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Estate Preservation: Specialized Trusts

Trusts actually date back to feudal times. Essentially, trusts are a device where you are putting trust in someone else to handle your assets for your chosen survivors.

On a basic level, there are two types of trusts: living and testamentary (by testament, or will). Living trusts may continue on after you die. Testamentary trusts are created by will and take affect after your death.

The person who wants to establish a trust is called a "grantor" or "settlor." The grantor can make his or her own rules in a trust, provided they adhere to the laws of each state, which vary. But there are a few basic rules: Few trusts, other than charitable or employee trusts, can last forever. Most states stipulate that a trust lasts only as long as the lives of the people in it, plus 21 years. A few states have eliminated the laws against perpetuities.

The articles below will explain how trusts can help you minimize the effects of federal estate taxes and maximize control over the disbursement of your assets.

  • Did You Know...?
    The first recorded trust in America was drafted by Patrick Henry in 1765 for Robert Morris, governor of the colony of Virginia. The trust, the North American Land Company, is still operational.

The Marital Deduction and Bypass Trust
This is the tax-planning cornerstone for many marital estates that exceed the unified gift and estate tax credit equivalent ($1 million in 2003 and 2004). A married couple can maximize use of their credits by using a simple trust arrangement (often called the "A/B" trust) that provides for the survivor during their lifetime and passes assets to their ultimate beneficiaries after the second death with reduced estate taxes.

Here's how it works: Each spouse puts a portion of their individual taxable estate (equal to the unified credit amount, which is $1 million in 2003 and 2004) in an irrevocable trust at their death for the ultimate benefit of their beneficiaries, but not their spouse. This bypasses (hence the "B" name for the trust) the estate tax on this portion of their estate. The rest of their taxable estate uses the unlimited marital deduction to avoid tax and goes into another trust (called the "A" trust) for the surviving spouse.

The "A/B" trust arrangement allows the surviving spouse:

  • To receive all annual income produced by the "B" or bypass trust for the beneficiaries.
  • The annual right to withdraw money ($5,000 or 5% of the "B" trust principal, whichever is greater) for any reason.
  • The limited right to invade the principal if necessary for the survivor's "maintenance, health, support, or education."
  • Access to the entire family estate.
  • The ability to pass appreciation of "B" trust assets to non-spousal beneficiaries free of gift and estate tax.

To take advantage of this trust, though, each spouse must own sufficient separate property to transfer into the "B" trust. It may be necessary to re-title assets and accounts while both spouses are alive so each spouse has about half the family property in his or her individual name. For example, a brokerage account registered to, "John Doe and Mary Doe Joint Tenants with Rights of Survivorship" should be changed to, "John Doe and Mary Doe Tenants in Common." Failure to do this is a very common planning blunder.

If you already have an "A/B" trust estate plan, you should contact your advisors to review the plan to be sure it still meets the new limits set forth in The Tax Relief Act of 2001.

The Irrevocable Life Insurance Trust
One way to avoid tax is not to "own" insurance at the time of your death. However, this may become a problem for another owner's estate if he or she dies. So what we need is an owner who can't die. For many people, a trust is the answer.

Set up the trust and either place an existing life insurance policy in it or provide funding for the trustee to buy a new policy. The trust owns the insurance and is the beneficiary — both income tax-and estate tax free. This is so because the trust is recognized as a distinct legal person (and can't die). (But you need to live three years after transferring a policy to the trust to avoid estate taxation.)

But there is a catch: Put simply, an irrevocable life insurance trust cannot be revoked. That means the grantor gives up the right to income from the trust, or change it in any way (including beneficiary names and so on). But in return, the grantor can receive tremendous income and estate tax savings, choosing to pass his assets (without the taxes that come with them).

Set up the trust and either place an existing life insurance policy in it or provide funding for the trustee to buy a new policy. The trust owns the insurance and is the beneficiary. Gifts are made to the trust, which the trustee can then use to pay premiums. This requires appropriate drafting of the agreement by an attorney. Upon the death of the insured, the insurance proceeds are paid directly to the trust. (Again, the owner must survive three years in order to avoid estate taxation if an existing policy is transferred to the trust.)

A trust also provides for the use and management of the policy proceeds in accordance with the grantor's wishes. Your beneficiaries might not be old enough to manage money or lack financial and investment savvy. Often, having just lost a loved one, survivors tend to just not care about money matters. This is a terrible time to have to make important decisions. Not coincidentally, it is also a time when grieving spouses are most vulnerable to bad advice and scams.

Trusts are sophisticated planning tools and should not be created without counsel of qualified legal advisors. For example, the trust should have other investments besides the insurance. The trust should truly own the policy and demonstrate it pays premiums and has the right to change beneficiaries. Policies transferred into a trust within three years of death will still be included in the decedent's gross taxable estate, so don't put-off transferring policies once the trust is created. Be sure that you file gift tax returns for donations to the trust unless it qualifies for the annual gift tax exclusion. Consult with a qualified trust attorney to be sure your trust is valid in your state.

  • Did You Know...?
    Trusts used to have lower income taxes than individuals. But now, trust income can be taxed as high as 38.6%.

  • Did You Know...?
    Like its name implies, a revocable or living, trust lets you change or alter your trust in any way, including ending it, if you need the money. It has no taxes advantages. However, other reasons for it include management. Many people put their assets, or business, is a trust that someone else manages. The grantor or his family can still be beneficiaries, but someone else does the day-to-day work.

  • Did You Know...?
    Transfers of property such as land can forfeit the state property tax-exemptions for the owner in some states if not worded correctly in the deed.

The Qualified Terminable Interest Property Trust
Taking advantage of the unlimited marital deduction, all assets are passed into a Qualified Terminable Interest Property (QTIP) trust. The surviving spouse receives a lifetime income from the trust, but all its assets are passed to beneficiaries chosen by the first spouse on his or her death.

So although the surviving spouse has an income interest in the QTIP trust, he or she cannot direct to whom the property shall pass after his or her death. Furthermore, no distributions are permitted to anyone but the surviving spouse during his/her lifetime.

All trust assets are included in the survivor's gross taxable estate. A QTIP trust delays federal estate tax on the property placed in the QTIP trust until the second death.

  • Did You Know...?
    If you are thinking about giving a gift to a person one generation removed or more, the Generation Skipping Transfer Tax will take 50% of it in 2003. The good news, though, is that each donor is allowed $1.1 million exemption. In 2010, generation skipping taxes will be repealed.

  • Did You Know...?
    When TeleCommunications, Inc. (TCI) founder Bob Magness died of cancer in 1996, he left about $55 million to his second wife (of which $35 million was in a QTIP).

Remainder Trusts and the Charitable Remainder Trust
Trusts that provide income to a current beneficiary (e.g. the grantor, his or her family, etc.) for a specified term and the remainder of the principal to a different beneficiary (e.g. family, friends, charity, etc.) at the end of the term are called remainder trusts. The advantage of such trusts is that current assets continue to provide "income" benefits to a current beneficiary while the value of the remainder and appreciation on the principal is generally immediately removed from the grantor's estate, which can lower estate taxes. Furthermore, the grantor no longer has to worry about managing those assets. Depending upon the structure of the trust and who the beneficiaries are, some gift tax may be due when funding these trusts.

Perhaps the most well-known remainder trust is the Charitable Remainder Trust (CRT). This is extremely popular with individuals who will incur large taxes at death and who want to give to charity. An added plus: The grantor may receive a substantial current income tax deduction for a charitable contribution, too. To offset the loss of the remainder to the family, the grantor usually has another trust purchase an insurance policy to replace the remainder value to the family at the grantor's death.

  • Did You Know...?
    The Taxpayer Relief Act of 1997 mandates that the charitable remainder must be 10% or more of the value of the assets of the trust.

Grantor Retained Interest Trusts
These are a type of irrevocable trusts for assets that are quickly appreciating in value. Essentially, this type of trust allows you the right to transfer assets (typically to a grandchild), yet receive income from them or use them. The value of your gift will be reduced by the income you receive when it is passed down.

With the Grantor Retained Annuity Trust, you put your assets in a trust and name a beneficiary. You can specify a fixed percentage of the assets to come to you annually and pick a mandatory pay-out time; after that time, the assets become the property of your named beneficiary, but at a lesser value (minus your annual income for time).

In the Qualified Personal Residence Trust, a grantor with a large residential value donates his or her residence to an irrevocable trust but retains the right to live in the residence for a certain period (again reducing the value of the home by the time he or she uses it). After that term, the residence becomes the property of the remainder beneficiaries (usually the family). With this trust, the grantor's residence can remain in the family while providing a significant estate tax savings, especially if the property appreciates.

However, there may be current gift tax consequences, but the overall benefits should be greater than the current taxes. If the grantor dies before the term of the trust expires however, the value of the residence will go back into the estate. If all parties understand the transaction, there usually isn't a problem finding a suitable place for the grantor to live after the trust ends; the recipients might even rent it back to the grantor.

Lead Trust
A trust arrangement that provides income to someone else with the remainder reverting back to the grantor or grantor's family is called a lead trust. Lead trusts are not as prominent as remainder trusts, but they can be used to create tax savings when the income beneficiary is a charity. Charitable Lead Trusts generally provide an estate with a current income tax deduction that can substantially offset the estate tax on the remainder included in the decedent's estate.

  • Did You Know...?
    Jackie Onassis died in 1994, and her estate was estimated at $100 million. A small portion was probated, and a vast majority of her assets were reported to have gone to a charitable lead trust. The trust would have made donations to charities for 24 years, according to a 1996 New York Times report, then dissolve with the assets passing to grandchildren estate tax-free.

There was no requirement, however, that her children pass any money from the sale of her assets to the trust. The children instead decided to pay estate taxes on the sale of her assets. It is estimated that the children owed $23 million in estate taxes, while the remaining estate was valued at $18 million.

Some experts argue that Onassis should have made more provisions to ensure more efficient payment of estate taxes. But in the end, she felt more comfortable leaving that decision up to her children.

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Estate Preservation: Specialized Trusts

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