Trusts are not used primarily for reducing taxes any more. And trusts are not only for the wealthy. The non-wealthy are more financially sophisticated and have more wealth than in the past. The non-wealthy turned to trusts in recent years and for reasons other than tax reduction.
In this part of the visit, we’ll review the most frequent reasons for using trusts, the Types of Trusts available, and who should consider using these trusts.
First, let’s review the basics. A trust is a legal agreement or contract. The trust settlor or creator drafts the trust agreement and transfers property to the trust. The trustee has legal title to the property and manages it according to the terms of the agreement and state trust law. The beneficiary (or beneficiaries) receives the income and principal of the trust, usually over time, according to the terms of the trust agreement.
A trust can be testamentary, meaning that it is created in your will and not set up until after your death. Or it can be an inter vivos or Living Trust, which is set up during your lifetime. A revocable trust is one that the settlor can change at any time, including terminating it and taking back the property. The right to revocation also can survive the settlor and be transferred to another person. An Irrevocable Trust cannot be changed once created. Generally, a trust must be revocable to obtain tax and asset protection benefits.
Estate tax reduction. The traditional use of a trust is to save estate taxes. These days, this use matters only to someone whose estate exceeds the $2 million estate tax exempt amount. There are several types of trusts that reduce estate taxes.
There is the standard credit shelter or Bypass Trust, also known as the A/B trust. This is used by a married person with assets exceeding $2 million. The will states that assets up to the exempt amount are put in the trust. That keeps them out of the estate of the surviving spouse and ensures that the lifetime exemption of the first spouse is used. The surviving spouse receives the rest of the assets. All the assets of the first spouse to die avoid estate taxes because of the use of the lifetime exemption and the marital deduction. The trust usually provides that the surviving spouse receives all income plus any principal that is needed from the trust. After the surviving spouse dies, the remaining assets in the trust go directly to the children and avoid being taxed in the second spouse’s estate.
An inter vivos trust also can avoid estate taxes. Money or property is put in the trust during life for the benefit of the children. By funding the trust early, all future appreciation is out of the estate. The trust also can control how income and principal are distributed to the children (or grandchildren) over the years. For an inter vivos trust to reduce estate taxes, it must be irrevocable. If the settlor can change key terms or get the property back, the trust is included in the estate.
An irrevocable life insurance trust also can reduce estate taxes. Life insurance benefits face estate taxes if payable to the estate or if the insured controlled the “incidents of ownership.” But the benefits are excluded from the estate if the policy is owned by an irrevocable trust. Often, a trust is created to buy life insurance. The settlor transfers enough money to the trust each year to pay the insurance premiums. When the trust is created and operated properly, the life insurance premiums avoid all income and estate taxes. The estate or the family receives advantage of the full insurance benefits. The trust also can control how the benefits are used. The same result, without as much control over distributions, can be accomplished by having family members or a partnership own the policy.
Heir protection. Often a parent wants to ensure that his or her children ultimately receive the wealth, after the surviving spouse passes away. This is particularly true when at least one spouse has children from a prior marriage or the surviving spouse is young enough to re-marry and begin another family.
The QTIP (qualified terminal interest property) trust provides this result. The property is put in trust for the surviving spouse. The trust is required to pay the spouse all the income each year and to tap principal for necessities of the spouse. But the property eventually will go to the children of the trust settlor, and the spouse cannot change that. When properly set up, the QTIP trust qualifies for the marital deduction. It avoids estate taxes when the first spouse dies but is included in the estate of the surviving spouse.
Asset control. Another traditional use of a trust is to protect assets from heirs, or heirs from the assets. Many heirs do not have the knowledge or maturity to manage their inheritances. They need professional management of the assets. They also need trust terms that control distributions until the heirs are mature enough to spend and invest the wealth responsibly.
These wealth preservation trusts can be either testamentary or inter vivos. When they are inter vivos, they usually have the dual benefits of reducing taxes in addition to preserving wealth.
The terms of these trusts are very flexible. Some dole out all the income or a fixed amount of income each year, and distribute portions of the principal at fixed ages during the beneficiary’s life. Others aim to have the wealth last for more than one generation. They pay only income or a percentage of the trust each year to ensure the trust will continue to benefit future generations. We have discussed many possible structures of such trusts, and the articles are on the Estate Watch section of the Archive on the web site.
Asset protection. Once an after-thought, asset protection now is common among anyone with a modicum of assets and potential legal exposures: professionals, business owners, and anyone with creditors. Potential legal liabilities are expanding, so the use of trusts is increasing.
Most irrevocable trusts provide asset protection. Many people are using inter vivos irrevocable trusts to protect assets to ensure that they will be available for their children and spouses regardless of any future legal actions. There are numerous versions of these trusts. Anyone interested in them needs to meet with an estate planner and discuss goals.
Keep in mind that the exotic and expensive offshore trusts are not needed to receive asset protection benefits. U.S.-based trusts provide many of the same benefits. The main benefit of an offshore trust is that it inconveniences the creditors enough that they might settle for a lesser amount. Significant assets must be involved to justify the extra cost of setting up and administering the offshore trust.
Probate avoidance. In a number of states, probate still is a costly and time-consuming process. Such states include California, Florida, Connecticut, and New York. A way to ensure assets are received faster and at lower cost is to have them owned by a revocable living trust. The trust assets are not included in the probate estate of either spouse, because they do not own the assets. The trust owns them. The spouses can be the trustees and manage the property as trustees. The property is passed to future generations according to the terms of the trust agreement, not the will.
There are no income or estate tax benefits to this trust. All assets are included in the taxable estates of the spouses, and they are taxed on all the income from the trust each year.
This type of trust also aids in disability planning. When one trustee becomes incapacitated, a co-trustee or substitute trustee takes over under the terms of the trust agreement. There is no need for a power of attorney or to have a court appoint a new trustee.
Privacy. Trusts can provide a level of privacy. Trust agreements are private contracts that do not have to be filed in any public record. If a partnership or corporation is formed, the directors, shareholders, and agents usually are accessible to the public. A trust can own property without having to reveal the settlor or beneficiaries of the trust to the public.
Assets held in a trust also are not part of the probate process, so they are not listed in public probate records. Also, unlike a will, the trust is not filed publicly. So, the public cannot discover how assets owned by a trust are distributed to heirs.
Special needs. Many people are helping children, grandchildren, or other relatives with special needs. Setting up a trust ensures that these people will have help as long as they need it. A trust also helps increase funding from other sources. Assets held in trust for the beneficiary usually do not count against income and net worth qualifications for assistance programs.
Income and tax benefits. Sometimes a person is ready to shed assets to save estate or income taxes, but cannot give up the income. A GRAT is most likely to produce the desired results.
In a grantor retained annuity trust, the settlor transfers assets to the trust. The settlor receives a fixed annuity payment from the trust for life. After the settlor passes away, the children or other beneficiaries of the trust receive the remaining assets. When properly structured, the assets in the trust are out of the settlor’s estate. There will be gift taxes when the trust is created. It should be created with appreciating assets, so that the future appreciation is out of the estate. Generally, an estate should be worth $5 million or more for this trust to be considered.
Charitable giving. Trusts can be used to make charitable gifts, generate tax deductions, and still retain some income or assets for the family. Two types of trusts typically are considered.
Appreciated property can be transferred to a charitable remainder trust. The trust sells the property and owes no capital gains taxes on the sale. The proceeds are reinvested. The trust pays either a fixed annual amount or a percentage of the trust assets to the settlor (or a beneficiary designated by the settlor) each year. After the settlor dies or a period of years has passed, the payments stop and a charity receives the remaining assets of the trust.
The settlor receives a tax deduction equal to a percentage of the value of the assets transferred. The percentage depends on current interest rates and the length of time income will be paid. The settlor owes no capital gains taxes on the appreciation of the assets. The settlor’s estate owes no taxes on the assets.
The charitable lead trust is the opposite. Assets are transferred to the trust, and the trust pays income to the charity for a period of years. After that, the property is returned to the settlor or is given to a beneficiary designated by the settlor. The settlor gets a tax deduction of a percentage of the value of the property, based on interest rates and the length of time the charity will receive income. The property is included in the settlor’s estate if he receives it after the charity receives the income.
Because of the costs involved, these trusts usually are recommended only for estates of $5 million or more.
Trusts are extremely flexible. Discuss your goals with an estate planner to determine if there is a trust that suits your needs. Do not hesitate to do some price shopping. Fees among estate planners vary, because few people do comparison shopping for estate planning services. Fees for the same services can vary by thousands of dollars, even for planners of similar experience and quality.