Outside the Box: Trusts are useful for almost everything in estate planning

United States

Trusts are among the most used, most useful and most misunderstood tools of estate planning. Much of the misunderstanding arises from the fact that trusts come in so many different forms depending on their purpose. In a series of articles I will try to explain and unravel the mystery of trusts and help you understand how best they can be used.

Here are just some of the types of trusts you might run across:

·       Revocable trust (sometimes called a living trust)

·       QTIP trust

·       Credit shelter trust

·       Irrevocable life insurance trust

·       Special needs trust

·       Income-only trust

·       Charitable remainder trust (also, CRIT, CRAT and CRUT)

·       QPRT (also, GRIT, GRAT and GRUT)

·       Asset protection trust (or DAPT)

·       Spendthrift trust

·       Generation skipping trust

·       (d)(4)(A) trust (or first-party special needs trust)

·       (d)(4)(C) trust (or pooled disability trust)

·       Realty trust

·       QDOT

Each of these trusts has elements different from the others and even trusts of the same type can be somewhat different as each is tailored to the client’s needs.

Common elements of trusts

However, despite all the possible variations, all trusts share a number of common elements. These include the following:

Each trust is its own financial entity. The trust document (or “instrument” or “indenture” or “agreement”) sets the terms under which the trust operates, terms that the trustees must follow.

The grantor or donor is the person (or in some cases people) who creates the trusts and sets its terms. If the trust is revocable, the grantor is free to change or terminate it whenever she chooses.

The trustee manages the trust following the directions of the trust document. There can be more than one trustee and they can be individuals or institutions, such as banks or trust companies. Depending on the type of trust, the grantor or beneficiaries may or may not be able to serve as trustee. Their actions are governed by both the trust document and state trust law. Trustees have a “fiduciary” duty to act in the best interest of the beneficiaries.

The trust and the trust instrument only apply to property transferred to and titled in the name of the trust. This is an area where things often slip through the cracks. The attorney and client work together to create a trust that ideally fulfills the client’s goals, and then they neglect the next step of retitling the client’s assets into the trust. As a result, the trust’s terms can become irrelevant. (Sometimes this is remedied by a so-called “pour over” will that transfers assets to the trust upon the grantor’s death, but then it doesn’t provide the probate avoidance and incapacity protections described below.)

The trust beneficiaries are the people for whom the trust is created. They have rights to distributions from the trust as set out in the trust document. This might be a right to income or for a distribution of principal for particular purposes, such as for healthcare, education or the down payment for a home. Beneficiaries may have a current or a future interest. For instance, a trust may provide that it will pay income to a surviving spouse and that upon his death the trust principal will be distributed to the couple’s children. In such a case, the children have a real (or “vested”) interest in the trust, but no current right to a distribution. Yet, the trustee must take their interests into account as future beneficiaries.

Revocable trusts use the grantor’s Social Security numbers for bank and investment accounts they hold. Irrevocable trusts must obtain their own tax identification number and file an annual 1041 income tax return. Yet, irrevocable trusts rarely pay taxes because tax liability generally follows the income. So, if the trust distributes its income to the beneficiaries, the income will be taxed to the beneficiaries. This is usually a good result because trusts have accelerated tax brackets, reaching the top rate of 37% on income above $ 13,050 (in 2021).

What are trusts good for?

With this basic understanding of what trusts are and how they work, the next question is: What are trusts good for? The answer is: Just about everything in estate planning, which is why I think of them as the Swiss Army knife of estate planning. Here are some of their possible uses:

·       Probate avoidance: Usually revocable trusts are used to avoid the expense, delay and administrative burden of the probate process. To the extent assets have been transferred to a revocable trust, the trustee can simply follow through on the terms of the trust without having to first seek court appointment, a process that can take extra time and trouble.

·       Planning for incapacity. Trusts are ideal tools for managing assets of individuals who become incapacitated. This is especially important for older individuals who risk dementia, illness and exploitation by scammers. Older adults can name a co-trustee or successor trustee to step in upon their incapacity. This often works better than durable powers of attorney which some banks and investment firms resist honoring.

·       Protection of minor children or grandchildren. It rarely makes sense to leave assets to minors or often to younger adults. A trust can permit a trustee to manage the funds for their benefit and make distributions as appropriate. Some parents provide that inheritances will be distributed at various ages, perhaps a third each at ages 25, 30 and 35. This gives children and grandchildren the opportunity to learn about managing money before receiving everything at once.

·       Asset protection, for oneself or for family members. It’s possible to protect assets from the claims of creditors either for oneself or for other family members. For oneself, the trust must have limitations on distributions or be established in one of the states that provides for domestic asset protection trusts (DAPTs). Such trusts can only protect against future claims, not those that already exist. It’s much easier to set up a trust for someone else – usually children — that protects against their current or future creditors. These have been traditionally known as “spendthrift” or “generation skipping” trusts, though the latter term also refers to certain estate tax benefits of such trusts.

·       Divorce protection, usually for children. Divorce protection trusts are similar to those for asset protection and the same trusts can serve both purposes. This is especially important for many parents who want to make sure that half of any inheritance they leave their children doesn’t end up in the hands of ex-spouses. Even where there is no divorce, these trusts can make sure that if a child dies before her spouse, inherited funds pass to grandchildren and not to the surviving spouse and potentially to his or her new husband or wife.

·       Estate tax planning. Many types of trusts are used to avoid or minimize estate taxes. Credit shelter or QTIP trusts make certain that assets left by the first spouse in a couple to die don’t get taxed upon the death of a surviving spouse. Life insurance trusts remove the proceeds of life insurance policies from the estates of the insured. QPRTs and related trusts allow discounted valuations of property passing to heirs. These tools are used less today than in previous years with the higher thresholds for estate taxation, but are still quite relevant in some states with lower thresholds and will be of use to more well-to-do individuals if the threshold for estate taxation drops from the current $ 11.7 million to $ 5 million as proposed in pending legislation on Capitol Hill.

·       Income tax planning. Much less used are trusts to reduce income taxes. They often involved creating trusts for children so that income will be taxed at their lower tax rates than that of parents. Charitable remainder trusts can permit the sale of highly-appreciated assets without incurring taxes on capital gains while also allowing charitable deductions on income taxes.

·       Long-term care (Medicaid) planning. These are forms of asset protection trusts that permit older individuals to shelter assets, often their homes, from having to be spent down before qualifying for Medicaid to cover their long-term care costs. They also protect such property from so-called estate recovery claims after their deaths by state agencies seeking reimbursement for the cost of their care.

·       Protection of child or grandchild with special needs. Individuals with special needs often need help managing their finances and it can be vital that they maintain eligibility for various public benefits, including Medicaid, Supplemental Security Income and subsidized housing. Special needs trusts provide for both results, proper financial management and public benefit eligibility. Trusts must have different terms depending on whether they are designed to shelter the individual’s own funds or those given or left to him by someone else, usually a parent or grandparent.

As you can see, trusts can serve many purposes, just like a Swiss Army knife. Depending on the grantor’s goals, the attorney will use a different form of trust and modify it as appropriate. The best solution is usually arrived at by clients and attorneys working together.

Next time I’ll address the often misunderstood differences between revocable and irrevocable trusts

Harry S. Margolis is a Massachusetts estate and elder law planning attorney. He answers consumer questions about estate planning at AskHarry.info and most recently published The Baby Boomers Guide to Trusts: Your All-Purpose Estate Planning Tools.