Trusts

What is a Trust?o Trusts are a financial planning tool (legal

documents) that• Provide for ownership of assets• Control of interests in assets• Transfer of assets outside of probate

o Trust has a “maker”o Trust has a trusteeo Trust has a beneficiary

Trust o Vests legal title for property with trusteeo Beneficiaries hold equitable interest in propertyo Maker (a.k.a. grantor, settlor, creator, or trustor)

provides assets to the trusts and instructions to trustee for managing the assets and beneficiaries interests

o Maker, Trustee, Beneficiary can be the same person

o Beneficiaries can be split into two types• Income beneficiary• Remainder beneficiary

o Trustee follows the Prudent Man Rule as a fiduciary

What does if mean to be a fiduciary?o One who acts in the best interest of another party

• Duty of loyalty• Duty of care

o Prudent Man Rule – act in the same manner as a prudent “person” would act if acting for their own benefit

o Prudent Man Rule codified in most states into Prudent Investor Act• Limits nature and types of investments a trustee can make• Performance standard for trustee

Issues with appointing the trustee (when not the maker)o Skills to perform fiduciary responsibilitieso Potential conflict if also a beneficiary

Why use a Trust?o Managing trust property – not everyone can properly

manage assets and this is a vehicle to have professional management of assets for the benefit of the beneficiaries (for example, minor or disabled individual)

o Creditor protection – removes the asset title from the beneficiary and vests it with the trustee (with spendthrift clause)

o Split interests in property – maker can designate an income beneficiary and a remainder beneficiary to same property

o Avoid Probate – assets retitled through instructions provided to the trustee (vested owner) for beneficiaries

o Avoid or postpone taxes

Background on Trust lifeo The rule against perpetuities (never ending trust)

• A trust “should not” permanently remove property from commerce

• Case of Duke of Norfolk 1500’s• Trust contained property with instructions that prevented

future sale• Lord Chancellor of Nottingham issued rule against perpetuities

o Maximum life of a trust (varies by state)• Must expire at the end of the youngest living beneficiary

named in trust plus 21 years• Uniform statutory rule is 90 years maximum• Trusts can be perpetuity if they do not have instructions to

trustee to not sell property

Trusts are Hybrid Entitieso Income is taxable to beneficiary, trust, or makero Simple trusts mandate distribution of all trust income to the

beneficiaries annually and thus beneficiaries pay the taxo Complex trusts can retain some income, distribute to

charities or distribute principal• Each beneficiary is tax on their pro rata share• Income retained in trust is taxed at trust tax rates• In any year all income is distributed to beneficiaries and no

distributions to charities and principal distributions, trust reverts to simple trust

o Transfers to irrevocable trusts are potential “gifts”o Tax rules are very complex on what is Distributable Net

Income

Types of Trustso Irrevocable Trusts – Maker cannot take back propertyo Inter Vivos Trusts – Trusts made while maker is alive (all

revocable trusts are Inter Vivos Trusts)o Testamentary Trusts – Trust made after the death of the

makero Standby Trust – Trust formed during life of maker but is

contingent on an event to become hybrid entity o Pourover Trust – Trust that is created at death of maker and

typically receives assets from another trust or will or untitled assets of maker

o Living Trusts – Trust that serves the maker as beneficiary and the trustee is usually the maker. Primary trust for financial planning of clients with estate in excess of $2,000,000

Examining the Living Trusto Fred and Wilma have accumulated $3,000,000 in their estate

and have one child, Pebbles.• Assets consist of home ($400,000), Life Insurance policies

($200,000 each), IRA ($350,000), Investment Portfolio ($1,800,000), Checking and Savings Accounts ($10,000) and untitled assets ($40,000).

• Fred and Wilma both are professionally employed and earning income

• Pebbles is just entering 1st gradeo Fred and Wilma make a Living Trust – Revocable Trust

• What assets go into the trust?• What instructions should the trust have?• Who should the trustee be?• How should the beneficiaries be listed (both income and

remainder)?

Fred and Wilma’s Living Trusto Trustees – Fred and Wilmao Beneficiaries

• Surviving Spouse and then Pebbles (contingent)• If Pebbles has not reach age of majority then contingent trust

o Assets in trust• Home, Investment Portfolio, Checking and Savings

o Assets outside of trust• Life Insurance and IRA – avoid probate by contract law

o Instructions• Stand-By Trust for surviving spouse (A-B By Pass Trust)• Pourover Trust for all untitled assets at death of second spouse

o Trust provides vehicle to avoid Probate – Becomes irrevocable at death of second maker (when surviving spouse dies)

More on Irrevocable Trustso In general, avoid probate, are private documents (not

available to the public like a will), discourage contesting, property avoids creditors of beneficiaries while in trust

o To the last point, large family trusts• Anyone can “transfer” assets to the trust• Family members can be beneficiaries of the property

(income) from the trust without owning property in trust• Trust pays taxes on non distributed income• Kennedy’s Family Trust – property avoids creditors or others

suing for injury or damages

More on Revocable Trustso Not a completed gift and not a vehicle for avoiding estate

taxes

Gift Tax and Trustso In general, a gift to a trust is a future interest and not

eligible for the annual gift tax exclusion unless• Beneficiary has right to withdraw the annual gift (power of

appointment)• Trust has a Crummey Power provision allowing withdraws

(typically in the first 30 days (thus power of appointment)• The 5/5 Rule for Lapsing Amounts

• The beneficiary has right to withdraw $5,000 or 5% annually (whichever is larger)

• This right can be lost each year or extended into future years on annual contributions

Life Insurance Trusts - More on these in Chapter 11

By-Pass Trustso Typically created at the death of first spouse and used to

retain ability to pass on gift tax exclusions to heirs of the couple

o Example – for Barney and Betty and their child Bam-Bam• Barney and Betty set up Living Trust (revocable) and transfer

$10,000,000 of assets into the trust with Bam-Bam as the beneficiary of the trust

• Note – as makers and trustees, instructions are set up such that Barney and Betty can “enjoy” the income of the trust during their lifetime

• Revocable trust so Barney and Betty can make changes to trust in future (remove assets, exchange assets, change beneficiaries, etc.)

• Trust contains a contingency for a by-pass trust at the death of either Barney or Betty for surviving spouse

By-Pass Trust (continued)o If Barney (or Betty) passes – a By-Pass Trust is established for

Betty (Barney) and transfers $5,000,000 of assets into By-Pass Trust with Betty (Barney) as trustee and income beneficiary• Betty (Barney) can withdraw income annually and some

principal (with some restrictions) for personal support• At death of Betty (or Barney) all property of original trust

and by-pass trust pass to Bam-Bam and one-time gift exclusion can be used by both trusts

• The By-Pass trust passes the property to Bam-Bam (from the first in death) and also applies one-time gift tax exclusion for the first in death

• The Living trust passes the property to Bam-Bam (from the second in death) and also applies one-time gift tax exclusion for the second in death

By-Pass Trust (continued)• Total gift tax exclusion used by Barney and Betty is

$10,000,000 for estate tax purposeso Failure to use By-Pass Trust as contingency trust for

Barney and Betty• Assume Living Trust set up with the $10,000,000 of assets• When first in death dies, surviving spouse receives all assets

“gift tax” free as part of the estate of the first in death• When second in death passes assets are transferred to

beneficiary, son Bam-Bam• Second in death uses one time exclusion and $5,340,000 of

assets pass to Bam-Bam avoiding gift/estate taxes• Remaining $4,660,000 is passed but incurs gift/estate taxes

and potential loss is roughly $1,800,000 (current rates)

By-Pass Trust during lifeo For very wealthy individuals on assets expected to appreciateo Difference here is a surviving spouse does not need the asset

for living (retaining current life style)o By-Pass Trust receives property and one-time exclusion is

used for the transferred property o Appreciated property transferred at death of trust maker and

basis for estate is the original transfer value o Example – Transfer of $5,340,000 into trust

• By-Pass Trust is used for one time exclusion (irrevocable trust)• At death of maker, asset fair market value is $15,340,000• The appreciation asset passes to heirs of by-pass trust but

estate of maker is not taxed on fair market value avoiding $4,000,000 of taxes

Other types of Trustso Grantor Trusts (Chapter 7)o Estate Trusts, Surviving Spouse Trusts with Powers of

Appointment (Chapter 10)o Qualified Terminable Interest Property Trusts (Chapter 7)o Qualified Personal Residence Trusts (Chapter 7)o Tangible Personal Property Trusts (Chapter 7)o Charitable Remainder Trusts (Chapter 9)o Life Insurance Trusts (Chapter 11)

What are the implications for Financial Planning?o What is the most efficient way to transfer property for the

client to their heirs?o What potential events to the plan may render the transfer

choice ineffective or inefficient?• Pre-mature death• Asset value changes• Cash flow needs of the donor/grantor

o Changing tax lawso IRS potential challenges to the transfero Gift tax changes (size of one time exclusion or annual

exemption)o Availability of trust maker to change mind about transfer, both

assets and beneficiaries and thus tax implications of trust