What tax advantages can be built into trusts created in one’s Will?

Trusts can be structured so that the assets held in trust are not taxed as a part of the beneficiary’s estate when the beneficiary dies (up to a limit). This tax advantage may apply to a spouse’s trust (often called the “bypass trust”) or to a child’s or grandchild’s trust (often called a “generation-skipping trust”). Review the article on trust planning appearing elsewhere on this website for a discussion of these considerations.

Can a trust protect property from the reach of the beneficiary’s creditors?

One of the longstanding uses of trusts is to protect property from a beneficiary’s indiscretions. This type of trust can be protected from the beneficiary’s creditors, as long as the beneficiary is not the party who created the trust (the “grantor”). Under traditional English jurisprudence, a person cannot shield his or her own assets from his or her own creditors, but the grantor may very well restrict the beneficiary’s rights, and therefore the rights of the beneficiary’s creditors, to trust assets. In order to achieve this result, the grantor must create an irrevocable trust with specially-designed terms.

Can a trust protect property from a future divorce of a beneficiary?

A trust can be structured so that its assets will be available only to the beneficiary and not to his or her spouse, either during the marriage or at the time of a divorce. In fact, to many of our clients, this is one of the most appealing features of a trust for an adult beneficiary. To better assure this result, the trust should include language specifying that all distributions from the trust will remain the separate property of the beneficiary. If the beneficiary serves as trustee of this trust, he or she should be vigilant to maintain the distinct nature of the trust, including separate accounts, records, and income tax returns for the trust, and the beneficiary should not contribute his or her own assets to the trust.

How can a trust be structured to avoid probate?

Many individuals place their own assets in trust during their lifetimes, so that the trust will act as a “Will substitute” and direct where those assets pass at their deaths. In such a case, the assets held in trust need not go through the probate process to determine their disposition at the death of the owner. These types of trusts are commonly called “living trusts” or “revocable management trusts,” and they typically offer no tax advantage over Will planning (since the assets in the trust continue to be enjoyed and controlled by the original owner(s)). In states where probate is difficult or expensive (such as California, New York or Florida, to name a few), they are widely-used in estate planning. In states such as Texas, where probate is neither cumbersome nor unduly costly, they are not typically used for probate avoidance. Some Texans design their estate plan using a living trust for other reasons, including incapacity planning, privacy concerns or the fact they own real property in another state with onerous probate requirements. Note, however, that in order for an individual to accomplish probate avoidance, all of his or her assets must be transferred to (titled in the name of) the trust. Simply signing the trust document accomplishes nothing in the way of probate avoidance, if one’s assets are not subsequently transferred into the trust.

What kind of trust is used for asset management in the event of incapacity?

The “living trust” or “revocable management trust,” discussed in question 4 above, is also frequently used for asset management in the event of incapacity. In Texas, this is one of the most common uses of living trusts. If mental capacity is a concern, then a living trust is often recommended (especially for unmarried persons). An individual would typically transfer his or her assets to a living trust, often acting as trustee himself or herself for as long as he/she remains capable. Upon incapacity, the living trust then specifies another individual (or corporate fiduciary) to manage the trust assets as trustee. This allows for an easy succession of asset management, although the assets held in the trust continue to be used for the benefit of the (now) incapacitated individual who created the trust. This incapacity planning should be coordinated with the use of a statutory durable power of attorney.

If an IRA passes at death to a trust, is the IRA income tax accelerated?

Trusts can indeed be structured to receive IRA distributions without accelerating the related income tax upon death, but this requires very technical drafting. Generally, the post-death period for stretching out the distribution of the IRA (and therefore its income taxation) is over the life expectancy of the oldest beneficiary involved in the trust (including the beneficiaries who are to receive the trust at its ultimate termination). Leaving an IRA to a trust can achieve this powerful income tax deferral, as well as the traditional trust objectives of creditor protection, divorce protection and avoidance of estate tax on the IRA/trust at the beneficiary’s death (up to a limit). However, the Treasury Regulations regarding the payment of IRAs to trusts are extremely complex and have changed dramatically over the past decade. If a Will (or trust agreement) has not been reviewed to assure that the trusts it creates can accept IRA payments without accelerating the income tax, then these trusts should not be designated as the IRA beneficiary. See also the discussion appearing at question 9 below.

How should I structure my life insurance beneficiary designation?

This will depend on your estate plan, since these designations should be coordinated with your other planning. However, use of the word “estate” or “executor” as your beneficiary will subject the proceeds to any creditors existing at your death and therefore caution is in order. If you are married and utilizing a bypass trust at the death of the first spouse, then generally you should designate “the testamentary trustee named in my Last Will” as your primary life insurance beneficiary. This will allow the insurance proceeds to pass to your trustee under your Will, where they can then be used to fund your bypass trust and avoid being subject to estate tax in your spouse’s estate later. A similar designation would be in order if you are single and wish your assets to pass into trusts created under your Will for your children at your death. One of the most common errors we see in beneficiary designations relates to naming minor children (who cannot receive the proceeds until adulthood), which would cause a court-controlled guardianship to administer the funds until the child reaches the age of majority. Again, the watchword is “coordination” with your Will plan.

How should I structure my commercial annuity beneficiary designation?

Assuming you are the “owner” and “annuitant” of the commercial annuity, you have an important choice between coordinating with your Will plan (see the discussion in question 7 above relating to life insurance), and using individual beneficiaries. Unfortunately, only individual beneficiaries can enjoy substantial income tax deferral on a commercial annuity, but this is likely divergent from your overall Will plan. Accordingly, these assets require special consideration and discussion, with the ultimate advice depending on the terms of the specific annuity contract in question and the size of the annuity that might deviate from your overall Will plan.

How should I structure my 401k or IRA beneficiary designation?

All beneficiary designations should be considered and reviewed along with Wills, to coordinate their disposition. In particular, IRA and 401(k) beneficiary designations (i) should always avoid paying to your “estate,” and (ii) should pay to trusts only if those trusts have been specifically designed for post-death income tax deferral. The IRA-to-trust rules were overhauled in 2002 by then-newly adopted final Treasury Regulations. If your IRA or 401(k) will pass to a pre-2002 drafted trust, it is time to update your trust/Will. Even more recently drafted trusts should be reviewed by estate tax counsel.

How should I structure my Roth IRA beneficiary designation?

In general, Roth IRA beneficiary designations are subject to similar considerations expressed in the answer to the preceding question, though the disposition of a Roth IRA is particularly well-suited for payment to much younger beneficiaries who can “stretch” their receipt of the funds over their life expectancies (to maximize the time in the tax-free environment). Moreover, a Roth IRA probably should not be left to a charity, whereas a traditional IRA should indeed be thought of as a favored source of a charitable bequest (to avoid the otherwise applicable income tax and possible estate tax on the IRA at death).

What is the recommended style to hold joint accounts? TIC, JTWROS, POD/TOD?

TIC (“tenants-in-common”) is the estate planner’s favored account style in general, given that it does not attempt to dispose of the account funds at death. The issue with the other listed options (JTWROS, POD/TOD, aka, “joint tenants with rights of survivorship,” “pay on death” or “transfer on death”) is that these accounts will pass by operation of law to the survivor so named, whereas the estate plan may well not intend the estate to pass to the survivor. In other words, sometimes the account holder does not realize that the account will pass to someone other than as provided in his or her Will. Unexpected tax consequences can also result due to lack of the account’s coordination with the overall estate plan. TIC avoids these problems, because it results in the share of the deceased account holder passing via his or her Will. Many people are under the mistaken impression that these alternate account styles will help provide easy access to the account without the burden of probate, but access to a TIC account is generally gained by the executor within two weeks of filing the Will in court for probate.

Are family limited partnerships useful for non-tax purposes?

Many families find a family limited partnership the perfect vehicle for consolidating their respective interests in property for management reasons. The partnership agreement governs the succession of management, and is adaptable with changes of circumstances, unlike an irrevocable trust for example. If the partnership invests in securities, it may be able to obtain economies of scale in terms of the associated investment advisory fees, and even in terms of access to certain investment firms, not otherwise available to a given family member alone. A family limited partnership can offer the family the ability to restrict the ownership of interests in certain property to family members only. The general partner(s) control the operation, investment and administration of the partnership, even if their interests are only a minority of the whole. Limited partner interests can be shared among family members without splintering this control and restrictive ownership arrangement. The family limited partnership also offers asset protection in that the partnership asset(s) [e.g. a family farm] cannot incur a liability which exposes a limited partner’s personal assets to a creditor’s claims. The partnership shields the limited partners, whereas if they owned the farm directly, they would be liable for risks associated with the farm. However, the converse is not the case. In other words, if the owner has a personal creditor, that creditor can claim the [limited] partnership interest. Even so, the partnership agreement and state law will usually restrict the creditor’s rights to participate in the partnership, thus encouraging the creditor to settle the claim more readily. (See article on Exclusive Content page, available to Firm clients, for more comprehensive asset protection discussion.)

What are some important tips in managing a family limited partnership?

Any entity, be it partnership, corporation or limited liability company, will be respected by creditors and the Internal Revenue Service only to the extent the entity is respected by its owners. In other words, families must treat their partnership as unrelated partners would. This means avoiding the ownership of personal-use property in the partnership and avoiding disproportionate distributions. In addition, proper formalities should be followed consistent with the partnership’s governing instruments. Annual meetings of partners and accompanying minutes are a good practice, as well as a formal set of books for the partnership. Annual income tax returns for the partnership must be filed with the IRS, as well as annual Texas margin tax returns. Other state returns may be required if the partnership holds property in other states.

What does a charitable lead trust accomplish?

The most common form of charitable lead trust is the “CLAT” (charitable lead annuity trust). The CLAT is a trust that defines a fixed amount to be distributed every year to charity for a predetermined number of years. A CLAT is created by transferring cash or other assets to an irrevocable trust. Charity receives the fixed annuity payments from the trust for the number of years you specify. At the end of that term, the assets remaining in the trust are transferred to the non-charitable beneficiaries that were specified when the trust was established (commonly the children of the individual(s) who created the trust).

In order to avoid paying any gift tax on such a transaction, many people set up the CLAT with large required annual payments to charity, so large that the present value of what will go to their children is essentially zero (referred to as a “zeroed-out CLAT”). This can be accomplished because the Treasury Regulations allow the children’s ultimate share to be valued at zero by using a defined “discount” rate which changes monthly, but is determined when the trust is established. Let’s assume the rate is 3% in the month the CLAT is created.

Here is how the zeroed-out CLAT works. If charity will receive the full amount of what is initially contributed to the trust plus an assumed 3% rate of return for its term of years, then the grantor’s gift tax return can reflect that the portion ultimately transferred to children is $0. Indeed, if the trust assets perform at a 3% rate of return (or less), the children will receive nothing at the end of the term. However, if the experience of the assets exceeds such rate, then all of the excess ultimately will be left in the trust at the end of the term and will pass to children – at no gift tax cost. So, a CLAT is a means to help charity and give children the “upside” potential on the trust principal at the same time..

Is a charitable remainder trust a estate tax strategy or an income tax strategy?

A charitable remainder trust (CRT) is primarily an income tax strategy, since (unlike a CLAT) it is an income tax-exempt entity. As its name suggests, the charity gets the “remainder” of the trust. Whereas, the stream of annual payments goes to the donor or someone of his or her choosing. Here are the three principal income tax advantages: First, if a given property would incur a capital gain tax if sold, it can instead be contributed to a CRT and then sold, with no resulting capital gain (since it is being sold in a tax-exempt entity). Second, the grantor receives an income tax deduction for the [future value] of the charity’s remainder interest in the trust property. Third, the proceeds [unreduced by income tax] from the sale are reinvested within the CRT and the earnings are not subject to income tax within the CRT (again, due to its tax-exempt status). However, every CRT requires a fixed sum or a fixed percentage of its value to be distributed to the individual beneficiary each year. When the distribution occurs, that carries out income tax consequences. Accordingly, many people view the CRT as a means of deferring rather than avoiding income tax, in exchange for giving the ultimate “remainder” left after the defined term of years to charity.