In the early part of the last decade, the most common reason for families to replace their wills with a revocable living trust was to reduce exposure to estate taxes (a.k.a. death taxes or inheritance tax). With the advent of a $5 million per person exclusionary amount in the 2010 legislation1, and with the addition of portability provisions, many might think trusts are no longer necessary. But there are many reasons trusts should still be on the financial planner’s recommendation list.
First, there are a plethora of advantages a trust has over a will, beyond just the estate tax issue. When I talk to clients who have taken an estate through the probate process, most say they’d like to have their loved ones avoid that necessity if they could, mostly because the process is arduous, time-consuming and costly. In our great nation, the law says you can’t own anything when you are no longer living, and therefore, the probate process is the court-supervised method we utilize to transfer assets to the proper beneficiaries.
I explain to my clients that when they establish and properly fund a trust, they no longer own any assets under the jurisdiction of the probate courts. I suggest that a trust is akin to establishing a special corporation and that we move everything we own into it. We are the sole owner of this special corporation. Therefore, we have complete control over everything inside it, including the right to distribute out anything we want for our use. When we pass, we have no assets owned directly in our name that would be subject to probate. This special corporation is also exempt from the probate process.
When we pass, we assign new managers to run the corporation (trustees) and new shareholders to receive distributions (beneficiaries). We leave instructions for the new managers on how to run things, including how and when to make distributions to the new shareholders. For tax purposes, this new special corporation uses our Social Security number, so it is transparent to the IRS and administratively easy to manage.
Less Expensive Than Probate
The cost to establish this special corporation is typically under $3,000. In contrast, the average for attorney’s fees and court costs to probate an estate is between 4% and 10% of the assets.2 For someone with a $500,000 estate, that could easily amount to $25,000 at 5%.
Eliminating probate also saves the executor or personal administrator from much work. With the trust, the new managers simply step in and seamlessly continue to manage affairs according to the client’s wishes. When removing the jurisdiction of the court, this also makes access to assets rather immediate. For some, this could be an important issue.
For others, privacy is a prime concern. The probate process is extremely public, with the executor needing to file financial records. The names and addresses of beneficiaries also becomes public knowledge. I can only imagine how con artists might attempt to use that information. With a trust, the affairs of the special corporation are kept confidential.
Two of the most important reasons to consider a trust have to do with what I refer to as inheritance protection and spendthrift control. If I am a beneficiary and elect (or am required to by the terms of the trust) to leave assets inside this special corporation, those assets are safe against most creditor actions, including divorce.3 Most of us would desire our kids benefit from the assets we leave behind, rather than their ex-spouse-to-be. If we simply have a will and leave $300,000 to our child, who then deposits those funds into the joint savings or investment account and files for divorce one year later, chances are we’ve just left $150,000 to our child and $150,000 to the ex.
I have a client whose spouse passed away at 33 years of age in a snowmobile accident. He left behind a daughter from a former marriage and a wife carrying his unborn child. Stating that the probate process was arduous for her would be an understatement. If I recall, she indicated the process took about four years. In hindsight, it is difficult to determine whose greed was larger — the former spouse or the multitude of attorneys, including the independent attorney who needed to be hired for the benefit of the yet-to-be-born child. In the end, over one-third of the estate was spent on attorney fees and taxes, and the remaining assets were split equally between the daughter from the first marriage, the spouse and the unborn child.
But perhaps the greatest tragedy is that the unborn child is now turning 18 and has complete access to 100% of her wealth, including ownership of the family home. I have assisted my client in petitioning the court to move the daughter’s money into a trust to be able to restrict distributions as necessary. But the judge’s response was, “I don’t want to be sued by the 18 year old, and therefore I won’t do it.” Our only hope is that the 18 year old displays wisdom well beyond her years. I cannot imagine most kids that age would manage their financial affairs astutely.
All of this could have been avoided with a trust. The estate taxes and the attorney’s fees could have been sidestepped as well as the unfettered access to funds when the minor turns 18.
As I indicated, you can provide instructions to managers on how and when to distribute to shareholders (beneficiaries). In the case of my trust, when it comes to my children, a small amount of income supplement is stipulated until age 35. Before then, besides the income, I made funding available for college, dependent on a C grade or better, a lump sum for marriage, a lump sum for having or adopting a child and, up to the discretion of the manager, a lump sum for starting a business if the trust manager believes the business idea to be of sound judgment. I personally would much rather have this restrictive schedule than provide unfettered access at age 18.
Many of us think that since we have adult beneficiaries, this is not a concern. But most clients would want their assets to pass per stirpes, so that if any child of theirs predeceased the client or died in a common accident, that child’s share would then distribute to the child’s children. Chances are, the child’s children are still minors, and we may be back to desiring restricted access to funds.
I have two final thoughts. First, the portability provisions introduced in the 2010 legislation aren’t as good as they sound and still face many potential challenges. The greatest of those being that, for a spouse to have access to any unused exclusionary amounts, the proper tax returns have to be filed to claim it.4 Some spouses and/or their tax counsel may not be aware of that. Some may also see it as unnecessary, only to have future circumstances change.
My last final thought is this: everything changes on Jan 1, 2013, when the rules established in December 2010 expire. If Congress remains gridlocked, estate taxes come back at $1 million and a 55% tax rate, and portability goes, too. The only thing that is certain is uncertainty.