and the trustee was to use the income from the trusts to pay the insurance premiums. (57) Relying on section 219(h) of the Revenue Act of 1924, the Internal Revenue Service ("IRS") assessed to Wells, taxes on the trusts' income. (58) Justice Cardozo wrote in the opinion:
Income permanently applied by the act of the taxpayer to the maintenance of contracts of insurance made in his name for the support of his dependents is income used for his benefit in such a sense and to such a degree that there is nothing arbitrary or tyrannical in taxing it as his. (59) Cardozo surmised that life insurance policies, while directly benefiting someone other than the taxpayer, would not be maintained unless there was also some substantial benefit for the taxpayer. (60)
The third case that paved the way for the promulgation of Treasury regulations and the grantor trust rules was Helvering v. Clifford, (61) Mr. Clifford created a trust--of which he was the trustee--for the benefit of his wife that would terminate after five years or the death of either party. (52) She was to be paid income from the trust assets, and any unpaid income was to be held for her benefit. (63) He retained all investment powers, a discretionary power to pay or retain income, as well as a reversionary interest in the balance of the trust corpus after all withheld income had been paid to the wife. (64) Justice Douglas held that because of the trust's short duration, familial distribution, and retained powers, "control over the corpus was in all essential respects the same after the trust was created, as before." (65) Mr. Clifford was deemed, regardless of property title, to be the owner of the trust for income tax purposes. (66)
1. Codifying the Grantor Trust Rules
In the wake of the Clifford decision, the Treasury Department issued what came to be known as the Clifford Regulations. (67) Enacted under section 22 of the 1939 Code, these regulations set forth a simple test; if any of three identifying factors derived from the Clifford decision were present in a trust, the grantor would be taxed on any trust income. (68) As enacted in the regulations, the first factor was whether within "a relatively short term of years"--ten years for most trusts or two years for gifts to certain charities--the corpus or income of the trust might revert to the grantor. (69) The second factor was whether '"beneficial enjoyment' of the corpus or income was 'subject to a power of disposition' in the grantor" or any other non-adverse party. (70) The third factor was whether the grantor retained certain, "administrative controls], exercisable primarily" for his "benefit." (71) While the Clifford Regulations offered a black-and-white delineation of grantor and non-grantor trusts, many commentators felt the door had been left open for tax controversies, which would require Congressional intervention over the regulation of grantor trusts. (72)
In 1954, Congress, in order to create the grantor trust rules, codified the Clifford Regulations by combining them with certain trust provisions already contained in the Internal Revenue Code. (73) The objectives were to: (1) simplify and centralize grantor trust provisions; (2) remove from the IRS the ability to use the broad scope of other tax statutes in order to determine grantor trust status; and (3) elaborate on the specific income tax consequences of a trust if it obtained grantor trust status. (74) These provisions created a series of tests to determine whether the grantor or another person has retained "substantial dominion or control" over trust corpus and income, and to determine whether the trust is a grantor trust or a non-grantor trust. (75) The grantor trust rules remained relatively intact until the Tax Reform Act of 1986 ("TRA '86"). (76)
2. Short Term Grantor Trusts and the Income Tax Inversion
TRA '86 made two significant changes to the grantor trust rules. (77) First, it amended section 673(a) to remove the ten-year time constraint initially enacted by the Clifford Regulations. (78) Rather, the amended version triggered grantor trust status on any portion of a trust over which the grantor has retained a reversionary interest of five percent or more of the income or corpus of the trust. (79) The second change added section 672(e), treating any power held by the grantor's spouse as if the grantor held the power himself. (80) TRA '86 changed the rules for short-term grantor trusts but ensnared trusts that would have been closely held through marital relationships. (81)
Another effect of TRA'86 that changed estate planning strategies significantly was the inversion of the income tax rates under section 1(e). (82) Subsequently, it was no longer a stigma for the taxpayer to obtain grantor trust status. (83) With the reforms of income tax rates for both individuals and trusts, grantor trust status began to provide sanctuary to taxpayers by taxing the individual at a lower rate than the trusts. (84)
3. Estate and Gift Tax
On the other side of the grantor trust tax situation--estate and gift taxes--the rates have shifted, but the rules have not changed significantly for over sixty years. (85) In 1976, the estate and gift tax rates were integrated under the unified transfer tax, which drastically changed the estate and gift tax landscape. (86) From 1942 through 1976, the estate tax exemption remained at $60,000 with a maximum tax rate of 77%. (87) Starting in 1977, the exemption increased to $120,000 and rose steadily through 1997 while the maximum tax rate fell from 70% to 55%. (88) The Taxpayer Relief Act of 1997 ("TRA '97") was supposed to steadily increase the exclusion amount to $1 million by 20 06. (89) But the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") accelerated the increase in the exemption amounts first to $1 million in 2002, stepping up to $3.5 million by 20 09. (90) Concurrently, the maximum tax rate stepped down from 50% to 45%. (91) EGTRRA also de-unified the estate and gift tax exemptions leaving the gift tax exemption at $1 million. (92) EGTRRA's other impact was that it scheduled a temporary repeal of the estate tax in 2010 while providing for its reinstatement in 2011 at the 2001 rates. (93) In December 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 ("TRUIRJCA") was signed into law which reinstated the estate tax for two years, reunifying it with the gift tax at a low maximum rate--35%--with an exemption of $5 million that was set to increase for inflation to $5.12 million for 2012. (94) TRUIRJCA also instituted an estate tax portability feature that allows the surviving spouse of a decedent to carry over the remainder of the decedent's estate tax exemption. (95)
Grantor trusts are considered incomplete gifts for income tax purposes, but are considered completed gifts for estate and gift tax purposes. (96) This means that the assets in the trust will not be included, normally, in the grantor's estate at his death for the calculation of estate taxes. (97) Depending on the type of grantor trust, and the method of contributing to the trust, trust contributions may have gift tax consequences that could apply toward the gift tax exclusion amounts. (98) By using grantor trusts to keep assets out of the grantor's estate, wealthy families can preserve the estate tax exemption for use on other assets at the grantor's death, or, with portability, at the grantor's spouse's death. (99)
C. Operation of The Grantor Trust Rules
The first two provisions of the grantor trust rules describe the tax consequences of attaining grantor trust status and define certain integral terms found in the subpart. (100) More specifically, section 671 attributes taxable income to the grantor (or another person) any portion of a trust that achieves grantor trust status. (101) Section 672 defines the terms of art used in the rest of the subpart; it describes who would be relationally too close to the grantor to avoid initiating grantor trust status should they be given certain powers. (102)
The remaining sections "identify those trust characteristics that cause a taxpayer to hold dominion and control of all or a portion of a trust," thus initiating grantor trust status. (103) Section 673 initially triggered grantor status for short-term trusts with a term of less than 10 years (a throwback to the Clifford decision) but now triggers grantor trust status on reversionary interests of 5% or more. (104) Section 674 assigns grantor trust status to any portion of a trust over which the grantor, a non-adverse party, or both control a power of disposition in the "beneficial enjoyment of the corpus or the income there from." (105) Section 675 triggers grantor trust status over any portion of a trust if the grantor or non-adverse party retains the following interests, as summarized by Huffaker and Kessel:
Certain administrative powers, exercisable in a nonfiduciary capacity by any person without the consent of any person in a fiduciary capacity, including the power to borrow without adequate interest or security, the power to purchase, sell, or dispose of trust property for less than adequate consideration, or the power to reacquire trust property by substituting property of equal value.... (106)
In section 676, grantor status is achieved over any portion of a trust that the grantor or non-adverse party retains a power to revoke. (107) Section 677 assigns grantor trust status over any portion of a trust whose income may be distributed or held for future distribution to the grantor or grantor's spouse, used to pay life insurance premiums on the grantor or grantor's spouse, or used to pay the grantor's obligations of support. (108) Section 678 imparts grantor trust status to a person other than the grantor when that person is given the exclusive power to vest trust corpus or income in himself or herself. (109) Finally, in 1976 section 679 was added to the grantor trust rules, which initiated grantor trust status on any portion of a foreign trust, established by a United States citizen, of whom any United States citizen is a beneficiary. (110)
D. Grantor Trusts 101
1. GRIT: Grantor Retained Income Trust
A GRIT is an irrevocable inter vivos trust wherein the grantor retains an interest in all the trust income for a term of years while transferring a remainder interest in the corpus to a beneficiary other than himself. (111) GRITs, and for that matter GRATs and GRUTs, divide interests in property into a present interest and a future interest. (112) The present interest is a current income interest for the grantor, and the future interest is a remainder interest for the beneficiaries. (113) The grantor retains an income stream for the term of the trust, and at its expiration, the corpus passes to the beneficiaries or remains in trust for their benefit. (114) These trusts function because section 7520's actuarial tables value the remainder interest in property transferred at a level typically lower than the real value the beneficiaries receive at the termination of the trust. (115)
In the 1980s, estate planners were using GRITs for their significant gift tax savings in lieu of outright inter vivos gifts. (116) In an outright gift, the entire value of the transfer counts for gift tax purposes; however, with the creation of a GRIT, the gift for tax purposes is only "the discounted present value of the remainder interest." (117) In 1988, Congress attempted to limit the tax savings of certain "estate freeze" strategies that would have included GRITs were it not for an exception written into its amendment to section 2036(c). (118) The exception offered GRITs a "safe harbor" as long as: (1) the income interest did not exceed ten years, (2) only the grantor received the income from the trust, and (3) the grantor was not the trustee. (119) But two years later, the enactment of the Revenue Reconciliation Act of 1990 repealed section 2036(c) and enacted section 27 02. (120) Section 2702 virtually put an end to the effectiveness of the GRIT. (121) It mandated, "[t]he value of any retained interest which [was] not a qualified interest shall be treated as zero" when a member of the transferor's family was a beneficiary. (122)
As far as GRITs were concerned, a retained income interest was not a qualified interest. (123) Giving the retained interest a zero value meant the entire amount of the transfer counted as a gift for gift tax purposes instead of the discounted actuarial value of the remainder interest. (124) This eliminated the effectiveness of the tax savings realized by a GRIT transferred to a family member. (125) Today, the last real refuge of the GRIT is the rare instance when the beneficiary is not a member of the grantor's family. (126)
2. GRAT: Grantor Retained Annuity Trust
A GRAT is an inter vivos irrevocable trust instrument wherein the "grantor retains an annuity for a term of years and transfers a remainder interest" to a beneficiary. (127) Section 2702 provided special valuation rules for certain qualified interests; these interests would not be subject to the zero-value rule. (128) One of these qualified interests was the "right to receive fixed amounts payable not less frequently than annually ...." (129) In essence, this rule statutorily sanctioned the use of a GRAT. (130)
Like the GRIT, the main advantage of a GRAT is to reduce or even eliminate the gift tax associated with a transfer. (131) Here again, the value of the gift for gift tax purposes is measured by subtracting the value of the retained annuity interest from the total value of the assets transferred at the creation of the trust. (132) Because the gift is a future remainder interest, it is not includible in the annual gift tax exclusion. (133) If, however, the value of the gift can be reduced to zero (134) or can be absorbed by the lifetime gift tax exemption, the grantor will not be required to pay any gift taxes. (135) This allows transfers of substantial wealth without the burden of transfer taxes. (136) The three main factors that have the greatest impact on the calculated value of the remainder interest are the length of the term, the amount of the annuity, and the section 7520 rate. (137)
The first factor, the length of the GRAT term, is currently not specifically limited other than it necessarily must terminate no later than the death of the grantor. (138) Using a short-term GRAT reduces the risk that the grantor will die before the term expires, but the assets may not have time to appreciate in value to the benefit of the remainder person. (139) On the other hand, a long-term GRAT will reduce the gift tax to a greater degree, but there is an increased likelihood that the grantor will die before the term expires. (140)
The second factor of impact on the value of the remainder interest is the amount of the annuity. (141) The annuity can be a fixed dollar amount or a percentage of the initial value of the trust. (142) It can increase or decrease by up to 20% of the prior year's annuity amount. (143) Increasing the annuity payment decreases the value of the remainder interest subject to gift tax because it reduces the possibility that there will be anything left to transfer to the beneficiaries at the termination of the annuity interest. (144)
The third factor, the section 7520 rate, has fluctuated in the last ten years between 6.2% to an all time low of 1%. (145) The section 7520 rate is equal to 120% of the midterm Applicable Federal Rate, a rate that fluctuates monthly and is determined by the Secretary of Treasury. (146) A low interest rate decreases the gift tax value of the remainder interest because it is assumed that a greater portion of the trust principle will be required to make the requisite annuity payments. (147) This offers unique advantages when interest rates are low. (148) If assets in the trust appreciate more than the section 7520 rate, a GRAT is considered successful. (149) This is because the gift tax amounts have already been determined, and the appreciation is transferred to the beneficiaries without any further gift tax. (150) For this reason, it is particularly beneficial to fund GRATs with assets that have a high potential for appreciation. (151) However, this creates risk. (152) If the assets fail to perform above the section 7520 rate, the GRAT is ineffective because the "value assigned to the remainder interest will have been paid back to the grantor in satisfaction of his or her annuity payment." (153)
One method to minimize this risk is through the use of a "zeroed-out" GRAT. (154) In a "zeroed-out" GRAT, the value of the annuity interest so nearly equals the total value of the assets transferred to the trust that the remainder interest, and therefore the gift tax liability, is effectively zero. (155) In other words, the grantor sets up the annuity payments so that the grantor gets back almost all of what was contributed to the trust, leaving only the appreciation to pass to the beneficiary. (156) An increase in the annuity interest value is accomplished either by a very long-term GRAT, which risks the death of the grantor, or by structuring the annuity payments so that the entire corpus is paid back to the grantor. (157)
Recently, short term "zeroed-out" GRATs enjoyed significant popularity because of the decreased risk that assets would depreciate over the short term of the trust. (158) While this strategy does have benefits, certain commentators caution against it because of recent changes in regulations. (159)
In drafting a GRAT, certain provisions are required, including that: the trust must prohibit distributions to anyone other than the annuitant; it must prohibit use of a note issued by the trust in satisfaction of the annuity; it must prohibit commutation (that is, early termination accompanied by a division of the GRAT's assets between the grantor and the remainder beneficiaries on an actuarial basis); and it must have appropriate provisions for an adjustment of the annuity payments if the original value is determined incorrectly. (160)
Another requirement of a GRAT is that it disallows additional contributions after the initial funding transfer. (161) There is, however, no prohibition on the grantor serving as trustee. (162) This is a great advantage of a GRAT because it allows the grantor to retain control of any trust assets for the duration of the trust. (163)
3. GRUT: Grantor Retained Unitrust
Another qualified interest from section 2702 is "any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually)...." (164) This allows for the creation of the inter vivos irrevocable trust instrument known as a GRUT. (165) A GRUT performs in much the same way as a GRAT. (166) The major difference lies in the retained interest. (167) Instead of the right to receive a fixed annuity, the retained interest in a GRUT is "the right to receive a fixed percentage of the fair market value of trust property determined annually." The advantage of this strategy is that it keeps the grantor involved in the growth potential of the assets in the GRUT169 because, "unlike the GRAT, where the grantor is entitled to receive a fixed sum of money in the future irrespective of the trust's actual rate of return--both the Unitrust interest and the remainder interest grow in accordance with the rate of return generated by trust investments." (170)
It is, however, the annual determination of the fair market value of the assets in trust that makes the GRUT less attractive as an estate planning tool. (171) First, accounting costs are associated with making the determination of the fair market value of the property every year. Second, because the grantor's interest increases or decreases proportionately to any appreciation the trust enjoys, it becomes impossible to "zero out" a GRUT. (173) The third downfall of the GRUT is that, because the grantor's payment is a percentage of this annual redetermination, the value of the remainder interest--what the beneficiary takes--now includes a lesser portion of any appreciation. (174) Even if any appreciation exceeds the section 7520 rates, the actuarial value of the remainder interest would be equal to the outright gift value of the property transferred. (175) In short, "the grantor would be in an equivalent position from a transfer tax savings perspective by gifting the remainder component of the GRUT directly to a beneficiary versus establishing the GRUT." (176)
Nevertheless, using GRUTs can still have advantages. (177) For example, estate planners may wish to capitalize on a GRUT's income tax shifting properties. (178) Because the GRUT is almost always a grantor trust, the grantor rather than the trust or the beneficiary would be taxed on the trust income. (179) On the other hand, if the assets in trust were a direct gift, the donee would be taxed on the assets' income. (180) Another advantage of the GRUT is that, unlike a GRAT, there is no prohibition against adding trust assets after the initial transfer, giving the GRUT a bit more versatility. (181)
4. PRT: Personal Residence Trust and QPRT: Qualified Personal Residence Trust
Section 2702 includes an exception that states the zero-value rule will not apply to a transfer "if such transfer involves the transfer of an interest in trust all the property in which consists of a residence to be used as a personal residence by persons holding term interests in such trust." (182) While section 2702 generally destroyed the effectiveness of the GRIT, this exception gave rise to two variations, the PRT and QPRT, known also as "house GRITs." (183) The PRT, closely following the statutory language, is fairly restrictive in that the only asset it allows to be transferred into the trust is the personal residence of the grantor. (184) The QPRT allowed more flexibility as a trust instrument, but also integrated several limitations. (185)
The PRT and QPRT are irrevocable inter vivos trust instruments designed to reduce the gift and estate tax costs involved in transferring personal residences to family members. (186) A single personal residence, usually the grantor's home or vacation home, is transferred into trust with the grantor retaining the right to occupy the property for a term of years. (187) As long as the grantor survives this term, the property passes to the beneficiaries without inclusion in the grantor's gross estate. (188) Gift tax savings are realized by the reduction in the value of the beneficiary's present remainder interest--the gift amount--that comes from subtracting the value of the grantor's retained possession interest from the fair market value of the property at the creation of the trust. (189) Additionally, because the gift amount is determined and taxed at the creation of the trust, any subsequent appreciation in the property's value is transferred tax free to the beneficiaries. (190)
Both a PRT and QPRT allow the grantor to deplete the estate coffers and continue living in the residence for the period of the term. (191) At the end of the term, however, should the grantor continue to occupy the residence, there is a risk that the residence may be included in the grantor's gross estate under section 2036(a), defeating the purpose of the trust altogether. (192) Should the grantor wish to remain in the residence after the term expires, an IRS sanctioned method of avoiding estate tax inclusion is to have the grantor lease the residence back from the beneficiary for an appraised fair market value. (193) Additionally, when the grantor makes rent payments it further decreases the grantor's estate transferring that wealth gift tax free to the beneficiaries. (194)
The differences between a PRT and QPRT are, first, that the PRT generally cannot hold cash. (195) A QPRT on the other hand, can hold enough cash for six months worth of maintenance and repair costs of the residence. (196) Second, comprising the only real advantage of using a PRT over a QPRT, the PRT does not expressly prohibit commutation of the term and remainder interests. (197) Third, while both the PRT and QPRT prohibit the grantor (or the grantor's spouse, or any entity controlled by either of them) from buying back the property at any time during the term, the QPRT, unlike the PRT, allows for the sale of the residence during the trust term. (198) The proceeds from this sale can be held in the trust for up to two years or until the expiration of the trust term if within that two years, or may be used to purchase a different qualifying residence. (199) Fourth, if the property ever ceases to be used as a personal residence, the trust may be terminated with the trust property distributed to the grantor, and in a QPRT--but not a PRT--the trust may be automatically converted to a GRAT. (200) Lastly, because a QPRT can hold income producing assets, the grantor "must receive all trust income and the trust must prohibit any distributions to anyone else." (201)
5. ILIT: Irrevocable Life Insurance Trust
An ILIT is an inter vivos irrevocable trust that holds policies of life insurance on the grantor (202). The ILIT is designed to remove insurance proceeds--the death benefits--from the grantor's estate. (203) This is no easy feat given the broad reach of section 2042. (204) This section will include in the grantor's gross estate insurance proceeds of any insurance over which the grantor "possessed at his death any of the incidents of ownership." (205) Among the "incidents of ownership" are "any ability to deal with the insurance policy, designate beneficiaries, borrow, select payment options and so forth." (206) This generally means the grantor should not act as trustee for the ILIT, the grantor "should not be a beneficiary, he [or she] should not hold even a limited power of appointment." (207) Because ILITs are frequently needed to "provide liquidity to pay estate taxes and estate administration expenses[,]" the trustee of the ILIT may be authorized to buy assets from the grantor's estate in probate and make loans to the estate. (208) The trust instrument must not obligate the trustee to do so, because that would put the trust at risk for estate tax inclusion. (209)
An ILIT may be funded, meaning it contains income-producing assets apart from the life insurance policies, or it may be unfunded, meaning it generally contains only the insurance policy. (210) When unfunded, there are practically no income tax implications for the trust. (211) When a trust is funded, however, trust income may be taxed to the grantor. (212)
Usually, ILITs are drafted as grantor trusts. (213) However, certain powers that would initiate grantor trust status in other grantor trusts may raise risks of estate tax inclusion. (214) The drafter should carefully shield the grantor from any incidence of ownership in the insurance policy. (215) Also, grantor trust status may be initiated simply by using trust income or principal to pay insurance premiums. (216)
An ILIT can better avoid estate tax inclusion if the trust purchases the life insurance policy from the beginning, ensuring the insured will possess no incidence of ownership. (217) However, a grantor can transfer an existing life insurance policy to an ILIT. (218) For gift tax purposes, this constitutes a gift, the value of which is the current replacement cost of the transferred policy. (219) The grantor would also make completed gifts to the trust should assets be transferred to the trust for the purpose of purchasing new insurance policies, or paying premiums on existing policies. (220) These gifts count toward the grantor's lifetime exemption, or could come out of the beneficiaries' annual exclusion amounts, depending on how the trust is drafted. (221)
Taking advantage of the annual gift tax exclusion is accomplished with the inclusion of Crummey withdrawal powers, a doctrine derived from Crummey v. Commissioner of Internal Revenue. (222) Normally, a gift to a trust is considered a future interest because the beneficiaries of the trust do not benefit immediately, but will benefit in the future. (223) Future interests do not qualify for the annual gift tax exclusion, because the Code only allows present interests to qualify. (224) Without a device to make gifts to the trust present interests, the gifts will all come out of the donor's lifetime gift tax exemption. (225) When the gift tax and estate tax were de-unified between 2001 and 2009, it became increasingly important for estate planners to find ways to take advantage of the annual gift tax exclusion. (226) This brought about a proliferation of the inclusion of Crummey powers in trust instruments. (227)
Crummey powers operate by granting trust beneficiaries the ability to make withdrawals, for a limited time--usually thirty days--of any contributions to the trust. (228) As long as notice of the withdrawal power is properly provided to the beneficiaries, any contributions count toward the beneficiaries' annual exclusion. (229) The risk in using Crummey powers is that a beneficiary could actually exercise the power to make a withdrawal. (230) This could deplete the trust of funds needed to pay premiums. (231) There also may be gift tax consequences for the beneficiaries if the value of the assets that the withdrawal powers allow exceed the greater of "(1) $5,000, or (2) [five] percent of the of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied." (232) The solution to this problem lies in the "hanging Crummey power" that allows the beneficiary to withdrawal only so much of the contribution so that it falls within the $5,000, or five percent threshold. (233) The power to withdraw anything in "excess of that limit remains open and exercisable until its lapse does not constitute a gift by the beneficiary under I.R.C. section 2514(e)." (234)
In addition to estate, income, and gift tax considerations, ILITs might be subject to Generation Skipping Transfer ("GST") taxes. (235) Unlike all of the previously discussed grantor retained interest trusts, ILITs do not necessarily terminate at the death of the grantor, which allows assets in the trust to benefit future generations (i.e. grandchildren). (236) This makes ILITs a particularly attractive option in states like South Dakota where the absence of a RAP would allow the trust to be set up as dynasty trust. (237) Should one wish to set up an ILIT to benefit "skip persons," the grantor would need to decide whether to use part of the GST exemption toward trust contributions to avoid GST taxes. (238)
6. IDGT: Intentionally Defective Grantor Trust
An IDGT is an irrevocable trust designed to remove assets from the grantor's gross estate but is "defective" for income tax purposes in order to take advantage of the discrepancies in income and estate taxation. (239) One very simple form of IDGT takes advantage of the annual gift tax exclusion. (240) In this form of IDGT, the grantor transfers assets into the trust up to the value of the annual exclusion amount for each intended beneficiary. (241) The beneficiaries are given a present interest in the gift, possibly through the use of a Crummey power, which makes the gift applicable to the annual exclusion. (242) More often, however, grantors sell income producing assets to an IDGT in exchange for a promissory note at the applicable federal interest rate. (243)
With this form of IDGT, a grantor should transfer seed money or assets into the trust to act as security for the future purchase. (244) These assets should be worth at least ten percent of the value of assets to be purchased, and the initial transfer counts as a gift for gift tax purposes. (245) The grantor then sells assets to the trust in exchange for a promissory note for the full value of the property plus interest. (246) The interest rate should equal the section 7872 applicable federal rate, which is lower than the section 7520 rate that applies to GRATs, making an IDGT potentially more profitable than a GRAT. (247)
Because the IDGT is set up as a grantor trust, the grantor is taxed on trust income. (248) For income tax purposes, however, the sale is not taxed because the grantor is treated as having made a sale to himself or herself. (249) This is the main advantage of the IDGT; its ability to freeze the value of assets sold to the trust. (250) When an asset is sold to the trust, it is treated as a completed sale and therefore will not be included in the grantor's gross estate for estate and GST tax purposes. (251) After the sale, the trust holds title to the appreciating property for estate and gift tax purposes, and the grantor holds a note for the fixed value of the sale price. (252) The estate tax value of the asset is frozen, and any appreciation that occurs after the sale passes without further transfer taxes to the beneficiaries. Like the 1LIT, an IDGT is another great candidate for a dynasty trust making it particularly useful for South Dakota estate planners. (254) Because of its versatility, the IDGT has become an indispensable estate planning tool. (255)
Several competing interests have weighed in on the future viability of grantor trusts. (256) Some legal scholars argue that grantor trusts have overstayed their welcome; those scholars call for reform. (257) In addition, certain governmental interests would seek to curtail some of the revenue lost to grantor trusts and dynasty trusts. (258) Taxpayers and estate planners have a stake in the future of grantor trusts too, in the continued availability of grantor trusts for estate planning. (259)
A. SCHOLARLY OPPOSITION
Starting even before the enactment of the grantor trust rules in 1954, some commentators have called for reforms to grantor trust treatment. (260) Advocates for change argue that (1) the discrepancies between income taxation and estate and gift taxation cause confusion and promote the inefficiency of these tax systems, (2) the grantor trust rules have been rendered obsolete by subsequent legislation, and (3) the unscrupulous rich and their estate planners bilk the government out of huge sums of money using tax avoidance stratagem. (261) These opponents of grantor trusts herald reform or even repeal of the grantor trust rules as the only viable solutions to the problems identified. (262)
The discrepancy between the income taxation system and the estate and gift taxation system lies in the two systems' differing definitions of "control." (263) The courts have determined that the governing sections of code for the income tax system will not be construed as being the same as the definitions in the estate and gift system. (264) The result is that a grantor can retain just enough control so that the trust gains grantor trust status--an incomplete gift for income tax purposes--but relinquishes all control of the property for the trust to be a complete gift for estate and gift tax purposes, thereby avoiding inclusion in the grantor's gross estate. (265) This dichotomy is what gives grantor trusts the capability to shift wealth while reducing the tax burden. (266)
Subsequent legislation has changed the meaning and original purpose of the grantor trust rules. (267) Initially the grantor trust rules were aimed at "preventing] high-bracket taxpayers, during their lifetimes, from avoiding the progressive-rate structure of the federal income tax simply by creating and funding trusts." (268) But taxpayers and their estate planners have been using the shelter of the grantor trust rules to do this very thing. (269) According to at least one commentator, the grantor trust rules have now been rendered obsolete by: the enactment of the joint return; the kiddie tax; lower overall rates; low capital gains and qualified dividends rates; bracket compression under section 1(e); and consolidation of multiple trusts. (270) Additionally, with the estate and gift tax exemptions at an all-time high for 2012, and with estate tax portability in place, it would be possible to transfer $10.24 million tax-free in 2012. (271) For families with less than $10 million in assets, complex estate planning strategies are no longer necessary and simple outright gifts may be more attractive. (272) These high exemptions reduce the number of taxpayers that would need to employ grantor trusts. (273)
The most vehement argument by those seeking change is in the government's lost tax revenue caused by use of grantor trusts. (274) Classifying the grantor trust rules as swords or shields, these commentators vilify "those wealthy enough to create lifetime trusts" for using the trusts to avoid taxes. (275) Accordingly, it is antithetical to Congressional intent to allow taxpayers and estate planners to intentionally "flunk" the grantor trust rules for tax savings. (276) The tax dollars lost to grantor trusts is depicted as "low-hanging fruit" that, through grantor trust reform, easily may be gleaned for the government's benefit. (277)
Proposals on what shape that reform should take are varied. (278) One approach would be to repeal the grantor trust rules altogether. (279) Another plan is to repeal all but sections 676 and 679 of the grantor trust rules, allowing only revocable trusts' and foreign trusts' income to be taxed to the grantor. (280) A third suggestion, proffered by Professor Soled, is to reform the grantor trust rules so that grantor trust status applies only:
(1) when the terms of the trust require payments of trust property to the grantor or grantor's spouse or (2) when payments of trust property can be made currently to the grantor or the grantor's spouse under a discretionary, revocation, or amendment power exercisable by the grantor or the grantor's spouse, whether acting alone or in conjunction with any other person. (281)
This approach would allow continued use of GRITs, GRATs, and GRUTs, revocable trusts, and certain QPRTs, among others. (282) Another strategy, which has been deemed "harmonization," would be to coordinate the estate, gift, and income tax provisions. (283) These suggestions number just a few of the multitude of ideas for how the transfer tax system may be improved. (284) However, should the advocates for change get the reform they demand, the South Dakota trust industry could change dramatically. (285)
B. Potentially Detrimental Legislative Proposals
Governmental interests have caught wind of the calls for reform and proposals have started to percolate in the legislative realm. (286) One proposal would impose a minimum ten-year term on new GRATs while establishing a maximum term of "the life expectancy of the annuitant plus ten years." (287) The proposal would also require "the remainder interest [to] have a value greater than zero at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term." (288) The proposal is supposed to limit transfer tax savings, creating "some downside risk in the use of this technique" by increasing the chance the grantor will not survive the GRAT term and therefore owe estate taxes. (289) The maximum term would have little effect on those considering a GRAT for their estate planning needs; however, the minimum term would put an end to the short-term GRAT. (290)
A second proposal would place a federal limit on the duration of the GST tax exemption, in essence imposing constructive RAP. (291) In a state like South Dakota that currently allows dynasty trusts, taxpayers can allocate their GST exemption to transfers to a trust and effectively avoid transfer tax on any appreciation or income the trust generates. (292) This makes South Dakota a very attractive situs for trusts. (293) The proposal would effectively "do away with dynasty trusts." (294) It would terminate any allocated GST exclusion on the ninetieth anniversary of the creation of the trust starting with the first contribution to the trust. (295) In essence, a trust that could last longer than ninety years would have to pay GST tax on everything left in the trust--corpus, income, and appreciation--on the ninetieth anniversary of the creation of the trust. While this proposal would only apply to grantor trusts that have been set up as dynasty trusts, it has the effect of limiting those trusts to ninety years, defeating the purpose of the perpetuity in a dynasty trust. (297)
The final proposal, presented for the first time in the Department of the Treasury's 2013 Greenbook, is titled "Coordinate Certain Income and Transfer Tax Rules Applicable to Grantor Trusts." (298) The proposal plans to put an end to certain versatile grantor trust planning opportunities. (299) It states:
To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would (1) include the assets of that trust in the gross estate of that grantor for estate tax purposes, (2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor's life, and (3) subject to gift tax the remaining trust assets at any time during the grantor's life if the grantor ceases to be treated as an owner of the trust for income tax purposes. (300)
It goes on to state that it would not "change the treatment of any trust that is already includable in the grantor's gross estate under existing provisions of the Internal Revenue Code...." (301) It expressly indicates the treatment would not change for GRITs, GRATs, PRTs, and QPRTs, but implicitly would include the GRUT as well. (302) The proposal would affect trusts created on or after its enactment as well as any portion of an existing trust contributed after enactment. (303) Because ILITs and IDGTs are designed to avoid inclusion in the grantor's gross estate, these types of trusts would be covered by the proposal and would be added to the assets in the grantor's gross estate. (304) Alternatively, these assets would be subjected to gift tax if they are distributed to a beneficiary while the grantor is still alive. (305) The proposal is also meant to catch any toggling of grantor trust status by gift taxing the trust if the grantor turns off the grantor trust power. (306) ILITs and IDGTs would no longer enable gift or estate tax savings, destroying their effectiveness. (307)
C. A Plan For South Dakota
Proponents of the status quo take a more optimistic view of the usefulness of grantor trusts. (308) The key benefactors to the current situation--those wealthy enough to create lifetime trusts--enjoy the tax savings they realize through grantor trust planning. (309) Their estate planners and trustees--the lawyers, bankers, and accountants--that set up and administer these trusts, stand to gain from their continued existence as well. (310) But they recognize the uncertainty that lies ahead for grantor trusts. (311)
Admonitions to take advantage of current high exemptions, before they disappear, are rife in the estate planning media. (312) If the exemption comes down and the rates go up, it most likely would have a negative impact for taxpayers, but it could bring more trust business to South Dakota. (313) Higher estate and gift taxes with lower exemptions could instigate more estate planning using trusts, particularly IDGTs that allow grantor's to freeze estate values, and ILITs to remove insurance policies from the grantor's estate. (314) By encouraging a tax plan that raises estate and gift taxes while decreasing the exemptions, the South Dakota trust industry could benefit. (315)
It is unlikely that Congress will enact the sweeping changes proposed by those demanding repeal of the grantor trust rules any time soon. (316) This is particularly true in light of the fact that Congress has repeatedly refused to enact less invasive changes to the transfer tax system; (317) however, the three proposals described above would damage South Dakota's trust industry. (318) The ten-year GRAT term would increase the risk that grantors might die before the expiration of the GRAT term, which would cause the assets to be included in the grantor's estate. (319) This would put an end to short term GRATs for estate planning, and as forecasted by some commentators could generate $4.45 billion over the next ten years. (320) But, this revenue would come at the expense of an effective estate planning technique, and limiting the estate planner's toolbox would hurt the South Dakota trust industry. (321)
Additionally, the GST exemption limit has been suggested as means of arresting the "dynasty trust problem." (322) However, this would artificially impose a sort of RAP, an archaic doctrine that South Dakota repealed in 1983. (323) South Dakota's lack of the RAP is a major reason trust clients decide to situs their trusts in the state. (324) This proposal would "wreak havoc" on dynastic planning, but imposing a Federal limit on the GST exemption duration would level the playing field for states that still have a RAP and would "drive more focus on some of the administrative trust benefits," like directed trust provisions and state income tax. (325)
Finally, estate inclusion for ILITs and IDGTs would have a detrimental effect on the whole of the estate planning world, not just in South Dakota. (326) The ILIT and IDGT are the most widely used of the grantor trusts. (327) Estate planning would "lose a lot" if these tools were no longer available. (328) In South Dakota, with many of the large estates being farms or businesses, ending the ILIT would have a devastating effect. (329) Farm and business owners are typically cash poor, and many devisees cannot come up with the money to pay estate taxes on the assets they inherit. (330) Farm and business owners often rely on life insurance death benefits to help pay these taxes, so the ILIT is a crucial planning tool to save them from paying even more estate tax on the death benefits they receive. (331)
By knowing how grantor trusts work, and helping clients plan using them, South Dakota can remain one of the best places to set up a trust. Because of its lack of the RAP, no income tax, and favorable trust planning statutes, South Dakota has offered trustors a tantalizing combination of benefits. South Dakota's trust industry is flourishing, but with the specter of reform looming, recent legislative proposals could dramatically alter the estate planning landscape. Governmental interests seek to increase tax revenues by imposing a ten year minimum GRAT term, a ninety year GST exemption limit, and including the assets in an ILIT or IDGT in the grantor's estate, and other commentators call for more stringent reforms, but these proposals would stymie grantor trust planning. Without grantor trusts, wealthy clients would have less incentive to situs in South Dakota, and South Dakota farmers and business owners would lose an estate planning tool valuable in protecting their assets from estate taxes. South Dakota estate planners should oppose these reforms and promote the continued availability of grantor trusts for use in estate planning.
(1.) See generally John G. Steinkamp, Decoding Estate Planning: A Review of Frequently Used Acronyms, 2001 Ark. L. Notes 73 (2001). A Grantor Retained Income Trust ("GRIT"), a Grantor Retained Annuity Trust ("GRAT"), and a Grantor Retained Unitrust ("GRUT") are closely related irrevocable inter vivos trust instruments that perform in significantly similar ways but with some distinct differences. David W. Olsen, So ... What's For Breakfast: GRITS. GRATS Or GRUTS?, 7 J. SUFFOLK ACAD. L. 49 (1990-91). A Qualified Personal Residence Trust ("QPRT") and its parent, a Personal Residence Trust ("PRT"), are variations of a GRIT--a QPRT is usually, primarily funded with one's home, whereas a PRT closely follows the statutory language of Section 2702(a)(3)(A)(ii), which allows only the residence as an asset. Steinkamp, supra, at 81; I.R.C. [section] 2702(a)(3)(A)(ii) (2011). An
(2.) Black's Law Dictionary 1516 (7th ed. 1999).
(3.) John B. Fluffaker & Edward Kessel, How the Disconnect Between the Income and Estate Tax Rules Created Planning for Grantor Trusts, 100 J. Tax'n 206, 206-07 (April 2004). See also Jay A. Soled, Reforming the Grantor Trust Rules, 76 Notre Dame L. Rev. 375, 378-79 (2001).
(4.) Compare Mark L. Ascher, The Grantor Trust Rules Should Be Repealed, 96 Iowa L. Rev. 885 (2011) (asserting that the grantor trust rules have been made obsolete by subsequent legislation), and Daniel L. Ricks, I Dig It, But Congress Shouldn't Let Me: Closing the IDGT Loophole, 36 ACTEC L.J. 641 (2010) (suggesting reform to end IDGT planning), with Poker, supra note 1 (describing the benefits of IDGTs and GRATs and methods of drafting these trusts to avoid litigation), and George A. Dasaro, Tax Planning Strategies for Estate and Gift Taxes, 87 Prac. Tax Strategies 213 (2011) (suggesting the use of grantor trusts as effective estate planning strategy).
(5.) See Fluffaker & Kessel, supra note 3, at 209.
(6.) John L. Peschel & Edward D. Spurgeon, Federal Taxation of Trusts, Grantors and BENEFICIARIES [paragraph][paragraph] 4.01 , 4.01[a] (3d ed. 1998 & Supp. 2012). This is beneficial because in 2012, a trust was taxed at the maximum rate of 35% on all income in excess of $11,650, while the grantor would not reach the maximum rate until his income was in excess of $388,350. See Rev. Proc. 2011-52, 2011-45 I.R.B. 701.
(7.) See Scott Martin, Alaska, Delaware, Nevada, South Dakota Remain Top Trust States, The Trust Advisor (Feb. 5, 2011), http://thetrustadvisor.com/news/states2011.
(8.) See Soled, supra note 3, at 397-98. In 1986, new tax laws compressed the marginal tax rate schedule for trusts, while lowering the rates for individuals. Id. at 398. This meant that an individual would typicially pay less in income tax than a trust would pay. Id.
(9.) See, eg., Ascher, supra note 4; Ricks, supra note 4; Soled, supra note 3.
(10.) See generally Dep't. of the Treasury, General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals 75-84 (2012), available at http://www.treasury.gov/resource- center/taxpolicy/Documents/General-Explanations-FY2013.pdf (explaining the administration's revenue proposals for 2013) [hereinafter Greenbook].
(11.) See infra Part III.C.
(12.) See infra Part II. A.
(13.) See infra Part II.B.
(14.) See infra Parts Il.C-D.
(15.) See infra Part III.
(16.) See, e.g., Kristen McNamara, States Want Your Trust, The Wall Street Journal (June 14, 2010), http://online.wsj.com/article/SB20001424052748703315404575250182089881138.html; Martin, supra note 7; Michael J. Meyers & Rollyn H. Samp, South Dakota Trust Amendments and Economic Development: The Tort of "Negligent Trust Situs" At Its Incipient Stage, 44 S.D.L. REV. 662 (1998-99).
(17.) See generally GEORGE Gleason Bogert et al., Bogert's Trusts And Trustees [section] 214, at 227 n.28 (2007) (discussing the states' history of the RAP). John Chipman Gray described the RAP by saying "[n]o interest is good unless it must vest if at all not later than [twenty-one] years after some life in being at the creation of the interest." Id. [section] 213 (quoting Restatement (Second) OF PROP.: Donative Transfers ch. 1, intro, note (1983)).
(18.) See Note, Dynasty Trusts and the Rule Against Perpetuities, 116 Harv. L. Rev. 2588 at 260305 (2003).
(19.) McNamara, supra note 16.
(20.) See id.
(22.) Why South Dakota?, SOUTH Dakota TRUST COMPANY LLC, http://www.sdtrustco.com/About -South-Dakota-Trust-Company/Why-South-Dakota-.aspx (last visited Oct. 31,2012).
(23.) See Christopher M. Reimer, The Undiscovered Country: Wyoming's Emergence as a Leading Trust Situs Jurisdiction, 11 WYO. L. REV. 165, 176 (2011).
(25.) Cf. Thomas E. Simmons, Decanting and its Alternatives: Remodeling and Revamping Irrevocable Trusts, 55 S.D. L. REV. 253 (2010) (describing the "surprising" ease by which irrevocable trusts may be modified in South Dakota).
(26.) Id. at 254. See also S.D.C.L [section][section] 55-2-15 to 21 (2012).
(27.) See Simmons, supra note 25, at 254.
(28.) Id. at 255.
(29.) See id. at 266-70.
(30.) See id.
(31.) Id. at 254.
(32.) Telephone Interview with Heath R. Oberloh, Partner, Lindquist & Vennum (Sept. 21, 2012). See also S.D.C.L. [section][section] 55-1B-1 to 5 (2004 & Supp).
(33.) Mary Clarke & Diana S.C. Zeydel, Directed Trusts: The Statutory Approaches to Authority and Liability, EST. PLAN., Sept. 2008, at 13, 14.
(34.) See id. at 14, 16.
(35.) Id. at 14.
(37.) See id. at 20-21 (listing applicable sections of the South Dakota Codified Laws).
(38.) Telephone Interview with Heath R. Oberloh, supra note 32.
(39.) Jerry Cooper, Are Directed Trusts Too Good to Be True?, THE TRUST ADVISOR (Feb. 5, 2010), http://thetrustadvisor.com/news/directedtrusts ("[T]rustees are held more-or-less blameless for anything that goes wrong in an area the trust grantor explicitly assigned someone else to handle."). See also, S.D.C.L. [section][section] 55-1 B-l to 5 (2004 & Supp).
(40.) Cooper, supra note 39.
(41.) Why South Dakota?, supra note 22.
(42.) Id. (citing Mark Merric, Francis Becker & Pierce McDowell, Where Should You Situs Your Trust? A Look at South Dakota's New Third Party Discretionary Support Statute, STEVE LEIMBERG'S Asset Protection Planning Email Newsletter - archive Message #104 (May 10, 2007), http://intemationalcounselor.com/Merric%20Law%20-%20Documents/thirdpartytrustsl.pdf).
(43.) See S.D.C.L. [section] 55-1-43 (2012) (discretionary interests); S.D.C.L. [section] 55-1-26 (2012) (power of appointment); S.D.C.L. [section] 55-1-27 (2012) (remainder interests not certain by the language of the trust to be distributed within one year are not property interests).
(44.) Merric, et. al., supra note 42, at 4. See also S.D.C.L. [section] 55-1-25, 26, 43 (2012) (codifying South Dakota's third party beneficiary statutory scheme). This statutory scheme is essentially a codification of the Restatement (Second) of Trusts "which basically provides that until the assets are actually distributed, a creditor cannot force those assets out." Telephone Interview with Heath R. Oberloh, supra note 32. "One of the things that has come out of the Uniform Trust Code and the Restatement (Third) [of Trusts], is giving more power to the beneficiary to force the trustee to make a distribution .... [T]hat means the creditor can likewise step into the beneficiary's shoes and also enforce that distribution . . . ." Id.
(45.) Why South Dakota?, supra note 22. Asset protection for self settled trusts is covered in Chapter 55-16 of the South Dakota Codified Laws. S.D.C.L. [section] 55-16-1 to 16 (2012).
(46.) See Meyers & Samp, supra note 16, at 664 (quoting State of South Dakota Office of the Governor Exec. Order 97-10, Aug. 11, 1997, at 1, preamble).
(47.) Soled, supra note 3, at 378 (citing Revenue Act of 1916, Pub. L. No. 64-271, [section] 2(a)-(b), 39 Stat. 756, 757-58, repealed by Revenue Act of 1921, ch. 136, [section] 1400, 42 Stat. 227, 320-21).
(48.) 281 U.S. Ill (1930). The assignment of income doctrine states that income will be taxed to whomever earned it. See Soled, supra note 3, at 3 80-81.
(49.) Soled, supra note 3, at 381 n.31 (explaining that gift tax rates were lower than estate tax rates at the time which created an environment conducive to "inter vivos transfers rather than testamentary bequests").
(50.) See id. at 381.
(51.) 281 U.S. 376 (1930).
(52.) Id. at 377.
(53.) 281 U.S. at 377-78.
(54.) Id. at 378.
(55.) Soled, supra note 3, at 382. When assets were transferred into the trust, title to those assets went to the trust. See id. The trust owned the assets; however, the court found that because the man retained such substantial control over the assets, he should be treated as owning them for income tax purposes. Corliss, 281 U.S. at 378.
(56.) 289 U.S. 670 (1933).
(57.) See id. at 673-75.
(58.) Burnet, 289 U.S. at 674.
(59.) Id. at 680-81.
(60.) Id. at 680-82. Accord Soled, supra note 3, at 383.
(61.) 309 US. 331 (1940).
(62.) Id. at 332.
(64.) Id. at 332-33.
(65.) Id. at 335-38.
(66.) Id. at 336-38.
(67.) Huffaker & Kessel, supra note 3, at 207.
(68.) Id. See also, Soled, supra note 3, at 386-87.
(69.) Soled, supra note 3, at 386 (citing Treas. Reg. [section] 29.22(a) (as amended in 1947)).
(70.) Id. (citing Treas. Reg. [section] 29.21(b) (as amended in 1947)).
(71.) Id. at 386 (citing Treas. Reg. [section] 29.21(a) (as amended in 1947)).
(72.) See id. at 387-88.
(73.) Internal Revenue Code of 1954, [section][section] 671-678, 68A Stat. 3, 226-32 (current version at I.R.C. [section][section] 671-678(2006)).
(74.) Soled, supra note 3, at 388.
(75.) See id. (quoting Treas. Reg. [section] 1.671-2(b) (as amended in 2000)).
(76.) PESCHEL & SPURGEON, supra note 6, [paragraph][paragraph] 4.01  - 4.01 [a] (3d ed. 1998 & Supp. 2012).
(77.) Howard M. Zaritsky, How the New Law Affects Income Taxation of Trusts and Children Under 14, Est. PLAN., Jan.-Feb. 1987, at 4.
(78.) PESCHEL & SPURGEON, supra note 6, [paragraph] 4.01 [a] (quoting I.R.C [section] 673(a) (1954) and I.R.C. [section] 673(a) (as amended in 1986)).
(79.) Zaritsky, supra note 77, at 4.
(80.) BOGERT'S, supra note 17, [section] 268.15 at 174 (2012).
(81.) See Zaritsky, supra note 77, at 4.
(82.) Soled, supra note 3, at 397. See also supra note 8 (explaining the income tax inversion). The inverted tax rates made a proliferation of GRITs possible. See infra Part II.D. 1.
(83.) Soled, supra note 3, at 397.
(85.) Huffaker & Kessel, supra note 3, at 209.
(86.) See Jeffrey S. Kinsler, Taxation Without Explanation: The Federal Gift Tax, 2 APPALACHIAN J. L. 15, 18 (2003).
(87.) Darien B. Jacobson, Brian G. Raub, and Barry W. Johnson, The Estate Tax: Ninety Years and Counting, INTERNAL REVENUE SERVICE, STATISTICS OF INCOME BULLETIN , Summer 2007, at 122 fig.D, available at http://www.irs.gov/pub/irs-soi/ninetyestate.pdf.
(89.) Id. at 123. The marginal rates would have started at 39% up to 55% in 2006 with 5% surtax on estates between $10 million and $17,184 million. Vicent A. Liberti Jr., Using Trusts in Today's Estate Planning Climate, ASPATORE, July 2012, at 1, 4.
(90.) Jacobson et al., supra note 87, at 123-24.
(91.) Id. at 122, 124 figs. D., E.
(92.) See id. at 124 fig.E.
(93.) Id. at 124.
(94.) Michael G. Stevens, IRS Issues Carryover Basis Guidance for 2010 Estates, EST. PLAN., Oct. 2011, at 10; Liberti, supra note 89, at 3.
(95.) Liberti, supra note 89, at 4.
(96.) See Huffaker & Kessel, supra note 3, at 209.
(97.) See id.
(98.) See infra Part I.D. (describing gift tax consequences of certain grantor trusts.)
(99.) Cf. Dasaro, supra note 4, at 215-16 (noting the importance of planning with the high exemption in mind). But see infra notes 274-76 and accompanying text (questioning the need for grantor trusts given the high exemption amounts in 2012).
(100.) Soled, supra note 3, at 389.
(101.) I.R.C. [section] 671 (2006).
(102.) I.R.C. [section] 672 (2006).
(103.) Soled, supra note 3, at 389.
(104.) See supra notes 78-79 and accompanying text.
(105.) I.R.C. [section] 674 (2006).
(106.) Huffaker & Kessel, supra note 3, at 210 (citing I.R.C. [section] 675 (2006)).
(107.) I.R.C. [section] 676 (2006).
(108.) I.R.C. [section] 677 (2006). See also Soled, supra note 3, at 395 (summarizing Section 677).
(109.) I.R.C. [section] 678 (2006).
(110.) Soled, supra note 3, at 396 (citing I.R.C [section] 679 (1994 & Supp. IV 1998)).
(111.) Olsen, supra note 1, at 51.
(112.) Id. at 50.
(114.) Id.; Poker, supra note 1, at 27. This assumes that the grantor survives the term of the trust; if the grantor dies prior to the expiration of the trust, the income and corpus revert to the grantor's estate. Poker, supra note 1, at 29-30.
(115.) See Poker, supra note fat 29-30.
(116.) Mitchell M. Gans, GRIT'S, GRAT'S and GRUT'S: Planning and Policy, 11 Va. Tax Rev. 761, 763 (1992).
(118.) Id. at 791-92. See also Louis S. Harrison, The Effective Use of GRITs to Reduce the Gross Estate, THE Tax MAGAZINE, 523, 529 (July 1990), available at http://www.harrisonheld.com/library/ article%2030.pdf (explaining Congress's attempt to include GRITs in a class of estate-freeze transactions that Section 2036(c) was designed to limit by inclusion of family transfers in the transferor's gross estate).
(119.) Olsen, supra note 1, at 54. See also Harrison. Effective, supra note 118, at 530 (explaining how the "safe harbor" was created).
(120.) Jule E. Stocker Et Al., Stocker & Rikoon on Drawing Wills and Trusts [section] 5:10 (12th ed. 2009); Olsen, supra note 1, at 54.
(121.) See Olsen, supra note 1, at 54.
(122.) I.R.C. [section] 2702 (2006). Member of the family is defined in Section 2704(2) "with respect to any individual--(A) such individual's spouse, (B) any ancestor or lineal descendant of such individual or such individual's spouse, (C) any brother or sister of the individual, and (D) any spouse of any individual described in subparagraph (B) or (C)." I.R.C. [section] 2704(2) (1996).
(123.) Stocker Et Al., supra note 120, [section] 5:10.
(124.) Olsen, supra note 1, at 55-56. This meant that there was no longer any benefit to using a GRIT over an outright inter vivos gift. See supra notes 116-22 and accompanying text.
(125.) See Steinkamp, supra note 1, at 77.
(128.) I.R.C. [section] 2702(a)(2)(B) (2006).
(129.) I.R.C. [section] 2702(b)(1) (2006).
(130.) See STOCKER ET AL., supra note 120, [section] 5:11.
(131.) Poker, supra note 1, at 27.
(132.) STOCKER Et Al., supra note 120, [section] 5:11. The value of the annuity interest is calculated by applying the assumed growth rate from Section 7520. Id.
(133.) Steinkamp, supra note 1, at 77. The annual gift exclusion was put in place by Congress to "avoid having small or token gifts subject to gift tax." Jay A. Soled & Mitch el Gans. Sales to Grantor Trusts: A Case Study of What the IRS and Congress can do to Curb Aggressive Transfer Tax Techniques, 78 TENN.' L. REV. 973, 1006 (2011) (citing I.R.C. [section] 2503(b) (2006); H R. Rep. No. 72-708, at 29-30 (1932); S. Rep. No. 72-665, at 41 (1932)).
(134.) See Liberti, supra note 89, at 12.
(135.) Olsen, supra note 1, at 66.
(136.) Poker, supra note 1, at 27.
(137.) Id. at 28.
(138.) See Greenbook, supra note 10, at 81. This may change soon if current recommended legislation is passed. See infra Part III.B.
(139.) STOCKER ET Al., supra note 120, [section] 5:11.2. See infra notes 148-53 and accompanying text (discussion on the advantage of appreciation).
(140.) STOCKER ET AL., supra note 120, [section] 5:11.2. As discussed supra note 114, should the grantor die before the term of the GRAT, all or part of trust assets will be included in his estate. See id. [section] 5:11.2 (explaining recent treasury regulations clarifying the includible amount in the decedent's estate).
(141.) Poker, supra note 1, at 28.
(142.) Stocker ET AL., supra note 120, [section] 5:11.2.
(144.) Olsen, supra note 1, at 80-81.
(145.) Internal Revenue Service, http://www.irs.gov/Businesses/Small-Businesses-&-SelfEmployed/Section-7520- Interest- Rates (last updated Sept. 19, 2012); INTERNAL REVENUE SERVICE, http://www.irs. gov/Businesses/Small-Businesses-&-Self-Employed/Section-7520-Interest-Rates-forPrior-Years (last updated Aug. 3, 2012).
(146.) STOCKER Et AL., supra note 120, [section] 5:11; I.R.C. [section] 1274(d) (2006).
(147.) See Jan P. Myskowski, 7520 Rate Drop Creates Rare Opportunities for Lifetime Wealth Transfer Planning, Gallagher, Callahan & Gartrell PC (Jan. 2009), http://www.gcglaw.com/res ources/trusts/wealth_transfer.html.
(148.) See Stocker Et Al., supra note 120, [section] 5:11.
(149.) Contra id. See also Steinkamp, supra note 1, at 77.
(150.) Steinkamp, supra note 1, at 77.
(152.) See Stocker Et Al., supra note 120, [section] 5:11.
(155.) Michael D. Mulligan, The Reinvigorated GRAT: Is a Sale to a Defective Trust Still Superior?, Est. Plan., 379, 381 (Aug. 2002).
(156.) See Stocker Et Al., supra note 120, [section] 5:11.
(157.) See supra notes 138-44, and accompanying text.
(158.) See Greenbook, supra note 10, at 80.
(159.) See, e.g., Dasaro, supra note 4, at 220 & n.29 (stating that Rev. Proc. 2010-3,1.R.B. 2010-1, at section 4 (53) indicates the IRS's policy of not issuing a ruling if the annuity payment is greater than 50%, or the value of remainder interest is less than 10% of the initial trust assets); Stocker Et Al., supra note 120, [section] 5:11.2 (stating "the grantor may wish to consider a longer-term Grat" in light of new regulations).
(160.) Stocker Et Al., supra note 120, [section]5:11.2 (articulating additional technical requirements).
(161.) Poker, supra note 1, at 28.
(162.) Stocker Et Al., supra note 120, [section]5:11.2.
(163.) Dasaro, supra note 4, at 220.
(164.) I.R.C. [section] 2702(b)(2) (2006).
(165.) See Steinkamp, supra note 1, at 78.
(168.) Id. (citing I.R.C. [section] 2702(b)(2) (2006)).
(169.) See generally Gans, supra note 116, at 839-51 (describing the advantages and disadvantages of GRUTs).
(170.) Id. at 840.
(171.) Olsen, supra note 1, at 90.
(172.) John Jastremski, Grantor Retained Unitrust (GRUT), The Retirement Group, Benefits Blog (Thursday, July 27, 2011), http://trgcapital.blogspot.com/2011/04/grantor-retained-unitrustgrut.html. These costs can eat into any appreciation the GRUT enjoys. Id.
(173.) Olsen, supra note 1, at 81.
(174.) Louis S. Harrison, The Strategic Use of Lifetime Gifting Programs to Reduce Estate Taxes in Light of Recent Congressional and Internal Revenue Service Antipathy Towards Transfer Tax Reduction Devices, 40 DePaul L. Rev. 365, 371-72 (1991) (explaining the lack of gift tax savings a GRUT produces over an outright gift). This happens because any appreciation that the trust corpus generates is rolled into the fair market value for the next year, and the grantor's payment then includes a percentage of it. Id.
(175.) Harrison, Strategic, supra note 174, at 371 -72.
(176.) Id. at 372.
(177.) See generally Gans, supra note 116, at 839-51 (describing the advantages and disadvantages of GRUTs).
(178.) Id. at 843-44.
(179.) Id at 843 & n. 151. In a 2004 revenue ruling, and applicable for all grantor trusts, "the IRS reaffirmed that the payment by a grantor of tax on the trust income does not constitute a gift to the trust." Poker, supra note 1, at 16 (citing Rev. Rul. 2004-64, 2004-2 C.B. 7).
(180.) See Gans, supra note 116, at 844.
(181.) Peschel & Spurgeon, supra note 6, [paragraph]4.08(4][b][iii],
(182.) I.R.C. [section] 2702(a)(3)(A)(ii) (2006).
(183.) Peschel & Spurgeon, supra note 6, [paragraph] 4.08[d]; Steinkamp, supra note 1, at 81.
(184.) Peschel & Spurgeon, supra note 6, [paragraph] 4.08[d]; I.R.C. [section] 2702(a)(3)(A)(ii) (2006). Peschel and Spurgeon define the term "personal residence" for both a PRT and QPRT as the grantor's "(1) 'principal residence' and (2) 'one other residence' or an undivided fractional interest in either." Peschel & Spurgeon, supra note 6, [paragraph] 4.08[d] (quoting Treas. Reg. [section][section] 25.2702- 5(b)(2)(i), 25.27025(c)(2)(i) (as amended in 1997). This would also include "[a]purtenant structures and adjacent land not in excess of reasonable residential purposes ... but personal property such as household furnishings cannot be included." Id. (citing Treas. Reg. [section][section] 25.2702-5(b)(2)(ii), 25.2702-5(c)(2)(h) (as amended in 1997)). However, "[a] farm does not qualify." Id. at [paragraph] 4.08[d] n.261 (citing Treas. Reg. [section] 25.27025(d), Ex. (3) (as amended in 1997)).
(185.) Peschel & Spurgeon, supra note 6, H 4.08[d],
(186.) See generally John A. Bogdanski, Renting Mom Her House: Retained Interest and Estate of Riese, Est. Plan., June 2011, at 44 (explaining common use of QPRT).
(187.) Steinkamp, supra note 1, at 81; Olsen, supra note 1, at 63-64.
(188.) Steinkamp, supra note 1, at 81 (citing I.R.C. [section] 2036(a)(1) (2006)).
(189.) Dasaro, supra note 4, at 219. Three factors can increase the grantor's retained possession interest, thereby providing greater gift tax savings: a shorter grantor life expectancy, longer term, and higher Section 7520 rate. Id.
(190.) Bogdanski, supra note 186, at 45.
(191.) Steinkamp, supra note 1, at 81.
(192.) Bogdanski, supra note 186, at 45.
(193.) Id. (citing T.D. 8743, 1998-1 CB 543). This strategy received favorable treatment in the recent case of Estate of Riese v. Commissioner, T.C. Memo 2011-60 at 1-3 (2011), where a daughter and her lawyer convinced the eighty-year-old mother to set up a three year QPRT on her house for the benefit of her two daughters. Id. In the initial conversations, it was explained to the mother that she would be required to pay rent after the expiration of the term. Id. The term expired and the residence passed to the daughters, however, no arrangements were made for payment of rent, and no lease agreement was signed or discussed. Id. at 2-3. The daughter spoke with her lawyer who told her to make these arrangements before the end of the year, but the mother passed away in October of that year without ever having paid rent. Id. The tax court held that because there was no express or implied understanding that the mother would not have to pay rent at the end of the term, the fact that she had not paid rent after the expiration of the term would not force inclusion of the property in her estate under Section 2036(a). See id. at 5-6. See also Bogdanski, supra note 186, at 46.
(194.) David A. Holstein & Kim V. Heyman, Use of Grantor Trusts in Estate Planning, Green Seifter Attorneys, PPLC (Nov. 9, 2006 http://www.gslaw.com/resources/pdf/Use%20of%20Grantor %20Trusts%20in%20Estate%20Planning.pdf.
(195.) Nancy G. Henderson, QPRTs and PRTs: Planning Strategies for Transferring Family Homes, LexisNexis Communities, Tax Law Community (Aug. 12, 2010, 11:00 PM EST), http://www.lexisnexis.com/community/taxlaw/blogs/emergingissues/archive/2010/08/12/qprts-and-prtsplanning- strategies-for-transferring-family-homes.aspx. As an exception, a PRT can hold cash for certain "qualified proceeds" as from destruction by fire or casualty, or involuntary conversion. Id. Additionally, in both a PRT and QPRT, any of such proceeds must be "reinvested in a new personal residence within two years of the date of receipt." Id.
(196.) Stocker Et Al., supra note 120, [section] 5:10.
(197.) Henderson, supra note 195.
(198.) Stocker Et Al., supra note 120, [section] 5:10. The grantor, his spouse, or any entity controlled by either of them are also prohibited from buying back the property if the property is kept in a continuing trust that is a grantor trust after the term expires. See id. [section] 5:10 (citing Treas. Reg. [section] 25.2702-5(c)(9) (as amended in 1997)).
(199.) Id. at 5-83; Peschel & Spurgeon, supra note 6, [paragraph] 4.08[d] (citing Treas. Reg. [section][section] 25.2702-5(b)(7), 25.2702-5(b)(8) (as amended in 1997)).
(200.) Stocker Et Al., supra note 120, [section] 5:10.
(201.) Id. Income could come from rent on the property during the portion of the year it is not used by the grantor. Peschel & Spurgeon, supra note 6, [paragraph] 4.08[d] n.261 (citing Treas. Reg. [section][section] 25.27025(b)(2)(iii), 25.2702-5(c)(2)(iii) (as amended in 1997)). The trust must provide that these income distributions occur at least annually, and commutation of the distributions must be prohibited. Id. [paragraph] 4.08[d] n.263 (citing Treas. Reg. [section][section] 25.2702-5(c)(3), 25.2702-5(c)(6) (as amended in 1997)).
(202.) Steinkamp, supra note 1, at 78.
(204.) Stocker Et Al., supra note 120, [section] 5:7.
(205.) I.R.C. [section] 2042(2) (2006).
(206.) Stocker Et Al., supra note 120, [section] 5:7 (citing Treas. Reg. [section] 20.2042-l(c) (as amended in 1979)).
(208.) Steinkamp, supra note 1, at 78-79.
(210.) Id. at 79.
(211.) Peschel & Spurgeon, supra note 6, [paragraph] 14.03.
(212.) Steinkamp, supra note 1, at 79.
(214.) Stocker Et Al., supra note 120,85:7.
(217.) Steinkamp, supra note 1, at 79.
(218.) Id. For a policy that is transferred to an ILIT, because of [section] 2035, the transfer must occur three years prior to the grantor's death to avoid risking estate tax inclusion. I.R.C. [section] 2035(a) (2006). However, a policy may be sold to an ILIT to avoid the three-year rule. E-mail from Heath R. Oberloh, Partner, Lindquist & Vennum (Oct. 19, 2012, 08:15 CST) (on file with author).
(219.) Peschel & Spurgeon, supra note 6, [paragraph] 14.02[a],
(220.) Steinkamp, supra note 1, at 79.
(221.) See id. "Under this Code section, 'present interest gifts' are excluded from gift tax, and the donor need not file a gift tax return." Soled & Oans, supra note 133, at 1006 (citing I.R.C. [section] 6019 (2010)).
(222.) 397 F.2d 82 (9th Cir. 1968) (holding that a beneficiary's right to demand a some portion of trust assets transferred to the trust within the same year was a present interest in those assets rather than a future interest).
(223.) Liberti, supra note 89, at 8.
(224.) See Steinkamp, supra note 1, at 79.
(225.) See id.
(226.) Melvin A. Warshaw, Recent Trends Affecting Large Trust-Owned Life Insurance, Est. Plan., March 2012, at 2, 3-4.
(228.) Dasaro, supra note 4, at 222.
(229.) Id. According to Dasaro:
[a]ggressive taxpayers have strategized that a holder of a Crummey power does not have to be a vested beneficiary of the trust. With the cooperation of the taxpayer's relatives who receive a contingent remainder interest in the trust and lapsing Crummey powers, the donor may be able to exclude from gift tax several times the annual exclusion amount.
Id. (citing Estate of Cristofani v. Comm'r, 97 T.C. 74 (1991)).
(230.) See Steinkamp, supra note 1, at 79.
(232.) I.R.C. [section] 2514(e) (2006). Lapses in excess of $5,000 or five percent in a single calendar year are treated as transfers subject to gift tax. I.R.C. [section] 2514(e), (b) (2006).
(233.) Michael D. Mulligan, Fifteen Years of Sales to IDITs--Where Are We Now?, 35 ACTEC J. 227,248 (2009).
(235.) Steinkamp, supra note 1, at 79. The GST tax is "imposed on gifts and bequests to transferees who are two or more generations younger than the transferor." Green book, supra note 10, at 81. It is a "flat tax on the value of the transfer at the highest estate tax bracket applicable in that year. Id. Annual contributions to an ILIT that use the annual exclusion, however, may be subject to GST taxes. Jon J. Gallo, Estate Planning and the Generation-Skipping Tax, Real Prop., Prob. & Tr. J., 457, 505-06.
(236.) Grantor retained interest trusts including GRITs, GRATs, GRUTs, PRTs, and QPRTs are no longer grantor trusts at the death of the grantor. See supra Parts I.D. 1-4. See also Steinkamp, supra note 1, at 79 (describing gift tax considerations for generation skipping ILITs).
(237.) See generally Note, supra note 18 (explaining the benefits of the dynasty trust).
(238.) Steinkamp, supra note 1, at 79. A "skip person" is "a natural person assigned to a generation which is [two] or more generations below the generation assignment of the transferor," or a trust in which will not make a distribution to a non-skip person. I.R.C. [section] 2613(a) (2006).
(239.) Poker, supra notel, at 15. "Defective" in this sense simply means that the trust fails some portion of the grantor trust rules, causing the grantor to be taxed on the trust's income. Id.
(240.) Liberti, supra note 89, at 13.
(242.) Id. See discussion on Crummey powers supra notes 222-34, and accompanying text.
(243.) Liberti, supra note 89, at 13. The promissory note could be in the form of a Self-Canceling Installment Note ("SCIN") that would cancel any outstanding payments on the note in the event the grantor dies before the note term. Id. The term for a SCIN must be shorter than the grantor's actuarially determined life expectancy. Steinkamp, supra 1, at 83 (citing I.R.S. Gen. Couns. Mem. 39,503 (May 7, 1986)). Additionally, in exchange for the cancelation benefit of the SCIN, the note must include a higher interest rate, an increased purchase price, or both. Id. at 82-83.
(244.) Poker, supra note 1, at 15.
(245.) Id. Providing precidential treatment of the ten percent seed funding, Poker states:
The seed funds reduce the risk that the sale will be treated as a transfer with a retained interest by the grantor under section 2036. In PLR 9535026, the IRS required a contribution of 10 percent of the installment purchase price. In Petter v. Commissioner, 98 T.C.M. (CCH) 534 (2009), it was observed in a footnote that a 10 percent seed money gift is typically used.
Id. (italics added) (internal quotations omitted).
(246.) Id. at 18.
(248.) Poker, supra note 1, at 15. Poker recommends including provisions to toggle grantor trust status on and off to take advantage certain income tax savings that might be realized with low interest rates, or years with particularly high or low trust income. See id. at 26.
(249.) Id. at 16.
(250.) See id.
(252.) See id.
(253.) Cf. Soled & Gans, supra note 133, at 980-81 (describing this process in an example).
(254.) See infra notes 326-31 and accompanying text.
(255.) Id. See generally Poker, supra note 1 (discussing the benefits of IDGTs).
(256.) Compare Ascher, supra note 4, at 888 (asserting that the grantor trust rules have been made obsolete by subsequent legislation), and Ricks, supra note 4, at 641 (discussing the inadequacy of current law to deal with the IDGT loophole), with Poker, supra note 1, at 15 (describing the benefits of IDGTs and GRATs and methods of drafting these trusts to avoid litigation), and Dasaro, supra note 4, at 213 (suggesting the use of grantor trusts as effective estate planning strategy), with Greenbook, supra note 10, at 75-84 (outlining the administration's proposals to reform grantor trusts).
(257.) See infra Part III.A.
(258.) See infra Part III.B.
(259.) See infra Part III.C.
(260.) Ricks, supra note 4, at 658-59 (citing Erwin N. Griswold, A Plan for the Coordination of the Income, Estate, and Gift Tax Provisions with Respect to Trusts and other Transfers, 56 HARV. L. REV. 337, 342 (1942)).
(261.) Id. at 658; Ascher, supra note 4, at 888. Accord Soled, supra note 3, at 413.
(262.) See Ricks, supra note 4; Ascher, supra note 4; Soled supra note 3, at 413.
(263.) Soled, supra note 3, at 398-99 (citing I.R.C [section][section] 673-79 (2006 & Supp. IV 2010); I.R.C. [section][section] 2036-44 (2006)).
(264.) Id. (citing Farid-Es-Sultaneh v. Comm'r, 160 F.2d 812, 814 (2d Cir. 1947); Lockard v. Comm'r, 166 F.2d 409,412 (1st Cir. 1948)).
(265.) Id. at 399. Accord Ascher, supra note 4, at 905-06.
(266.) Liberti, supra note 89, at 3.
(267.) Soled, supra note 3, at 397.
(268.) Ascher, supra note 4, at 887 (citing S. Rep. No. 83-1622, at 86-87, 364-72 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 4718-19, 5005-13; H.R. Rep. No. 83-1337, at 63-64, app. at 211-17 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4089-90, 4350-57).
(269.) Soled, supra note 3, at 397.
(270.) Ascher, supra note 4. at 895-901. According to Ascher, the joint return lowered the tax burden for married couples which would have nullified the cause of action in Clifford. Id. at 896. The kiddie tax, which taxes the unearned income of certain youths at their parent's highest marginal rate, curtailed the incentive for transfers to inter vivos trusts for these youths. Id. at 896-97. The highest income tax marginal rate in 1954 was 91%; today that rate is 35% reducing the need for tax avoidance in the first place. Id. at 897-98. Because trusts' income investments frequently generate "net capital gain," and "qualified dividend income," the 1986 flat tax on capital gains and qualified dividends made shifting these investments less necessary. Id. at 898-99. The Section 1(e) compression of a trust's marginal rates taxes more of a non-grantor trust's income than the same assets in a grantor trust. Id. at 899-901. According to Ascher, this signals the obsolescence of the grantor trust rules. Id. at 869-901. But cf. Soled, supra note 3, at 401 ("Because non-grantor trust income is taxed under the compressed rate structure of Code [section] 1(e), ... it is a rare occasion when it does not make sense to secure grantor trust status.") (footnotes omitted). Lastly, when trusts are "largely identical" they are consolidated and taxed as one trust. Ascher, supra note 4, at 901.
(271.) Bertram L. Levy, Observations on Estate Planning in 2012, ASPATORE, July 2012, at 1, 1-2.
(274.) Cf. Ricks, supra note 4, at 642 ("[Cjracks in the tax law ... have allowed billions of dollars to escape the income tax and transfer tax bases."); Ascher, supra note 4, at 940 ("[T]axpayers and their advisors have ... laughed all the way to the bank....").
(275.) Ascher, supra note 4, at 888 ("The grantor trust rules have thus become swords...."). See also Soled, supra note 3, at 377 ("[T]axpayers use as a shield what was once a sword....").
(276.) Ascher, supra note 4, at 888.
(277.) Ricks, supra note 4, at 643.
(278.) Compare Ricks, supra note 4, at 662-64, with Ascher, supra note 4, at 930-36, and Soled, supra note 3, at 415.
(279.) Soled, supra note 3, at 413 (citing Joseph M. Dodge, Simplifying Models for the Income Taxation of Trusts and Estates, 14 AM. J. TAX POL'Y 127 (1997); Sherwin Kamin, A Proposal for the Income Taxation of Trusts and Estates, Their Grantors, and Their Beneficiaries, 13 AM. J. Tax POL'Y 215 (1996)).
(280.) Ascher, supra note 4, at 930-36.
(281.) Soled, supra note 3, at 415. Though, his proposal would require additional provisions to prevent "income shifting opportunities" that the change would expose. Id. at 416.
(282.) See supra Parts II.D.1-4; I.R.C. [section] 676 (2006) (explaining GRITs, GRATs, GRUTs, and funded QPRTs that require distribution of trust income to the grantor would all fall under (1) of Soled's proposal; revocable trusts would fall under (2)).
(283.) Griswold, supra note 260, at 340-41. Harmonization would make a gift complete in all three systems, therefore subjecting it to gift tax. Id. at 342. Alternatively, the gift would be incomplete in all three systems, thereby subjecting it to estate and income taxes. Id.
(284.) See Ricks, supra note 4, at 662-64; Ascher, supra note 4, at 930-36; and Soled, supra note 3, at 413-18 for more proposals.
(285.) See infra Part ULC.
(286.) See Soled & Gans, supra note 133, at 1011 (citing Permanent Estate Tax Relief Act of 2006, H.R. Res. 885, 109th Cong. (2006); Death Tax Repeal Permanency Act of 2005, H.R. Res. 202, 109th Cong. (2005)). See also Greenbook, supra note 10, at 75-84 (outlining the Administration's proposals for 2013).
(287.) Greenbook, supra note 10, at 80. This proposal was included in the Treasury Department revenue proposals for 2011 and 2012 as well, and, "was approved three times by the House of Representatives in 2010," but faltered in the Senate each time. Ronald D. Aucutt, Capital Letter No. 31, ACTEC (Feb. 27, 2012), http://www.actec.org/public/CapitalLetter31.asp.
(288.) Greenbook, supra note 10, at 80. While it would still be possible to create a GRAT in which the remainder interest approaches zero, this provision of the proposal would preclude truly "zeroed-out" GRATs. Cf. supra notes 154-59 and accompanying text (describing the use of "zeroed-out" GRATs).
(289.) Greenbook, supra note 10, at 80.
(290.) Levy, supra note 271, at 1.
(291.) Greenbook, supra note 10, at 81. This proposal was also included in the Treasury Department revenue proposals for 2011 and 2012. Aucutt, supra note 287. The proposal would only affect grantor trusts which can be set up as Dynasty trusts, including ILITs, and IDGTs. See supra, notes 235-38, 254 and accompanying text.
(292.) See Greenbook, supra note 10, at 81.
(293.) See supra notes 16-20 and accompanying text.
(294.) Deborah L. Jacobs, Obama Takes Aim at Rich Folks and Wealth Advisors, FORBES.COM (Feb. 14, 2012, 1:55 PM), http://www.forbes.eom/sites/deborahljacobs/2012/02/14/obama-declares-war-onrich-folks-and- wealth- advisors (explaining the impact of the Treasury Department proposals on the wealthy and their estate planners).
(295.) Greenbook, supra note 10, at 81. The proposal would, however, allow an exception that would permit:
an incapacitated beneficiary's distribution to continue to be held in trust without incurring GST tax on distributions to the beneficiary as long as that trust is to be used for the sole benefit of that beneficiary and any trust balance remaining on the beneficiary's death will be included in the beneficiary's gross estate for Federal estate tax purposes.
Id. at 82.
(296.) See id at 81-82.
(297.) See Jacobs, supra note 294.
(298.) Greenbook, supra note 10, at 83.
(302.) Id. A GRUT would include the trust property in the grantor's gross estate in the event the grantor did not survive the trust term in the same way that GRITs, GRATs, PRTs, and QPRTs do. Steinkamp, supra note 1, at 78. Thus, GRUTs presumably would fall into the category of trusts this proposal would not affect. See Greenbook, supra note 10, at 83.
(303.) Greenbook, supra note 10, at 83.
(304.) See supra Parts II.D.5-6; Greenbook, supra note 10, at 83.
(305.) Greenbook, supra note 10, at 83.
(306.) See id. See also supra note 248 and accompanying text.
(307.) See Jacobs, supra note 294.
(308.) See, e.g.. Levy, supra note 271 (describing estate planning opportunities for 2012).
(309.) See generally Jacobs, supra note 294.
(311.) Levy, supra note 271, at 1.
(312.) E.g., Liberti. supra note 89, at 10. Without Congressional intervention, TRUIRJCA and its $5.12 million exemption, and 35% top rate, expires at midnight December 31, 2012. See Greenbook, supra note 10, at 75. If that takes place, rates will revert to what they would have been had EGTRRA never been enacted. 55% and a $1 million exemption. Id.
(313.) Cf. Liberti, supra note 89, at 2. With more wealth being taxed, either as gift tax or estate tax, taxpayers may rely more heavily on the income shifting a grantor trust, in particular, provides. Id. In a trust friendly state like South Dakota, this increased reliance would mean more business for estate planners and South Dakota practitioners. See Reimer, supra note 23, at 166 (describing South Dakota as a trust friendly situs).
(314.) Telephone Interview with Heath R. Oberloh, supra note 32.
(315.) Id. But cf. Levy, supra note 271, at 1 (describing the effect of high exemptions by encouraging planning through outright gifts instead of trusts).
(316.) Cf. Andrew Taylor, House Heading Toward Election-Year Tax Showdown, BLOOMBERG BUSINESSWEEK (Aug. 01, 2012), http://www.businessweek.com/ap/2012-08-01/house-heading-towardelection-year-tax- showdown (describing the projected stalemate in Congress).
(317.) See Soled & Gans, supra note 133, at 1011 (asserting Congressional inaction due to lack of public support; "[a]lthough the transfer tax system remains an easy target for scorn and ridicule if it continues to be littered with loopholes and silly absurdities such as those described in the prior subsection, constituents are not interested in paying more taxes."). See also Small Business and Infrastructure Jobs Tax Act of 2010, H.R. 4849, 111th Cong. [section] 307 (2010) (proposing a ten year minimum GRAT term but the bill faltered in the Senate).
(318.) Cf. Jacobs, supra note 294 (describing the impending changes for estate planning).
(319.) See Greenbook, supra note 10, at 80.
(320.) But cf. Ashlea Ebeling, Goodbye GRATs?, FORBES.COM (Mar. 24, 2010, 11:17 AM EDT), http://www.forbes.com/2010/03/24/estate-gift-tax-house-jobs-bill-personal-fmance-obama-gratcrack down.html (asserting Congress' Joint Committee on Taxation believes this proposal could raise $4.45 billion over ten years).
(321.) Cf. Jacobs, supra note 294 (describing the proposals' "unfavorable results").
(322.) Soled & Gans, supra note 133, at 1009.
(323.) See Note, supra note 18, at 2603-05.
(324.) See Reimer, supra note 23, at 173-74.
(325.) See Jacobs, supra note 294; Telephone Interview with Heath R. Oberloh, supra note 32.
(326.) Cf. Jacobs, supra note 294 (explaining how the proposal would effectively end estate planning with ILITs and IDGTs).
(327.) Telephone Interview with Heath R. Oberloh, supra note 32. Mr. Oberloh stated that "the vast majority [of grantor trusts set up in South Dakota] are IDGTs." Id.
(329.) Id. See also Lee Lytton, "Save the Land From Unde Sam Using Life Insurance Premium Financing in Estate Planning, 2 EST. PLAN. & COMMUNITY PROP. L.J. 421,423 (2010) (describing the "devastating effect of the federal estate tax on American farms").
(330.) Lytton, supra note 329, at 423.
(331.) Telephone Interview with Heath R. Oberloh, supra note 32 ("The ILIT is a key component to many business owner and farm estate plans").
BEAU C. T. BARRETT ([dagger])
([dagger]) J.D. Candidate, 2014, University of South Dakota School of Law; B.A., 2006, University of Montana. The author would like to thank Professor Randall Gingiss and Heath R. Oberloh for their valuable input, Professor Allen Madison for his encouragement, and his wife, April, for her support.
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|Author:||Barrett, Beau C.T.|
|Publication:||South Dakota Law Review|
|Date:||Mar 22, 2013|
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