The ABCs of Trusts

Any individual, who aspires to practice estate planning and elder law, must be proficient in the areas of will drafting and trusts, and basic taxation. Competent attorneys recognize that individual and financial factors must be evaluated prior to preparing a will or trust. An evaluation of these factors will determine what clauses should be utilized in drafting a will or trust, whether a living trust should be utilized as an alternative to a will, and the extent to which federal and state death taxes must be addressed.

This article shall focus on the basic elements of drafting for trusts in the context of estate and tax planning.

Many types of trusts exist to assist an attorney in drafting an adequate estate plan for his or her clients. These trusts can be broken into three categories: (1) simple estate planning trusts, (2) tax planning trusts, and (3) public benefits planning trusts.

Simple Trusts
In general, there are two types of simple trusts. They are: (1) minors’ trusts and (2) revocable living trusts.

Minors’ Trusts – Many boilerplate wills provide that any minor have his or her distribution from an estate held in trust until attaining the age of eighteen (18) or twenty-one (21). This notion is unfortunate as many individuals are incapable of handling assets until a much more mature age. In addition, many of these boilerplate clauses do not provide for either a trustee or for maintaining the basic needs of a minor.

Any basic will should provide for an age requirement clause. This clause will state the requirement to hold any distribution in trust for a minor. It is frequently prudent to state that such distributions be held in trust until a particular age is reached, such as thirty (30) or thirty-five (35). Prior to attaining this age, the trustee can be given the power to make distributions of income and/or principal for a number of purposes, including: (1) the health, education, maintenance and support of a beneficiary, (2) assistance in making a down payment on a residence as well as closing costs for such a purchase, and (3) assistance with starting a business so long as the Trustee feels it is a worthwhile venture.

In the event a client has more than one minor or young adult child, the use of a sprinkle and share trust system should be implemented. A sprinkle trust directs that the entire estate be placed in one collective trust for all children, recognizing that the needs of young children should be addressed prior to unrestricted distributions. This trust will also recognize that different children have different activities and may require varying distributions from the estate. For example, parents typically will not adjust estate plans just because one child participated in soccer versus theater, or because one child went to an Ivy League school versus a state college.

When the youngest child attains a particular age, or completes college, the sprinkle trust is discontinued and the remaining principal and accrued income, if any, is separated into as many trusts as there are children. These trusts are known as share trusts. Subject to the exceptions set forth in the age requirement trusts, shares will be held in trust until an age at which the client feels his or her children will be financially responsible to receive an outright distribution.

Revocable Living Trusts
Revocable living trusts, for lack of a better term, are a substitute for a will. Their genesis was the response to the costs and delays of administering estates due to the probate laws of many states. Their primary purpose is to avoid probate. In essence, a living trust is established with similar dispositive provisions as a will and uses a trustee rather than an executor to administer the trust estate after the death or incapacity of the client. It is formally a contract between the client, who is known as the grantor (or in the alternative settler or trustor), and a trustee. In most instances, the client will be initial trustee so that he or she may manage their assets until death or incapacity. The client will name a series of successors to serve as trustee in response to either of those events.

In order for the trust to be effective, a client’s assets must be re-titled so that they are owned by the trust rather than by the client. Of course, this cannot occur with tax deferred investments such as 401ks and Individual Retirement Accounts (IRAs). Changing the ownership of these assets will precipitate an immediate tax obligation. As such, it is advisable to name individuals (or if necessary, the trust) as the beneficiary of such assets to maintain the avoidance of probate.

Tax Planning Trusts
A variety of trusts exist to minimize or eliminate federal estate tax. They include:
(1) Credit Shelter Trust – This trust is also known as an applicable exemption trust, a bypass trust, and a unified credit trust, among other titles. It is the most commonly used trust in representing married couples who possess estates in excess of the federal applicable exemption credit amount.

A federal tax is assessed upon an individual’s estate upon his or her death. This tax has varied over the years; however, it has ranged in progressive rates from 37% to 55%. In general, there are two exceptions to this tax. First, if the surviving spouse is aUnited   Statescitizen, no tax will be imposed due to the unlimited marital deduction. Second, distribution to any other class of individuals will be given a set monetary exemption, known as the applicable exemption amount.

Many estates are unnecessarily taxed when married couples, with significant net worth, utilize simple wills. These wills provide for outright distribution to a surviving spouse, then distribution to the children or other beneficiaries upon the survivor’s death. By utilizing this approach, one of the spouse’s applicable exemptions is wasted.

By using a credit shelter trust, the first spouse will leave his assets in trust for his spouse, allowing her to utilize same during her lifetime, but precluding such assets from being taxed when she dies. The trust must provide that the spouse have the right to the income generated off of the trust assets as well as any amount of principal to maintain the health, education, maintenance, and support of the surviving spouse. This latter right can be extended for the needs of the decedent’s children. In addition, the client can choose to include the right of the surviving spouse to invade 5% or $5,000 of the trust corpus, whichever amount is greater, on a non-cumulative annual basis without restriction as to how the funds are used. This right is commonly known as the “5 and 5 power”.

(2) Disclaimer Trust – An alternative to the credit shelter trust is the disclaimer trust. The disclaimer trust can provide the same tax benefits as the credit shelter trust, but it provides flexibility to the surviving spouse. Whereas the credit shelter trust is mandated upon the death of the first spouse, a disclaimer trust is an option for the surviving spouse who can decide whether to set up the trust or to take her spouse’s estate outright. In addition, if the disclaimer trust is elected, the spouse can decide to what extent it will be funded so as to allow for a combination of trust establishment and receipt of an outright bequest.

If a disclaimer trust is utilized, it provides for the right to income as well as health, education, maintenance, and support. However, it does not provide for the 5 and 5 power.

Traditionally, this trust was infrequently used as the benefits to a surviving spouse, under a credit shelter trust, were greater. However, in light of the increases in the exemption under the federal death tax structure, as well as new and/or increased death taxes from the states, this trust has become very attractive. It allows for greater flexibility in post-mortem planning which has become an important factor in light of the number of important changes to death tax laws over the past ten years.

(3) Irrevocable Life Insurance Trust. Life insurance can provide ready cash for estate taxes. However, life insurance is included in the policy owner’s estate. The majority of clients with life insurance policies designate the insured as the owner and the surviving spouse as beneficiary of the policy. Accordingly, the policy death benefit is included in the survivor’s estate. Some clients try to circumvent this problem by naming their children as both owners and beneficiaries of the policies. However, problems can arise if a child is beset with financial trouble or predeceases the parent. Furthermore, the surviving spouse would not have access to any of the life insurance proceeds.

In order to avoid these problems, yet still shield the life insurance proceeds from estate tax, an individual can transfer ownership of his or her policy or policies into an irrevocable trust. The trust becomes both the owner and the beneficiary of the policy. When the insured dies, the trustee collects the insurance proceeds on behalf of the trust and reinvests or distributes the money in accordance with the terms of the trust. The trust can remain in effect after death. Typically, the surviving spouse is given the right to income and principal during his or her lifetime. At the surviving spouse’s death, the remaining assets pass to the beneficiaries. Provisions can be made to continue the trust even after the surviving spouse’s death by establishing an age requirement for distribution. This maintains the assets beyond the reach of creditors and limits the beneficiaries’ ability to spend the proceeds immediately.

Although a life insurance trust saves estate taxes, it has certain drawbacks. For instance, the life insurance trust is irrevocable. The terms cannot be altered or amended once executed. Second, the previous owner of the policy must relinquish control over the insurance. That means that the insured cannot be the trustee.

(4) Qualified Personal Residence Trust. A qualified personal residence trust can be used to reduce estate taxes on a primary or secondary residence, or both. To establish a qualified personal residence trust, a homeowner must transfer title of a residence to a trust, the terms of which provide that the trust grantor retains the use of the residence for a specified period of years. Thereafter, the residence will pass to designated beneficiaries (usually the children). For a qualified personal residence trust to work, the person establishing the trust must outlive the term of the trust, or the residence will be included in that person’s estate.

During the trust term, so long as the trust is structured as a “grantor trust,” the grantor is entitled to the same income tax deductions as if he held the property individually. For instance, the grantor should be entitled to the income tax deduction for real estate taxes and mortgage interest, and he should be entitled to exempt up to $250,000 ($500,000 if married filing jointly) of gain upon the sale of the property.

If during the term of the trust the residence is sold and a new house is purchased for less, the sale proceeds must be otherwise invested in the new residence. If the entire proceeds from the sale of the old residence are not reinvested in the new residence within a certain period of time, the trust converts to an annuity trust for the benefit of the person establishing the trust for the remainder of the term of years specified. At the end of the trust term, the donor has to vacate the property or enter into a lease to pay rent at the market rate.

The trust establishes a means to leverage the applicable exemption amount and remove all future appreciation from the estate. Since the beneficiary of the trust does not receive the property immediately, the I.R.S. discounts the value and reduces the amount of the gift. The amount of the discount depends on the owner’s life expectancy, the terms of the trust, and the current interest rate. If the value of the property increases from the inception date of the trust, the appreciation is removed from the estate.

(5) Grantor Retained Annuity Trust – A Grantor Retained Annuity trust can be established to undertake with liquid assets the same function a Qualified Personal Residence Trust does for real property.

(6) Family Limited Partnership. A Family Limited Partnership can be an attractive method of shifting wealth to younger generation family members to reduce federal estate taxes. Transferring assets to a Family Limited Partnership permits older family members to retain management and control of assets while making tax-free gifts of equity in the asset to intended beneficiaries. Typically, assets that are placed into a Family Limited Partnership include stock in a family owned business, rental real estate, or liquid investments such as stocks and bonds. The partnership creates two classes of partners: general and limited. The general partner makes all decisions relating to the partnership, while the limited partner has no voice. In a typical Family Limited Partnership, the husband and wife are the general partners. In some partnerships, however, they are the limited partners. The children, grandchildren, or other family members can also be limited partners.

Each year, the parents may amend the partnership agreement to decrease the share of their limited partners’ interest and increase the share of the other family members. If the partnership is properly structured, the family can also obtain valuation discounts for having a minority interest and a lack of marketability. Since children are limited partners and the parent is the general partner, the children, initially, would not have any control over the partnership assets. In addition, a properly drafted partnership agreement would provide that the children could not dispose of their interest without first offering it to either the remaining partners or the partnership.

These restrictions placed upon the limited partners’ interest allow a discount to be taken for the value of the partnership interest transferred. Therefore, it may be possible to transfer an amount in excess of the annual exclusion gift amount to each of the beneficiary children without triggering any gift or estate tax consequences. Also, while maintaining control of the assets, the general partners are removing the partnership assets from their estates.

(7) Charitable Remainder Trust. Individuals with assets that have a low cost basis should consider gifting to charity. Due to its nonprofit status, the charity would then be able to sell the assets without paying any capital gains tax. Out of the proceeds, the charity would then pay the trust grantor an income stream based on a market rate of interest for the full value of assets which were initially transferred.

The charitable remainder trust setup routinely reduces income taxes for clients because they receive a substantial charitable gift income tax deduction which can be spread over five years. Furthermore, the value of the property that will pass to charity will be excluded from the trust client’s estate.

Because with this planning technique, the donated assets will not be distributed to children, it is recommended that a life insurance policy be used to replace the value of the investment. The insurance policy should be of an amount at least equal to the value of the transferred assets. Premiums may be paid out of the income stream from the charity. Moreover, the value of the life insurance policy can be excluded from the estate as well through an irrevocable life insurance trust.

Public Benefits Trusts
There are a range of trusts available to assist individuals who require Medicaid planning. The rules regarding these trusts have changed substantially over the past decade and many state Medicaid offices seek to challenge such trusts on a regular basis. At this time, the most significant Medicaid planning trusts are: (1) under 65 disability trusts, (2) pooled trusts,
(3) real estate preservation trusts and (4) “sole benefit of” trusts.

Without question, the discussion of these trusts is beyond the scope of this introductory article. However, the need for public benefits planning must be recognized by attorneys who represent elderly or disabled clients and their families.



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