Keep It in Trust
“Put not your trust in money, but put your money in trust.” – Oliver Wendell Holmes
One of the most valuable presents that you can ever give to your children and grandchildren, if you will be leaving them a significant inheritance, is to leave it to them in the form of a trust.
The trust is an enormously powerful asset protection and tax planning tool, and should be used far more often than it is.
If the trust is drafted as a “spendthrift” trust, then as a general rule in almost every state, the trust assets will not be subject to the claims of the beneficiary’s creditors.
However, the key to using trusts for creditor protection is understanding that the creditor protection generally only applies to a trust set up for the benefit of a person by a third party. If you set up a trust for yourself, your creditors will be able to reach the trust assets just as though you still owned them individually. Such a trust is called a “self-settled” trust. The popular Living Trust is a type of self-settled trust.
While certain offshore jurisdictions allow you to set up a trust for yourself that is exempt from creditors claims, and some states, including Alaska, Nevada, and Missouri, have set up statutory schemes that purport to provide the same benefit (but may not, under the Full Faith and Credit Clause under the U.S. Constitution), the general rule in the United States is that self-settled trusts don’t protect assets from your creditors.
So, in terms of creditor protection, by establishing a trust, you are providing a benefit to your children and grandchildren that they literally cannot provide for themselves.
A lot of people don’t like trusts, based upon how they are presented in the popular media. However, the typical objections don’t stand up to close scrutiny. Let’s take a look:
Objection #1: I don’t want my kids to have to deal with some bank trustee in order to get their money.
If you don’t want that, they don’t have to.
Your child can serve as sole Trustee, if you wish, and can have the ability to receive the trust income and to receive principal from the trust based on an ascertainable standard relating to health, education, maintenance and support.
If you don’t want a child to serve as sole Trustee, then there are an almost limitless number of alternatives available. A trusted family member, friend, advisor or a trust company can serve as sole Trustee or as Co-Trustee with the child. The child can have the ability to replace the Co-Trustee under such terms as you deem appropriate.
Objection #2: I was always told that trusts are used to hold assets for my kids while they are minors or if they are disabled or have other problems, such as substance abuse, gambling, or a history of frivolous spending habits. My kids are (or will be) responsible adults and I trust their ability to manage their inheritances.
This is a commonplace view of trusts often seen in the popular press. May I respectfully suggest that it is also dead wrong. Certainly, trusts should be used in the above situations, but the potential benefit does not end there. The questions you should be asking in determining whether a trust is appropriate are:
Will my child ever be divorced? Statistically, divorce is likely. About half of all U.S. marriages end in divorce. While the law in most states is that property received by inheritance, gift or bequest is generally not considered marital property subject to division on divorce, a growing minority of states do not follow this rule. And in all 50 states, your child would have the burden of proof to show that his or her inheritance was separate non-marital property – a major problem if there has been any commingling of assets!
Will my child ever be sued? According to published reports, the average business owner or professional (doctor, dentist, lawyer, accountant, etc.) can expect to be sued an average of six or seven times during his or her lifetime. Any assets left to a child outright will be subject to seizure by creditors to satisfy any judgment. As already discussed, in almost every state, assets held in a spendthrift trust established by a third party (i.e. you) will not be subject to the child’s creditors.
Many clients who are in professions where they are more likely to be sued and who anticipate a large inheritance from their parents establish a “beneficiary trust” on their own and ask their parents to name the trust rather than themselves personally in their estate planning documents.
Will my child ever become incapacitated in his or her lifetime? With today’s medical advances, more people are living longer. Stroke, Alzheimer’s disease, arteriosclerosis and other ailments affect the ability to make sound financial and personal decisions, a fact well known to unscrupulous persons who make their living from preying on the elderly. Many older persons who had been financially secure have been duped out of their lifesavings and had to spend the remainder of their lives in poverty – a very sad and all too common story.
A trust for your children can be drafted to become a “special needs” trust when your child becomes a senior citizen so as to ensure that the assets are properly administered for that child’s needs and to permit qualification for Medicaid and other public benefits, if necessary.
Will estate taxes be a concern in my child’s estate?
Any assets that you leave outright to a child will be subject to federal estate taxes (if not repealed) and any applicable state estate or inheritance taxes upon the child’s death. While your child can do estate planning to avoid these taxes on his or her own, these techniques can be expensive and generally require the child to relinquish access to and control of assets to be effective.
To the extent that you leave assets to a child in the form of a Dynasty Trust that is exempt from generation skipping transfer tax by allocation of your GST exemption (which is $11,180,000 in 2018), any undistributed trust assets will not be subject to federal estate taxes upon the child’s death, nor upon the deaths of his or her own children, or grandchildren, or great-grandchildren, for as long as the trust continues. Under Florida law, a trust can last for as long as 360 years!
Even if the trust is not GST tax-exempt, federal estate tax savings are possible. For example, assume that a child dies childless, and that child’s assets instead pass to a brother or sister. If the child owned the assets outright, they would be subject to estate taxes. If the assets were instead held in the form of a trust that provided that federal estate taxes would not apply except to the extent necessary to avoid the federal GST tax, there would not be any estate taxes in this situation.
Objection #3: A trust is too expensive.
The major expenses with respect to a trust are its set-up costs: the creation of the trust document and initial funding. Once the trust is set up, assuming that the child is the sole Trustee or that the Trustee serving is not charging a fee, the only additional expense is the preparation of an additional income tax form each year (IRS Form 1041).
If your estate plan provides for trusts which provide for outright distribution at ages (e.g. 1/3 at 25, 1/3 at 30, 1/3 at 35) as is commonplace, you’re paying for the trust, but your children won’t benefit from it because you directed it to be dissolved!
The other answer to this objection is too expensive as compared to what? Many successful professional people pay enormous fees to set up and maintain offshore asset protection trusts to shield their assets from creditors. A garden-variety domestic spendthrift trust that you provide for your children will provide at a fraction of the cost possibly better asset protection than any offshore trust arrangement that they can set up for themselves.
Objection #4: Don’t trusts have to pay a lot of income taxes?
No – in fact, a trust can help your children save income taxes!
A trust pays income taxes on its ordinary income that is not distributed to a beneficiary using the trust tax rate tables under Internal Revenue Code Section 1(e). These rates are very compressed, and the highest marginal rate begins after the first few thousand dollars of income (37% rate on income over $12,500 in 2018). The capital gains rate for trusts is currently capped at 20%, the same as with individuals.
However, to the extent that income is distributed to a beneficiary, the beneficiary pays the tax at his or her own marginal rate.
By including a “sprinkling” power in the trust document which permits the Trustee to “sprinkle” the income among family members, the Trustee has some ability to choose who pays the tax! Presumably the family member chosen will be the one subject to the lowest combined marginal federal and state income tax rate – a teenager without other significant income, for example.
A trust can be used to save state income taxes as well. A Florida resident can establish a trust for a family member who lives in a state with a state income tax, and depending on the laws of that state, the trust assets may not be subject to its state income tax.
In addition, a trust that you establish during your lifetime may be designed to qualify as a “grantor” trust, which means that you would pay the income taxes at your own marginal rate on the trust assets just as though you still owned them personally. This makes establishing the trust a “wash” for income tax purposes and allows the trust assets to appreciate income-tax free, increasing the amount that will pass estate- and gift-tax free to your children. Under current law, your payment of the tax on the trust’s income is not considered an additional gift to the trust. You may release the “grantor trust power” in the trust at any time if you decide that you no longer wish to pay the income taxes on trust assets.
Additional Note – Trust Protectors. The Trust Protector is an individual or institution that you can name that can have control over certain aspects of the trust that you desire without actually serving as Trustee. This role is helpful under many circumstances and can greatly add flexibility in trust administration.