The living trust is a topic of substantial controversy.
The controversy began a number of years ago with a book called "How
To Avoid Probate" by Norman Dacey. Since then, numerous books have
been written that offer do-it-yourself revocable living trusts that are
promoted as being able to help you to avoid the costs and other problems
of probate. Some books also claim that a revocable living trust can help
you to save estate taxes. I'm surprised that none of the books I've seen
went so far as to claim that a living trust could help you to save income
taxes because it's technically true - and misleading.
In addition, seminars on living trusts have become extremely popular
in most larger cities. Most of the seminars are being promoted by lawyers,
insurance agents or financial planners. The headlines promoting the trusts
virtually scream at you about the terrible pitfalls of probate, which are
often exaggerated.
Meanwhile, a number of articles have been critical of the promotional
hype. A headline in Retirement Life (3/93) says, "Avoiding Probate
Is Certainly Desirable, But Beware Of The Income Tax Implications." The
Jan. 18, 1993 issue of Business Week had an article with the headline
"Before You Trust In A Living Trust". An article in Probate and Property
discusses the post death tax benefits of a will compared to a living trust.
A Personal Financial Planning article (9/93) discusses the "hidden
estate planning problems" of a joint (living) trust.
An extensive article about the living trust appeared in the August 12,
1996 issue of Medical Economics. Written by Martin A. Goldberg,
J.D., the author argues that for many people the living trust does not
save money or hassles. According to Goldberg, "These highly touted estate-planning
tools are more glitter than gold. Sometimes they're even counterproductive."
The problems are not so much due to any defects of the revocable living
trust as with the pre-packaged, do-it-yourself books and manuals that are
being peddled as low cost alternatives to the expense of hiring a qualified
lawyer to help you develop an estate conservation plan that is appropriate
for you. (And .... in case you are wondering if I'm a lawyer, the answer
is "No. I'm not.")
What Is A
Living Trust ?
There are two ways to create a trust. You can create one while you are
living or you can create one by will, after your death. The first is called
an "inter vivos" (living) trust and the second is called a testamentary
trust. One author has coined the phrase "Loving Trust" to describe a living
trust. Various authors have used their own name (i.e.,, The "Austin Living
Trust") to describe a specific trust that they drafted.
There are also two types of trusts. A trust can be revocable or it can
be irrevocable. However, since the concept of revocation usually applies
to the person who creates the trust, only a living trust can be revoked
by the creator. (It's technically possible for a testamentary trust to
give the beneficiary the power to revoke the trust, but it's rarely done.)
The type of trust that is commonly used to avoid probate is a revocable,
living trust. In most cases, whenever anyone refers to a "living" trust,
they're also referring to a revocable trust.
The
Three Parties To A Trust
There are at least three parties who are involved in any type of trust.
One is the grantor, who is sometimes called the "settlor", the "creator"
or "trustor". The grantor selects the terms of the trust and puts the property
into the trust.
The second party is the beneficiary - the one who is to benefit from
the trust. The two types of beneficiaries are income and remainder beneficiaries.
The income beneficiary gets the income earned by the trust. The remainder
or principal beneficiary gets what is left after the death of the income
beneficiary or upon some event spelled out in the trust agreement. In a
revocable, living trust, the grantor is often the only beneficiary.
The third party to every trust is the trustee. This is the party who
is responsible for the management of the trust property in accordance with
the provisions of the trust agreement. The title to the trust property
is in the name of the trustee. In a revocable, living trust, the grantor
is usually the trustee.
What Is Probate and
Why Do So
Many People Want To Avoid It?
Why would anyone put property into a trust where they are the beneficiaries
and the trustee? The main reason is to avoid probate. Adrian G. Berg, author
of Keys To Avoiding Probate and Reducing Estate Taxes (Baron's Educational
Services) said,
"Many people would like to avoid probate, but very few people actually
know what probate is"
Probate is the legal process of carrying out the desires of the decedent
with respect to the disposition of his estate. If there is a will, then
the court attempts to oversee the actions of the executor. If there is
no will, the court will administer the estate according to the laws of
the state. The following are often mentioned as the "Pitfalls of Probate".
1. The Costs. Legal fees, accounting, appraisal fees and executor
fees can consume a large part of a small estate. These costs can range
from 5% to 25% of the gross estate. In a few extreme cases, the fees have
consumed a modest estate.
2. The Delays. It can take anywhere from eight months to many
years to close an estate. Where heirs are hard to locate or where a will
is contested, the probate process can drag on interminably.
3. The Publicity. Probate is a public process. In fact, the court
must advertise that there is an estate so that all potential creditors
have an opportunity to file any claims they may have against the estate.
The details of the will and an inventory of the assets are available for
public inspection.
4. Family Disputes. The probate process gives everyone who might
have any interest in the estate a chance to submit their claims. Thus,
there is a greater chance that disgruntled heirs would contest a will than
a trust or joint ownership arrangement.
5. Multi-state Probate. Where real property is owned in more
than one state, there will be a probate process in each state where real
property is owned.
6. Bureaucratic Inflexibility: The probate process is often obsolete
and more concerned about the details of the applicable laws than about
the survivors. There is less flexibility than with a trust. However, a
number of states have adopted uniform rules of probate administration to
reduce this problem.
Some of The Benefits of A Living Trust
Despite the fact that the revocable, living trust has been oversold to
a lot of people, it does offer some real benefits to many families. Here
are some of the reasons why a revocable, living trust might be worth the
costs and inconveniences to you.
1. You want to avoid the publicity of probate. This may be one
of the most real concerns about probate and one of the major benefits of
the living trust. But if any assets are probated, some states may then
require disclosure of the trust agreement and assets. Although probate
can also be avoided with joint ownership (with the right of survivorship),
that exposes your assets to two sets of creditors.
2. You want to avoid probate if you are disabled. If you become
disabled or incompetent, your family will have to get the probate court
to give them the power to manage your affairs. A living trust can include
provisions to avoid that problem. So can a durable power of attorney, but
some financial institutions may not accept the power of attorney.
3. You want to reduce the costs of probate by pre-arranging your
financial affairs so that it won't be necessary to hire a battery of legal
and financial professionals to gather your assets and debts and appraise
your assets. That means you are willing to do that work yourself, and to
keep it up from year to year. However, you could accomplish most of those
savings without a trust.
4. You want professional management now. One of the best reasons
for having a revocable, living trust is because you want someone to manage
some of your investments NOW, and you want to be able to change trustees
or the terms of the trust or to take back any money in the trust at any
time.
5. You want a trust to separate marital assets. In some states,
living trusts can be used instead of a pre-nuptial agreement so you won't
have to ask a fiancee to sign such an agreement. The assets in the trust
before you marry are not marital property if you don't co-mingle assets
after you are married. And, the trust protects your own children if a spouse
remarries after you die.
6. You want to avoid multi-state probate problems. If you have
real property in multiple states, that's a good justification for having
a living trust.
Some of The Myths About Probate and
Living Trusts
Those who want to sell you on buying their do-it-yourself book, software
program or quick and easy legal service have an incentive to overstate
the problems of probate or the benefits of setting up a living trust. Here
are some of the common myths.
1. Avoiding probate will save money. Except for actual probate
fees, most of the costs of probating an estate are incurred for fees to
accountants, appraisers, attorneys and the estate administrator. The administrator
or executor is required to be sure all the assets and debts are identified
and that all of the heirs are found. If an estate is large enough to require
filing an estate tax return, the assets in a living trust will be included
in the estate. A major cost in the probate process is the process of valuing
the assets in the estate and preparing the estate tax return. A living
trust doesn't reduce those fees. In some cases, a living trust will result
in more legal fees if the trust and the executor are not represented by
the same lawyers, according to Martin Goldberg. A lot of the expenses of
probate are incurred when there is no will (or when there is more than
one will), when heirs can't be found or when the estate includes property
that is hard to value. A living trust doesn't really prevent these expenses.
2. A living trust will/won't save estate taxes. The advocates
of a living trust will tell you that the trust will save estate taxes.
The critics will tell you it won't help you to save estate taxes. Who is
right? Both are right and neither is right. A living trust can be drafted
so that a second trust is created, when you die, that makes maximum use
of two lifetime estate tax exemptions
if you are married. However, this estate planning arrangement isn't unique
to a living trust. It's often done with a well drawn will and trusts that
are created at the time of your death. And if you are single, you are only
eligible for one lifetime estate tax exemption
- which is available to you regardless of whether you have a will or a
trust.
3. You need a trust so that funds can be distributed to your heirs
without delay. A well designed will and a qualified executor can make
distributions to the family even while the estate is being probated. In
addition, life insurance and jointly held assets can provide immediate
funds for the family. Sometimes, a living trust can backfire with respect
to distributions to the heirs. If the trustee of the living trust is not
the same person as the executor of the estate, the trustee might make distributions
in excess of what is needed for estate taxes. If that happens, the IRS
can collect the taxes from the heirs and the trustee is then liable to
the heirs for any losses they might have sustained in the process. If the
IRS can't get the money from the heirs, they will try to get it from the
trustee. So if you are ever the trustee of a living trust, you should make
an extreme effort to coordinate your management of the trust with the management
of the rest of the estate.
4. You don't need a will with a living trust. That's only true
to the extent that the trust includes all the necessary instructions to
carry out your wishes and only if the trust is the owner of all of the
assets of the decedent. In most cases, there are other assets that are
not included in the trust and these assets must still go through the probate
process. For co-ordination most lawyers advocate having a "pour over will"
to transfer any probate assets to the trust so that they can be managed
as a whole.
5. A living trust provides creditor/asset protection. No!
No! No! Not so. Not if you are talking about a revocable
living trust created and funded by the grantor who is also the beneficiary.
Asset protection implies protection during the lifetime of the grantor
of the trust. Until the grantor dies, he or she has the power to recover
any or all of the assets from the trust. Therefore, those assets are available
for the satisfaction of any creditor's claims.
6. A living trust can't own S corporation stock. It's commonly
believed that trusts can't be shareholders of the stock of an S corporation.
However, there are exceptions for a grantor trust, a testamentary trust,
certain voting trusts and a "qualified sub- chapter S corporation trust"
that distributes all of its income to one income beneficiary.
Other
Ways To Avoid Probate
If your primary concern is to avoid the costs, delays and publicity of
the probate process, there are other alternatives. One of the most popular
with those who have small estates is the use of joint ownership with the
right of survivorship. The major problem with this arrangement is that
the jointly owned property is subject to the claims of any creditors of
both property owners. And, for those with estates in excess of the lifetime
estate tax exemptions (per spouse), joint ownership has estate tax
disadvantages.
There are many other problems with joint ownership that are beyond the
scope of this article, but even in smaller estates, there is an income
tax disadvantage with jointly owned property. If a spouse is the joint
owner of an asset, only half the value of the asset is included in your
estate. If the asset is highly appreciated, the half in your estate gets
a new cost basis equal to the value at the time of your death. The half
that isn't included in your estate is still subject to income taxes on
any appreciation (over the original cost) when the asset is sold.
Any assets that require a beneficiary designation will go to your beneficiary
without going through probate. Examples include pension or IRA assets,
life insurance and annuities with residual benefits. If you have a living
trust, these assets will be paid to the named beneficiary instead of to
your trust.
You can also avoid probate on any assets that you transfer by gift while
you are living. Thus, a family limited partnership could be an alternative
to a living trust to the extent that you choose to give your limited partnership
interest to your heirs while you are living. Meanwhile, you can be the
managing partner and can receive some compensation for managing the partnership.
This arrangement also provides substantial protection from lawsuits and
other claims that are a threat to your life savings. However, the partnership
does not offer the privacy of a living trust and it's likely to cost a
lot more to establish and to maintain.
Some Limitations On Using A Living
Trust
A living trust isn't appropriate to shift income to lower bracket family
members or to avoid estate taxes. It offers no creditor protection and
provides no independent review of how your representative handles your
estate. Here are some additional observations about these and other related
issues.
Income Tax Savings
With a living trust, all of the income of the trust is treated as the
income of the grantor of the trust. As long is the grantor is also the
trustee, there is no requirement to get a separate trust tax I.D. number
and to prepare a trust tax return. But ... if a trust tax number is obtained
and is used for tax information reporting to the IRS, it will be necessary
to report the income from the assets owned by the trust on a form 1041.
In most cases, it's only necessary to prepare a summary of the income and
expenses that will be reported on your personal tax return and to attach
that summary to the form 1041.
By putting income producing assets into an irrevocable
trust and naming lower income bracket family members as beneficiaries,
the beneficiaries will pay income taxes on any trust income distributed
to them. However, similar benefits can be achieved with a family limited
partnership.
Estate Tax Savings And Tax Compliance
There is no gift tax on transferring property to a revocable living
trust because you still own the property. Nor does the trust help you to
save estate taxes by using the $10,000 annual exemption from the gift tax.
The entire amount of any assets in the living trust will be included in
your estate for federal estate tax and state inheritance tax purposes.
However, without the benefit of probate, you need to be sure that your
trustee or executor is familiar with the requirements for complying with
the state and federal tax reporting rules. Severe penalties can be imposed
on trustees/executors who fail to pay all required taxes.
If you have more than the lifetime estate
tax exemption in net assets and life insurance, you need a good estate
tax plan. Depending on the amount and type of assets, you might be able
to avoid all estate taxes (up to the lifetime
estate tax exemption per spouse) with a well drafted will that creates
two trusts for you after you die. The typical arrangement for a couple
is a "his and hers" trust (also called an A/B trust) where up to the lifetime
estate tax exemption goes into a trust for your children with the income
to your surviving spouse while alive. The other assets go directly to the
surviving spouse or into a trust for the spouse. Each spouse thereby gets
a full lifetime estate tax exemption,
if there are enough assets to accomplish that.
If your total estate is more than the lifetime
estate tax exemptions per spouse, additional arrangements are
needed to avoid estate taxes while also providing a secure income for a
surviving spouse. Some advanced estate tax arrangements often include an
irrevocable life insurance trust for the children and grandchildren. In
some cases, a charitable
trust may be involved or a family private annuity arrangement. The
plan may include an irrevocable foreign asset protection trust and one
or more family limited partnerships. Lifetime gifts via a family limited
partnership may be used to create opportunities for valuation discounts
of 20% to 40% of the estate, even where most of the assets are stocks and
bonds listed on a major exchange.
Creditor
Protection Of Your Assets
In order to remove some of your assets from the reach of future creditors,
you must relinquish legal title and control. A revocable living trust doesn't
do that. For asset protection, you may need one or more irrevocable trusts,
and possibly a foreign asset protection trust, combined with one or more
family
limited partnerships.
Special
Problems In Community Property States
Many of the books and packaged trusts are not designed to handle the special
problems in community property states. There are eight states that are
community property states and a ninth (Wisconsin) that follows community
property rules for tax purposes. The nine states are ...
