Do I Need a Trust?

The popularity of trusts as an estate planning technique rises and falls with changes to the “unified credit.” The unified credit is the amount of assets a person is allowed to transfer to others during or after their lifetime without paying taxes on those gifts or bequests. Congress passed the Tax Cuts and Jobs Act in 2017 which raised the unified credit to $11.2 million from $5.49 million. This means that far fewer estates will be subject to estate taxes under the new law. The $11.2 million credit will remain in effect and be adjusted for inflation through 2025 unless congress votes to extend this provision.

Under previous tax regimes, trusts were an incredibly important technique for individuals looking for ways to avoid paying estate tax. Despite the fact that fewer estates will owe estate tax under the new tax law, many valuable uses for trusts remain. Before getting into other benefits of using trusts, I thought it would be useful to give a broad overview on how trusts work, and how they are used to reduce estate taxes.

What is a trust and how do they work?

A trust is a legal entity that is neither a person nor a business. It is created through a trust document, which is drafted by an attorney at the direction of the person or persons funding the trust (the grantor or trustor). A trustee is appointed to take legal title of the assets or property within the trust. The trustee must act as a fiduciary in accordance with the wishes of the grantor as described in the trust document. Trusts are created for the benefit of the beneficiary or beneficiaries named in the trust document. Depending on the type of trust, taxes on capital gains and income within the trust are paid by either the grantor or the trust itself. Trusts can be either revocable (can be amended or terminated by the grantor) or irrevocable (no changes allowed).

How are trusts used to reduce estate taxes?

Trusts have long been used as an “estate freezing technique” to help high net worth individuals avoid some or all of their potential estate tax liability. By transferring assets from the individual’s personal ownership to a trust before death, the assets are removed from the estate and are not subject to estate taxes. However- the transfer of those assets will reduce the amount of the unified credit thereby reducing the amount that can be transferred estate tax free at death. The technique works because when assets are transferred to a trust, the transfer removes from the estate not only the present fair market value of the assets, but also the future growth of the assets.

Let’s look at a simplistic example. This scenario has been created for illustrative purposes only. There are many rules associated with estate taxes and this simplified example should not be used in lieu of financial planning or legal advice:

Mrs. A has an estate consisting only of $10 million in cash and $1.2 million in high growth stock.

Year 2019

Trusts Estate Tax

Mrs. A does not currently have an estate tax problem because the size of her estate is equal to the unified credit ($11.2 million) which reduces the size of her taxable estate to zero. If Mrs. A were to die today, her estate would be able to transfer all $1.2 Million in stock and all $10 Million in cash to whoever she wanted estate tax free. However, if the value of the stock grows, she will have an estate tax problem because she is currently right at the limit of the unified credit. Any amounts over the $11.2 million unified credit will be subject to the 40% estate tax.

Let’s assume that Mrs. A wishes to leave the stock to her son at her death. If, instead of holding the stock herself, Mrs. A transfers the stock to an irrevocable trust with her son as the beneficiary, she will “freeze” the value of the stock at $1.2 million and avoid estate taxes regardless of any amount growth in the value of the stock. Let’s see what this looks like:

In this example, without transferring the stock to an irrevocable trust, the value of the estate would have been $15,000,000 at the death of Mrs. A ($10 million in cash plus $5 million in stock). With a unified credit of $11.2 million, her estate would owe $1,520,000 in estate taxes. By transferring the stock to the irrevocable trust today, Mrs. A can “freeze” the value of the stock at $1.2 million for estate tax purposes. At her death, Mrs. A will not owe estate taxes- regardless of how much the stock grows.

This example is meant to highlight the benefits of using trusts to avoid estate taxes. Keep in mind that this technique will only result in zero estate taxes when the value of the taxable estate at death is less than or equal to the unified credit amount. However, the transfer of growth assets to irrevocable trusts can always be used to reduce estate taxes. Even large estates that will pay estate taxes can benefit from a reduction in estate taxes through the use of trusts.

Why else would trusts be used?

Aside from reducing estate taxes, trusts can be used for a wide variety of other important financial planning objectives- both from an estate perspective and while living. From an estate planning perspective, trusts can be used: to provide enhanced post-mortem control over assets, to ensure assets are transferred according to the decedent’s wishes in the event of a contested will or complex family situation, to avoid probate, in planning for family members with special needs, to ensure proper care for children and pets, to transfer assets to a minor, and for life insurance purposes. While living, trusts can be used as part of a charitable gifting strategy or as part of an intrafamily gifting strategy.

Trusts have countless uses in estate planning. The most powerful benefit is the enhanced post-mortem control trusts give to decedents. When assets pass to heirs through the probate process (under the terms of a will) or by operation of law (named beneficiaries on an IRA for example), there are no strings attached. Heirs are able to use the assets as they see fit. In many situations, people wish to control not only the amount their heirs will inherit, but also how they use the assets.

Trusts allow decedents to craft a document outlining their exact wishes for the bequest. A trust document can specify a schedule stating when the beneficiary is able to receive distributions. Grantors (those creating and funding the trust) can also specify the age a beneficiary must attain before receiving distributions or milestones that must be met before receiving distributions (graduating college for example). Grantors may also give broad discretion to the trustee to distribute assets as the trustee sees fit. This is a very powerful tool when the grantor wants to control the beneficiary’s spending. These types of arrangements are often used in the case of a spendthrift beneficiary or a beneficiary who has substance abuse issues, for example.

Trusts allow property to pass from the decedent to the heir in a more secure and private way than wills. While a will specifies the decedent’s wishes, it does not guarantee that those wishes will be executed. Wills must be “probated,” meaning they must be “proved” in court to be valid. Family members may also contest the will, raising the possibility that property passes to a person the decedent did not intend. When a will is probated, it becomes public record. Many people wish to maintain their privacy after death, which can often only be achieved through the use of trusts. Furthermore, depending on the complexity of the estate and probate process, a trust can potentially be a cheaper option than probating an estate. Trusts are a universally accepted legal structure- a trust that is valid in one state is valid in all states. The same cannot be said for wills. This is another reason why trusts are often more effective than wills.

When Do You Need a Trust?

Family situations are often complex. It is not at all uncommon for a family member to have multiple divorces, children from previous marriages or unmarried partners. These types of familial characteristics often lend themselves to the use of trusts. While the titling of assets (Joint Tenancy with Right of Survivorship, for example) or named beneficiaries offer transfer of assets by operation of law (as opposed to probate), the decedent loses control of the assets at death. Let’s take the example of an IRA with named beneficiaries. Typically, spouses name each other as their primary beneficiaries with their children as contingent beneficiaries. When the first spouse dies, the second spouse becomes the account owner with the children being named as the primary beneficiaries. A potential problem arises when the spouses have children from previous marriages- after the death of the first spouse, the second spouse can legally change the beneficiaries to whomever he or she chooses! A poor relationship with the children of the first spouse to die can result in the second spouse changing the beneficiary to their own children- against the wishes of the first spouse. Similarly, when assets are passed to a beneficiary by will, the beneficiary takes legal ownership of the property and can do with it as they see fit- the decedent gives up control. Trusts can mitigate these issues.

Trusts are a valuable tool for estate planners for creating a plan to care for those who can care for themselves- minors, family with special needs, and even pets. Furthermore, because children are not able to legally conduct business, it is often preferable to have transferred assets held in a trust rather than in their name outright. In all of these situations the transfer of assets can be completed without the use of a trust, but the use of a trust comes with the added benefit of enhanced postmortem control. Special needs trusts in particular come with several added benefits- the trust structure insulates the beneficiary from potential fraud from bad actors, protects governmental benefits, and can even help in the case of litigation settlements arising disability caused by accidents.

Trusts are often used in conjunction with life insurance. Most commonly, trusts are used to remove the face value (the death benefit) of life insurance from the owner’s estate. If drafted correctly, an Irrevocable Life Insurance Trust (ILIT) removes all “incidents of ownership” from the original owner of the policy. Incidents of ownership are all the rights the owner of a life insurance policy would normally have- the right to terminate the policy, name beneficiaries, gift the policy, or change beneficiaries, to name a few. Life insurance proceeds will not be included in the decedent’s estate if they: 1) retain no incidents of ownership, 2) gifted or transferred the policy more than three years prior to death, and 3) the proceeds were not paid to the executor of the decedent’s estate. Transfer of the policy to an ILIT more than three years before death satisfies all of these conditions. Another type of ILIT is a “Wealth Replacement Trust.” Wealth Replacement Trusts are often used as part of a charitable gifting plan. Because planned charitable gifting often results in a substantial reduction in the value of the estate, there is often not enough liquidity for estate settlement. Like all other ILITs, the trust owns a life insurance policy. At the death of the insured, the life insurance proceeds are used to provide estate liquidity.

Many individuals consider charitable or intrafamily gifting as part of their estate plan. There are many different types of trusts that allow people to remove assets from their estate, fulfill their desire for charitable or intrafamily gifting, and do all of this on their own terms:

Grantor Retained Annuity Trust (GRAT)

GRATs are valuable in an intrafamily gifting strategy. A GRAT is an irrevocable trust where the grantor retains the right to income for a certain number of years (the term). After the term ends, the remaining assets in the trust are transferred to the named beneficiaries. The amount of assets transferred to the beneficiaries will not be included in the grantor’s estate as long as the grantor outlived the term of the trust.

Grantor Retained Unitrust (GRUT)

GRUTs are similar to GRATs in structure. The main difference is that a GRUT pays a fixed percentage of the trust assets each year to the grantor where a GRAT pays the income generated by the trust, which fluctuates.

Grantor Retained Interest Trust (GRIT)

GRITs are similar to both GRATs and GRUTs. However, whereas a GRAT or GRUT actually pays the income or percentage of the account value to the grantor, a GRIT only give the grantor the right to income for the term. This feature gives the grantor the ability to leave the assets in the trust if he or she so desires.

Qualified Personal Residence Trust (QPRT)

QPRTs are another valuable intrafamily gifting tool. As the name implies, QPRTs allow the grantor to transfer a personal residence while retaining an interest in the property for a period of time. After the initial term, the property is passed to the beneficiaries. Like a GRAT, GRUT, or GRIT, if the grantor dies before the end of the term the entire value of the residence will be pulled back into the estate.

Charitable Remainder Unitrust (CRUT)

CRUTs operate like GRUTs, with the remainder amount going to charity rather than an individual. Donors can make multiple donations to the trust and are paid a fixed percentage of the trust value per year (the percentage must be at least 5% and the assets are revalued each year). Payments can last for life or for a certain number of years. If a term of years is used, the maximum number of years payments can last is 20.

Charitable Remainder Annuity Trust (CRAT)

CRATs are similar to CRUTs with two distinct differences: CRATs pay a fixed amount of income (at least 5% of the initial account value, the dollar amount does not change after the initial payment) and no additional donations can be made. The remainder interest must be at least 10% of the initial donation.

Net Income Charitable Remainder Unitrust (NICRUT)

NICRUTs are similar to CRUTs but pay the lesser of the stated percentage or the actual income earned by the trust.

Net Income with Make-up Charitable Remainder Unitrust (NIMCRUT)

NIMCRUTs are very similar to NICRUTs but have the added advantage of allowing the donor to receive “make-up” payments in future years when the income earned by the trust is less than the stated percentage. This feature can be highly advantageous when a donor wishes to defer income for a certain number of years. This type of trust is often selected when a donor is close to retirement but has not yet retired.

Charitable Lead Annuity Trust (CLAT) and Charitable Lead Unitrust (CLUT)

CLATs and CLUTs follow the same rules as CRATs and CRUTs respectively. The major difference is that the income is paid to the charity (rather than the donor) and the remainder amounts are transferred to the remainder beneficiaries (often the donor’s children).

What is a Trust

As you can see, no matter what your desires are for charitable or intrafamily gifting there is a trust structure available to suit your needs. Furthermore, each of these types of trusts has significant advantages that help individuals reduce income or estate tax liabilities. The rules regarding the value of the gift or charitable donation vary according to the type of trust used. For example, some of the intrafamily gifting trusts allow the grantor to use the annual exclusion (the amount that can be gifted per individual per year tax free, $15,000 in 2019), while others do not. These complexities can have a major impact on estate and income taxes. We recommend clients seek advice from a CERTIFIED FINANCIAL PLANNER™ and attorney prior to making the decision to use one of these types of trusts.

Trusts are often thought of as only useful for high net worth individuals looking to reduce their estate tax liability. This could not be further from the truth. The fact is there are many people who have no estate tax issues whatsoever who could greatly benefit from using a trust.