One unfortunately common and major mistake made in estate planning is the failure to use trusts to the maximum extent the law permits. Trusts may be the most important development under English common law, which pervades the United States, with the exception of Louisiana. That state and many countries through the world that do not use English common law as its fundamental legal system have adopted trusts by a variety of means including legislation. That is because trusts are, in many ways, the most powerful and important tool in estate and financial planning. Unfortunately, trusts are not used with the frequency or duration they should be.
Disabilities of Beneficiaries
Few, if any, attorneys would fail to recommend strongly that a client put his or her assets in trust for a family member who is under a legal disability, such as being a minor or being incompetent. Giving or bequeathing assets outright to a minor or an incompetent is a recipe for disaster, resulting in maximizing court interference with the management of the property, reducing flexibility in the use and investment of the property for the benefit of the person for whom it was set aside, and increasing fees of attorneys, guardians, appraisers and courts relating to the transmission, management, and expenditure of the property.
Change the facts slightly, however, to a case where a client wishes to leave property to a grown son. At present, the son is 40 years old and legally competent, but what if this son were diagnosed with, for example, Alzheimer’s Disease? Certainly, almost all attorneys would recommend placing the assets in trust for the son as the probability of him becoming legally incompetent is quite high if not certain. But what lawyer has a client whose beneficiaries will never become legally incompetent? None. In fact, the ravages of age continue to be so severe that for the foreseeable future a high percentage of individuals will suffer substantial difficulty in managing financial affairs prior to death. The 40-year-old son in the example very likely will someday be in a nursing home, not only unable to write checks but incapable of understanding what options are available for the management of his property. In fact, one renowned lawyer (so brilliant he graduated so young from one of the country’s leading law schools that he could not sit for the bar exam) became a victim of dementia before he was 40 and as unable to make any decisions before he was 45. It can happen to anyone.
Of course, there are things the son could do later in his life to protect against certain adverse effects of that disability and subsequent incapacity to manage assets. He can create a revocable trust, execute a power of attorney, or take other steps. However, if the son is like most people, he will do none of these. Therefore, it makes sense to start with a trust for virtually any transfers for beneficiaries. Remember, it is always easier to get toothpaste out of the tube (or remove assets from a trust) than to get the paste into the tube (or get assets back into a management vehicle, such as a trust, after they have been removed).
Protection from Claims
In many ways, a trust’s greatest attribute is its ability to protect assets against claims – not just claims of creditors, which will be discussed later in this article, but claims or demands by others to the property. The 40-year-old son in the example may someday be subject to unwise, unfair, and unreasonable demands that he cannot resist. Those demands may come from financial charlatans, unethical lawyers or unbalanced accountants, but they also may arise from friends, relatives or someone else looking to take advantage of him. As is well known, older individuals, on average, are more prone to financial scams than are younger people, and because everyone (if he or she is lucky) ultimately becomes a senior citizen, the chance of becoming a scam victim increases for just about everyone.
A trust protects against that situation, at least when there is a trustee other than the beneficiary. If a client is living in a nursing home and someone were to suggest that funds should be invested in land on Mars, an independent trustee likely would decline that investment opportunity even if the beneficiary (who may or may not be a co-trustee) desperately wants to make it.
Marriage represents another situation in which individuals commonly are subject to unwise demands or suggestions. When a spouse wants something, such as money to be invested in his or her business, it becomes almost impossible for the spouse holding the money to refuse. However, if the assets are in a trust where the investments can be made only with the consent of a trustee other than the beneficiary or his or her spouse, the investment may not be made, and the assets, therefore, are more likely to be preserved.
Although in most jurisdictions property received by gift, bequest, or inheritance (sometimes called “separate property”) is not subject to award to the “other” spouse upon a divorce, usually the person claiming that exemption must prove the separate “pedigree” nature of the property. Especially in long-term marriages, separate property often becomes mixed with marital property and, therefore, may be subject to division between the spouses by the courts upon divorce. Also, in some states, such as Connecticut and Massachusetts, property received by gift, bequest, or inheritance is subject to division in a divorce. A somewhat similar rule prevails in Colorado. Yet a properly constructed trust almost never is subject to division by a court although in some states income received or receivable by a divorced spouse may be used by the courts to fund alimony and/or child support. With over half of American marriages ending in divorce, it seems appropriate to consider a trust for any beneficiary who might be married at some time.
Even if the pedigree of an asset (as a gift, bequest, or inheritance) can be proved, it nevertheless may be subject to claims of a surviving spouse on a variety of grounds such that the owner spouse’s efforts caused the property to grow in value during the marriage and thereby making at least the growth subject to property division in the event of divorce. That is the rule in most states. However, again as a general rule, property that has been placed in trust by another will not be subject to claims of the surviving spouse upon the death of the spouse who is the trust beneficiary.
From a historic standpoint, trusts have been especially effective in protecting assets from claims of creditors. Nearly 24 million lawsuits are filed each year in the United States. Almost everyone in America is sued one or more times during his or her lifetime. The judgment usually can be enforced against any property owned by the defendant subject, usually, to limited exceptions. Yet the United States Bankruptcy Code itself provides an exemption for interest in trusts to the extent governing state law protects trusts from claims. In almost all states a trust created for a beneficiary by someone else, such as by one spouse for the other or by a parent for a child, may be entirely immunized from claims of such creditors. Because of the extremely high risk of a lawsuit, it makes sense to provide for the property to be placed in trust for beneficiaries.
Some states, including Alaska, Delaware, Nevada, New Hampshire and other states have passed laws that protect from claims of creditors property placed in a trust for and by the property’s owners. These trusts created, or as the English say “settled,” for oneself are called “self-settled” trusts. Until 1997, all states allowed the creditors of the person who created the trust permanent access to the trust assets even if that person could only receive distributions or benefits from the property in the discretion of a third party trustee, such as an independent bank or trust company. But that all changed on April 1, 1997 when Alaska adopted the Alaska Trust Act which permits individuals who resides inside or outside Alaska to create trusts for their own benefit without permanently subjecting the trust assets to claims of creditors. And now approximately a dozen states have similar rules.
One significant advantage of creating a self-settled Alaska trust is that the trust can be structured so the property in the trust will not be included in the gross estate for Federal estate tax purposes of the person who creates the trust. Hence, the property owner can give property to the trust, remain a trust beneficiary and keep the assets from being subject to estate tax at death. See IRS Private Letter Ruling No. 2009-44-002 (not precedent), discussed in detail in Rothschild et al., "IRS Rules Self-Settled Alaska Trust Will Not Be in Grantor's Estate, "Estate Planning, Vol. 37, No. 1, January 2010.
Trusts provide other tax advantages as well including income tax planning opportunities. However, as explained above, even without considering the tax advantages trusts provide, they should be used in almost all cases for other very important reasons.
In some cases, for tax or other reasons, trusts must be structured in a certain way. For example, in order for a trust for qualify for the marital deduction (so gifts to it will not be subject to gift tax), the trust must require, as a general rule, that all of the trust income (e.g., dividends and interest) be paid each year to the spouse for whom the trust was created. Most trusts, however, do not have to be in a certain form in order to achieve some of the beneficial results described above. In fact, a trust providing no specific benefits to beneficiaries probably is the best of all: It provides the greatest opportunity for safeguarding the property and minimizing taxes with respect to the assets.
However, the question of how the individuals will benefit from the trust naturally arises. Benefits are bestowed through the exercise of discretion by the trustees. Usually, it is best for the property owner who creates the trust to provide the trustees with guidance to what he or she wishes to accomplish for the beneficiaries. Even a suggestion like “it is my hope and expectation that the trustee will pay my daughter $1,000 each (adjusted for inflation) each month” is the kind of guidance almost all trustees will follow.
Experience indicates that corporate fiduciaries (such as banks and trust companies) readily welcome such guidance and, unless it would cause an adverse effect, almost certainly follow it. Further guidance may include a statement of expectation that trust funds will be used to pay for education, to provide funding to start a business, and/or to make investments the trust does not feel comfortable in doing (for example, those that are more speculative than a trustee would normally make).
Trusts also can be used to try to enhance “good” behavior and/or discourage “bad” behavior by beneficiaries. For instance, the grantor might provide that he or she prefers that the beneficiary receive no distributions except for education until the beneficiary graduates from an accredited college or it is determined that some factor, such as a disability, prevents him or her from doing so. Alternatively, the trust might allow a beneficiary to appoint an amount of trust corpus to charity equal to what the beneficiary personally has donated.
In addition to permitting the trustees to make distributions to the beneficiaries, there may be another way to benefit them benefits to continue to preserve the protective nature of the trust. That is to authorize and, in fact, encourage the trustees to acquire assets for the use of the beneficiaries.
Although it is not widely known, the law appears to be relatively well settled: The rent-free use of property owned by a trust by its beneficiary does not result in imputed income to either trust or the beneficiary. Acquiring property (such as a home, recreational property, works of art, for example) for beneficiaries and allowing them to use it for free means the assets continue to be owned by the trust. As such they are not subject to claims arising in the event of divorce or bankruptcy, generation-skipping and income taxes are minimized, and it prevents the foolish dissipation of the assets by the beneficiaries. In some ways, therefore, a trust can be used to allow beneficiaries to live like millionaires but not have to face the potential adverse effects of being millionaires.
Examination of the Use Trust disproves the perception that homes, works of art and similar assets should not be in trust. In fact, it is usually best for such property to pass into trust rather than outright.
When the Beneficiary Dies
Trusts may be structured so the beneficiary may specify by his or her will where the property passes when the beneficiary dies. The class of persons to whom the beneficiary may direct the property could be quite narrow, such as only among the grantor’s descendants, or very broad, everyone other than those entities (such as the beneficiary’s own estate), which would cause the trust to be taxed as part of the beneficiary’s estate. The power may be made exercisable only with the consent of an independent trustee if that appears desirable, and, in fact, if carefully structured, be exercised to cause the property to be subject to estate tax rather than generation-skipping tax when the beneficiary dies.
How Long Should a Trusts Last?
Most jurisdictions limit how long a trust may last by what is known as the “rule against perpetuities,” which may be as long as 100 years or a little bit longer. Some states, such as Alaska, Delaware, and South Dakota, permit trusts to last forever. Although 100 years may seem like plenty of time, the trust may end at a most inappropriate time, such as while the beneficiary is being threatened by a judgment or is about to die. Allowing the trust to last as long as makes sense means the trustees (or the beneficiary at death if granted a power by Will to do so) may end it, in whole or in part, at the “right” time rather than have it end at some random time.
Who Should Be Trustee?
Beneficiaries may and often should serve as trustees holding certain duties, such as to make or participate in investment decisions. Beneficiaries, however, should not be permitted to participate in decisions to pay themselves income or principal – such a power may cause tax and/or creditor claims problems.
In any case, some person or institution needs to be the independent (non-beneficiary) trustee or trustees. Often, someone or some entity will be the clear choice. However, many times that is a perplexing decision for the property owner. Even if one individual is the ideal choice now, that person probably will not serve as long as the trust lasts. Therefore, the difficult issue of selecting a successor arises.
Experience indicates that the trust should build in a system of “checks and balances” just as the U.S. Constitution does. That may be structured in several ways. One way allows a group of independent persons (typically called “trust protectors”) to remove and replace trustees for stated reasons or for no reason at all, but does not permit the trust protectors to appoint themselves or persons or institutions “close” to them. It even may be appropriate to allow the beneficiaries for stated reasons or at stated intervals (such as once every five years) to remove the trust protectors and appoint other independent persons to take over that position.
What Is It All About?
Sometimes individuals will claim that trusts are an invention of lawyers to keep heirs from receiving the property to which they are entitled. That claim is wrong for two reasons: There is no entitlement as a general rule and trusts are not used to deny the beneficiaries’ benefits. Rather, trusts, if properly structured and administered, are used to make sure the benefits will always be there.