Most estate planners know the three basic elements of a trust: a trustee, a corpus, and one or more beneficiaries. Many commentators regard the presence of a beneficiary as the most important element, because without a beneficiary there would be no one to enforce the trust and hence there could be no trust.1 There is, of course, one traditional, notable exception to this rule: A charitable trust may have no beneficiaries per se and still not fail. That is because it is well-settled law that the attorney general in the applicable jurisdiction has the power to enforce the trust.
Because of the beneficiary requirement, there has been a problem for those who want to create trusts to care for pets, maintain family property (such as antique cars or homes) or sustain a family business. Such trusts, considered to be established for a purpose rather than for beneficiaries, would fail as non-charitable purpose trusts. This is because neither the antique automobiles, nor the cats and dogs, nor the family home could sue the trustee to enforce the trust — and none of them is capable of having a personal representative.
But the Uniform Trust Code (UTC), the Uniform Probate Code (UPC), and the global implementation of trusts from various jurisdictions may make purpose trusts widely available. This will enable planners to establish trusts to accomplish objectives not previously available, such as a trust for the sole
purpose of holding and maintaining a family vacation home for the use of generations to come.
A trust as we know it must have beneficiaries whose identities can be established with certainty. If the identity or method of determination of the ultimate beneficiaries of a trust is so vague that neither the trustee nor a court could readily determine whether any given individual at any time was or was not a beneficiary, the trust would be unenforceable under common law and therefore, invalid, unless, of course, its purpose was charitable.2
FROM ENGLISH LAW
In the past, the laws of the various states in the United States have by and large followed the English rule, refusing to recognize trusts without beneficiaries,3 even though there may ultimately be identifiable beneficiaries after a non-charitable purpose was satisfied. For instance, a purpose trust could be established for the maintenance of the settlor's collection of automobiles, and if and when the automobiles were unusable or disposed of, or simply after a set period of time, the trust would terminate, and the settlor's children would receive any assets (for example, the automobiles) remaining in the trust. The fact that the children may be designated remaindermen after the purpose is carried out does not change the character of the trust nor by itself give it validity as a trust. In most U.S. jurisdictions, which do not recognize purpose trusts, a trust with these provisions (that is to say, a non-charitable purpose) would be totally disregarded and void, and one of two things would happen. Either the bequest would pass directly to the children without regard to the instructions to maintain the automobiles, or the entire bequest would fail and pass by intestacy in the settlor's estate. Cases have held both ways.4
Although some U.S. states have adopted a form of purpose trust law, they've done so in a far more limited way than the offshore jurisdictions,5 and it appears to be primarily to suit the “pet” (animal) trust objective.6 The thrust in the United States to adopt purpose trust legislation appears to be largely related to and motivated by the public's desire to be able to establish valid trusts for their pets, although other “honorary” trusts (such as trusts to maintain gravesites) are usually allowed on the same theory. The popularity of pet trusts is clearly reflected in the 1993 amendment to the UPC. Section 2-907 (b), which is optional for states adopting the code, specifically acknowledges and validates honorary trusts and trusts for pets. Of these two categories, the UPC distinguishes trusts established for pets in greater detail, apparently recognizing the strong public interest in establishing such trusts. Further, the California and Colorado statutes that were fashioned after the UPC both contain specific provisions under which trusts for pets can be valid.7 Contrast this focused, limited purpose legislation with the broad and flexible purpose trust legislation found in offshore jurisdictions, where the question of pet trusts could hardly be less relevant.
U.S. purpose trusts also are allowed in the few states that have adopted the UTC since it was promulgated in 2001. Section 409 of that code provides that “a trust for a non-charitable purpose without a definite or definitely ascertainable beneficiary or for a non-charitable purpose to be selected by the trustee is valid.” The UTC goes on, however, to limit the term of such a (purpose) trust to 21 years. Interestingly, the wording of the UTC does not invalidate the trust after the 21-year-period, it merely declares it to be unenforceable. Presumably, then, a court, upon a petition, could declare the trust invalid, inasmuch as its terms are then unenforceable. When that happens, unless otherwise provided in the trust, the corpus would revert to the settlor or her estate. It would be unusual if not a lack of foresight if a drafter did not provide for disposition of the trust property at the end of the 21-year-period, or after the purpose was carried out, or in the event that it could not be carried out.
A few states allow some form of purpose trust through case law (Pennsylvania,8 for example), but whether through case law or a version of a uniform code, the application and use of purpose trusts in the United States is extremely narrow and the term unnecessarily limited. For instance, if an individual wished to provide for the long term maintenance of a private building without mingling that asset with other assets in a “person trust” (one that provided for individual beneficiaries, in which dispositive disputes could arise and restraint on sale of the property could be overridden), why should he be limited to 21 years?
Accordingly, if a U.S. person9 wanted to establish a purpose trust with a broader scope and for a longer term than permitted in the states that allow such trusts, it would be a relatively straightforward matter to settle one in any of the several offshore jurisdictions recognizing such purpose trusts, then administering it in the United States (in a move sometimes referred to as “importing the law”).
Depending on the purpose of the trust and the situs of the trust assets, the purpose trust established offshore but administered here should be honored by U.S. courts, as it is well-settled law that a settlor of an inter vivos trust may designate the jurisdiction whose law will apply to the validity and administration of the trust.10 Associated with this rule, however, is the requirement that there be some nexus between the designated law and the trust itself.11 In the case of the purpose trust containing intangibles (such as stocks, bonds and other “paper assets”), this should not present a problem, because, if necessary, the intangibles could be moved to the desired jurisdiction to establish the nexus.12 Furthermore, as most of the offshore jurisdictions require a “local” trustee to serve, this would clearly establish the necessary nexus to apply the law of the jurisdiction designated by the settlor. It is also important to note that if the only asset of the foreign purpose trust is real estate located in the United States, a U.S. court may hesitate to apply foreign law to its administration, unless it is found that the trust does not violate the strong public policy of the situs state.13
As to which jurisdiction to select, there are, of course, numerous factors to consider both domestic and offshore, including the purpose and term of the trust, the most logical place for administration, the laws of the respective jurisdictions under consideration (that is to say, the flexibility of the applicable statute), and perhaps, the client's travel preferences.
In fact, the purpose trust statutes of the offshore jurisdictions and their fundamental requirements of the trust are quite similar in substance. While the purpose trust law of Bermuda, the Cayman Islands, and the British Virgin Islands are generally regarded as the most thoughtful, it would be difficult to say that one is much better than another for most purposes. Thus, the selection of jurisdiction or governing law may be based on offshore contacts that the client and/or the advisor may have, selection of initial trustee, fees, and as noted, the client's travel preferences.
Lawyers familiar with the establishment of trusts in jurisdictions other than the United States will agree it's a relatively simple matter to form a purpose trust for a U.S. person in a selected offshore jurisdiction and then make the transfer of desired assets to the offshore trust, including a U.S. account in the name of the offshore trust. Typically, the trust is drafted so that the transfer to the trust is tax neutral for U.S. tax purposes and the income is taxed to the grantor (that is to say, a “grantor trust” under Internal Revenue Code Sections 671 to 679), so there should be no new taxes to worry about (though pursuant to IRC Section 6048 and Revenue Procedure 97-37, there are Internal Revenue Service information forms that must be filed to avoid substantial penalties where a foreign trust is concerned).
Due to the fact that a purpose trust has no beneficiaries, however, if it is drafted so that it is not a U.S. grantor trust, some tricky, if not odd tax considerations apply. For instance, IRC Sections 641 and 651 provide for a deduction for amounts that a trust distributes to a beneficiary, and corresponding Sections 642 and 652 provide that the beneficiary receiving such distributions shall include such distributions in his gross income. But what happens to these rules with a purpose trust that distributes income for the upkeep of an automobile or the care of a cat? Obviously neither the car nor cat will be filing a tax return, and it wouldn't seem fair that the trust should simply be denied the distribution deduction and taxed at the higher trust tax rates, as it's not accumulating the income. On the other hand, to allow a deduction for trust distributions that are not taxed to anyone just won't fly under U.S. tax laws.
Under U.S. income tax laws, if a trust is treated as a grantor trust, the deductibility of trust distributions becomes unimportant, because all income, losses, credits, etc. are passed through the trust and the person deemed to be the grantor (typically the settlor of the trust) is treated as the taxpayer. The trust, though recognized for all other purposes, is ignored for U.S. income tax purposes. The grantor trust may be a domestic trust or a foreign trust.14 It is also important to note that if the trust is a foreign trust but not a grantor trust, the settlor will be exposed to a capital gain tax on the transfer of appreciated assets to the trust under IRC Section 684, although most advisors are successful in avoiding this merely by adding one or another of the grantor trust provisions.
If the trust is not treated as a grantor trust (which would be highly unlikely if it is a foreign trust and the settlor is alive, on account of the IRS's likely application of IRC Section 679), then no U.S. income tax may be due until distributions are made. But, note, the IRS has not ruled on distributions from a purpose trust for a U.S. “object.” The great likelihood is that such trusts would be treated as benefiting the U.S. persons connected with or benefiting from the object or purpose of the trust.
Thus: if the purpose trust is a grantor trust,15 all of the income will be taxed to the grantor, and if the funding of the trust was not a completed gift, the grantor will be deemed to have made gifts as the funds are distributed. Even though the trust distributions may be made directly to individuals (as opposed to objects) for the trust purpose, gift tax exposure would still result.16 For instance, under a purpose trust to provide for the care of a horse, a distribution to a handler for the care of the horse would not be a taxable gift to the handler or to the horse (though it may be income to the handler), but it would be a gift nonetheless.17 A distribution from a grantor-type purpose trust to a corporation for the preservation or continuation of the business is normally a gift to the shareholders in proportion to their interests.18 A distribution from a purpose trust for the maintenance of a building owned by the trust may not appear to be a gift to anyone, but under IRC Section 2501 it is a gift nonetheless, and it does not qualify for the annual exclusion. Further, use of trust funds for improvements on the building could be treated by the IRS as a gift to the remaindermen if the original transfer was not a completed gift and if the trust remains a grantor trust as to principal.
If the trust is a non-grantor trust and the funding of the trust was a completed gift, no additional gifts would result when trust distributions were made in furtherance of the purpose. But the practitioner must be mindful, as always, of any generation-skipping transfer (GST) tax issues that may apply. However, if the distributions had been made from the non-grantor purpose trust to a closely held corporation, there would be a different result. That is, if a trust distribution of income was made from a non-grantor purpose trust to a closely held corporation, the corporation, unlike an animal or other non-taxpayer, as a taxable entity and as a trust “beneficiary,” would be subject to income tax on the distribution. (The corporation would be treated as a beneficiary only for U.S. tax purposes, as the purpose trust does not have beneficiaries, per se.) In such a case, the trust would be entitled to a distribution deduction under IRC Sections 641 and 651.
As far as U.S. estate taxes are concerned, the question of inclusion generally hinges more on whether certain powers or benefits were retained than on whether the trust is a grantor trust. For instance, if a settlor reserves the right in a non-fiduciary capacity to withdraw trust assets by substituting trust assets of equal value, this right would cause the trust to be treated as a wholly grantor trust as to the settlor19 but would not by itself cause inclusion of the trust assets in the settlor's estate. Typically, estate tax inclusion of a purpose trust would be the result if the settlor retained some benefit from the trust, or a power over the trust such as the power to change the purpose of the trust, withdraw trust assets, add or delete beneficiaries, or appoint the property either during life or at death.20
GIFT AND ESTATE TAX
Even though the trust may be established in an offshore jurisdiction, if the settlor is a U.S. person we still have other U.S. tax laws to consider. For instance, what about U.S. gift tax issues? Is it possible to make a taxable gift to a cat? Not surprisingly, there are virtually no tax rulings or cases shedding light on the U.S. gift or estate tax issues that may be associated with purpose trusts. That's primarily because the U.S. states generally do not recognize purpose trusts and even the offshore purpose trust statutes are relatively new. But basic tax concepts can be applied to make some educated guesses.
First, as to whether taxable gifts could be made to pets, cars or buildings: the fact is that except for qualified charities, the federal gift tax laws do not care who the donee is.21 Whether a taxable gift is made for gift tax purposes depends on whether the transfer is treated as a taxable gift (that is to say, when the donor has relinquished dominion and control) and not on the identity of the donee.22 Furthermore, the IRC Section 2503(b) annual exclusion from taxable gifts does not apply to purpose trusts, as that code section specifically applies to gifts to “persons.”
Accordingly, when an individual settles and funds a purpose trust (the funding of which is not a completed gift because of a reserved benefit or power in the settlor thereby making the trust a grantor trust), all distributions from the trust in furtherance of the trust purpose will be subject to a gift tax and not be eligible for the Section 2503(b) annual exclusion. This would be so, of course, whether or not the actual settlor is identified in the trust instrument, as the tax laws look to the substance rather than the form of the transaction.
Similarly, a transfer to a purpose trust that did constitute a completed gift of income and principal would always be a taxable gift of a future interest; but annual distributions, whether from income or principal, would not be taxable gifts. The yearly income would be taxed to the trust generally without a corresponding deduction (unless, for example, to a corporation or other entity); but distributions from the trust to carry out its purpose would not be taxable gifts. Even if the trust was a grantor trust, the same gift tax results would apply, but the income would be taxed to the settlor/grantor each year, even though not received by her. The grantor's payment of the tax on trust income is not considered a gift, because the grantor is simply satisfying her liability to pay the tax.23
As for estate taxes: all the normal rules of estate tax inclusion of trusts apply. For instance, when the settlor reserved the power to appoint the trust property, if that power existed at her death, the property would be included in the settlor's estate under IRC Sections 2036 and 2038. And if the settlor relinquished that power within three years prior to her death, the property would be included in her estate under IRC Section 2035. Of course, in substantial situations, advisors might recommend that clients obtain formal rulings from the IRS.
The purpose trust poses some interesting questions in relation to the GST tax. For one, if we have a “pure” purpose trust that has no individual beneficiaries and can never have individual beneficiaries, there should be no GST tax issues, as the trust does not fall within the definition of a skip-person.24 On the other hand, this could change dramatically if the purpose of the trust involved distributions to or for the benefit of a non-charitable entity. For instance, a trust for the purpose of advancing the interests of a family business could typically involve distributions to a family corporation. In such a case, for GST tax purposes distributions to the corporation are deemed to be transfers to the owners of the entity.25 Accordingly, if a skip-person was a shareholder of the corporation the distribution attributable to that shareholder would appear to be a taxable distribution for GST tax purposes.26 A problem with this possible outcome is how and when to allocate the transferor's GST tax exemption to the trust, or whether the allocation would be automatic. For certain lifetime transfers, whether by direct or indirect skip, the allocation of the transferor's GST exemption is automatic.27 With a purpose trust, this may not always be clear. But for purposes of determining whether the skip is direct or indirect, at least we know that the “look-through” rule (to ownership of the entity) does not apply.28
For most purpose trusts (other than very short-term U.S. purpose trusts established under the UTC or the UPC), GST issues are very relevant, as such trusts are typically designed to continue for more than one generation, and seldom, if ever, would the trust be designed to pour over (be included for estate tax purposes) into the estates of children of the settlor (in which case the GST issue would be eliminated). In this regard, practitioners employing purpose trusts must carefully consider all possible GST ramifications that may emanate from the special nature of these trusts.
ONLY THE BEGINNING
With the advent of the UTC and the UPC, the purpose trust in the United States can offer important new planning possibilities in an estate plan. But if its purpose is for maintenance of a family business or other non-charitable family purpose, the trust should be established in one of the several offshore jurisdictions that have purpose trust statutes. Given the administrative and tax issues with foreign trusts, it may also be wise to consider importing the offshore trust (and its governing law) to the United States and causing it to be treated as a U.S. trust for income tax purposes.29 When the settlor is a U.S. person, the advisor and drafter must be constantly mindful of the somewhat tricky U.S. income, gift and estate tax ramifications, even though the trust is to be governed and administered by the law of the selected offshore jurisdiction. That is, so long as the offshore statutory requirements of the purpose trust are met, it may generally be administered anywhere in the world, including the United States. But if the settlor is a U.S. person, it will still be subject to U.S. tax laws. Therefore, it should be possible to establish a purpose trust in an offshore jurisdiction, and after a short time, move it to the United States while retaining the governing law of the original jurisdiction.
But as planners become more familiar with purpose trusts, no doubt more creative and useful purposes will be found.
- Austin W. Scott and William F. Fratcher, The Law of Trusts, Section 112 (4th Ed., 1989).
- George Palmer, “Private Trusts for Indefinite Beneficiaries,” Michigan Law Rev. 359 (December 1972).
- James Barr Ames, “The Failure of the Tilden Trust,” 5 Harvard L. Rev. 389 (1892).
- See, for example, In re Renner's Estate, 57 A.2d 836 (Pa. Super. Ct. 1948); The Fidelity Title and Trust Company, Executor v. Ethel Clyde, 121 A.2d 625 (Conn. 1956).
- For example, the Cook Islands, Liechtenstein, Bermuda, British Virgin Islands, Nevis, Jersey and the Isle of Man (about 20 jurisdictions worldwide). Most offshore purpose trust legislation was adopted in the 1990's but Liechtenstein trust law enacted in 1926 allows purpose trusts.
- See, for example., N.Y. Est. Powers & Trusts Law, 7-6.1, Cal. Prob. Code 15212, and Colo. Rev. Stat. Ann. 15-11-901.
- In re Renner's Estate, 57 A.2d 836 (Pa. 1948).
- “U.S. person” as defined under IRC Section 7701(a)(30).
- Scott and Fratcher, supra, note 1 at Section 598.
- See, for example, City Bank Farmers Trust Co. v. Cheek, 93 N.Y. L. J. 2941 (June 7, 1935). See also Watts v. Swiss Bank Corp., 43 Misc. 2d 758 (N.Y. Sup. Ct. 1964), where a settlor domiciled in France established a custodial account in New York and delivered securities to the New York trustee to administer the fiduciary arrangement there under New York law. The arrangement (and selection of governing law) was held to be valid.
- See Peterzell Trust, 7 Pa. D. & C. 2d 400 (Pa. 1956), holding that a trust established by a California settlor designating California law as governing law of the trust was valid even though the trustee and situs of the trust property was in Pennsylvania. But see also Scott and Fratcher, supra, note 1 at Section 648(1), and Restatement (Second) Conflict of Laws, Section 277 (1971).
- IRC Sections 7701(a)(30)(E) and 7701(a)(31)(B).
- IRC Sections 671-679, causing trust income and losses to be passed through to the person or entity treated as the owner for income tax purposes.
- Treas. Reg. Section 25.2511-1(c)(1).
- Treas. Reg. Section 25.2501-1-(a)(1).
- Treas. Reg. Section 25.2511-1(h)(1).
- IRC Sec. 675(4)(c).
- See generally, IRC Sections 2035, 2036, and 2038.
- I am not unmindful of the fact that different donees may produce different gift tax results, such as gifts to spouses (IRC Section 2523) or gifts to trusts with retained interests producing different results based on the relationship of the remaindermen to the donor (IRC Section 2702).
- Treas. Reg. Section 25.2501-1-(a)(1).
- Rev. Rul. 2004-64.
- IRC Section 2613(a).
- IRC Section 2651(f)(2).
- IRC Section 2612(b), Treas. Reg. Section 25.2511-1(h)(1).
- IRC Sections 2632(b) and (c). However, the transferor can elect to “opt out” of the automatic allocation. IRC Section 2632(b)(3) and IRC Section 2632(c)(5).
- IRC Section 2612(c)(2).
- IRC Section 7701(a)(30)(E) and Section 7701(a) (31)(B). The offshore trust could be converted to a U.S. trust by adding a U.S. co-trustee or a U.S. protector with powers to make “substantial” decisions in trust administration and a provision that allows the trust to be subject to the jurisdiction of a U.S. court.