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Financial Planning > Trusts and Estates > Trust Planning

Conventional wisdom about irrevocable trusts needs to change

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The general rule (IRC Sec 2036(a)) is that if the grantor of an irrevocable trust retains any power over the trust or the assets, then the value of the trust is included in the grantor’s taxable estate.  However, there are provisions that can be included in the trust that allows the grantor to keep the trust flexible.

1. Since 1995, one is the power to remove (and maybe replace) the trustee (Rev Rule 95-68).  The grantor can retain the power to fire the trustee. 

It is not clear whether the grantor can also then replace the trustee. 

  • Some attorneys include both the power to remove and replace. 
  • Others require a majority of the adult beneficiaries to replace the trustee. 
  • Still others are concerned about retaining the right to remove at all. 

That’s where the trust protector comes in.  The grantor can not only pick a trustee but also a trust protector who has the power to remove and replace the trustee.  The trust protector can have other powers, as well, discussed further below.

2 . Another is the power to protect your descendants after you die

Holding assets in trust should not send the message that you don’t trust your children.  Instead, you should communicate to your heirs that you want their inheritance protected from their creditors, including divorcing spouses and estate taxes. 

Most trusts provide for outright distribution after the death of the grantor (or surviving spouse) at specified ages (e.g., one-third at 25, one-half at 30, and the balance at 35).

(Note:  Beware of trusts that say equal thirds at ages 25, 30, and 35.  Look at the math.  If the share is $300,000, then one-third at 25 is $100,000.  With no further growth, one-third of the remaining $200,000 at 30 is $66,667, not $100,000. And one-third of the balance ($133,333) is $44,444.  That leaves $88,888 still in the trust.)

Instead, consider holding the assets in trust (what we refer to as the “family bank”.  For each beneficiary’s share, the trustee has the power to:

  • Distribute or loan
  • Some, all, or none
  • Of the income and/or principal
  • To or for the benefit of the beneficiary

This gives the trustee the power to treat your children fairly instead of equally, based on their needs.  I am the proud father of three wonderful children.  I am very proud to say that I have never treated them equally.

Their needs differ.  When I take one child to dinner, I don’t write a check to the other two.  When two needed expensive orthodontia, I did not write a check to the third.  If one of your children needed expensive surgery, would you ever consider writing a check to the others for that same amount?

You can give the beneficiary the power to remove (and maybe replace) the trustee, but, depending on the beneficiary, you may not want to.  That, again, could be a power left to the trust protector and his or her successor.

The current estate tax exemption of $5.34M in 2014 is also the generation skipping tax exemption, except that the GST is not portable.  Since you don’t have to pay estate taxes (state or federal) on your assets in every generation, why distribute the assets outright and voluntarily cause those assets to be subject to estate taxes again? In some states where the rule against perpetuities has been repealed, the assets can go on and on without again being subject to estate taxes.

3. Lastly, you can save income taxes during your lifetime by putting income producing assets into your irrevocable trust.

If the trustee is also a beneficiary, then the trustee’s right to distribute income must be limited to an “ascertainable standard” usually defined as for “health, education, maintenance, and support (abbreviated as HEMS).  If there is a trustee who is not a beneficiary, or the non-beneficiary (so-called, “disinterested”) trustee is a co-trustee along with a beneficiary trustee, the grantor could give the non-beneficiary trustee broader powers than just for HEMS.  The income taxes for an irrevocable trust (with trustee discretion to distribute income) can be paid for by the:

  • Trust— but, it gets to the top income tax bracket with very little income;
  • Grantor — which allows the grantor to make additional gifts (the payment of the taxes he or she no longer owns) without using additional gift exemptions; or
  • Beneficiaries — who may be in lower income tax brackets than the trust or grantor, allowing them to pay for the grantor’s expenses with fewer pre-tax dollars (e.g., older child paying for younger siblings’ college costs once the older child passes the kiddie tax age).

Trust me.  All trusts are not created equally. 

First, let’s divide trusts into two types:

  • Revocable — changeable by the grantor during lifetime and included in the grantor’s taxable estate; and
  • Irrevocable — not changeable by the grantor, but can still be flexible.

Second, let’s divide the irrevocable trusts into two types:

  • Those designed for elder care planning
  • the assets are removed from the grantor’s Medicaid estate (after an up to 5-year wait);
  • but, remain in the grantor’s taxable estate, since the grantor retains rights during lifetime (e.g., the right to live in the house and/or receive the income from the assets in the trust); and
  • Those designed for estate planning
  • removes assets from the taxable estate (and Medicaid estate, after the look-back period).

Third, let’s now divide those estate planning irrevocable trusts into two types:

Grantor trusts

  • Designed so that the income taxes on the trust’s assets are paid by the grantor, even if the income is distributed to trust beneficiaries (not treated as additional gifts); and
  • Where the grantor can sell assets to his or her trust without incurring capital gains taxes.
  • In the trustee powers, include the power to swap assets with the grantor, for example

Non-grantor trusts

  • Designed so that income distributed to the beneficiaries is taxed to the beneficiaries, who are in lower income tax brackets than the grantor.
  • But any income not distributed is taxed to the trust at its tax bracket.

What are some of those after-tax expenses that could be paid from distributions taxed to lower tax bracket beneficiaries (parents, children beyond kiddie tax age, etc.)?

  • Life insurance premiums — no longer need to rely on Crummey gifts or split-dollar to find lower income tax bracket premium payor
  • College tuitions
  • Country Club dues — gift for your children to pay for you with your income taxed at their tax bracket
  • And much more

Read also these articles by Herbert K. Daroff:

Conventional wisdom in retirement planning needs a change

Exit planning: When the selling owner is also a retiring key employee

The benefits of estate-enhanced cross-purchase agreements



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