Trust in Trusts

Almost everyone has heard about trusts, but few really understand them. Financial advisors and lawyers tell clients trusts are a good idea. Friends say they have a trust. Wealthy people set up trusts for their grandchildren. Trusts are everywhere! But what is a trust?

A trust was historically defined as separation of legal title from beneficial ownership. An example would be giving the bank money for a grandchild with direction to pay college expenses of the grandchild. The purpose of establishing a trust was to provide some benefit to a third person without directly giving that person the funds. 

Trusts are still used for that purpose, but modern law also allows a trust to be created under which the same person is trustee and beneficiary. That trust is generally known as a revocable or living trust and its primary purpose is to avoid probate. The trustee/beneficiary retains complete discretion to use the funds in a living trust, but at death the assets are treated as owned by the trust and not the individual. That is how probate is avoided.

The living trust gets most of the publicity these days, but there are a lot of other reasons for trusts. Let us take a look at some.

Many trusts are created to save taxes. To do that, ownership of assets at some point has to be separated. A good example is the Qualified Personal Residence Trust (“QPRT”). 

A QPRT is created by the owner of a personal residence (primary or secondary) under which the person is trustee, the residence is transferred to the trust and is available for exclusive use by the person for a term of years. When the term of years expires, the residence passes to the successor beneficiaries of the trust (usually the person’s children). 

This is a trust used primarily by people who have an estate that may exceed the federal estate tax exemption. Transferring the residence is considered a gift to the successor beneficiaries at time the trust is created. The value of the gift is discounted to what someone would pay for a home they would not own until the trust expires. Any growth in value of the residence is also kept out of the estate of the person creating the trust. 

What are some of the drawbacks of a QPRT? One, the person has to outlive the term of the trust or it is part of the person’s estate for estate tax purposes. Two, if the successor beneficiaries sell the residence, they pay capital gains taxes (usually lower rate than the estate tax). Three, the person loses the residence at end of the term. The latter drawback is usually overcome by leasing the residence back from the children at fair market rate (paid rent also reduces the person’s taxable estate and avoids the higher estate tax as it is taxed to the children at income tax rates).

Spousal Lifetime Access Trusts (“SLAT”) have become more popular of late. In a SLAT, spouse one transfers property owned solely by spouse one to a trust for benefit of spouse two. Spouse two is usually trustee but to make sure not treated as owned by spouse two a co-trustee is usually appointed (not absolutely required but a good idea). This trust takes assets out of spouse one’s estate.

 The benefit of a SLAT? Current federal estate tax exemption is $12.92 million but scheduled to reduce to approximately $6.5 million after 2025. A SLAT locks in the larger exemption for assets transferred to the SLAT and potentially saves the 40% tax on everything over the exemption amount.  To make this even more attractive, Florida amended its statutes to allow spouse two to direct that the trust continue for benefit of spouse one if spouse one outlives spouse two, so the assets never leave the marriage until the last spouse dies.

A life insurance trust can pass life insurance benefits on without estate tax. If a person dies owning a life policy, the death benefits are included in the person’s estate for tax purposes. In the most common life insurance trust, a person creates a trust, appoints a third-party trustee, gives the trustee funds and the trustee buys a life insurance policy. Each year the person gives the trustee money and the trustee uses the money to pay the policy premiums. The beneficiaries have to be given opportunity to take their share of the money given the trustee, but why would they take it when they will get a much larger distribution when the policy pays off?

The beneficiaries of a life insurance trust are usually the person’s children. When the person dies, the life insurance is owned by the trust and the death benefits not included in the person’s estate for tax purposes. 

Trusts can be established as part of a Will or a living trust to take care of a spouse for life and then pass to children. This is a particularly popular arrangement in second marriages. If properly drafted, estate tax savings are also available as the trust can take advantage of the unlimited estate tax exemption on gifts to a surviving spouse as long as the trust requires all income be distributed to the surviving spouse. The surviving spouse can even be the trustee. Whatever is left when the surviving spouse dies usually goes to the first spouse’s children.

There are a lot of people who cannot or should not receive a large amount of money. Trusts can be established for their benefit under which a trustee administers and distributes funds rather than giving the money directly to the beneficiary.

One example of this type of trust is an education trust for family members. Funds can be set aside for a trustee to use for education of a family member with limitations on what and how much can be distributed. 

Similarly, some do not think it a good idea for a young person or an improvident person to be given funds. A gift to a minor usually requires a guardian be appointed and the minor gets what is left when turning 18.  Simply deferring distribution to a later age might be good even for an adult. If someone has drug or gambling issues (or is simply bad with money), perhaps distributing funds over time would be best. These goals can be achieved with a trust. A trust has the added benefit of allowing the creator to tailor the use of funds with as much detail as desired.

Disability is another reason for establishing a trust. If a person receiving government assistance gets money, the assistance can end until the money is spent. By setting aside funds in what is known as a special needs trust, the trustee can use the funds to benefit the disabled person in a manner that will not disqualify that person from government assistance.

Unknown and possible future problems might be a reason to establish a trust. Instead of giving all assets to a surviving spouse, one might create a trust instead that is funded at death. Assets in the trust can be placed beyond reach of the surviving spouse’s creditors. The surviving spouse can be protected from being taken advantage of and even the unforeseen creditor created by a car accident.

Trusts can be an important part of estate planning. They can be as flexible as one might want and can accomplish goals that would not be easily accomplished by direct gifts. Possible use of trusts should be part of all estate planning.