An Overview of Trusts

The following is an overview of different trusts that can be formed:

Living Trusts

A living trust is a popular vehicle that avoids the cost and delay of probate for your heirs as well as the dangers of jointly owned assets. Unfortunately, it will not protect the beneficiaries from lawsuits. And, a "homesteaded" home transfered to a living trust can lose its homestead protection and become subject to claim.

Living trusts are effective because without one a court will distribute assets under the will of the deceased, which is an expensive and time-consuming process that can consume as much as four percent of an estate and take years to conclude. A living trust circumvents the probate process and allows assets to be immediately transferred to beneficiaries.

An intelligent strategy is to title assets to a limited partnership (which makes them creditor and lawsuit-proof) that is owned by a living trust (which avoids probate). At the time of death, ownership in the LP immediately transfers through the living trust to heirs, avoiding probate.

Irrevocable Life Insurance Trusts

Life insurance is a key component of any family protection program that can build up a large cash value that would be appealing to a creditor. Most people don't realize that even a term policy without cash value can be a valuable asset with future cash value—to both your family and your creditors. Life insurance can also pay estate taxes and make funds immediately available to survivors, preventing the delay and expense of liquidating other assets.

We recommend that large life insurance policies be titled to an irrevocable life insurance trust (ILIT), an entity that is specifically designed to own life insurance and has traditional trust components (such as a trustee, beneficiaries and terms for distribution). An ILIT owns the insurance policy and the sole beneficiary is the trust—not an estate. At time of death the insurer pays the trust and the trustee follows the distribution provisions of the trust outside of probate.

Under an ILIT it is important that the premiums be paid by the trust either through annual payments made by the trustee, or by depositing the fully paid insurance policy into the trust. Any other payment could void the trust and cause its tax benefits to be lost.

ILIT's are irrevocable and protect the policy's cash value, death proceeds, and distributions from the trust to the beneficiaries. Because some states do not protect life insurance from creditors, the ILIT is an essential component of Asset Protection that can also save on estate taxes because the ILIT owns the policy that is excluded from a taxable estate.

The ILIT also provides better control over policy distributions than insurance owned by an individual because under personal ownership an insurance company directly pays the named beneficiaries the full amount of the policy at the time of death. An ILIT allows greater control over who receives death benefits as well as how and when the policy proceeds are distributed. Some strategies have an ILIT trustee pay estate taxes and other costs (including taxes due on IRAs or other retirement plans, probate costs, legal fees and debts) prior to the distribution of funds to the trust beneficiaries. Alternatively, a trustee can be directed to pay beneficiaries over any number of months or years with spendthrift, anti-alienation, discretionary distribution, and other protective provisions that protect the insurance proceeds from the creditors of the beneficiaries. An ILIT can also avert court interference if a beneficiary becomes incompetent because most insurers will not pay life insurance proceeds to an incapacitated beneficiary, which the ILIT would permit under the guidance of a trustee.

Children's Trusts

An irrevocable children's trust (ICT) can reduce taxes as well as provide protection to future generations because property that is transfer to a children's trust cannot be seized by creditors and it will not be included in a taxable estate. Income from the trust is taxed at a child's lower income tax rates, making it advantageous in many instances.

One possible disadvantage, however, is that at age 21 a child can demand the trust assets and because the ICT is an irrevocable trust, the grantor cannot withhold distributions from. Any extension of the distribution age will require written consent of the child at age 21.

Charitable Remainder Trusts

The Charitable Remainder Trust (CRT) permits the donation of assets to charity (where they are protected from creditors) and permits income derived from the protected assets to be distributed to the donor.

Under the CRT, a grantor selects a tax-exempt charity as the beneficiary of their irrevocable trust and makes a charitable donation in exchange for an immediate tax deduction for the value of the assets contributed to the trust. Over the lifetime of the grantor, the trust pays a fixed annual income to the grantor and, as applicable, pays other expenses and income derived from the principal donation.

Here's an example of a CRT at work: Assume that an individual has $200,000 in securities that were purchased 15 years ago for $60,000. If the securities were sold to invest in treasury bonds the individual would pay $21,000 in capital gains taxes on the profit and at the time of death, if the treasury bonds were valued at $200,000, the estate would pay an additional $88,000 in estate taxes and the heirs to the estate would inherit, after taxes, just $91,000 of the original $200,000.

Strategy: Don't sell your stocks. Instead, transfer them to a CRT where you can receive the same annual income as from treasury bonds as the CRT's income beneficiary. Deduct the $200,000 donation as an immediate charitable contribution and with the tax savings from your charitable deduction buy a $91,000 life insurance policy to cover the $91,000 that your beneficiaries would have received had you donated your stock to the CRT. The net result: a large tax deduction this year, the same perpetual fixed retirement income as with treasury bonds, you donate to your favorite charity, and the donated trust assets are lawsuit-proof.

CRTs are an excellent way for an individual to achieve their philanthropic goals while simultaneously protecting family assets and creating a stream of future income at the most advantageous tax rate.

Qualified Personal Residence Trusts

A Qualified Personal Residence Trusts (QPRT) allows one to transfer their residence to the trust and retain a tenancy for up to ten years. At the end of the term the residence passes to established beneficiaries at a lower tax value than that which would typically be expected in the future, serving to reduce estate taxes.

A QPRT can also lawsuit-protect a home because the home is owned by the trust and only under select circumstances could a creditor attempt to claim any interest in your use of the home.

For individuals in a second (or third) marriage the Q-TIP (Qualified Terminable Interest Property) trust is an effective way to ensure that a current spouse will receive a lifetime income from the trust. However, after the death of a current spouse the beneficiaries become the children from an original marriage and not the current spouse's children or family, who would become the probable beneficiaries of an estate bequeathed outright to a surviving spouse. A Q-TIP is essentially a spendthrift trust to shelter your assets from your spouse's creditors or subsequent mates.

Income from a Q-TIP trust must be used solely to benefit the surviving spouse during the spouse's lifetime or the trust won't qualify for an unlimited marital deduction. A further advantage of the Q-TIP is that estate taxes on the principal are deferred until the surviving spouse dies.

Because the Q-TIP is a testamentary trust it will not protect assets from creditors. But a Q-TIP trust can shelter wealth from a spendthrift spouse, a spouse who may have future financial or legal difficulties, or a spouse that intends to leave an estate acquired through marriage to their children from a previous marriage.

Principal in a Q-TIP trust is protected from a spouse's creditors but income is not and must be distributed immediately as earned. No distributions can be withheld.

Land Trusts

Land trusts are widely used in a number of states to partially protect real estate against lawsuits. A land trust can own any real estate (including a family residence) and is typically managed by a bank as the trustee, who also holds title to property. As a result, the donor's beneficial interest is in personal property, not real property and we typically advise that the interests be held by a LP, LLC or an irrevocable trust.

Disadvantages to a land trust include difficulty in obtaining refinancing because of reconveyance requirements and certain tax considerations related to a Section 1031-tax free like-kind exchange. However, the land trust does provide privacy as public records will indicate the trustee as the owner, not the original donor.

Medicaid Trusts

Medicaid trusts are designed to cover the cost of expensive nursing home and long-term end-of-life expenses so that proceeds of an estate will pass to heirs and not be spent on health care.

The Medicaid trust is similar to other irrevocable trusts and is funded by a grantor (an individual or couple) transferring their assets to an irrevocable trust. However, unlike other irrevocable entities, the grantor can be the income beneficiary with their children (or a surviving spouse) as the residual beneficiaries. The grantor receives income from the trust to the maximum amount allowed by Medicaid and the now, asset-free grantor qualifies for Medicaid nursing home assistance.

The Medicaid trust offers about the same Asset Protection as any other irrevocable trust but prohibits using the trust assets for other health care purposes. It also limits the beneficiaries' income-to-income limits set by Medicaid. Additionally, a Medicaid trust must be created and funded 60 months before an application for Medicaid, which is a prime disadvantage because it is difficult to anticipate long-term care needs that far in advance.

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