Trusts Can Save Estate Taxes and Meet Your Estate Planning Goals

Many people think that a "Trust" is an exotic vehicle only for rich people. However, there are many types of Trusts that can be used for many different purposes (save taxes, plan for children, provide for management of assets). In this article we will briefly examine some of the Trust options available to meet your estate planning goals.

1. Tax Saving Trusts. Under the estate tax law, the estate tax is imposed on all estates with values in excess of $650,000. (This $650,000 exemption amount will continue to increase incrementally until it reaches $1 million in 2006.) For purposes of simplicity, however, in this article we will continue to refer to the exemption as the "$650,000 exemption.") For these purposes, the proceeds from pension plans and life insurance policies are included as part of your estate. The estate tax rates start at 37% and progressively increase until they hit 55%! A married couple, even without extensive estate planning, can pass $650,000 of assets to their children free of estate tax.

With proper planning, however, a married couple can increase to $1.3 million the amount they can pass free of estate tax. Sheltering this additional $650,000 from the estate tax can result in a tax savings of up to $357,500! However, these savings will be realized only if: (i) the first spouse-to-die's Will provides for the creation of a so-called "credit shelter" or "by-pass" Trust for the surviving spouse's benefit, to be funded with $650,000 of assets, and (ii) each spouse has $650,000 of property titled in his/her separate name (jointly held property generally cannot be used to fund the Trusts, so asset titling is important).

Some people are wary of these Trusts because the surviving spouse does not want to give up the $650,000. However, the $650,000 Trust can, and usually does, provide that the surviving spouse (and children if you want) can receive generous benefits from the Trust property. This Trust, then, is an important and flexible estate planning tool that can be used to save taxes while still providing for your family.

2. Trusts for Children. Another concern many people have is their children will not be sufficiently mature to intelligently manage their inheritance and may throw it away. Creating a testamentary Trust (i.e., a Trust under your Will) for children can help alleviate this concern. These Trusts can be structured in different ways. For example, you can create a single "pot" trust for all of your children. Under this type of Trust, the Trust funds can be "sprinkled" among all of your children at the Trustee's discretion. When your youngest child is, for example, age 25, presumably all of your children's educational needs will be provided for; the Trust can be then divided equally among all of your children. The pot Trust also can ensure that a child with special needs can be provided for, without depleting his or her entire Trust share.

Alternatively, you can create separate equal Trusts upon your death for each of your children.

Either type of Trust can provide that distributions of Trust principal to the children can be staggered over a number of years. For example, a common distribution scheme is for the child to receive one-third of his or her Trust share upon reaching age 25, another one-third at age 30, and the remaining at age 35. (Of course, the Trustee may distribute Trust principal to the child at any time prior to attaining these ages, if needed for education or other reasons.) In this scenario, if a child wastes the property amount received at age 25, he or she still has two-thirds of the inheritance in trust for later distribution.

The Trust can be as flexible as you want, so that money can be used for almost any purpose, including education, starting a business, and purchasing a home. In contrast, the Trust terms can limit distributions for only one purpose, such as education. Also, the Trust can include language to direct the Trustee to withhold funds if a child has creditor or drug problems, or is disabled.

3. Trusts for Spouses. As seen above, the generally recommended estate plan for a married couple is for the first spouse-to-die to leave $650,000 of assets in trust for the surviving spouse. What happens if the first spouse has more than $650,000? Often, the first spouse will leave this excess amount outright to the surviving spouse. However, there are many situations where the first-to-die wants the excess to also be placed in trust for the surviving spouse's benefit, rather than distributed outright.

This type of Trust (commonly known as a "Q-TIP Trust") is useful in many situations. For example, a woman in a second marriage with children from a prior marriage may want to provide for her new husband and still ensure that her children will receive the property upon her husband's later death. If she gives the property outright to her husband, it is very likely that he will leave the assets upon his death to his children. However, by placing the assets in a Q-TIP Trust (with an independent Trustee), she can rest assured that the property will pass to her children upon her husband's death. Note that there are some requirements that the Q-TIP Trust must meet to be effective. For example, the surviving spouse is the only permitted Trust beneficiary during his or her lifetime, and must receive all of the Trust income. (If these requirements are not met, the property in the Q-TIP Trust will be subject to estate tax upon the first spouse's death, rather than being deferred until the survivor's death.)

The Q-TIP trust is also advantageous where: (i) the surviving spouse has creditors who could reach the property if he or she owned it outright, or (ii) there is a concern that the spouse may remarry and leave the property to a new spouse. The Q-TIP trust can also provide post-morten estate tax planning since the Personal Representative can elect to have some or all of the Q-TIP assets qualify for the marital deduction.

4. Trusts for Non-Citizen Spouses. Historically, one of the benefits of the estate planning scenarios described above is that no estate tax is due until the surviving spouse's death. The U.S. Congress, however, became concerned that noncitizen spouses, upon the death of their U.S. citizen spouses, were fleeing the U.S. and avoiding the estate tax entirely. Accordingly, in 1988, a new wrinkle was added to the tax code in situations where the surviving spouse is not a U.S. citizen. In general, this law provides that the amount in excess of $650,000 passing to a surviving spouse who is not a U.S. citizen will result in the imposition of an estate tax upon the first spouse's death! However, Congress generously provided an exception to this rule -- the tax is deferred until the survivor's death if the excess property is left in a "Qualified Domestic Trust" ("QDT Trust") for the surviving spouse's benefit. The requirements of the QDT Trust are similar to those in the Q-TIP trust, with certain exceptions. For example, one of the Trustees must be a U.S. citizen or corporation. There are other technical rules imposed to ensure that the goals of the QDT Trust are met.

Generally, distributions of QDT Trust principal to the spouse will result in an estate tax (unless the distribution qualifies as a "hardship distribution"). However, the law does provide that if the spouse becomes a U.S. citizen, the assets may be distributed outright to the spouse without the imposition of a tax.

The QDT rules for noncitizen citizen spouses place a greater premium on effective estate planning in situations where one spouse is not a U.S. citizen.

5. Irrevocable Life Insurance Trust. Many people find it surprising that the proceeds from a life insurance policy (and not just the cash value) are subject to U.S. estate tax. One way to avoid the estate tax on life insurance proceeds is through the use of an Irrevocable Life Insurance Trust. If an Irrevocable Life Insurance Trust is properly structured and administered, then the proceeds from any policies applied for and obtained by the Trust will avoid estate tax in both spouses' estates. (Note, however, that the proceeds from a policy transferred by the insured to the Trust avoid estate tax only if the insured survives the transfer by three years. This is why it is important that, to the extent possible, the Trustee, rather than the insured, apply for the policy.)

In many situations, especially for parents with young children, insurance proceeds comprise a substantial portion of the couple's assets. Accordingly, the Irrevocable Life Insurance Trust is especially useful for "insurance-rich" couples. Not only does the use of the Trust increase the amounts passing to your children, it also provides liquidity to help pay any estate tax liability that may exist.

There are many procedural requirements that the insured and the Trustee must meet for the proceeds to avoid estate tax. However, due to the substantial estate tax savings available, the Insurance Trust is one of the most popular estate tax planning vehicles still available.

6. Trusts for Disability and Probate Planning. One often overlooked part of estate planning is providing for the management of your affairs (both financial and medical) if you become disabled. In case of disability, without prior planning, family members may have to go to court to get a conservator or guardian appointed to handle your affairs.

To avoid this problem, you can create a revocable living trust. Unlike the other Trusts discussed above, this type of Trust is revocable and can be amended or changed at any time. A primary advantage of this Trust is that the person (or bank) named as the Successor Trustee can step in and manage your assets with a minimum amount of disruption. The living trust is a more flexible option than the durable financial power of attorney in that the Trustee generally has less problems conducting the Trust affairs than the attorney-in-fact may have.

Another advantage of the revocable Trust is that assets placed in the Trust before death are not subject to probate. This can be a substantial advantage for residents of states where probate is expensive and time consuming. It can also be advantageous to avoid ancillary probate in states where you own real estate.

7. Conclusion. This is only a partial listing of the Trusts available for estate planning purposes. Many other Trusts exist (such as a Personal Residence Trust and Charitable Remainder Trust) to help you meet your estate planning goals. Because of their many advantages, Trusts are options that many people should consider as part of their estate planning.

Jeffrey Kolender, Esq.
Paley, Rothman, Goldstein, Rosenberg & Cooper, Chartered
www.paleyrothman.com

© SBCA 2006
Neither SBCA Inc., nor any individual member of this association assumes any liability for any action taken based on any articles contained herein.