June 15, 2018


A “defective” trust is a trust in which the grantor (or in certain cases, the beneficiary) is treated as the “owner” of the trust for income tax purposes, but no for estate, gift, or generation-skipping transfer tax purposes. This means that the grantor is taxed on the trust income and gets the benefit of all the deductions and credits attributable to the trust. IRC §671. Many practitioners believe that one of the benefits of a defective trust in which the grantor pays the income tax is that the payment of the tax is the equivalent of a tax-free gift to the trust to the extent no reimbursement is made (unless the trust instrument or state law requires reimbursement to the grantor from the trust). This benefit is important if the trust is purchasing life insurance because the trust can grow free of income tax and be able to pay larger premiums.

Another technique used by many practitioners is the intra family transfer of closely held business interests, family limited partnerships, and other types of fractional or minority interests for which the fair market value (determined by reference to a hypothetical willing buyer and willing seller in accordance with Treasury regulations and court rulings) will be less than the proportionate value of the underlying assets owned by the corporation or partnership, due to discounts for lack of control and lack of marketability. By selling a discounted minority interest to a defective trust, the grantor can increase the “leverage” of the sale, providing additional value to the beneficiaries without gift tax.

The first step is for the grantor to make a gift to the trust as initial equity so that the trust is not under-capitalized and the transaction is a real sale and not a “sham”. (If the sale is too highly leveraged, the seller is totally dependent on the asset itself for the payment of the purchase price, would could lead the IRS and the courts to conclude that the transaction was not really a sale at all.) The grantor subsequently sells interests in a limited partnership (or other entity) to the trust in exchange for an interest-only promissory note with a balloon payment at the end of the term. The sale is income tax free because the trust is “defective” for income tax purposes. (See Rev. Rul. 85-13.) The interest rate for the sale is a market rate of interest determined under IRC §1274(d). Because the minority interest transferred represents a discounted value from the proportionate share of the business or assets owned by the partnership or other entity, the income from the minority interests should be higher than the income from other assets with the same fair market value. If the trust is “defective” and does not pay income tax, the income will be able to accumulate more rapidly. The difference between the trust income and the interest on the promissory note may therefore accumulate tax-free for the beneficiaries of the “defective” trust.

A dynasty trust is an irrevocable trust drafted to last for multiple generations without any estate, gift or generation-skipping transfer taxes at the death of the grantor’s children and in some cases without any such taxes at the death of lower generations as well. Unlike most trusts that require distributions to be made to the children at certain ages, the dynasty trust instead gives the children and other descendants the use and control over the trust property as trustee upon reaching the age at which most standard trusts would otherwise distribute the trust property to the beneficiaries free of trust. This gives the beneficiaries control over and enjoyment from the trust assets as if they owned the property outright, but without causing inclusion in their taxable estates and without subjecting their property to their personal creditors, including ex-spouses.

In order to prevent the avoidance of the estate tax through long-term trusts, Congress imposed a generation-skipping transfer tax equal to the maximum federal estate tax rate on each generation-skipping transfer, payable from a generation-skipping trust at the death of each generation. However, there is a generation-skipping tax exemption for each person, and it is possible to “leverage” that exemption through life insurance, so that a multi-generation dynasty trust can be created that can benefit each generation free of federal estate tax and generation-skipping tax.A major limitation on multi generational dynasty trusts is the traditional “rule against perpetuities”, which states that each trust must “vest” (or terminate for tax purposes) and be distributed to the persons then entitled to the income from such property within the time period specified under §689.225 of the Florida Statutes, as amended, unless vested sooner as provided in the trust. The Trustee shall distribute any remaining trust property to any one or more of the beneficiaries then entitled to receive the income from such property in such proportions as the Trustee considers advisable. In exercising its discretion, the Trustee shall have no obligation to consider the interests of any other person in the trust. By extending the term of the trust, the grantor can delay (or avoid altogether) the imposition of any estate tax on the principal and accumulated income of the trust.

Estate taxes are due within nine months of the death of a single individual or the second to die of a married couple. In almost all cases, life insurance is used to provide the liquidity to pay the taxes without having to sell the estate assets at low values. Life insurance proceeds are income tax free (subject to exceptions), but not estate tax free. In order to make it estate tax free, the life insurance should be purchased by an irrevocable life insurance trust. Most life insurance trusts are structured as Crummey trusts (named after the case by that name) so that transfers to the trust qualify for the gift tax annual exclusion. For larger estates, however, there often aren’t enough Crummey beneficiaries to pay the premiums without making taxable gifts. This often results in the client not purchasing enough insurance to fund the estate tax (or other obligation). Since the sale to a “defective” trust can create such a large cash flow, significant insurance premiums can be supported by the trust assets. In addition, the “defective” trust can also be used to purchase an existing policy from either the insured or an existing life insurance trust without violating the transfer for value rules (IRC §101(a)(2)) and without causing estate inclusion under the three-year rule (IRC §2035).