Third-party trusts integrate estate and asset-protection planning.

• Author: Brown, Edward D.

A third-party trust (TPT) enables a client to maintain and protect businesses and investments, while reducing potential estate tax liability and exposure to creditors. This article explains how TPTs work and explores strategies for accomplishing these goals.

For several years now, taxpayers have used a combination of trusts, limited liability companies (LLCs), limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) as vehicles for owning property. They have proven to be useful as a way to achieve certain gift, estate and asset-protection planning goals. One tool often overlooked in this regard, however, is the irrevocable third-party trust (TPT), which combines the benefits of owning assets and possibly conducting a business, without the drawbacks of estate taxation and accessibility by creditors. This article explains how TPTs are settled, taxed and integrated with other estate planning and asset-protection strategies.

Overview

A TPT allows a client to place property into a structure via a tax-free sale, while continuing to retain control over the property. The client may continue to use the property and receive distributions of the income or principal therefrom. A trustee has total discretion, without limits, to make these distributions. Also, in most cases, the client personally retains the ability to direct the TPT to make transfers to any other person. The TPT can accomplish all this while protecting the property from potential future lawsuits. Further, it is typically designed to hold the property outside of the client's taxable estate.

Although the client will ultimately transfer property to the trust via an installment or other sale, a third party is the TPT's settlor, (1) and the only transferor who can gift assets to it; hence, the name "third-party mast." This is critical, because if the primary beneficiary (i.e., the client) were the settlor, the trust would be a "self-settled" trust, (2) and would not protect assets from the client's creditors in the vast majority of states, regardless of any spendthrift provisions. Thus, when a client sells assets to a trust previously settled by a third party, the sale is treated as an arm's-length transaction between the client and the TPT.

The TPT can be designed as a domestic trust or as a foreign trust with stronger asset-protection features, yet be treated as a domestic trust for Federal income tax reporting purposes.

Settling a TPT

A TPT is typically settled by a relative for the client's benefit. It is an excellent way for a parent to advance an inheritance to a child. The child reaps the benefits of the TPT's assets, and the assets are protected from the child's creditors (e.g., in a child's future divorce or other creditor situation). Because the child is a "natural object of his or her parents' bounty," it is unlikely that the TPT would be classified as a sham or nominee arrangement.

The settlor should fund the trust with sufficient assets to avoid any appearance that he or she is making such initial contribution as an accommodation to the client or as the client's agent. (3) The settlor should have an independent motive for settling the TPT, such as a parent wanting to advance an inheritance to a child to see how he or she manages the assets. If the child makes prudent decisions as a TPT trustee, then the parent would be more comfortable leaving a larger inheritance to that child at death.

The amount with which the third party funds the TPT should be sufficient to allow the mast to meet its initial payment obligation on any anticipated installment sales the client intends to make to the TPT. There is no safe harbor. However, 10% of the value of the assets the client intends to sell to the TPT may suffice as "seed money."

Managing TPT Assets

A TPT typically has at least two trustees. One is an independent trustee who possesses the power to make distributions and provide benefits to the client. This avoids a situation in which a client's creditor can access the trust assets by forcing the trustee to make distributions. Also, it avoids providing the client with tax-sensitive powers that could cause the trust assets to be taxable in his or her estate.

As the TPT's primary beneficiary, the client may receive distributions at the complete discretion of the independent trustee. This trustee may also allow the client to use TPT assets (such as living in a TPT-owned home rent-free).

Except for the independent trustee's powers, the client may possess all other powers over the trust assets in his or her capacity as the family trustee, including power over their day-to-day management and reinvestment. As family trustee, the client also has the power to replace the independent trustee if the latter is not fulfilling his or her fiduciary obligations and duties under the trust instrument (4) (if the TPT is a foreign trust, the family trustee's power can also include the ability to remove or replace the foreign trustee).

The client may also have powers under the trust instrument to veto certain decisions that could otherwise be made by the independent trustee (and foreign trustee, if any). (5) This results in even greater control over TPT assets without causing them to be included in the client's estate or available to creditors. Some of these veto powers include the power to veto the independent trustee's exercise of (1) trust amendment powers, (6) (2) a power to remove the family trustee (7) and (3) a power to delegate certain powers to third parties.

The client, as family trustee, typically also has the power to direct which distributions are to be made to other TPT beneficiaries. (8) Exercising this power would not be treated as a gift by the client, because he or she does not have sufficient rights or power over the TPT assets. The client can replace an independent trustee who violates his or her duty to act in the TPT beneficiaries' best interests.

Estate Planning

A TPT can also be used as an estate planning vehicle. As long as it does not grant a client a general power of appointment or any other power (9) over the TPT assets that could subject them to estate taxes at the client's death, they will not be included in the client's estate. Because the client does not contribute assets to the TPT by gift, Sec. 2036 will not apply. The client's only "contributions" are via a sale for full consideration; Sec. 2036 does not apply to transfers made for full consideration.

The fact that the TPT's assets are excluded from the client's estate creates an opportunity to decrease the estate. The client will sell the assets to the trust in return for consideration of equal value; those assets, and their appreciation, will be...