Trusts can serve many purposes in a family’s financial, retirement, estate, and tax planning. Trusts can ensure that assets are professionally managed across generations and distributed in line with the grantor’s intentions. Trusts can, among other things, remove assets from one’s estate, carry out charitable intent, reduce income taxes, protect beneficiaries from spendthrift propensities, protect assets from becoming marital property in a divorce, protect assets from creditors, and provide lifetime income to one or more beneficiaries while providing the remainder interest to another generation of beneficiaries. Trusts can also provide privacy and confidentiality in the transfer of wealth (trusts avoid probate and the terms are confidential).

There are three parties to a trust: a grantor, a trustee, and a beneficiary. Sometimes a single person can play all 3 roles, or any role can be played by more than one person. A trust is established when a grantor transfers property to a trustee, who agrees to administer the trust assets for the benefit of the beneficiaries. The trust is created by a document (a living trust is created by a trust agreement while a testamentary trust is created by a will). The document gives directions to the trustee to follow in administering the trust assets (state law also defines certain powers and duties of a trustee).

Trusts can be either revocable (capable of being changed by the grantor at any time) or irrevocable (the grantor gives up all control over the trust assets during his or her lifetime). Revocable trusts are always living trusts because the grantor must be alive to revoke or amend the trust. Revocable trusts become irrevocable upon the grantor’s death. Revocable trusts are commonly used to avoid the cost, delay, and publicity of the probate process. Revocable trusts are also frequently used to provide for professional investment management of trust assets. Because the grantor retains control over the trust assets, assets in a revocable trust are included in the grantor’s estate (hence there is no estate tax benefit to a revocable trust). Depending on the type and terms of the trust, income may be taxed to the grantor, the trust, or the beneficiaries.

Irrevocable trusts can be either living (created during one’s lifetime) or testamentary (created by will). Once established, the grantor can no longer change or revoke the trust, or control trust assets. For this reason, in most cases the assets are removed from the grantor’s estate and are not subject to estate tax. Irrevocable trusts are often used to reduce estate taxes and in some cases, income taxes (if the income is taxed at a lower rate than the grantor’s rate). With few exceptions, the transfer of assets to an irrevocable trust is considered a completed gift, triggering a potential gift tax liability. Because assets are removed from the grantor’s estate, irrevocable trusts are useful to receive life insurance, highly appreciating assets, as well as assets whose valuation can be reduced at the time of transfer through valuation reduction techniques (among others, minority discounts and lack-of-marketability discounts for closely-held businesses or privately traded stock).

Here are a few of the commonly-used trusts, and the primary purposes for which they are employed:

1. Marital Trusts: Marital trusts are typically set up to take advantage of the “unlimited marital deduction.” They provide income to the surviving spouse for life and, in some cases, distributions of principal for healthcare, maintenance, education and so forth. The assets are not subject to estate tax in the decedent’s estate because of the unlimited marital deduction (married couples can pass unlimited amounts of money and assets to each other both during lifetime and at death, with no estate or gift tax). The assets that remain in the trust at the time of the surviving spouse’s death are included in the estate of the surviving spouse and thus are subject to estate tax. Thus, marital trusts do not eliminate estate tax, but defer it. Marital trusts can take several forms, among them: 1) General Power of Appointment Trusts: provides income for life to the surviving spouse and typically allows the surviving spouse to decide who will receive the assets remaining in the estate: 2) QTIP Trusts: income is paid to the spouse during his/her lifetime, but the decedent controls who receives the remainder. The corpus of the trust is typically bequeathed to the children or other heirs determined by the decedent. QTIP trusts are often used by individuals who have been married more than once and have children from prior marriages to whom they want to provide an inheritance, but also want to take care of the surviving spouse for life.

2. Credit-Shelter Trusts: Also called a “bypass trust”, a credit-shelter trust is a non-marital trust (the assets do not qualify for the marital exemption). Assets placed in a bypass trust usually take advantage of the “uniform lifetime exemption.” Currently, this allows up to $5.45 million of assets in the bypass trust to escape estate tax liability. Bypass trusts are useful to keep assets from a first marriage from going to the spouse of a second marriage. Typically, a bypass trust provides for discretionary income to be paid to the surviving spouse and their children, and upon the death of the surviving spouse, the remainder to be paid to the children (with none going to the second spouse of the surviving spouse). Because the assets were included in the decedent’s estate and the uniform lifetime exemption of the decedent was applied to shield them from estate tax, no estate tax is ever paid on the assets in these trusts.

3. Asset Protection Trusts: An asset protection trust is an irrevocable trust directing that the funds be held by the trustee on a discretionary basis. Beneficial enjoyment of the assets is split from legal title to the assets. The goal of these trusts is to limit the interests of beneficiaries in such a way as to preclude creditors (from bankruptcy, divorce, litigation) from collecting against trust assets. Most of these trusts are formed under foreign law, though some states have adopted trust laws that resemble foreign jurisdictions.

4. Dynasty Trusts: A dynasty trust is an irrevocable trust that is designed to pass wealth down through multiple generations without incurring estate, gift, or generation skipping taxes, usually by taking advantage of the Uniform Estate and Gift Tax exemption and the Generation Skipping Tax exemption (both of which were $5.45 million in 2016). These trusts are long-term trusts that can survive for as long as allowed under state law (which ranges from 21 years after the death of the last beneficiary to hundreds of years). Highly appreciating assets and assets that can take advantage of valuation discounts are well-suited for these trusts.

5. Spendthrift Trusts: Designed to prevent the beneficiary’s creditors from collecting against trust assets, these trusts contain a “spendthrift clause” which prevents the beneficiary from assigning his/her interest in the trust income and corpus. Because the beneficiary cannot borrow against payments or spend them in advance, the beneficiary is protected from his/her own spendthrift propensities.

6. Standby Trusts: A standby trust is a trust that becomes operational when the grantor becomes disabled or incapacitated. The primary benefit for a grantor who becomes unable to manage his/her assets is that professional management has been arranged in advance to step in to provide investment expertise and sound judgement in the handling and distribution of assets. This is an excellent way for individuals to “insure” against the risk of dementia, Alzheimer’s, and other incapacitating conditions.

7. Charitable Trusts: CRATs and CRUTs are irrevocable Charitable Remainder trusts which provide annual income to a non-charitable beneficiary (the grantor or other living person) for a fixed number of years (not to exceed 20) or for life. At the end of this period, the assets in the trust transfer to a charitable beneficiary. These trusts allow the deduction of the charitable remainder from income tax and remove the value of the remainder interest from the grantor’s estate. Charitable lead trusts (CLATs and CLUTs) operate in the opposite manner. Assets are transferred to an irrevocable trust to provide an income stream to a charitable beneficiary, while the remainder interest reverts to the grantor or other non-charitable beneficiary. These trusts provide a very large income tax deduction to the grantor in the year the trust is established (the present value of the future income streams to the charitable beneficiary), while preserving the principal to revert to the grantor or pass to the grantor’s heirs.

Trusts have many varied uses and benefits, primary among them: 1) ongoing professional management of assets; 2) reduction of tax liabilities and probate costs; 3) keeping assets out of a surviving spouse’s estate while providing income for life; 4) care for special needs individuals; 4) protecting individuals from poor judgment, poor investment decisions, and being taken advantage of by friends, family, and strangers; 5) protecting assets from creditors and/or from becoming marital assets in a divorce; 6) carrying out charitable intent in a tax-efficient manner; and 7) ensuring multi-generational transfer of wealth. A financial advisor who understands the family’s total financial picture and dynamics as well as the constructive role that trusts can play in financial, estate, retirement, and tax planning, is able to “quarterback” the client’s team of attorneys, CPA, and other professionals to carry out the client’s lifetime and testamentary objectives.

The Fiduciary Group is proud to announce that Julia Butler recently completed the CFP® Board’s certification requirements and has become a Certified Financial PlannerTM professional. In 2016, Julia completed an advanced college-level curriculum addressing the financial planning subject areas specified by the CFP® Board, which include insurance and risk management, investment planning, employee benefits planning, income tax planning, retirement planning, and estate planning. Julia also passed the comprehensive CFP® Certification Examination. She has fulfilled the 3-year financial planning-related experience requirement and has agreed to be bound by the high ethical standards set by the CFP® Board. Julia will be heading up the firm’s financial planning services alongside of continuing to provide investment advisory services to individual clients and company 401(k) plan sponsors and participants. Congratulations to Julia Butler, CFP®!

AUTHOR:

JULIA BUTLER, CFP®, JD, MBA, CFEI