A trust is a legal entity, like a corporation, in which one party, known as a trustor, gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary. While corporations and limited liability companies are used to protect business assets, trusts are used to protect personal assets. Some common objectives of a trust are to save time, reduce paperwork and, in some cases, avoid or reduce inheritance or estate taxes.
The purpose of a trust are as varied as the trustors who create them. For example, if you create a revocable living trust, you will always be the "trustor," but you can also serve as the trustee of your own trust. You can also be a beneficiary of the trust, withdrawing income and dipping into principle as you see fit. In such a case, your goal is simple: probate avoidance. When you die and the trust distributes the assets left behind, the successor trustee may distribute to your designated beneficiaries without probate. However, any trust that is revocable or the trustor also acts as the trustee and beneficiary means the trust is available to creditors to include tax and Medicaid agencies. The trade off is probate avoidance for asset protection.
The objective of most trusts is to determine how a person’s money should be managed and distributed while that person is alive, or after their death. Unlike a living trust, some trusts reduce unnecessary taxation and avoid probate. There are three disadvantages to these trusts: 1) they are taxed at a higher income tax rate; 2) they are complex compared to a living trust; and 3) require a court order to amend or revoke.
Probate avoidance of asset protection aside, all trusts exist longer than the life of the trustor. This means that you can pass to the next generation wealth and a stress-free management system to finance the beneficiary's quality of life.
Categories of Trusts
Although there are many different types of trusts, each fits into one or more of the following categories:
Living or Testamentary
A living trust – also called an inter-vivos trust – simply means that the trust is effective while the trustor is still living. A testamentary trust is created during the lifetime of the trustor, usually in a Will, and legally effective when the trustor dies. Living trusts can include sub-trusts that hold assets for the surviving spouse or the next generation that become effective upon the death of the trustor. In this sense, living trusts spring into testamentary trusts.
Revocable or Irrevocable
A trustor may revoke or amend a revocable trust during his lifetime. Absent a court order, a trustor may not amend or revoke an irrevocable trust. There are two exceptions to this rule but beyond the scope of this article.
Living trusts are usually revocable. This results in one significant disadvantage. Tax and Medicaid law consider assets in a living trust to be like any other personal asset owned by the trustor - available. In fact, tax agencies do not acknowledge the existence of living trusts. Worse, in Medicaid law, some jurisdictions require all assets in a living trust to be spent down to the Medicaid limit, $2,000. This is true even if the asset, notably a Medicaid applicant's primary residence, would be exempt if left out of the trust and protected. Judgment holders after a successful lawsuit will attach assets in a living trust. For these reasons, living trusts avoid probate but are the opposite of asset protection trusts.
Unlike a living trust, tax and Medicaid agencies consider irrevocable trusts to be completely separate from the trustor. These type of trusts can reduce or eliminate estate taxes, and protect assets from Medicaid spend-down rules and attachment by judgments and even probate creditor claims.
Funded or Unfunded
Living trusts are funded when the trustor transfers something of value into the trust. This is called a "funded" trust. Testamentary trusts are created by a Will but are not funded until the death of the trustor. Often, living trusts do not meet the objectives of the trustor because the trustor failed to transfer assets correctly into the trust. In most cases, a probate is required to correct this and properly title estate assets into the trust. Unfunded trusts are often more efficient because funding occurs when the trustor is not able to purchase additional assets and forget to correctly title them. Also, a trust that protects the inheritance of a decedent's surviving spouse against Medicaid spend-downs and liens must be created by a Will. If asset protection is a goal, unfunded trusts require the same amount of effort as funded trusts.
Common Purposes for Trusts
If drafted correctly and managed by a competent trustee, trust assets are safer than they would be in the hands of a family member outright. Even when a family member is financially responsible, inherited wealth asset owned outright is at risk from a lawsuit, divorce, high unreimbursed medical expenses, unemployment, and even fraud.
Trusts can also be used for tax planning
In some cases, the tax consequences provided by using trusts are lower compared to other alternatives. As such, the usage of trusts has become a staple in tax planning. By leveraging nuances in the estate and income tax codes, you can specify how assets in a certain type of irrevocable trust are taxed. Transfers to one such trust constitutes a complete gift for estate tax purposes, but is an incomplete gift for income tax purposes. It is possible to flip that so that the asset is not income taxable during lifetime as a transferred asset but is clawed back into the estate at death.
The reason to create such a trust is to eliminate or reduce capital gains taxation. Assets in a trust benefit from a step-up in basis, which can mean a substantial tax savings for the heirs who eventually inherit from the trust. By contrast, assets that are simply given away during the owner’s lifetime typically carry his or her original cost basis. In other cases, an irrevocable trust funded during the lifetime of the asset owner can preserve a tax loss when the assets has depreciated. When the trustor dies, the beneficiary inherits the tax loss to offset gains in future tax years.
Here's how the calculation works
Example 1: Adjusted tax basis at death is usually a Step-Up
After the longest bull market in history, most have stocks worth far more when they die then when originally purchased. Assume Mr. Jones bought a stock for $4,000 and sold for $10,000. Depending on the length of time he held the stock, he will pay tax on the difference between original cost, i.e., the tax basis, of $4,000 and the price when he sold it, i.e., $10,000, as either a long-term or short-term gain.
If Mr. Jones did not sell the stock but left it to his daughter when he died, she would not inherit the stock and his tax basis. Rather, her tax basis adjusts to the value of the stock at the time of his death or nine months later. She could sell the stock at the time of her father's death and pay no capital gains tax for doing so. If she held the stock until it reached a market price of $12,000, she would owe tax on a $2,000 gain.
Example 2: Harvesting tax loss with an irrevocable trust
Mr. Jones bought a share of ABC stock for $10,000. The stock tanked to $2,000. Mr. Jones transfers the stock into a specific irrevocable trust and names his daughter as the only beneficiary. He also bought a share of WIN stock for $2,000, which appreciate to $10,000. Mr. Jones designates his daughter as the beneficiary of WIN stock by using a beneficiary designation form associated with the stock's brokerage account.
Mr. Jones passes along the hot stock tip of the latter transaction. She takes her dad's advice and also bought WIN stock at $2,000, her tax basis. When her father died, her share of WIN stock had risen in value to $10,000.
After Mr. Jones' funeral, his daughter liquidated both stocks she inherited from her father, i.e., ABC in trust and the share of WIN outright. The stock in the specifically-drafted trust, ABC, does not experience an adjusted tax basis to the new depreciated value. Rather, daughter inherits the stock with her father's original tax basis, i.e., $10,000. This means that ABC avoided an adjustment DOWN in value.
The share of WIN left to daughter adjusts as one would expect with a new tax basis of $10,000 when she inherited it without probate.
Selling all three stocks will result in avoidance of all capital gains tax. The ABC stock in trust carries over to daughter a tax loss of $8,000, which offsets the tax gain of $8,000 from her own stock transaction. The stock she inherited from her dad outright adjusts upward and no tax is owed. Mr. Jones successfully gave his daughter wealth and a tax loss to harvest after his death.
Common Terminology Lawyers Use to Describe Asset Protection Trusts
Credit Shelter Trust:
Sometimes called a bypass trust or family trust, this trust allows a person to bequeath an amount up to (but not over) the estate-tax exemption. The rest of the estate passes to a spouse, tax free. Funds placed in a credit shelter trust are forever free of estate taxes – even if they grow.
Insurance Trust:
This irrevocable trust shelters a life insurance policy within a trust, thus removing it from a taxable estate. While a person may no longer borrow against the policy or change beneficiaries, proceeds can be used to pay estate costs after a person dies.
Qualified Terminable Interest Property Trust:
This trust allows a person to direct assets to specific beneficiaries – their survivors – at different times. In the typical scenario, a spouse will receive lifelong income from the trust and children will get what’s left after the spouse dies.
Separate Share Trust:
This trust lets a parent establish a trust with different features for each beneficiary (i.e., child).
A Spendthrift Trust:
This trust protects the assets a person places in the trust from being claimed by creditors. This trust also allows for management of the assets by an independent trustee and forbids the beneficiary from selling his interest in the trust.
Charitable Trust:
This trust benefits a particular charity or non-profit organization. Normally, a charitable trust is established as part of an estate plan and helps lower or avoid estate and gift taxes. A charitable remainder trust, funded during a person's lifetime, disperses income to the designated beneficiaries (like children or a spouse) for a specified period of time, and then donates the remaining assets to the charity.
Special Needs Trust:
This trust is meant for a dependent who receives government benefits, such as Social Security disability benefits. Setting up the trust enables the disabled person to receive income without affecting or forfeiting the government payments.
Domestic Asset-Protection Trust (DAPT)
This trust is an irrevocable self-settled trust in which the grantor is designated a permissible beneficiary and allowed access to the funds in the trust account. If the DAPT is properly structured, the goal is that creditors won’t be able to reach the trust’s assets. In addition to providing asset protection, a DAPT offers other benefits, including state income tax savings when sitused (yes, that is actually a word lawyers use “sitused”) in a no-income-tax state.
A DAPT is of no benefit until it’s funded with assets. Trust assets typically include: (1) cash, (2) securities, (3) limited liability companies (LLCs), (4) business assets like intellectual property, inventory and equipment, (5) real estate, and (6) recreational assets such as aircraft and boats. Each asset under consideration for transfer into a DAPT must be evaluated from different vantage points, including its effect on: legal protection, taxation, business and growth potential, and future distributions to spouses and heirs. Thus, the asset-transfer planning process is a critical area requiring the assemblage of a range of skills
The Same Trusts According to BoomX Planning
Below is a list of the same trusts but titled according to their purpose:
Save Death Tax Now Trust:
This is a Credit Shelter Trust but let’s call it what it is it – it saves death taxes when the asset owner dies. That’s all you need to know. Credits and deductions and taxable estate is important to know but really it comes down to this – Washington state has the highest tax rate for any individual state in the country on the property of anyone living in Washington if there estate is over $2.12 million.
Complicated Family and Tax to Save Trust:
What lawyers call a QTIP is really used when a couple has kids from different marriages or unions. My clients love their second or third or fourth (fill in your number here) spouse but want to leave something to their kids from the other marriages. That’s really all one should know about it. The lawyer jargon is ridiculous. In order to provide for the surviving spouse but also the kids, the assets of the deceased spouse have to be kept in a trust. QTIP is a tax term. That’s all.
Leave but Preserve the Ancestral Asset Trust:
This trust is used to preserve a family, ancestral asset and share it with descendants in a way that won’t erode the asset or blow the family up.
Save Our Kids From Themselves Trust:
This trust is used for a child who spends money like crazy. You know if you leave your estate to him or her outright, i.e., in cash, the Audi dealership is gonna make out like a bandito. Lawyers go on and on about how it can’t be reached by creditors, in a bankruptcy. Big whoop! How about this? Let’s draft it so the trust has an investment policy statement and meaningful rules to distribute income and even principal, if you desire, to your son or daughter or any other beneficiary in a way that empowers them rather than render them dependent.
Our Doggy Has Rights Too Trust:
This trust is a trust for charities. There are 5 major ways to craft these trusts. However, in my experience, they are rare. I call it the “Doggy Trust” because I have helped my clients give more money to the humane society than any other charity. By far.
Our Disabled Loved One Needs Extra Help Trust:
Depending upon the circumstances, a son or daughter who is disabled may lose all medical or needs based benefits if we are not careful. This trust helps finance care and support for a disabled family member without losing those benefits and provides a framework for managing the money in a better way, if drafted carefully.
What is Missing From this List?
The three most important trusts to protect assets are NOT listed above.
The trust I just described are important. They are asset protection trusts. However, they are not the most powerful and, in my view, the most necessary trusts for asset protection.
There are THREE important trusts missing from the list.
Spousal Protection Trust
Created by the Last Will and Testament of the first spouse to die, this trust holds assets of the deceased spouse for the benefit of the survivor. It is a tax savings trust. It also does NOT count as an asset of the surviving spouse for Medicaid purposes. The five year look back period does NOT apply. Medicaid liens do NOT attach. EVER! There are no transfer penalties. It is the single best way to transfer and protect assets for a family member, especially the surviving spouse.
Medicaid Asset Protection Trust
This trust is used for single people. It holds assets that were transferred into it more than five years prior to a Medicaid application. It requires foresight. But, once implemented, is a powerful tool in the asset protection toolbox.
Health Care Reimbursement Trust
Long-term care insurance is not necessary when and if a trust is funded during lifetime. Similar to a Medicaid Asset Protection Trust, this trust will purchase assets for the benefit of the estate of each spouse or of a single person. When the Trustor dies, the assets in the trust are used to fund the retirement of the surviving spouse, pay estate taxes (if any) but more importantly to replace any retirement assets that were spent on the medical bills of the Trustor who just passed. This is a wealth replacement trust but, really, it pays for long-term care costs retroactively far more efficiently and with greater flexibility that long-term care insurance.
