Using a trust can be an important tool in an individual’s estate plan. A trust is a legal arrangement where a “trustor” or “grantor” transfers property to a person having the fiduciary responsibility to conserve and protect the property. The person with this fiduciary responsibility is known as the “trustee.” The trustee holds the property for the benefit of one or more other individuals known as the “beneficiaries” of the trust.
Trusts can be “inter vivos” which are created while the grantor of the trust is still living. Alternatively, “testamentary trusts” are trusts that are created per provisions in the grantor’s will upon his or her death and are funded with assets from the grantor’s estate. Testamentary trusts are often used as a way to save federal and Washington estate taxes by sheltering an amount of assets up to the decedent’s lifetime exemption and/or qualifying the trusts for the unlimited marital deduction.
There are many possible advantages to using a trust in estate planning. One of the primary advantages is that it is a way to transfer wealth to younger generations while retaining some measure of control over the assets that are transferred. For example, a trust can be used to transfer assets to a minor child who does not have the capacity to manage or invest the property on his or her own. If the assets are income producing, the trustee may have the ability (if allowed in the trust agreement) to distribute income and in some cases, principal to the child which can then be used for education, health or living expenses. In addition, the grantor can allow for “milestone distributions” from the trust when the beneficiary reaches a certain age, such as one-third of the trust principal distributed at age 30, 35 and the balance at age 40.
A “special needs trust” is a way to provide for certain living expenses of a disabled individual or family member without the trust assets disqualifying the beneficiary from Medicaid, SSI or other need-based programs.
A trust may also be appropriate in the case of transferring property to benefit several family members, especially if the property is not easy to divide, such as a family business or a parcel of real estate.
Some states have complex probate rules, such as California. Real estate located in California, and owned by a non-resident of the state, should generally be owned in a revocable trust or an LLC. In addition, certain types of trusts can qualify to be shareholders in an S-Corporation.
In the case of a second (or later) marriage, a marital trust funded upon the first spouse’s death can benefit the surviving spouse during his or her lifetime, while keeping the principal available to distribute to the decedent’s children from a prior marriage. Gifts via trusts are considered to be the separate property of the trust’s beneficiaries while the property is in the trust. Assets held in the trust are protected in the case of a beneficiary’s divorce from his or her spouse. Assets held in a trust may also be protected from creditor claims of the grantor or the beneficiaries.
A popular tool in estate planning is the use of a “revocable living trust”. In this situation, assets are transferred to a trust that remains revocable during the trustor’s lifetime. The grantor continues to enjoy the ownership, flexibility and income produced from the assets during his or her lifetime. These types of trusts do not require a separate ID number or tax return to be filed. The income is directly reported on the grantor’s individual income tax return. Upon the grantor’s death, the trust becomes irrevocable and the Living Trust agreement directs the disposition of the decedent’s assets rather than using a will. In this way, the decedent’s estate avoids having to go through probate with respect to the trust assets.
A more advanced estate planning tool is the Qualified Personal Residence Trust (“QPRT”.) With a QPRT, the grantor makes a gift of a future interest in a primary or secondary personal residence while retaining the right to live in the residence for a fixed term. If the grantor survives the fixed term, the residence passes to the beneficiaries. If the grantor continues to occupy the residence, then the grantor must pay rent to the owner/beneficiaries.
Using a trust may not be an appropriate estate planning tool for every situation. In some cases, making a direct gift to a beneficiary may best accomplish estate planning goals and provide the beneficiary an immediate benefit. An example would be making a gift of cash to your child in order for him or her to purchase a home. In addition, one should consider the additional administrative burdens and costs that arise with assets held in a trust.
Before forming a trust, an attorney will draft the trust agreement and transfer title to the assets to the name of the trust. The grantor should carefully consider who will be named the trustee. In some cases, using a professional management firm or bank to act as the trustee could generate significant fiduciary fees.
Since a trust (other than a revocable living trust) is a separate taxpayer for income tax purposes, the trust will be required to file federal (and possibly state) income tax returns and will likely incur fees for each year’s tax preparation. In many cases the transferor will need to file a gift tax return to report the transfer of property to the trust in the year the gift was made, even if the transfer is less than or equal to the annual gift tax exclusion amount of $15,000 for 2018.
It should be noted that undistributed income accumulated in a trust reaches the highest tax bracket of 37% at a very low threshold. In 2018, this threshold is only $12,500. The trust may also be subject to an additional 3.8% on net investment income in excess of $12,500.
A final observation is that trusts are not very flexible. There may be limits on the discretion of the trustee to invest in certain types of assets. Since the term of a trust can last for a long period of time, the grantor or beneficiary’s needs or circumstances may change. It may be difficult to amend or terminate the trust without incurring significant cost or tax consequences.
This article is meant to be a basic introduction to using trusts in estate planning. Please contact Rebecca Olson or your Peterson Sullivan LLP tax professional for additional information on using trusts in your estate plan.