THE NUTS AND BOLTS OF TRUSTS
1. Funding the Trust
I call trusts “piggy banks.” The piggy bank is created when the trust is signed. The process of dropping the “coins” into the piggy bank is called funding the trust. Funding the trust is a simple process of signing documents changing the owner from the name of the person to the name of the trust. Voilà! The trust is funded. For retirement accounts, like an IRA or 401K, the owner cannot be the trust, but the trust can be named a beneficiary, so the trust is permitted to accept retirement accounts upon the death of the person. If my client chooses not to fund the trust while alive, most trusts can be left entirely empty until the person who created the trust passes away. Whenever someone signs a trust, I create a special type of will called a “pour-over will.” This means that after the person dies, all probated property passes directly into the trust.
For revocable trusts, the person who creates the trust, called the grantor, can fund it immediately, entirely, or partially, or they can leave it empty until the grantor passes away. In a revocable trust, the grantor is almost always the first trustee. At the time of the grantor’s death, if the grantor left some or all of his/her assets outside the trust, the “pour-over will” is filed in probate court to “pour” the assets left outside the trust into the trust.
Here’s an example. Let’s call the grantor Suzy. Suzy wants to create a revocable trust for one or more of the reasons I list below. If she wants to avoid probate, she must transfer ALL of her assets into her trust while she is alive. If she forgets one asset, like that bank account she opened up 50 years ago because the bank gave her a free iron, a decree from the probate court must be obtained before Suzy’s beneficiaries can collect this money. Unfortunately, and often, the family finds this out because the bank will not allow access to that account. I get the call from a beneficiary who says, “The banker said Mom’s money is ‘frozen.‘” The banker knows Suzy died and she was the sole owner of her bank account. A decree from probate court must be obtained before the bank can release Suzy’s money. On the other hand, if Suzy had changed the name of that account into “Suzy, trustee of the Suzy Revocable Trust,” no probate administration would be required.
2. Choice of Trustees
The choice of trustees in any type of trust is critical. The trustee must be trustworthy and someone who will responsibly follow the grantor’s instructions set forth in the trust. The trustee can be a person or a trust department of a financial institution. The person could be a family member, friend, or paid professional, such as an accountant or attorney. The family member/friend usually does not charge for their time but is permitted to do so if the trust permits. If the non-professional trustee wishes to charge, it must be fair and reasonable. For example, the trustee should charge no more than what it would cost to pay a third party to do the same thing.
As with all jobs in “The Big Five” documents, I always want what I call “a spare tire”—at least one successor trustee. Because trusts usually have a long “life span,” I like a nice lineup of sole successor trustees. The trust must state a procedure to choose a successor trustee if the trust runs out of trustees, which is usually due to the death or mental incapacity of the last remaining trustee. I do not like co-trustees because of the risk of deadlock, and double signatures are required for most every action. Too clunky.
Sometimes my clients suggest co-trustees, with one family member and the other trustee a financial institution. I have not seen that arrangement work very well. Either the family member complains that the trust department is not listening to him/her, or the trust department representative is stressed out because the family member is hassling them frequently. When my client wants, let’s say, two of their children to serve as co-trustees, I ask why. If they say, “to keep an eye on the other,” I say, “It sounds like you don’t trust either one of them. Let’s choose one person at a time that you trust.“ If my client says they want both of their two children to serve as co-trustees “to be fair,” I say, “Blame it on me” and pick one at a time. It’s so much smoother when double signatures are not needed.
MAJOR TYPES OF TRUSTS
1. The Revocable Trust
The most common type of trust is the revocable trust, also called the “living” trust. This type of trust can be revoked or amended. The most common reasons to create a revocable trust are as follows:
To avoid or minimize estate taxes
To avoid having to file multiple probate matters, one in each state where real property is owned
To stretch out payments to beneficiaries over time
To manage money in a flexible way in complex family situations
To set up education funds
To take care of two sets of beneficiaries, such as a married couple each with children from a previous relationship
To set up a system for the management of a family home intended to be preserved for one or more generations
And, yes, to avoid probate
2. The Special Needs Trust
An example of an underutilized trust is a special needs trust, referred to as an “SNT.” There are two types of SNTs: first party and third party. First party means it is the beneficiary’s money and third party means it is the money of someone other than the beneficiary. Both types of SNTs shelter money and other assets for the benefit of a person who is receiving public benefits or who is unable to manage their own financial matters. If possible, it is better to create a third party SNT because there are fewer limitations on the use of the trust funds.
Unfortunately, I see this scenario too frequently: Dad dies. A few years later, Mom dies leaving her $200,000 and her home to her three kids. When her permanently disabled child, let’s call him Bill, receives his one-third inheritance from Mom, he loses all of his public benefits because he now owns more than $2,000, which disqualifies him from SSI (Supplemental Security Income) and other public benefit programs. I have to do quick work preparing a first party SNT because it is Bill’s money, and Bill may have temporarily lost his public benefits. On the other hand, if a parent had prepared Bill’s SNT before the parent’s death, a third party SNT, Bill’s one-third inheritance would have passed into his SNT seamlessly without the loss of a day of benefits. It’s a beautiful thing! A first party SNT must be irrevocable. A third party SNT can be revocable or irrevocable.
3. The Testamentary Trust
Some wills have additional language creating a testamentary trust. When the person who signed the will, the testator, dies, the money from the testator’s estate passes into the trust. It is called a testamentary trust because it doesn’t “spring alive” until the death of the testator.
I prepare a large number of testamentary trusts in connection with my MassHealth/Medicaid planning. For example, let’s say the wife enters a nursing home and qualifies for MassHealth benefits to pay her nursing home bill. The husband, still living at home, is entitled to keep under $123,600, the primary residence, one vehicle, and some other assets. If the husband dies before the wife, the wife will most likely inherit all of the marital estate, including the amount under $123,600. After the husband’s death, the wife is now single and only entitled to have under $2,000, not the amount below the $123,600 she just inherited. This sum has to be reported to MassHealth, and she will lose her MassHealth benefits. The wife must spend the inheritance by paying the nursing home bill until she has under $2,000 remaining.
On the other hand, if the husband signs a new will containing a testamentary trust for the benefit of his wife, at his death, the testamentary trust, not his wife, would receive the $120,000. The trustee, selected by the husband, keeps the money safe for the wife, but can only spend it to supplement, not replace, the wife’s public benefits. The wife continues to receive her MassHealth benefits and usually will not need much of the $123,600 before her death. The beneficiaries will inherit the unspent funds.
4. The Irrevocable Income-Only Trust
The irrevocable income-only trust, IIOT, is a powerful MassHealth/Medicaid planning tool. Federal and Massachusetts Medicaid law permits the owner to transfer assets, such as real property, money, or other assets into an IIOT. The person who transfers the assets is called the grantor.
The rules are very strict: the grantor is not permitted to “have a peppercorn” of control over the principal of the assets transferred to the trust, nor should the grantor serve as trustee. The grantor is permitted to receive income from the assets held in the IIOT.
If the grantor later needs to enter a skilled nursing home and applies for MassHealth benefits, the assets in the IIOT are not treated as the grantor’s assets if more than five years have passed from the date of the transfer of assets to the IIOT. In other words, the assets will not have to be used to pay the nursing home or to pay MassHealth back.
Because the IIOT is such a powerful tool, upon the filing of a MassHealth application, MassHealth representatives carefully examine each and every term in the IIOT for its technical adherence to state and federal law. For this reason, IIOTs must be carefully prepared and managed.
5. The Pet Trust
In Massachusetts, we now have pet trusts. See my Article Here
6. Estate and Income Tax Planning
A grantor will often fund an irrevocable trust for estate and income tax planning reasons. Massachusetts currently imposes an estate tax on estates holding over a million dollars at the time of death of an unmarried or widowed decedent.
If an unmarried or widowed grantor knows he or she is likely to leave assets in excess of a million dollars at the time of his or her death, the grantor can give the excess assets to an irrevocable trust managed by a trustee other than him/herself.
Here are two examples of irrevocable trusts important for estate and income tax planning:
• Irrevocable Life Insurance Trust (ILIT)
The use of an irrevocable life insurance trust (ILIT) is a good method to keep life insurance benefits from being included in the decedent’s estate for estate tax purposes. I frequently hear life insurance representatives say that life insurance benefits are “tax free.” What they mean is life insurance benefits are income tax free, but not estate tax free. Without an ILIT, life insurance benefits are included in the estate for estate tax purposes. With an ILIT, if the rules are properly followed, life insurance benefits are not included in the estate for estate tax purposes.
The IRS rules mandate that life insurance proceeds are included in decedent’s taxable estate if (1) the proceeds are payable to the decedent’s estate, or (2) the decedent owned the policy, or (3) the decedent retained certain “incidents of ownership” at the time of decedent’s death. “Incidents of ownership” include the right to change beneficiaries, to borrow against the policy’s cash value, or to cancel or surrender the policy. In funding an ILIT with a life insurance policy, the trust, not the decedent, owns the policy at the decedent’s death.
There are two ways to fund an ILIT. An existing policy can be transferred to an ILIT, but the transfer must occur more than three years before the decedent dies. The better practice is to have the ILIT purchase the life insurance policy in order to avoid the three-year rule.
When the ILIT purchases the life insurance policy, the ILIT trustee signs the purchase documents. The ILIT must be named the owner and the beneficiary during the decedent’s lifetime. The life insurance will be paid upon the death of the person whose money is funding the ILIT, i.e., the insured. The trust must be irrevocable, but built-in protections can be included in the trust permitting the trustee to change certain terms if it becomes necessary. For example, the ILIT provisions could permit the trustee to amend the trust in the event the insured becomes incompetent and the tax law changes. The amendment would be permitted in this example as long as the beneficiaries received the same benefits as originally drafted.
The person whose death triggers the life insurance benefits, the insured, is not permitted to serve as trustee, but s/he names the initial trustees and is permitted to change trustees as long as the trustees are independent, meaning not a close relative or a beneficiary as defined by law. “Independent” means someone who the law presumes cannot be influenced by the insured (not a spouse or child or beneficiary, for example).
Typically, the life insurance policy is purchased and annual payments made by the insured through the use of the federal annual gift tax exclusion, which is $15,000 per beneficiary (2018). Instead of paying the beneficiary directly, the gift is paid to the insurance company for the life insurance premium. Each beneficiary must be given notice of this payment and technically has the right to claim the money. For this reason, the beneficiaries must be carefully chosen.
The ILIT owns the life insurance policy and the trustee selected must follow the ILIT instructions of distribution after the insurance company pays the proceeds upon the insured’s death. The most common set of instructions permit the trustee to use the proceeds to make a loan to or purchase assets from the insured’s estate or revocable trust, providing cash to pay taxes and expenses. The instructions could include setting up lifetime income to the surviving spouse, keeping the proceeds out of both the insured's/decedent’s and his/her spouse’s estates. The instructions could include keeping the money in the ILIT for years and have the trustee make distributions as needed to trust beneficiaries, which can include the insured’s children and grandchildren. It’s a beautiful thing!
• The Charitable Lead Trust
The use of charitable lead trusts (CLTs) is a common technique permitting the donor to make gifts to charities, usually for a term of years, such as 15 to 20 years, receive taxable deductions each year for such gifts, and, when the term of years ends, pass on the remaining funds to the family members or other non-charitable beneficiaries. The non-charity beneficiaries are called “the remaindermen.” Certain IRS rules must be followed to compute the value of the taxable gift ultimately passed on to the remaindermen. The goal is to create terms in the trust to get this number to zero, meaning all assets in the trust will be excluded from the grantor’s estate at the grantor’s death. The CLT must be a charitable lead annuity trust (CLAT) or a charitable lead unitrust (CLUT).
The CLAT sets out a fixed percentage of the assets in the trust to be paid to charities each year. The annual rate chosen is typically in the range of 5 percent to 6.5 percent. The more frequently used CLT is the CLUT because it is a hedge against unexpected changes in the value of the funds in the trust.
Your trust is like a road map that the trustee uses to follow the grantor’s directions as to how to manage and pay out grantor’s money upon the grantor’s death. Trusts can be tailor-made to the grantor’s needs and goals.