In Part I of our discussion, we introduced the Uniform Trust Code and why Virginia would deviate from it. Today, we explain Virginia’s rationale for changing its law on creditors’ rights to annual gifts into a trust and to inter-vivos marital deduction trusts.
What was Virginia’s concern regarding annual gifting into a trust?
Under current federal law, each individual can gift up to $13,000 each year to any other individual without any gift tax consequence. A married couple can therefore give up to $26,000 annually to each of their children. To qualify for the exemption, the gift must be of a “present interest”, which essentially means that the recipient must have control of the gift with no strings attached.
However, an exception to this rule exists. When parents want to give the gift to a trust on the child’s behalf rather than to their child directly, the parent must give the child written notice that she has a “Crummey Power” to withdraw the gift from the trust for up to 30 days after the gift was made.
The UTC, and Virginia’s original law, states that creditors did not have any rights to the $13,000 gift, even though the child had a “present interest” to it for 30 days. However, Virginia determined that this rule might apply to only one parent’s $13,000 gift, but not both. Virginia’s new law now protects both parents’ gifts (up to $26,000) into a trust from creditors.
What was the problem regarding “Inter-Vivos Marital Deduction Trusts”?
First, let’s define our terms. “Inter-vivos” means during life. The “Marital Deduction” is the federal tax law that allows all married individuals to give each other unlimited amount of gifts without any estate tax consequence. Similar to the annual gifting arrangement, the Inter-Vivos Marital Deduction Trust (hereinafter “IVMDT”) allows one spouse during his life to give a gift to an IVMDT for the other spouse’s lifetime benefit rather than to the spouse directly. If constructed correctly, the IVMDT helps the spouses “equalize” the amount of assets each one owns, which in turn reduces any potential estate tax.
However, for the strategy to work, the IVMDT must be considered the recipient’s property. U.S. tax law only allows this result if the recipient is deemed the contributor of the gift to the trust.
Why? That doesn’t make any sense.
The logic is this. If the husband gives the wife the gift outright with no strings attached, the property becomes hers. Therefore, if she dies first, the property is still hers and is included in her estate, and distributed according to her will (or trust). If her will said that the property is to go into a trust, then she, as owner of the property, will be deemed its contributor.
Now, let’s say the husband instead gives the wife the gift into trust. In other words, he gives her a gift, but with strings attached. Current tax law says that if the trust is drafted in one of two ways (either as qualified terminable interest property or with a power of appointment), the wife still has enough of a “present interest” in the property to still be deemed its owner or its eventual contributor.
So what does Virginia have to do with any of this?
Let’s look at the result of the above scenario. Husband gives Wife a gift in trust. Wife dies first, and under the trust, Husband is the new beneficiary of the trust. The effect is that Husband is now the beneficiary of a trust that he created and that contains property that he originally contributed.
Such a result closely resembles a “self-settled trust”, which is an instrument where one person is both the trust’s settlor (or its creator) and its beneficiary. Most states, including Virginia, do not allow these trusts to protect its assets from the settlor’s creditors.
The UTC is silent regarding this scenario. Virginia recognized that creditors might argue they are entitled to IVMDT assets if the original donor spouse became its beneficiary.
As a result, Virginia added a clause to its law that now states that after the recipient spouse’s death, the recipient spouse is automatically deemed the contributor of the trust assets. As a result, the survivor spouse in this specific situation by definition does not have a self-settled trust, and the trust assets are now protected from creditors in Virginia.
We will conclude with Part III by further defining qualified terminable interest property and powers of appointment.
- Pennsylvania Law of Trusts Commentary: Revolution or Evolution? (www.klgates.com)
- Drafting a Marital Deduction Trust for Second Marriages (www.wealthstrategiesjournal.com)
- Self-Settled Trusts Should Protect Assets, But Do They? (www.lodmell.com)
- 1600 Words About a 100-Word Addition to Virginia Trust Law (Part I) (estateplanninginfoblog.com)