An Intro to Retained Interest Trusts

Examining the chassis of many popular transfer techniques

This is a continuation of the series on everything you ever wanted to know about estate planning trusts.  For an intro and index to this series, please click here.  The linked article will have a series index that gets updated periodically as well, so please bookmark it.

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Table of Contents:

1. Intro and Background

2. Backdrop to IRC Section 2702

3. Why Is This Structure Required?

4. How Is This Paid?

5. Gross Estate Inclusion

6. Conclusion

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Intro and Background

Many of the 4-letter acronym trusts such as GRATs, QPRTs, CRATs, CRUTs, CLATs, and CLUTs take advantage of certain time-value-of-money discounts to reduce the gift value of a remainder, and/or to allow an income tax deduction for either a current income interest or a remainder. 

Some of these time-value-of-money discounts are covered by IRC Section 2702, which we will discuss at a very surface level in this article, but understanding the general principles of this Code Section creates the foundation for these various trusts. 

By time-value-of-money discount, what do I mean?  Under IRC Section 7520, actuarial values are assigned to certain income interests in property.  In this vein, the right to use property (such as in a life estate) may be treated as an income interest as well.  The fact that an income interest has a value for tax purposes is important, because of one central gift tax proposition:

There usually is no gift tax on a gift to yourself. 

As alluded to in prior articles, under Treas. Reg. 25.2511-1(a), a completed gift to trust will usually be treated as an indirect gift to the other trust beneficiaries.  What if, however, you (as the donor of the gift) are a beneficiary of the trust?  There is potential for gift and GST tax to apply for the gift to the other trust beneficiaries, but arguably the value of the gift should be less than the total value of the transfer to trust.  Why?  Because your interest in the trust that you have retained for yourself should not be subject to gift tax, as again there is no gift tax for a transfer to yourself. 

For example, let’s say you create an irrevocable trust and structure it like a life estate.  You retain, for your life, the right to all trust income.  Then, at death, the trust goes on to your children and descendants.  While the application of IRC Section 2036 (discussed below) would generally cause the inclusion of this trust in your gross estate at death (based on date-of-death FMV), the initial gift tax value should be less than the total transfer to the trust.  This is because IRC Section 7520 assigns a positive tax value to your retained income interest. 

So, in determining the value of your trust, you should be able to subtract the value of your retained income interest.  Right? 

Backdrop to IRC Section 2702