Trusts are created for many different reasons, and not all trusts can accomplish the same goals. So it is important that anyone with a trust have a clear understanding regarding the reasons the trust was established; and similarly understand what that trust can and cannot do.
A few of the more common varieties of trusts used in estate planning are summarized briefly below:
Trusts for Estate Tax Planning: Historically, the maximum amount that could be passed to a non-spouse beneficiary under federal law has been as low as $600,000. This meant that if a married couple’s combined assets exceeded that amount, children might be taxed at a rate as high as 55% on assets exceeding the permitted exemption. Careful tax planning could effectively double the permitted exemption for married couples. Instead of passing assets directly to the surviving spouse, upon the death of the first spouse, an irrevocable trust was created to shelter the maximum permitted exemption amount. The surviving spouse could be provided with access and even significant control over the assets held in trust without having those assets subject to estate tax upon the second death.
Connecticut is one of several states that elected assess its own separate estate tax, in addition to (and independent from) the federal tax. As a result, even as the permitted federal exemption amount began to rise, trust-based tax planning continued to be important here in Connecticut, simply to avoid the state’s estate tax of 7%-12% of amounts exceeding the permitted state exemption.
Over time, both the permitted federal exemption and the Connecticut state exemption have steadily increased. For some couples, minimizing estate tax is now a lower priority than it was when their estate plans were first drafted. For these couples, making sure that those plans have appropriate flexibility is a new priority.
Irrevocable Trust for Estate Tax Planning: More advanced tax planning may involve one or more irrevocable trusts designed to remove property from an individual’s gross taxable estate. This can be achieved when a donor makes a lifetime transfer of certain property to an irrevocable trust, so that the property is not owned by the donor at the time of death. The strategy works particularly well when property has a lower value at the time it is transferred to trust than at the time of the donor’s death.
An Irrevocable Life Insurance Trust (“ILIT”) is one of the more common examples of this type of trust, because the value of a life insurance policy is relatively small at the time the policy is purchased, in comparison to the death benefit promised upon the death of the insured. As long as the trust is created and the transfer of the policy occurs at least three years prior to the death of the insured, the life insurance proceeds can be completely excluded from the donor’s taxable estate. Trusts of this type were very common when tax exemptions were low, and continue to be popular when state or federal estate tax liability is anticipated.
Trusts for Probate Avoidance: When property is solely owned, with no joint owner or designated beneficiary, that property passes to beneficiaries because of the decedent’s instructions in a Last Will and Testament (or pursuant to the laws of intestacy, when someone dies without a will). In either case, a probate estate is required. The probate process takes time, because before anyone can lawfully assume control over assets, the court must act to appoint an executor or administrator to be in charge. Likewise, before assets can be distributed to beneficiaries, there is a required waiting period to allow creditors to come forward with any debts owed by the decedent. The absolute minimum amount of time necessary for a probate estate is 6 months. Depending upon individual circumstances, this time period can be much longer.
Revocable trusts are commonly used to bypass the probate process. Assets owned in trust can be accessed almost immediately following a death. Likewise, assets can be distributed as soon as the Trustee is confident the decedent’s debts and liabilities have been paid, or that there are sufficient assets set aside for this purpose. There is no set waiting period. If an individual owns property in more than one state, the value of bypassing the probate process is enhanced – instead of avoiding probate in one state, probate can be avoided in two, three or more jurisdictions.
Testamentary Trusts: Wills can create trusts too! Trusts created by the terms of a will are referred to as “testamentary trusts” because they do not come into existence until someone has died. For example, a will can create a tax-sheltered trust to accomplish the tax planning goals discussed above. Many wills also create trusts for minor beneficiaries, to provide supervision over assets until children have reached a specified age.
But testamentary trusts have become more expensive following the State’s 2015 rule change, which now charges all trusts established by the terms of a decedent’s will to an annual fee based on the value of the assets held in trust. This annual fee does not apply to non-testamentary trusts, managed outside the Probate Court’s supervision.
Irrevocable Trusts for Asset Protection: In some cases, an irrevocable trust can safeguard assets that might otherwise be lost in the future if retained by the owner. For example, a person who wishes to maintain the family home (or at least its value) for children may transfer the home to an irrevocable trust so that he or she doesn’t own the home when later applying for long-term care public assistance. To be an effective “asset protection trust,” the terms of the trust must be irrevocable – it cannot be amended or undone. While the transferrer may maintain a limited right to occupy the home or other residential property held in the trust, in all other respects the transferrer must surrender control over the trust property. He or she cannot receive distributions from the trust, and cannot use trust property as security for a loan. Notwithstanding these restrictions, irrevocable trusts can be valuable asset protection tools in the right circumstances. But most importantly, an irrevocable trust for asset protection is very different from a revocable trust which the trust maker is permitted to completely control until death.
Supplemental Needs Trusts: Transferring assets directly to a disabled beneficiary who is currently receiving public assistance may result in the beneficiary’s disqualification from those same public programs; and may further trigger “payback” requirements, reimbursing the State for funds previously expended on the beneficiary’s care. In those cases, parents, grandparents or other third parties are permitted to establish a special type of trust that will allow the beneficiary to remain eligible for public assistance and provide a source of additional funds to supplement and improve the beneficiary’s quality of care by providing for needs that are not met via public service programs. These trusts, commonly referred to as “supplemental needs trusts” or “special needs trusts” are created with the goal of asset protection for a specific beneficiary.
Retirement Benefit Trusts: Qualified retirement funds are very different from most other inherited assets. They do not receive a step up in basis at the time of the account owner’s death, because they are pre-tax assets. Instead, qualified funds are taxed as they are withdrawn by the beneficiary. Tax laws establish specific rules regarding the rate at which a beneficiary must withdraw funds from a retirement account. Assuming the withdrawal rate exceeds $10,000 per year (the recognized withdrawal rate for a $250,000 account paid to 50-year-old beneficiary), they are taxed first at a federal rate of 37% plus an additional 6.99% here in Connecticut. This combined rate of tax (44%) can only be mitigated by deferring the time period over which it is paid. To leverage the tax benefits of the maximum permitted stretch, as well as to insulate the assets from threat of bankruptcy, divorce or other creditors, a retirement benefit trust can be used. This type of trust does not hold or manage any other assets. It is designed to comply with the ever-changing retirement benefit rules.
Conclusion: Trusts are not “one size fits all” and they are not magic. Many people see the word “trust” and think it can or will do all things. It is important to make sure that a trust stays up to date and that it can achieve your current objectives.