Trusts
Trusts: A Valuable Estate Planning Tool
There are many circumstances in which you should consider a trust as an estate planning tool. A trust can be useful to provide for a beneficiary who is unable to manage finances, to provide for your own disability, to control income and principal distributions, to protect assets from claims of a beneficiary’s creditors, to limit objections to the distribution plan, to avoid probate, and to reduce estate taxes. What type of trust you should consider depends on your goals. Because of the variety and different purposes for establishing trusts, you should consult an estate planning attorney before making any decisions.
Trusts as an estate planning tool are specific to individual and family circumstances. Common types of trusts include:
· Testamentary trusts
· Revocable (living) trusts
· Marital trusts
· QTIP trusts
· Credit shelter trusts
· Generation-skipping trusts
· Irrevocable trusts
· Life insurance trusts
· Charitable Remainder trusts
Testamentary Trusts
If you are primarily concerned about estate tax reduction and management of a beneficiary’s funds, a testamentary trust may be most appropriate. A testamentary trust is a trust established in your will that does not take effect until after your death. Because this type of trust is contained within your will, you can change it as the circumstances of your family and assets change over time.
The most common use for testamentary trusts is as a vehicle to hold assets for a minor child if the other parent predeceases you. This same structure is also useful if you prefer to withhold distributions to children beyond the age of 18.
Testamentary trusts can be discretionary, meaning that the trustee has the discretion to withhold income or principal payments to the beneficiary until such time as the trustee believes it is appropriate to make them, useful, for example, for a beneficiary who has creditor problems. The beneficiary has no right to require distributions, and the only funds that become available to satisfy claims against the beneficiary are those funds that are distributed to the beneficiary. The funds remaining in the trust estate are protected from these claims. The trustee can, however, be given discretion to make payments for the benefit of the beneficiary even though no distributions are made directly to him or her.
A testamentary trust can also be used to reduce estate taxes if your you and your spouse’s combined estate exceeds the estate tax exemption amount. In this case, the testamentary trust can be split into a credit shelter trust (see below) to hold the exemption amount and a marital trust (see below) or a direct gift to the spouse of the remaining assets. The credit shelter trust can provide for an income stream to a surviving spouse with distribution to the intended beneficiaries at the spouse’s death. The marital gift amount will be subject to the complete control of the surviving spouse and will be taxed in his or her estate at death. If you have concerns about giving your surviving spouse complete control of the marital portion of the trust, a qualified terminal interest property trust can be established.
Revocable Trust
A revocable trust, also known as a “living trust,” is a trust you establish during your lifetime, usually naming yourself as trustee and as the sole beneficiary during your lifetime. As its name implies, the revocable trust is completely revocable during your lifetime and becomes irrevocable only upon your death. This type of trust is often popular among those at retirement age since assets that are held in the name of the trustee of the trust are not subject to the probate court.
In Illinois, assets in a revocable trust remain subject to creditor claims during your lifetime, and, after your death, the assets in the revocable trust remain subject to creditor claims, costs of administration of the your estate, the expenses of your funeral and disposal of remains, and statutory allowances to a surviving spouse and children, to the extent your probate estate is inadequate to satisfy those claims, costs, expenses, and allowances.These assets are also included in the estate of the settlor for estate tax purposes.
During your lifetime, your trust should name a successor trustee who will assume management of the trust if you become disabled or elect not to continue personal management of the trust. Including provisions for a successor trustee to assume management if you become incapacitated will avoid the need for a court-appointed guardian to manage the assets held in the trust. If you are interested in using gifts as a method of limiting estate tax exposure, you should include provisions in the trust permitting your successor trustee to make these gifts. You may wish to limit the successor trustee’s right to make gifts to only the client’s spouse or descendants.
A revocable trust is an excellent vehicle for holding title to out-of-state property. Because the property is titled in the name of the trust, there is no necessity for ancillary probate when you die. Any disposition of the property that is required under the terms of the trust or that is deemed advisable by the successor trustee can be made by the successor trustee without any court involvement.
As with the out-of-state property, the successor trustee will have immediate access to the trust property to provide support for your surviving spouse and children, to pay your bills if the trust directs, and to pay estate taxes if necessary. To avoid any conflict in distribution of your assets and permit the provisions of the trust to control, you should also prepare a pour-over will directs that the residue of your estate be distributed to the successor trustee of the revocable trust.
A well-drafted revocable trust should include provisions for the maintenance of you and your spouse during your lifetime and, after your death, division of the trust into a credit shelter trust and a marital trust or direct gift. When establishing a revocable trust, your assets must be transferred to the trustee after the trust is established. The terms of the pour-over will do not become effective without administration in the probate court, and the protection from probate will be lost if your assets are not transferred to the trust during your lifetime. The estate tax reduction portion of the trust, however, will still be effective because the pour-over will provides that all assets are to be distributed to the trustee of the revocable trust.
There are some downsides to using a revocable as an estate planning tool. Because the trust is a more comprehensive document than a will, it is more expensive to establish. Further, it requires more administration during your lifetime—you must transfer your assets to the trust, which will involve communication with and completion of registration forms for banks, brokerage companies, and other asset holders and deeds to transfer real estate into the trust. Finally, without probate of a will and publication of a claim notice, your creditors will have two years rather than six months to pursue their claims.
Credit Shelter Trust
Credit shelter trusts are a vital estate planning tool for estates with a value greater than the estate tax exemption amount. They are designed to allow you and your spouse to each take advantage of the estate tax exemption while retaining the benefit of all the estate assets to support the surviving spouse.
Without a credit shelter trust, if you and your spouse have a combined estate of twice the estate tax exemption amount and leave everything directly to each other, you will incur Illinois estate tax of up to 16 percent and federal estate taxes of up to 40 percent. Beyond saving on estate taxes, in a credit shelter trust, the surviving spouse will have access to the income from the trust as well as the principal if needed.
Even if you and your spouse do not have over $27.98 million, if the combined estate in more than $4 million, a credit shelter-marital trust arrangement may still be advisable as those assets will most likely continue to grow and you may have exposure for Illinois estate tax.
Marital Trust
Normally paired with a credit shelter trust, a marital trust takes advantage of the unlimited estate tax deduction for assets in excess of the estate tax exemption amount while providing a management structure for those assets that are not distributed directly to your surviving spouse. The most common terms of a marital trust permit the surviving spouse to elect to receive as much or all the income and principal of the marital trust as he or she wants.
The marital trust can also provide the surviving spouse with a limited power of appointment. This power of appointment can direct that the surviving spouse may appoint any remaining trust income or principal to his or her descendants or estate, but that if he or she does not do so, the income and principal of the trust remaining at the surviving spouse’s death shall be distributed as the settlor directs.
Qualified Terminable Interest Property (QTIP) Trust
If you are concerned that if your surviving spouse remarries, the new spouse will receive the trust assets to the exclusion of your descendants, or if you divorce and the trust assets become part of a settlement agreement excluding your descendants, you may want to consider a qualified terminable interest property (QTIP) trust.
Under a QTIP trust, the surviving spouse is entitled to all the income from the trust during his or her life, but no trust income or assets can be appointed to anyone else. At the death of the surviving spouse, the remaining principal in the trust is subject to estate tax in the surviving spouse’s estate but is distributed to the beneficiaries designated by you. A QTIP trust qualifies for the marital deduction but removes any control by the surviving spouse over the trust property.
Generation-Skipping Trust
If you have adult children who are financially secure or who have estate tax liabilities themselves you may want to consider providing for distributions to grandchildren or more distant descendants rather than to children. Be aware though that these types of distributions, if greater than $13.99 million, are subject to a generation-skipping transfer (GST) tax in addition to the estate tax.
Irrevocable Trust
If reducing your taxable estate is a concern, you may want to consider using an irrevocable trust. There are a limited number of applications for irrevocable trusts in most estate planning because once the property is transferred to the irrevocable trust, it is usually unavailable to meet your financial needs. In almost all cases, you unable to change the terms of an irrevocable trust once it is executed Because of these limitations, most irrevocable trusts are limited to holding life insurance policies or special needs trust for persons with disabilities.
Life Insurance Trust
You can establish a cash fund available after your death by placing life insurance in an irrevocable trust. You will be allowed to make contributions to the trust over a number of years that qualify for the annual gift tax exclusion and have the proceeds of the policies distributed to your intended beneficiaries without including the funds in your estate for estate tax purposes.
Section 2503(c) Trust
Section 2503(c) of the Internal Revenue Service code permits making annual exclusion gifts to children without placing the funds directly into the children’s hands. Because gifts to a §2503(c) trust qualify for the annual gift tax exclusion, the assets in a 2503(c) trust, as well as any increase in value of the assets, are not included in your estate for estate tax purposes.
The use of a §2503(c) trust gives you an opportunity to specify what distributions you feel are appropriate for the trustee to make. Trust provisions that permit distributions to be made for the child’s support, care, education, comfort, and welfare will be sufficiently inclusive to qualify transfers to the trust for gift tax exclusion. The trustee must, however, be restricted from using trust distributions to satisfy a parent’s obligation to support the child. If funds are used for this purpose, the trust assets will be included in the your estate for estate tax purposes.
One tax problem that is not avoided with this type of trust is income tax. Since the usual plan is to retain all income and principal in the trust until the child reaches age 21, the trust will have to pay tax on the trust income. This can be a concern because the trust tax rate usually is much higher than the individual tax rate.
If you are concerned about distribution of trust assets to a child at age 21, you can include a provision in the trust to extend the term of the trust automatically or for the child to elect to extend the term of the trust upon reaching age 21. Any provision to automatically extend the trust must be subject to the child’s right to withdraw the trust principal. This right to withdraw can be limited by providing a window of time after the child reaches age 21 to make the election. If the election is not made, the window closes, and the trust will continue.
Because of the §2503(c) trustee’s discretionary right to distribute income and principal, you should not be the trustee of this type of trust. If you were the trustee and died before the child’s reaching age 21, the trust assets will be included in your estate. This possibility can be avoided by appointing someone else as the trustee.
You should also include in the trust a provision permitting the child to appoint the trust assets to someone else in the event of the child’s death prior to distribution of the trust as well as a provision for distribution if the child fails to appoint a beneficiary. Otherwise, if no beneficiary is named, the trust will pass to the child’s heirs, which in most cases will be the child’s parents, thus defeating the purpose of placing the property in the trust in the first place.
Charitable Remainder Trust
If you want to make a gift to charity but want to retain an income stream from the gift during your lifetime and any other person’s lifetime, a charitable remainder trust may be appropriate.
A charitable remainder trust generally takes one of two forms: either a unitrust in which the distribution to the lifetime beneficiary is based on a percentage of the trust; or an annuity trust in which the distribution to the lifetime beneficiary is a fixed amount.
Making a gift to charity in the form of a remainder trust permits you to retain the security of an income stream from the asset during your lifetime while still accomplishing the dual goal of satisfying a charitable intent and minimizing estate taxes.
The value of the remainder interest in a charitable remainder trust is eligible for deduction from your income tax. Assets with large unrecognized capital gain and pretax investments are very good assets to contribute to a charitable remainder trust. You will pay tax only on the capital gain or income as it is paid out to you as part of the lifetime distributions from the trust.
Many of the larger charities have their own in-house forms and management systems for charitable remainder trusts, which make establishing the trust easier, and incur fewer fees for income tax return preparation and administration expenses. The IRS has also published forms for several variations of charitable trusts.
There are downsides to charitable remainder trusts. Once the trust is established, you cannot change beneficiaries, the amount of the payout, or the terms of the trust.
