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Financial Planning > Trusts and Estates > Trust Planning

After the Estate Plan . . .

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Don’t you love it when a client follows your recommendations to the letter? Consider, for instance, the following common scenario:

Taking your sage advice to heart, your client finally seeks the services of an estate planning attorney. The attorney drafts what will forever be known as the client’s estate plan. With the stack of freshly drafted documents in tow, the client enters your office and asks, “What now?”

As the client’s financial advisor, it is up to you to ensure that the estate plan is implemented correctly. Implementation includes, but is not limited to, retitling of assets, revising beneficiary designations, and securing life insurance. You also have an ongoing duty to manage the assets within the estate plan.

No two estate plans are exactly alike. While each plan may incorporate many of the same estate planning vehicles, the plans’ goals are as varied as the individuals and charities named as beneficiaries. These differences present unique challenges for advisors who manage the assets within those plans. Your ability to tailor the investment strategy so it complements the estate planning vehicles that hold the assets is a key contributor to overall plan success.

The following discussion focuses on factors you need to consider when managing assets as part of an estate plan.

Since trusts are the most common estate planning vehicles you will encounter, I will discuss various aspects of managing trust assets and provide a few examples of how investment decisions can directly affect the success of different types of trusts.

Understand the Goals

There are many different estate planning vehicles that may collectively make up the estate plan. Within each vehicle, you may find several named individuals. You may have a trustee charged with the fiduciary duty of “running” the trust. You may have a grantor, or creator, of the trust. And you will certainly recognize the beneficiaries, who may be numerous and have varied interests. For instance, some beneficiaries may have an immediate interest in the trust assets, while others’ interests may not vest until a future date. Then there’s the fact that beneficiaries may change over time due to birth, marriage, divorce, or death.

With so many different parties to a trust, how can you be sure that the proposed investment choices align with the needs of the proper beneficiaries?

To maximize the benefit of the estate plan to your client and your client’s heirs, you need to understand the goals of each trust within the plan. This doesn’t mean that you need the technical knowledge of the attorney who drafts the trust; rather, you should have a general understanding of how the trust works, the trust’s tax status, why the trust is part of the plan, and whom the trust is intended to benefit.

Don’t rely on the client to interpret the function of the trust for you. Take advantage of your professional relationship with your client’s attorney and ask the questions that will help you manage the assets in the most effective manner.

Consider asking the attorney some of the following questions when discussing the client’s estate plan:

  • Is it a grantor trust, where all trust income is reported on the grantor’s individual return, or is it a separate tax-paying entity?
  • Will the assets in the trust be subject to estate taxes, or will the assets pass to the beneficiaries estate tax-free?
  • Is there an income beneficiary due to receive income payments from the trust for a term of years or for life?
  • Has a qualified charity been named as beneficiary to the trust?
  • How much liquidity does the estate need to meet administrative and estate tax liabilities?

These are only a few examples you can use to identify the investment needs of any trust. Now let’s look at a couple of common trusts found in estate plans and discuss how investment decisions can affect the outcome of the estate plan.

Bypass Trusts

A bypass trust (also known as a credit shelter or B trust) is a common estate planning vehicle for married couples. It can effectively shelter the assets of the first spouse to die from federal estate taxes, which would otherwise be incurred if those assets passed directly to the surviving spouse. The use of a bypass trust allows both spouses to use their applicable exclusion amounts (currently $2 million and scheduled to increase to $3.5 million in 2009) at each death, which, in turn, allows the maximum amount of assets to pass to heirs estate tax-free.

Several factors must be considered when managing assets within a bypass trust. The first is the surviving spouse’s need for support from the assets in the trust. To avoid inclusion of the bypass trust assets in the surviving spouse’s estate, the surviving spouse’s access to those assets must be limited to an ascertainable standard (health, education, maintenance, and support). The surviving spouse may also have a right to receive all annual income from the trust. Knowing the needs of the surviving spouse is the key to allocating the investments within the trust.

If the surviving spouse has sufficient assets outside of the trust, there is likely no need for income or principal invasion. In this case, you can focus on growing the trust assets to maximize the amount to pass free of estate taxes. Since the first spouse’s applicable exclusion amount was allocated to the trust when it was initially funded, the assets will not be subject to estate tax when they ultimately pass to the beneficiaries upon the death of the surviving spouse.

If the surviving spouse will need support from the trust assets, you need to balance the needs of the current beneficiary (surviving spouse) against the needs of the remainder beneficiaries (commonly the children). This can be tricky, as it is common to hear complaints from beneficiaries who claim trust assets are being mismanaged in favor of one beneficiary over another. A balanced approach to investment allocation may work best in this scenario–providing current income to support the spouse while maintaining an underlying growth component to appease the remainder beneficiaries.

Courts seem to have favored the surviving spouse’s needs when remainder beneficiaries have brought suit against the trustee and advisor for mismanaging trust assets. To avoid such situations, consider creating an investment policy statement that clearly defines the investment approach for managing the trust assets. If possible, have all parties to the trust sign the statement in an attempt to proactively diffuse any future disputes that may arise.

Charitable Remainder Trusts

Another trust you may encounter in a client’s estate plan is a charitable remainder trust (CRT). A CRT is a split-interest tax-exempt trust. It is a split-interest trust because there are two beneficiaries: a noncharitable income beneficiary that receives a payment (at least annually) from the trust and a charitable remainder beneficiary that receives any remaining assets in the trust when the trust expires. The trust term may last from one to 20 years or for the life of the income beneficiary.

There are many benefits associated with establishing a CRT, including:

  • Income tax deduction upon funding the trust
  • Deferral of gain recognition upon sale of appreciated assets
  • Reduction of the taxable estate
  • Annual income stream
  • Remainder of assets go to a worthy cause

While they are wonderful estate and income tax planning tools, CRTs can be complex to administer and manage. That’s because CRTs are subject to special accounting referred to as four-tiered accounting, also know euphemistically as worst in, first out (WIFO). When assets are contributed to a CRT, they are sold by the tax-exempt trust without paying any tax on the built-in gain in the appreciated property. The gain, however, is tracked by the trust and used to determine the tax character of the payments to the income beneficiary.

The gain is allocated to one of four tiers:

  1. Ordinary income
  2. Capital gain
  3. Tax-exempt
  4. Principal

Let’s look at an example. Your client contributes property to a CRT with a value of $500,000, where $300,000 of that value represents long-term capital gain. Upon liquidation of the property, $300,000 will be allocated to tier 2 (capital gain) and $200,000 to tier 4 (principal). So what does this mean?

When the first payment to the income beneficiary is made, the full payment comes from the amount allocated to tier 1 (ordinary income). If there is no tier 1 income, then the income payment comes from tier 2 (capital gain). Once that tier is exhausted, the income comes from tiers 3 and 4. If the income beneficiary in this example is to receive $25,000 each year, the payments would be taxed as capital gain in the hands of the recipient for at least the next 12 years (12 x $25,000 = $300,000).

Suppose an advisor sought to generate tax-exempt income for the income beneficiary; she might consider tax-exempt municipal bonds. Although this may sound like a good plan, the income beneficiary in our example would not receive the first tax-exempt payment until year 13, once the capital gain income was finally exhausted. In the meantime, the portfolio underlying the CRT would not have a chance to grow.

Because capital gains are currently taxed at preferred rates compared with ordinary income, many advisors find investing CRT assets for tax-efficient growth to be a sound strategy. Aside from increasing the value of the remainder to the charitable beneficiary, the portfolio can be carefully managed to harvest capital gains without recognition of ordinary income, which would be allocated directly to tier 1 and therefore distributed in the next payment. You must always be mindful of the four tiers when managing CRT assets.

The Next Generation

Having an understanding of the client’s needs and the function of the various estate planning vehicles in her plan will help you entrench yourself as that client’s trusted advisor. The way in which you handle your clients’ estate plans can also serve to introduce you and your services to an extremely satisfied generation of beneficiaries who stand to inherit all of the wealth you helped create and preserve.

Gavin Morrissey, J.D., is an advanced planning consultant at Commonwealth Financial Network in Waltham, Massachusetts. He can be reached at [email protected]