Dollars and Sense
A trust is a legal agreement under which money or other assets are held and managed by one or more people for the benefit of another person or group of people. Different types of trusts, including the insurance trust, may be created to accomplish specific goals. Each kind of trust may vary in the degree of flexibility it has and the amount of control it offers.
The common benefits that trust arrangements offer include:
· Providing personal and financial safeguards for family and other beneficiaries;
· Postponing or avoiding unnecessary taxes;
· Establishing a means of controlling or administering property; and
· Meeting other social or commercial goals.
Certain elements are necessary to create a legal trust, including a trustor, trustee, beneficiary, trust property, and trust agreement.
The person who provides property and creates the trust is called the trustor. The person may also be referred to as the grantor, donor, or settlor.
The trustee is the individual, institution, or organization that holds legal title to the trust property and is responsible for managing and administering those assets. The trustee is usually designated by name, but a trustee may be appointed by the courts when applicable (in the case of minor children, for example). In some cases, the trustor can also be the trustee, which typically is the case for revocable living trusts. In revocable trusts, the owner of the assets may also manage them and have full access to them. As a result, there is seldom any tax advantages connected to revocable trusts. At most, they may delay the payment of taxes.
Trusts may have two or more trustees that serve together as a committee for the benefit of the testator and his or her beneficiaries. There may also be an individual and an organization named to act as co-trustees. Separate trustees may also be named to manage different parts of a trust estate. For example, one person may manage the assets for a minor beneficiary while another manages the minor’s personal care. When minors are among the beneficiaries this is often recommended to protect the interests of the child.
The beneficiary is the person or organization who receives the benefits or advantages (such as income) of the trust. In general, any person or entity may be a beneficiary, including individuals, corporations, associations, charities, or even units of government (although it is difficult to imagine anyone donating to the government).
To be valid, a trust must hold some property or assets. Because there are so many so-called “opportunities” to establish a trust, it is not unusual for a trust to be created, but never funded. This might happen because the testator used a do-it-yourself format that can be purchased or found on the internet. It may also happen because a salesperson, collecting a fee, sets up the trust but leaves funding to the testator. Although the salesperson’s intentions may have been good, if the testator fails to move any assets or money into the trust it remains unfunded or empty. When this is the case, the trust never becomes valid.
Trust property may include any asset, such as stocks, real estate, cash, a business, or insurance policies. Trust property may include both real and personal property. Trust property may also be called the “trust corpus,” “trust res,” “trust estate” or “trust principal.” Trust property might include some future interest or right to future ownership, such as the right to receive death proceeds from a life insurance policy. As previously stated, however, if property or assets are not transferred appropriately to the trust it cannot accomplish anything.
The trust agreement is the legal contract between the trustor and trustee. It generally contains a set of instructions for the trustees and may even hold instructions for the beneficiaries in some cases. It will provide duties, obligations, and personal instructions from the trust creator (trustor). It may state the purpose of the trust, the property to be held and invested, and how the proceeds may be used or distributed to beneficiaries.
Most of us would assume a trust must always be written. While trust agreements are typically written, they may also be oral agreements or even just implied. The trustor usually has considerable latitude in setting the terms of the trust. To be enforceable, some types of trust assets need to be in writing, however. For example, a trust involving an interest in land must be in writing.
Many kinds of trusts are available. Trusts may be classified by their purposes, by the ways in which they are created, by the nature of the property they contain, and by their duration. Trusts are often classified as either living trusts ("inter vivos" trusts), or testamentary trusts.
Living trusts are created during the lifetime of the trustor. It is always important to use professionals that specialize in trusts when using trusts to accomplish specific goals. Property held in living trusts are not normally subject to probate (the court-supervised process to validate a will and transfer property on the death of the trustor) although it may be necessary to list the trust assets in court proceedings. Not all states will require the trust be disclosed, so the individual should seek legal counsel in their state for specifics. When trusts do not need to be disclosed it is usually because they are not subject to probate or estate taxation. Therefore, they do not need to be listed in the court record and confidentiality is maintained. Trusts are widely used because they allow the trustor to designate a trustee to provide professional asset and distribution management.
In some cases, living trusts allow income to be taxed to the listed beneficiary resulting in income tax savings for the trustor. However, income earned by a trust established for a beneficiary under the age of 14 may be taxed at the beneficiary's parent's tax rate. The transfer of property to a living trust may also be subject to gift tax. As always, consult your attorney or accountant for details.
Testamentary trusts are created under a will and must conform to the statutory requirements governing wills in the individual’s state of residence. Testamentary trusts become effective upon the death of the person making the will and are commonly used to conserve or transfer assets. The will requires part or all of the decedent's estate to transfer to a trustee who is charged with administering the trust property and making distributions to designated beneficiaries according to the provisions of the trust.
Before the trust property becomes subject to the testamentary trust, it will normally pass through the decedent's estate. When the estate is probated, testamentary trust assets could be subject to probate. Trust assets are also potentially subject to estate and generation-skipping transfer taxes at the time of the decedent's death.
A testamentary trust gives the trustor substantial control over the estate’s distribution. Testamentary trusts can provide for a child's education or delay receipt of property until the child is old enough to appropriately handle wealth. Some types of trusts may exempt property from death taxes until the later death of the trust beneficiary. A generation-skipping transfer tax may still apply, however.
Living trusts can be either revocable or irrevocable. The trustor has the right to change the terms or cancel a revocable living trust. Upon revocation, the trustor resumes ownership of the trust assets.
A revocable living trust is typically used when the trustor does not want to lose permanent control of his or her assets. There may be varying reasons for this. Perhaps he or she is unsure of how well the trust will accomplish their goals or is unsure of how he or she wishes to distribute property upon death. The trustor may not feel secure putting assets into any vehicle that takes away personal control.
Revocable trusts do provide specific benefits, however. With a properly drafted revocable trust, the individual may:
1. Add or withdraw some assets from the trust during his or her lifetime;
2. Change the terms and the manner of administration of the trust; and
3. Retain the right to make the trust irrevocable at some future date.
The assets in this type of trust will generally be includable in the trustor's taxable estate, but may not be subject to probate, depending upon the state of residence and the exact terms of the trust document.
An irrevocable living trust may not, as the name indicates, be altered or terminated by the trustor once the agreement is signed – it is irrevocable. Irrevocable trusts have two distinct advantages:
1. The income may not be taxable to the trustor; and
2. The trust assets may not be subject to death taxes in the trustor's estates.
These benefits will probably be lost, however, if the trustor is entitled to:
1. Receive any income;
2. Use the trust assets; or
3. Otherwise control the administration of the trust in any manner that is inconsistent with the requirements of the Internal Revenue Code.
Since an individual may revoke or amend their will at any time prior to death, a testamentary trust may be changed or canceled too. Revisions can be made by drafting a new will or by using a codicil that is attached to the original will showing any changes or additions. It is not wise to use too many codicils since that can simply become confusing. If multiple changes occur, it is best to simply draft a new will. All codicils must be executed in the same manner required for wills.
The trust must be explicit regarding its revocability or irrevocability. Otherwise, the trust will likely be legally considered irrevocable.
Depending on several circumstances and state requirements, trusts may be established orally, in writing, or by conduct (intent). Trusts typically involve a number of legal concepts relating to ownership, taxes, and asset control. Although anyone can establish and execute a trust, usually attorneys or accountants assist in explaining options, considering contingencies, and preparing documents.
Unfortunately, unqualified persons often assist individuals or even urge individuals to establish a trust (usually for a fee) when it is not financially advantageous. Having an unnecessary trust is not likely to cause great problems (unless some assets are placed in trusts that should not be), but the cost of drafting a trust can be high. Such trust fees are wasted if the document is unnecessary, unfunded, or poorly written. When a trust is an advantage for the individual, several things should be considered, including:
Dependency exemptions, capital gains and losses, income, gift, estate, and generation-skipping transfer taxes also should be considered when planning certain types of trusts. Just as agents recommend with life insurance policies, it is wise to state contingents in the trust document. This would include trustees and even beneficiaries.
Like wills, once the trust is established it should be reviewed periodically. Life changes, such as marriage, divorce, the birth or death of children, and any other major changes in life may require trust changes. If the trust is irrevocable, there should be a provision written into the document that allows changes under specific conditions.
Most trustor’s probably establish the trust in their resident state, but it can also be established in the trustee’s state, if different. When deciding where to establish the trust, remember that each state has different laws governing the operation of trusts and trustees' powers. If the trustor changes his or her state of residence, the trust location can also be changed in most cases. This is referred to as a “change of situs.” A location change may also be desired due to tax reasons. Whether or not the move can be made, and how the move is accomplished, will be dictated by each state's laws.
A trustee, whether an individual or institution, controls legal title to the trust property and is given broad powers over maintenance and investments, unless restricted within the trust document. Trustees are required to follow all state and federal laws regarding their ethical and legal responsibilities. In general, a trustee must:
At no time may the trustee use any trust principal or income for his or her own benefit or profit. The trustee must administer trust assets solely for the designated beneficiaries. The trustee may not borrow or otherwise use assets in the trust, including selling his or her own property to it, or using the trust assets as collateral for personal debt.
It is important to consider the potential trustee's competence and experience in managing business and financial matters prior to selection. Naming a trustee does not necessarily mean he or she is available and willing to serve. This should be discussed with the desired trustee prior to naming them in the trust document.
Individuals and companies (such as banks) may serve as trustees. There are advantages and disadvantages to both. For example, a bank usually offers specially trained managers to provide administrative, counseling and tax services that an inexperienced individual may not have. Banks will also be available for many years, without worry that illness or relocation would make the duties difficult or even impossible for a single individual to continue. Most banks charge a fee for trust services. Some banks may not accept small trusts having less than a specified amount of assets. In fact, small trusts may not do well with a bank since the fees charged may eat up too much of the available trust assets over time.
Relatives, family friends or business associates may serve as trustee without charging for their services, but they are less likely to have the experience an institution would have. Even so, this person is likely to add a more personal touch that would not be available through banks or other institutions. If the beneficiaries are minors, this personal touch may be an advantage since the relative or friend will have special knowledge that the bank would not have. However, since these individuals are unlikely to have the skill and experience necessary to properly manage some trust assets, it may be important to write the trust with allowances for hiring those with such skills to assist the trustees.
The Life Insurance Trust
Insurance trusts take various forms. Some are business insurance trusts, which may be used to protect the “key men,” proprietor or partners of a business. Personal insurance trusts involve no business interests. Personal insurance trusts are generally intended to provide management of insurance proceeds and protect the estate from some forms of taxation. Insurance trusts may be revocable or irrevocable, and various types of agreements are available to accommodate an individual's circumstances and desires, or the requirements of a business.
One form of insurance trust is the life insurance trust. This trust, similar to a living trust, is created to receive proceeds payable under a life insurance policy. It is normally established to exclude proceeds from taxation in the decedent's estate. A life insurance trust can also be used to provide a vehicle for continued management and distribution of insurance proceeds for a beneficiary who may need assistance in those matters, such as a minor child or disabled adult. Sometimes life insurance trusts are used to manage estate assets for an adult who has not displayed financial maturity, spending recklessly, or refusing to accept normal adult responsibilities.
A life insurance trust is an irrevocable, non-amendable trust which is both the owner and beneficiary of one or more life insurance policies. Upon the death of the insured, the trustee invests the insurance proceeds and administers the trust for one or more named beneficiaries. If the trust owns insurance on the life of a married person, the non-insured spouse and children are often beneficiaries of the insurance trust. If the trust owns “second to die” or survivorship insurance that only pays when both spouses are deceased, only the children would be beneficiaries of the insurance trust.
An Irrevocable Life Insurance Trust, known as an ILIT, is a powerful estate planning tool. An ILIT is a special type of trust designed to own life insurance policies and to protect the proceeds from estate taxation. Because it is irrevocable, no changes may be made once it has been established.
Since the technical language required for an ILIT is designed to meet strict requirements of the Internal Revenue Code, it is very important to obtain services or advice only from professionals who have the knowledge, skills, and experience in creating life insurance trusts. Insurance agents should never offer such services or advice unless they are qualified to do so by having training and experience.
Life Insurance Trusts and Federal Estate Taxes
Most middle-class estates are not subjected to the federal estate tax, but estates valued in excess of a specified amount will be. Life insurance is often used to compensate for these taxes. However, life insurance could add to the tax it was meant to cover.
When a person buys life insurance, he or she intends to provide financial security for their beneficiaries upon their death, but they may inadvertently also leave their family with additional taxes. The Estate Tax is a tax on a person’s right to transfer property upon death. It is an accounting of everything owned, including certain interests, at death. The fair market value of these items is used, which may not necessarily be what was paid for them or what their values were when acquired. The total of all items is called the "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. There are specific deductions allowed.
Most relatively simple estates (cash, publicly traded
securities, small amounts of other easily valued assets, and no special
deductions or elections, or jointly held property) do not require the filing of
an estate tax return. A filing is required for estates with combined gross
assets and prior taxable gifts exceeding the current exemption amount. The
heirs who died in 2010, when it was $5 million and 35 percent tax rate, had a
choice. They could use the exemption or the tax rate. In 2017 the Tax Cuts and
Jobs Act passed and doubled that to $10 million (adjusted for inflation each
year) In 2023, the per-person federal estate-tax exemption grew to $12.92
million, so a married couple could pass down nearly $26 million to their family
or others without paying any federal estate tax. As
of January 1, 2026, the lifetime estate and gift tax exemption will
be cut in half and adjusted for inflation.
Families that may face estate tax liability in 2026 may benefit from
transferring assets and their appreciation out of their estate sooner rather
than later unless congress addresses this by the end of 2025 as the Act will
“sunset”.
|
Federal Estate Tax Exemption by Year |
Top Estate Tax Rate |
|
|
2013 |
$5,250,000 |
40% |
|
2014 |
$5,340,000 |
40% |
|
2015 |
$5,430,000 |
40% |
|
2016 |
$5,450,000 |
40% |
|
2017 |
$5,490,000 |
40% |
|
2018 |
$5,490,000 |
40% |
|
2019 |
$11,400,000 |
40% |
|
2020 |
$11,580,000 |
40% |
|
2021 |
$11,700,000 |
40% |
|
2022 |
$12,060,000 |
40% |
|
2023 |
$12,920,000 |
40% |
|
2024 |
$13,610,000 |
40% |
|
2025 |
$13,990,000 |
40% |
When determining estate values, the fair market value of all assets is included. The fair market value is the amount the asset would sell for on the open market. This includes real estate, stocks, bonds, all retirement accounts and usually the proceeds from any current life insurance policies. To keep the life insurance proceeds out of the taxable estate, the insured must not also be the owner of the policy. The beneficiary cannot be listed as the estate either – a person or other entity must be named. Who should own the life insurance policy? If the spouse owns the policy, the proceeds may not be included in the estate, but the amount left over will probably be taxed when the spouse dies. This is a primary reason an irrevocable life insurance trust is used.
Death benefits from life insurance policies are not subject to income tax, but they are subject to estate tax and inheritance tax. In 2010, for example, the federal estate tax disappeared, but only for that year. In 2011 the federal estate tax returned. Financial experts say that is why precise planning is constantly needed, to ensure heirs get the largest inheritance possible.
It should surprise no one that the IRS doesn't like these trusts and have successfully challenged some of them in court. That doesn’t mean they can’t be used, but life insurance trusts and Crummey trusts must be correctly used to be effective. Recent cases have approved their use when correctly drafted.
Unfortunately, too few people understand that it is best not to own their own life insurance policy. Therefore, if you are purchasing a new policy, you should not be designated as the owner or the applicant. You should first set up the trust, and have the trustee apply for the policy on your life.
The trust must be drawn with attention to every detail. Life insurance should be just one of the permissible investment vehicles rather than the sole purpose of the trust. It must clearly state that the trustee has all ownership rights to the policy.
Finally, make sure that the trust has appropriate language that will enable you to make tax-free gifts to the trust, so that the insurance premiums can be paid. Only those with proven experience in trusts should draft a life insurance trust.
When it comes to the irrevocable life insurance trust, doing things right means paying attention to detail and following all of the rules. Doing things wrong means that Uncle Sam could take a chunk of the life insurance proceeds. Therefore, the additional expense of preparing such a trust is worth the cost.
Disadvantages of Life Insurance Trusts
To recap, a life insurance trust is a trust that is set up for the purpose of owning a life insurance policy. If the insured is the owner of the policy, the proceeds of the policy will be subject to estate tax when he dies but by transferring ownership to a life insurance trust, the proceeds will be completely free of estate tax. The proceeds would be exempt from income tax either way.
There are several drawbacks to such an arrangement however, including:
1. Policy beneficiaries cannot be changed.
The insured must give up the right to change the beneficiary of the policy (the trust itself is the beneficiary). The trustee alone has that right, and the insured cannot serve as trustee of his own life insurance trust. The insured does designate the beneficiaries of the trust, but the designation cannot be changed once the trust has been set up. Therefore, the insured lacks flexibility to deal with changed family circumstances such as a new spouse, adopted children, or newly born children. This may be circumvented to some extent by stating beneficiaries less specifically, such as “all surviving and legally adopted children equally.”
2. Loans may not be made from the policy.
The insured can no longer borrow against his or her policy. If the trust allows him to borrow against the policy, he will be deemed the owner for estate tax purposes, losing all tax advantages.
3. Existing policies cannot be transferred to the trust unless the insured lives for at least 3 more years following the transfer.
If the insured transfers an existing policy to a life insurance trust and dies within the next three years, he will be treated as the owner of the policy and it will be taxed in his estate. Even if he survives another three years, he will have made a taxable gift in the amount of the cash value of the policy, which may be preferable to having the entire face value subjected to estate taxes. If the life insurance trust takes out a new policy on the insured's life, however, the insured will never be deemed to own the policy. No cash values will have built up yet, so no taxable gift is made.
4. The life insurance trust must be irrevocable.
Once the trust is set up and funded, the insured cannot get the policy back. If he or she becomes uninsurable, the trust will be the only source of life insurance.
5. Premium payments may use up your estate tax exemption.
If the policy has not yet endowed, premiums must still be paid without using up all the estate and gift tax exemption. If securities are transferred to the trust so that the trustee will have income with which to pay the premiums, the full value of the securities will be a taxable gift. If cash is transferred to the trust each year to pay premiums, each transfer will be a taxable gift. It may be possible to exempt these premium payments from gift or estate taxes by setting the life insurance trust up as a Crummey Trust. Then each premium payment can be sheltered by the annual gift tax exclusion.
6. You must find or hire a trustee.
The insured cannot serve as their own trustee of the life insurance trust. He or she will have to find or hire a third-party trustee. Many banks and trust companies offer reduced fees for life insurance trusts because they involve essentially no investing decisions, but there will be fees of some sort.
Despite these possible drawbacks many people find the tax saving potential of life insurance trusts worthwhile. It allows the trustor to remove a significant asset from the estate that probably would not be accessed during life so is unlikely to affect day-to-day living or financial quality of life. In the process it ensures that the life insurance proceeds go 100% to the beneficiaries, not to the federal government.
Providing Financial Structure
The benefits of life insurance may be maintained while avoiding estate taxes on the life insurance proceeds through an irrevocable life insurance trust. An ILIT is a trust that is separate from the individual’s primary estate plan. It is irrevocable, meaning the testator cannot change it once it has been created. Creating such an irrevocable trust requires certain steps, including:
1. Meeting with a financial advisor or attorney who is knowledgeable in trust planning and procedures. No trust is right for everyone, but many people can benefit from this type of trust. The meeting is to determine if it is right for the particular situation.
2. If an ILIT is right for the goals of the investor, a trustee and beneficiaries must be selected. The investor might use his or her life insurance agent, accountant, or any appropriate person as the independent trustee. The investor’s attorney creates the trust documents to reflect the individual’s decisions and plans.
3. Then the individual signs the trust document and the trust is created at that point. The trust is a separate legal entity that contains two important things: the instructions for what the trust creator wants done with his or her property held in the trust (life insurance and cash) and a delegation of authority to the trustee and successor trustee to carry out specified instructions.
4. Finally, money is placed in the trust on behalf of the beneficiaries. The trustee deposits the money in the trust checking account. The money is exempt from federal gift and estate taxes up to the annual exclusion amount and is treated as a gift to each beneficiary.
The proceeds of life insurance policies provide cash when beneficiaries may especially need them – after the primary wage earner has died. That same cash also faces federal estate tax. Life Insurance proceeds are exempt from income tax, but they are subject to estate tax where it applies.
For those who live in a state subject to estate tax, life insurance proceeds can help pay that tax. Having life insurance in the estate provides cash, but it is taxable cash. The very life insurance that helps pay state taxes is itself taxed. The more life insurance there is the more tax is due. Obviously it would be better for the insured and his or her beneficiaries if taxes did not reduce the life insurance’s value.
Avoiding Estate Taxation
By creating a life insurance trust, heirs avoid some estate taxes following
the insured’s death. The life insurance trust takes over the responsibility of
making premium payments and, after the insured’s death, the distribution of the
policy proceeds to the heirs. Estate tax only applies when the insured is
responsible for paying the premiums. By creating the trust, the policy is no
longer part of the estate so no estate taxes apply to it after the insured’s
death.
It is wise to hire an attorney that specializes in estates to draft the life
insurance trust. He or she must be someone who is responsible and reliable
because the trust could be in existence for several decades. The attorney
could also serve as trustee, but he or she will charge for those services. Banks
also usually have a trust department, but they will also charge a monthly or
annual fee for their services. The insured must purchase a life insurance
policy to put into the trust unless he or she already owns one, which could
then just be moved into the trust. Once the trust is set up nothing can be
changed. If changes are made after the trust has been set up, the government
might see this as an "incident of ownership," meaning the policy is
still in the insured’s name and therefore subject to estate taxes. In
addition, if the policy was purchased prior to the trust creation it must be
there for at least three years to avoid estate taxes. Many professionals feel
it is best to buy a new policy after the trust is created.
The insured needs to make a gift worth the first year's premium to the trust
so the trustee can make the policy payments. After the first year, the insured
would make gifts to the trust in the name of the beneficiaries approximately 60
days prior to the policy premium’s due date. If the payments are made as
"present interest gifts” it may be possible to deduct the gifts per
beneficiary in that tax year, so the payments would not be considered taxable
gifts.
If an old policy is brought into the trust, it may be considered a taxable gift – a good reason to buy a new policy rather than use an existing one. The insured may be able to use his or her unified credit to avoid taxes, but only if the unified credit has not already been used.
The Annual Exclusion
To qualify the gift for the annual exclusion, the beneficiaries must have the right to withdraw the gift each year. The trustee must give all beneficiaries notice of the gift and their rights to withdraw it. If the beneficiaries do not withdraw the gift, the trustee uses the gift to purchase life insurance on the trust creator, and gift in subsequent years to pay the annual premiums.
This cycle of gifts, notices, and premium payments continues each year. When the insured dies, the trustee collects the insurance proceeds. If all the requirements of annual contributions, notices, and so forth have been met, those proceeds will not be part of the insured’s taxable estate.
The trust language gives the trustee authority to use the funds (life insurance proceeds) in the ILIT to purchase assets from the trustee or the executor in the primary estate or to distribute the funds to the named beneficiaries following the trust creator’s instructions.
Although the procedures required to make a life insurance trust effective may seem complicated they are designed to meet specific criteria of the Revenue Code and of IRS rulings, including court decisions interpreting and applying the code. Once the trust and insurance policy are in place, however, the operation of the trust is a simple matter. An ILIT is certainly a better alternative than paying estate taxes to the government.
An individual may only create an ILIT while he or she is (1) considered competent and (2) able to qualify for the underwriting a life insurance policy requires, unless there is an existing life insurance policy that can be used. If either of those requirements does not exist, the ability to create an ILIT and to reap its substantial benefits is gone. Estate planning typically requires time to accomplish whatever goals are desired, so it is always wise to identify and implement goals as early as possible and appropriate.
This type of trust cannot be revocable, and the insured cannot retain any right to trust income. To ensure the tax advantages are retained, it is important that the document be properly drafted. The tax rules in this area are quite complex, so professional legal assistance may be helpful in the preparation of such a document.
A charitable trust is also called a “public trust” because it benefits‚ immediately or eventually, members of the general public through charitable organizations or directives. It can offer many tax advantages to the trustor not available to other private trusts. Unlike private trusts, it can be established to last indefinitely. There is no stated termination date.
Charitable trusts can offer great flexibility, if properly drafted. They can be complicated if the goals are very specific, but they need not be. Charitable trusts can be flexible if they are written with broader language. For example, a trust that will donate only when specific circumstances exist will be less flexible than one that donates broadly. Charitable trusts must be carefully drafted to receive the tax treatment desired.
A commonly used charitable trust is the “charitable remainder trust.” This type of trust allows the trustor to give a future interest in their asset to charity, while keeping an income stream for him or herself or for another named beneficiary.
A trustor may specify that a certain portion of the trust income be distributed to a non-charitable beneficiary for a certain period of time, with the charity to receive the money or property thereafter (upon the death of the non-charitable beneficiary, for example).
While offering an immediate tax deduction for the charitable contribution, the charitable remainder trust may also lower the estate taxes. To qualify for a charitable deduction, specific formats must be followed, and the charitable beneficiary must meet standards specified by the Internal Revenue Service.
The amount of the charitable deduction is based on complex tax laws that consider such factors as the beneficiary’s age, the property’s value, and the expected income from the trust. Because of the detailed legal concepts and changing IRS regulations, it is advisable to consult a lawyer when considering these trusts.
Charitable trusts are an excellent planning tool for maximizing income during the client's life and benefiting charities at death. The trustor avoids capital gains taxes on appreciated assets; the charity receives the assets sometime in the future. The only loser is the IRS.
A charitable remainder trust makes payments to the trustor for a term of
years or for life, depending upon how the trust document is written. At the
end of the term, the property that remains in the trust is transferred to a
predetermined charity. In a nutshell, the trust functions much like an annuity
retirement plan, with the two added benefits of capital gain tax avoidance, and
a charitable income tax deduction. Like an annuity, once the asset is
transferred to the trust, the trust pays an income to the trustor for life and
the life of their spouse, if applicable. The payment is a predetermined amount
(either a variable or fixed percentage). When both spouses finally die the
charity gets the assets that were transferred to the trust. No value was lost
to the capital gains tax, plus a tax deduction was received on the present
income tax return. The heirs may not actually lose anything despite the
donation to the charity if other estate planning techniques are used in concert
with the charitable remainder trust.
Not everyone will benefit from using the charitable remainder trust. Usually,
if the individual has highly appreciated property (real property or stocks for
example) and/or are in a position where he or she will owe the government taxes
upon their death because of their total estate values, then a charitable
remainder trust makes sense.
Once it is determined that such a trust is appropriate, the trust must then
be created. The provisions of the trust will either set up what is called a charitable
remainder annuity trust (CRAT) or a charitable remainder unitrust
(CRUT). The unitrust provides a variable income based upon a percentage
of the charitable gift and is usually paid on a quarterly basis. The annuity
trust is a fixed amount per month.
Once the trust is created the trustor transfers the gift into it. Depending
on the asset, it can be as easy as signing a quit-claim deed to the trust's
name. This transferred property is then used to generate the income for the
"donor". The trust then takes this asset or property and uses it in
the most appropriate way, which may mean converting it into liquid assets with
greater income producing ability.
Since many people do not want to diminish the inheritance their children and
grandchildren would receive, other estate planning must be done. This can
usually be accomplished by using an irrevocable life insurance trust. Some of
the monthly income generated by the charitable trust is used to purchase a life
insurance policy on the client's life, which is then placed into an irrevocable
life insurance trust. When the client dies, the policy replaces the
approximate value that was given to the charitable trust.
The steps taken would include:
As is typically the case, there are both advantages and disadvantages to using charitable trusts.
Advantages:
Disadvantages:
There are two disadvantages to a charitable trust:
The payments to the income beneficiary are limited to the amount set forth in the trust instrument. No additional distributions can ever be made to the income beneficiary, no matter what the need may be. The individual can never get to the assets that were placed in the trust, only to the monthly income that is generated. As with an annuity that has been annuitized, payments only are accessible.
When the income beneficiary dies, the trust property passes to charity rather than to children or other beneficiaries. For many, this seems like an insurmountable problem, but it should not be if a life insurance trust is also created and appropriately funded. If the life insurance trust is created, intended beneficiaries get the same amount of assets, only they receive it in cash and without any estate taxes taken out.
Bypass Trusts
A bypass trust is a long-term planning device. If an individual leaves property to someone in the form of a bypass trust, that property will not be subject to estate taxes but it will still be taxed in the estate. A bypass trust is particularly useful for spouses who plan their estates together. By leaving property to each other in bypass trust form, they can guarantee that the property will only be taxed once between the two of them.
To effectively save taxes, a bypass trust must follow certain rules laid out by the IRS. Suppose the will sets up a bypass trust for one’s husband, and the wife dies first. In order to keep the trust from being subject to estate tax when the husband dies, the wife’s will must place the following conditions on the trust:
1. The husband's power to access the trust during his lifetime must be limited.
The husband cannot have unrestricted rights to withdraw principal. He may, however, have the right to withdraw principal to provide for his health, education, maintenance, or support. He may also have the right to withdraw up to 5% of principal per year for any purpose.
He may also be granted the right to all of the interest and dividends earned in the trust each year. He can also be appointed as trustee. As trustee, he would have full discretion to decide whether principal is needed for his "maintenance" or "support." This allows the trust to be very flexible.
2. You must limit your husband's power to distribute trust assets upon his death.
Except as provided above, the husband cannot have the right to give the trust assets to himself, his creditors, his estate, or his estate's creditors. He can be given the right to name specific persons in his will who will succeed to the trust upon his death. For example, he could be authorized to leave the trust to any of his nieces or nephews, or to divide it as he pleases among his children. On the other hand, the wife could specify who gets the trust next leaving him no discretion.
The bypass trust can be very flexible but it is critical that it be carefully drafted. The IRS has specified the words that may be used in a bypass trust, and if those words are not duplicated perfectly the trust might not be excluded from tax in the second estate. Even the slightest drafting error can cost hundreds of thousands of dollars in taxes. Therefore, only an experienced tax law attorney should ever draft a bypass trust.
Crummey Trusts
Many people wish to make lifetime gifts to their children in order to save estate taxes. As long as a parent gives his child no more than allowed per year, the gifts will be entirely excluded from gift or estate taxes. Unfortunately, many parents realize their children are not equipped to handle large cash gifts due to immaturity or circumstances. Parents may appoint themselves custodians of the funds preventing access to the money until age 21, or in some states 18. However, reaching legal age does not necessarily mean financial maturity also exists.
In order to give the gifts, but still keep it out of the child's hands until a later age, many parents set up a formal trust. The parent then continues to make the gifts, but they are made to the trust, with the trustee investing the money. To conserve costs, the parent may even act as trustee themselves. The trust document could direct assets to be distributed to the child upon reaching a specified age. It is also possible for the trust to distribute funds in steps. Perhaps the child receives one-third when he turns 25, one-third when he turns 30, and the final third when he turns 35.
Life insurance trusts can benefit the living, too. Cash payments or "gifts" are made to the trust to be used for life insurance premium payments. It is possible to avoid paying gift taxes if the policy is in a trust. This tax loophole is called "Crummey power." A man named Clifford Crummey created a trust and transferred his assets into it. His goal was to avoid estate and inheritance taxes when he died. In 1968, the Internal Revenue Service took Crummey to court, claiming he was using an illegal tax loophole. Crummey won and established a precedent, making the trust a legally acceptable tool.
To make this work, an individual writes a check for each beneficiary as a "gift" to the trust and gives it to the trustee. The amount gifted should be no more per beneficiary than allowed to exempt it from gift taxes. The trustee then writes a letter to the beneficiaries, informing them they can withdraw the money from the trust in the next 30 days.
The depositor does not want the beneficiary to actually withdraw the funds. In order to get the gift-tax break, however, the beneficiary must have this legal right. If the beneficiary does not withdraw the money it becomes trust property. In most cases, the trustee will send part of the money to the life insurance company to pay the life insurance premium. The rest will remain in the trust and go to the beneficiaries when the trustor dies.
The annual exclusion only applies to gifts in which the recipient has a "present interest" in the gift (as opposed to a "future interest"). In order to completely avoid gift or estate tax on the money put into the child's trust, the child must have some right that qualifies as a "present interest." The child must have the right to take the money and spend it immediately. However, the parent can place significant restrictions on this right without losing the gift tax exclusion.
If a beneficiary withdraws the money that is supposed to pay premiums, there might not be enough cash left to make the payments. Insurance policies could lapse and beneficiaries would not get the death benefit.
A Crummey Trust does not give the child any rights to the income but it does give the child the right to withdraw the amount of each gift for up to 30 days after each gift is made. Since the withdrawal right begins immediately after the gift is made, it is considered a present interest. If the child does not withdraw the gift within that 30 days, the withdrawal right lapses and the money remains in the trust until the child reaches the designated distribution age.
The parent must convince the child not to withdraw the money during those 30 days. However, even if the child decides to withdraw the money, he can only withdraw the amount of the most recent gift - not the entire trust. The parent could eliminate all future withdrawal opportunities simply by ceasing to make any more gifts. The assets in the trust remain intact and growing until distribution.
Inheritance Tax versus Estate Tax
An inheritance tax is a tax imposed on beneficiaries receiving property from a deceased individual. The tax is calculated separately for each beneficiary, and each beneficiary is responsible for paying his or her own inheritance taxes. Not all states impose inheritance taxes. States that do impose them frequently tax spouses and children of the deceased at lower rates than other heirs.
An estate tax is a tax imposed on the deceased's estate as a whole. The executor fills out a single estate tax return and pays the tax out of the estate's funds. The heirs will only be held liable for the tax if the executor fails to pay it.
The federal government imposes the estate tax on all citizens and residents of the United States. Inheritance taxes are a state tax and not all states have them. Many middle class Americans will owe no federal estate tax due to the allowed exemptions
Life insurance beneficiaries will not have to pay income taxes since life insurance proceeds are exempt from the federal income tax if they are received as a result of the insured's death. The estate may owe estate tax on the value of the proceeds, however. Without careful estate tax planning, life insurance proceeds will be included in the taxable estate.
There is no specified trust life time. Each document may specify how long the trust will exist or establish no termination point at all. State laws must be considered however. For example, some state laws will not allow a private trust to continue longer than a specified amount of time following the death of a person living at the time the trust was established. Charitable trusts, however, may continue indefinitely due to the intent of the trust.
The use of trusts can help achieve certain goals, usually asset preservation or the reduction of taxes. While trusts can offer a number of tax advantages, tax avoidance should not be the sole motivation for using them since they may not achieve the savings the trustor desires in all situations.
The laws governing trusts and their taxation are complex and subject to change. Federal and state governments have tax attorneys too and their goal is to maximize collection of taxes, not allow citizens to avoid paying them. As an example, under the Tax Reform Act of 1986, income earned in a trust having a beneficiary under age 14 will be taxed to his or her parents. This is a significant departure from prior tax law, which provided that such income be taxed to the child at his or her own tax rate, often resulting in little or no tax being due.
With constant changes in tax laws, an individual contemplating a trust for tax purposes should consult with his or her accountant or attorney to determine whether the trust can meet their tax objectives. By carefully choosing the proper type of investments within a trust, it may still be possible to accomplish tax goals, but careful planning and drafting are required. At no time should a consumer rely on salespeople without provable tax or accounting experience and skills.
The cost of creating and administering a trust varies, depending on its type and duration. It is important to realize that the cost of establishing the trust is not necessarily tied to its effectiveness. The experience of the individual creating the document is especially important, so the consumer or agent should seek out those with previous trust experience. The lawyer's fees to create a trust will usually be based on the time involved in consulting with the trustor and in planning and preparing documents. Before hiring an attorney fees should be discussed. Some will charge hourly or while other may have a flat trust creation fee. Ask for an estimate or arrange a written fee agreement.
The trustee's fee typically varies with the skill and expertise possessed. Charges may be influenced by the size and complexity of the trust estate as well. This affects the nature and amount of services required, such as record-keeping, asset management and tax planning. There may also be accounting, real estate management, or other service fees. Other common charges include annual, minimum, withdrawal and termination fees.
Trusts and Wills
Even though a trust document of some type has been created, a personal will is still necessary. There is no situation where a will is not appropriate; any person of legal age should draft a personal will. Having a trust does not change this.
A will backs up the trust. While it may seem duplication in some areas, having a will covers any asset or contingent situation not covered under the trust.
While everyone needs a will, those with children most certainly have a moral obligation to write a will. A will is needed to appoint guardians for minor children. Trustees may also be needed to manage assets for the children’s benefit. If there is not a will, the court may appoint any guardian they feel appropriate, even someone the parents would not have approved of.
Even when there are no children, a will is still necessary. In some cases, a legally married spouse has not received the entire deceased spouse’s property – especially if there are parents or siblings wanting to inherit. Parents or siblings might inherit part of the home and become co-owners with the remaining spouse. The spouse would not be able to sell the house or other property without their permission, and vice versa. Parents and siblings can be recognized in the will or left specific pieces of property if that is the goal; a will directs property to the person intended.
Many people have heard that a living trust avoids probate, so they assume a will is not necessary. A living trust works because none of the assets are in the deceased’s name at death. If the trust creator has vigilantly transferred everything owned to the trust, the distribution of assets at death will be handled under trust law rather than probate law. In some states, such as California and Ohio, trust law is much simpler than probate law but that is not true in all states. In many states the differences are minor so, as always, it is necessary to know the laws of the domicile state. Probate is a necessary service in many cases since it identifies all involved parties (preventing fraudulent claims against the estate) and closes the financial affairs of the deceased. Insurance agents may not realize, for example, that probate closes the time period for lawsuits against the agent and his or her estate for errors and omissions claims. Trusts cannot close this possibility so even if an agent has a trust holding all assets, it may still be wise to go through probate.
Even if there is a fully-funded living trust, the distribution of assets can still be delayed if your estate is large enough to owe estate taxes. Federal law holds the trustee and executor personally liable for any unpaid estate tax. Therefore it would be foolish for the trustee of a living trust to distribute the trust assets before making sure the IRS is satisfied with the amount of estate taxes paid. The IRS will, upon request, issue a "closing letter" providing some protection to the trustee or executor, but the process of requesting and obtaining the closing letter can take a long time. When we hear of an estate tied up in probate, it is entirely possible that the probate court is not to blame at all; it may really be the fault of the estate tax system. Avoiding estate tax is very different from avoiding probate. A living trust or properly drafted will can both accomplish the same thing when it comes to estate taxes, so either document could be used.
Probate horror stories are often caused by events outside the probate system. Simply setting up a living trust to avoid probate without dealing with the other issues causing delays will not prevent an estate from suffering the expense and delay of contested heirs, assets that difficult to value, or estate taxation issues. While a well drafted trust might eliminate the primary issues, it takes very little to also draft a will. That small document may avoid many problems later on.
End of Chapter 5