Chapter 16

Focusing on Estate Taxes and the Many Types of Trusts

IN THIS CHAPTER

Bullet Recognizing the individuals involved in trusts

Bullet Understanding the different types of trusts

Bullet Planning your estate with trusts that fit your needs

Trusts have been a key element of estate plans for centuries and began as a way to avoid taxes. Now, trusts remain central to estate planning for estates of all levels and serve many purposes, but tax reduction remains a key use of trusts for those individuals rich enough to worry about estate taxes.

Many types of trusts are available, and they can get complicated. But the simple fact of estate tax reduction is that putting an asset in a properly-designed trust can avoid estate taxes on that asset. When tax reduction is one of your estate planning goals, your estate planner will ask you to at least consider using different types of trusts. Although tax reduction isn’t the main goal of estate planning and affects fewer estates each year, when you are fortunate enough to have an estate that may be taxable, tax reduction is one of your top goals and different types of trusts may be potential solutions.

Trusts used to be the province only of the very wealthy. In the last few decades, however, trusts have found their way into more estate plans because they can solve many problems. Now, many people use trusts in all kinds of estates to avoid probate, ensure that assets are well managed, or control how and when assets are distributed to loved ones.

Trusts really are fairly simple, but they’re made to seem more complicated than they are. Our goal in this chapter is to demystify them a bit so you can better comprehend what trusts are and how to use them in your estate plan. You should have a working understanding of trusts in order to be better prepared to work with your estate planning team to develop an effective estate plan. If you need some basic information on estate planning, check out Chapter 13.

Identifying the Cast of Characters

A trust is simply a legal agreement or contract among three people. The agreement usually concerns how money or property will be managed and distributed. The agreement can be fairly detailed, or it may simply empower the trustee to use her best judgment. In order to know what you can do with a trust, you first need a firm understanding of who’s involved. The three people involved are:

  • The grantor: Also referred to as the creator or trustor, this person creates the trust and usually transfers the assets to the trust.
  • The trustee: This person takes title to the trust property and manages it according to the terms of the trust agreement and state law. A trustee is also a fiduciary, meaning he must act in the best interests of the beneficiary and not treat the property as his own.
  • The beneficiary: This person receives the trust income or principal, or both. The trust was created and is managed for the benefit of the beneficiary. A beneficiary may be given additional rights in the trust agreement, such as the ability to replace the trustee or name who receives benefits after the beneficiary. A trust can have several types of beneficiaries, including:
    • The income beneficiary, who receives the income. This person also can be known as a lifetime beneficiary, because she’ll receive income or other distributions from the trust for the rest of her life.
    • The remainder beneficiary, who receives the remaining assets after the income beneficiary’s rights end.
    • The primary beneficiary is the first to receive income and other distributions from the trust for life or a period of years, whichever is specified in the trust agreement.
    • The contingent beneficiary who receives the trust principal or distributions when the primary beneficiary passes away or whose right to receive distributions from the trust ends for other reasons.

The same person can take more than one of these roles; in fact, one person can even be trust grantor, trustee, and beneficiary. Also, a group of people (rather than one person) can fill any of the roles. A trust can have co-grantors, co-trustees, and co-beneficiaries as well.

Remember The terms of the trust and the rights and duties of each person are spelled out in the trust agreement. The trust agreement is drafted by the grantor (or, more likely, the grantor’s attorney). Trust laws provide a lot of flexibility, so the trust agreement can say almost anything the grantor wants regarding the management of the trust property and its distribution to beneficiaries. Either the grantor or the beneficiary can sue the trustee for violations of the trust agreement or state law.

Naming the Types of Trusts

Before you can decide that a trust may be an option to include in your estate plan, you need to know the ins and outs of trusts to help you make an informed decision. Many different types of trusts are available. This section gives you an overview of the four broad categories of trusts, with two types in each category.

Remember A trust isn’t operational or functional after it’s created. In other words, someone still needs to fund the trust by transferring money or property to it. Oftentimes you fund the trust by transferring assets to it at the time you create it or soon after. Yet, it isn’t unusual for a trust to be created during your lifetime and not be funded until the will is probated. Sometimes a trust may be created but never funded. All trusts are some combination of the different types of trusts we discuss here. Note: As we explain the different types of trusts in the following sections, we refer to you as the grantor.

Looking at when trusts take effect

The first category divides trusts based on when they take effect or “spring to life” as old-school estate planners liked to say. Here are two types of trusts in this category:

  • Living trust: This type of trust, also called an inter vivos trust, takes effect during your lifetime. You create the trust and put assets in it now, and the trustee begins managing the assets.

    Remember The term “living trust” creates some confusion at times. Chapter 14 discusses the fact that putting assets in a trust is a way to avoid probate. These trusts are properly called revocable living trusts; we discuss the importance of the revocable part in the next section.

  • Postmortem trust: You create this type of trust through your will, which doesn’t take effect until after your passing. These also are called testamentary trusts.

Revoking or retaining rights

The second category of trusts is divided between those where you, when drafting the trust agreement, retain the right to change or revoke the trust and those where you give up those rights. The following sections take a closer look at these two types of trusts. Note: The tax law treats these two trusts very differently for both the income tax and estate tax.

Revocable trusts

Probably the most common trust is the revocable living trust, which is used to avoid probate (see Chapter 14). A revocable trust is one that allows you, as the grantor, to change the terms of the trust or revoke the trust entirely. You transfer titles to your property to the trust, including homes, cars, checking accounts, investment accounts, and household furnishings. You and your spouse usually are the initial trustees and beneficiaries. The trust agreement spells out who succeeds you both as trustees and beneficiaries. All the property in the trust avoids probate and is distributed to heirs according to the terms of the trust rather than according to their wills.

Remember The grantor of a revocable trust generally is treated as the owner for tax purposes. All income earned by the revocable trust is included in gross income on your income tax return, and all property owned by the revocable trust is included in your gross estate on the estate tax return.

Irrevocable trusts

Irrevocable trusts are used to reduce income or estate taxes. With an irrevocable trust, you can’t change it after the trust agreement is signed. The income of an irrevocable trust isn’t included in your gross income, and trust property isn’t included in your gross estate. To achieve these tax savings, the trust must be truly irrevocable, and you can’t retain rights to receive income or property from the trust.

Determining how income is distributed

The third category is a fairly new way of defining trusts. This category separates trusts based on how the amount to be distributed to an income beneficiary is determined. It introduces the concepts of income beneficiary and remainder beneficiary and shows how to resolve potential conflicts between the two. The following two sections give a bit more detail about these two types of trusts.

Income trusts

An income trust is the traditional trust that most folks think of when the term comes up. The assets of the trust are divided into income and principal. The annual income of the trust (interest, dividends, and rent) is distributed to an income beneficiary (usually the spouse of the grantor). After the income beneficiary passes away, the principal is distributed to remainder beneficiaries (usually the grantor’s children). Capital gains aren’t income. They’re added to the trust’s principal.

Remember The income trust creates tension between the income beneficiary and the remainder beneficiaries — with the trustee stuck in the middle. The income beneficiary naturally wants the trust invested to maximize current income. The remainder beneficiaries prefer at least part of the trust to be invested for growth so they eventually receive more wealth.

Total return trusts

A total return trust does away with the income and principal distinction. Either a percentage of the trust value or a fixed amount is distributed to the income beneficiary each year. The trustee invests in a diversified portfolio with a long-term risk and return trade-off rather than worrying about whether the portfolio generates enough income to sustain the income beneficiary’s standard of living. The income beneficiary may be paid from income, capital gains, or even principal. When a fixed amount is distributed each year, the potential exists for the income beneficiary’s purchasing power to decline because of inflation. This is one reason to have the trust pay a percentage of its value instead of a fixed amount. Or the fixed amount can be adjusted periodically for inflation.

In either case, the remainder beneficiaries receive whatever is in the trust after the income beneficiary passes. Because the trust was invested to generate a total return instead of primarily income, there is the potential for both the income and remainder beneficiaries to be better off. When the trust’s investments do well, the income beneficiary receives higher payouts over time, and the remainder beneficiaries receive more than they would have if the trust had been invested for income.

Addressing the trustee’s powers

The fourth category of trusts separates trusts based on the extent of the trustee’s powers. This category has two basic types, which we discuss in the following sections.

Discretionary trusts

In a discretionary trust, the trustee decides when to distribute income and principal to the beneficiaries and how much to distribute. The trustee uses her judgment to balance factors such as knowledge of the beneficiaries’ needs, the grantor’s goals, the investment performance of the trust, and other factors. The discretion may be total or partial.

An example of a trust with partial discretion is one that instructs the trustee to pay all the annual income to the beneficiary unless the trustee decides it isn’t in the best interests of the beneficiary. For instance, the distributions could be withheld if the beneficiary has a substance abuse or gambling problem, is involved in an acrimonious divorce, or for some other reason.

Nondiscretionary trusts

In a nondiscretionary trust, the trustee is told to make distributions on a specific schedule or using a formula. The trustee first may be instructed to distribute all the income to the beneficiary each year. When the beneficiary turns 25 years old, for example, the trustee is directed to distribute one-third of the trust principal and continues distributing income annually. The rest of the principal is to be distributed when the beneficiary turns 30.

Another typical nondiscretionary trust requires the trustee to pay all the income to the income beneficiary for life. After the income beneficiary passes away, the trust principal is distributed equally to the remainder beneficiaries.

Using Trusts in Estate Planning

Many types of trusts are available to help you achieve your specific personal finance goals during your senior years and after your passing. These trusts are variations of the different types of trusts we discuss in the previous sections.

In this section, we review some specialized trusts and help you determine when to use them. Many of these trusts are established at least in part to reduce income or estate taxes or both.

Remember These trusts must meet strict and detailed tax code requirements to achieve the tax savings, so don’t try to establish them without an estate planning attorney. (Chapter 15 discusses basic estate planning trusts for married couples, such as marital deduction trusts and QTIP trusts. We also discuss irrevocable living trusts to avoid probate.)

Donating to charity with charitable trusts

In your estate planning, you can use trusts to make charitable contributions while retaining some income or wealth for you or your loved ones. These trusts can be created during your lifetime or in your will. You have two options with charitable trusts, and we discuss them in the following sections.

Charitable remainder trusts

If you want to give money or assets to benefit a charity, retain some income for you or loved ones, avoid taxes on capital gains, or reduce your estate tax, a charitable remainder trust may be a good option for you. The charitable remainder trust (CRT) is best used for appreciated assets (those that have risen in value) with substantial capital gains.

So how does a CRT work? The following steps walk you through the process:

  1. You (or your estate) transfer appreciated property to the CRT.
  2. The trust sells the transferred property at market value.

    Because it’s a charitable trust, it’s tax exempt and no taxes are due on the gains.

  3. The trust reinvests the sale proceeds in a diversified portfolio.

    The trust begins to make annual distributions to you and any other beneficiaries you name in the trust agreement. The income lasts for life or for a period of years, whichever you determine. The income may be a fixed amount or a percentage of the trust’s value — again, whichever you choose.

  4. After the income period ends, the property remaining in the trust (the remainder interest) is distributed to the charity.

    The present value of the remainder interest that the charity eventually receives is deductible in the year property is transferred to the trust. If you transfer property to the trust during your lifetime, the contribution is deducted on your income tax. If you have your estate transfer the property, the charitable contribution deduction is taken on the estate tax return. Internal Revenue Service (IRS) tables using current interest rates and the life expectancies of the income beneficiaries determine the amount of the deduction. The older the beneficiaries are (or the shorter the payout period), the greater the percentage of the property’s value that can be deducted. Also, the lower interest rates are, the greaer the deduction.

Charitable lead trusts

Perhaps you want to pay income to a charity for a period of years, and then you want the trust to pay income and distributions to you and any other beneficiaries. If so, you may want to consider a charitable lead trust. The charitable lead trust (CLT) is sort of the opposite of the CRT (which we explain in the preceding section). As with the CRT, you (or your estate) transfer property to the trust. Then the trust sells the property and invests in a diversified portfolio.

Remember An important difference from the CRT is that the CLT isn’t tax exempt, because the charity isn’t the ultimate beneficiary. When property is sold at a gain and income is earned, the trust pays taxes on it. However, like the CRT, the transfer of property is considered a charitable contribution and creates a deduction.

A CLT basically operates in the following fashion:

  1. After the transfer of property, the trust makes payments to a charity for a period of years determined by you.

    The payments may be either a percentage of the trust’s value or a fixed amount.

  2. After the income period ends, the property remaining in the trust is distributed to you or any other beneficiaries you named.

    The transfer of property to the trust is considered a charitable contribution, so a deduction may be taken. IRS tables based on current interest rates and the time the charity will receive payments determine the amount of the deduction. The longer the charity is paid, the greater the percentage of the property’s value that is deductible.

Opting for retained income trusts

You may want to take advantage of some estate planning benefits with trusts without completely giving away property. With these types of trusts, known as retained interest, or income, trusts, the grantor receives income from the trust or eventually has the trust remainder returned. (Refer to the earlier section “Identifying the Cast of Characters” for more on who plays the role of grantor.) The charitable trusts we discuss in the previous section are considered retained interest trusts, but the trusts we introduce in the following sections don’t involve charity.

Qualified personal residence trusts

A qualified personal residence trust (QPRT) is a special trust involving either the principal residence or a vacation home of the grantor. Here’s how this type of trust works: The grantor transfers the house to a trust. The trust makes the grantor the income beneficiary, allowing the grantor to live in the home for a period of years. After that period, the home belongs to the remainder beneficiaries of the trust, who usually are the children of the grantor. Because of this last point, the QPRT generally is used for second homes instead of the primary residence.

The goal of the QPRT is to remove the house’s value from the grantor’s estate at a low tax cost. When the house is transferred to the trust, a gift is made to the children. The potentially taxable amount of that gift is the present value of the interest the children will receive. IRS tables using current interest rates determine the value of the gift. The longer the children wait to receive the home, the lower the value of the gift. In addition, future appreciation of the home isn’t subject to gift or estate taxes.

Warning When the grantor dies during the income period, the estate tax effect is as though nothing had been done. The house is included in the estate, and the estate receives a credit for any gift taxes paid when the house was transferred to the trust. When the grantor outlives the income period, however, the house isn’t included in the estate. So, for the QPRT to have any tax benefits, the grantor must outlive the income period of the trust.

Remember After the income period, the grantor has no legal rights in the home. When the grantor desires to live in or use the home, he has two options: He can rent the home from the children, or they can allow the grantor to live in it rent-free, making a gift of the annual rental value. For these reasons, the QPRT frequently is used only after other estate tax reduction strategies have been used and with a house other than the principal residence.

Grantor retained income and annuity trusts

Retained income trusts that don’t involve a home include the grantor retained income trust (GRIT) and the grantor retained annuity trust (GRAT). In each of these trusts, property is transferred to the trust, and then the trust pays income to the beneficiaries (usually the children of the grantor) for a period of years chosen by the grantor. After that, the property is returned to the grantor.

At first, this circular strategy seems to have no benefits. But nuances in the tax law make these trusts an effective way to transfer wealth to others at a low tax cost. IRS tables that use current government interest rates are used to value the gift made to beneficiaries. When the trust earns more than the government interest rates and transfers that income to the beneficiaries, the excess income is transferred free of estate and gift taxes.

Tip Estate planners generally favor establishing these trusts for short periods of time, usually two to five years. Assets transferred to the trust should be those that are expected to earn income or capital gains exceeding the government interest rates.

Warning The estate tax law is likely to be changed to require these trusts to last at least ten years to have tax benefits. Your estate planner should know the current law, but be aware of the potential for change when formulating your estate plan.

Taking care of special needs with SNTs

You may have one or more family members with chronic illnesses or conditions that require extra expenses, special care, or lifelong attention. You may be the person with the illness or condition, or it may be your loved one, such as a child. In either case, your estate plan requires the following adjustments and special considerations:

  • When you, the estate owner, are the one with the condition: A revocable living trust may be more important for you than for others (see the earlier section “Revocable trusts” for more information). The advantage of the revocable living trust in these situations is the ability of a successor trustee or co-trustee to step up and manage property when the principal trustee is unable to. The co-trustee arrangement allows the estate owner to supervise and be in control while the co-trustee performs the ministerial tasks of managing the property and learning about it. A revocable living trust also provides a smooth transition to the successor trustee.
  • When a loved one, especially a child, is the one with the chronic condition: The concern is how to provide continuing care when the parents are gone. It isn’t a good idea to depend solely on government programs to provide support. Another bad idea is to leave assets to the other children with instructions to care for their sibling. Even when the other children have the best intentions, they may die first, or their assets could be dissipated in divorce or lost through their own financial difficulties.

The solution for either of these cases usually is a special needs trust (SNT). This trust is drafted so it doesn’t count as part of the beneficiary’s income or assets under government programs such as Medicaid. An SNT can be set up with assets from several different sources, including the following:

  • The special needs person’s own assets: An example of this case may be a child who was injured in an accident and received a settlement. Under the law, the person could qualify for Medicaid during life, but Medicaid is reimbursed from the trust after that person’s death.
  • The assets of others: In this case, the SNT may be set up with parents’ assets or with the benefits of a life insurance policy. The trust can be set up so Medicaid isn’t reimbursed from it. Any remainder in the trust could go to the other siblings or other heirs. A life insurance policy also could be used to provide for other heirs while leaving most of the estate to the SNT.

Remember With a special needs child, it’s important to use an estate planner experienced with government programs so the will, trust, and any gifts don’t make the child ineligible for Medicaid or other government programs. For example, a key term should say the trust will provide only supplemental care beyond that provided by the government and any income the child earns. Otherwise, the trust assets are considered the child’s assets when considering eligibility for government programs.

Spreading the wealth through dynasty trusts

Instead of leaving wealth to the next generation and letting them use it or pass it on as they wish, you can set up a dynasty trust, which limits the distributions to each generation. A dynasty trust basically benefits several generations of a family. This type of trust that once was restricted to the very wealthy is now being used more often.

In the typical dynasty trust, the parents set up an irrevocable trust (refer to the earlier section “Irrevocable trusts” for more information). Some parents transfer a range of assets to the trust during their lives or through their wills. Most often, however, the only asset is life insurance. When life insurance is the main asset, the parents transfer cash to the trust annually, and the trustee uses the cash to pay the insurance premiums.

Tip The cheapest life insurance for a married couple is a joint and last survivor, or survivorship, policy that pays benefits only after each of the spouses has passed on.

The policy benefits eventually are paid to the trust. The trustee invests and manages the money and also uses it to benefit the family members designated in the trust agreement. The distribution rates and formulas are limited only by your imagination and goals. For the trust to really be a dynasty trust, however, the distributions should be less than the fund earns. Often family members begin receiving distributions only after reaching a certain age, and family members share in receiving a fixed percentage of the trust’s value each year. The trust also may make loans to family members to buy homes, start businesses, attend college, or for other needs.

Remember A dynasty trust has more than tax benefits. The wealth is protected from creditors of family members as well as from mismanagement by family members, divorces, lawsuits, medical bills, and the like. Plus, assets in the trust aren’t subject to probate as family members die.

A dynasty trust usually is limited to about six generations. At that point the trust winds down by distributing its assets to the latest generation or other designated beneficiaries.

Creating life insurance trusts

You may want to include life insurance as part of your estate plan. You can use it to pay taxes, to ensure the estate has enough cash, or to increase the inheritances of loved ones. Permanent life insurance is used in these situations. You also may own term life insurance to cover specific expenses, such as the mortgage, child education, and income replacement.

Chapter 15 points out that the life insurance benefits are included in your gross estate when you have any incidents of ownership over the policy. This term means you can’t be allowed to cash in the policy, change its beneficiary, or take any other actions the owner of the policy can take. To avoid having life insurance benefits reduced by estate taxes, the policy should be owned by an irrevocable life insurance trust. This type of trust has an independent trustee who’s empowered, but not required, to buy insurance on the grantor’s life with the trust as beneficiary. The trust agreement provides that any insurance benefits will be distributed to the grantor’s estate to pay the taxes and other expenses. Any additional amounts will be paid to other beneficiaries designated by the grantor.

Remember After the trust is created, you contribute money each year to pay insurance premiums, and the trustee pays the premiums. The trust needs a Crummey clause (see Chapter 15) for the gifts to qualify for the annual gift tax exclusion. When these and other technical terms (generally limiting your ability to control or influence the trust) are met, the life insurance benefits are paid to the trust and not included in your gross estate. Your loved ones benefit from the full policy benefits instead of the after-tax amount.

Tip You may achieve the same result without a trust. You could make annual gifts to your children and have them buy insurance on your life and pay the premiums. Of course, this setup has no legal requirement that they use the gifts to pay the premiums. Another alternative is to form a partnership to own the policy. The steps are similar to those for the trust. This strategy hasn’t been used as long as the trust, so the rules aren’t always as clear.

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