Metz Lewis Brodman Must O'Keefe

Metz Lewis Brodman Must O'Keefe

Posted on November 10, 2014

Lifetime trusts offer families both tax and non-tax benefits.  Careful drafting of lifetime trusts allows greater-than-expected flexibility to address unexpected future circumstances.

Tax Benefits

Tax benefits are always somewhat fluid, due to the inevitability of change in the tax code over time.  That means that what we identify as the tax “savings” today is dependent upon current rates and exemptions.  Changes in rates and exemptions in turn change the future benefits, making it difficult, if not impossible, to reliably quantify future tax savings.

That said, lifetime trusts can offer significant estate tax savings to your children and grandchildren in two ways.  First, by removing from your taxable estate appreciation on the assets transferred to the trust.  (This is not unique to lifetime trusts, and applies to all gifts.)  Second, by allowing you to allocate exemption from Generation Skipping Transfer Tax (“GST”) to the trust, and permitting the trust assets to escape taxation in your children’s’ estates, and possibly even the estates of your descendants.

Assuming your children have taxable estates and current federal estate tax rates remain intact (40%), $100,000 in a GST exempt trust for your child’s lifetime saves $40,000 at your child’s death.  That enables your child to pass $100,000 to your grandchildren, not just $60,000.  Put another way, GST exemption planning for a $100,000 legacy cuts Uncle Sam out of your estate plan to the tune of $40,000 (just considering the present value).

In many ways, the federal estate and gift tax system is voluntary because it allows taxpayers to choose whether to take advantage of certain opportunities granted under the tax code to reduce tax.  The GST exempt trust is one such opportunity.  If a parent does not choose to create a GST exempt trust, the benefit – estate tax free assets in the hands of his or her children — is lost.

On the income tax side, where the parents can afford to pay the income tax bill on the income generated from the trust, so-called “grantor trust” status can be appealing.  In a grantor trust, the trust’s income is taxed to the parents, who funded the trust.  The parents’ payment of the trust’s income tax bill relieves the trust of its obligation to pay income tax and is therefore effectively a tax-free gift to the trust.  However, grantor trust status can be problematic in situations where the trust income is very high, and the parents’ cash flow is insufficient to both fund lifestyle needs and pay the tax bill.  Careful forethought, coupled with flexibility to change in the future, are keys to planning using grantor trusts.

Non-Tax Benefits

The major non-tax benefits of lifetime trusts are creditor protection and continuity in asset management.

The general rule in most jurisdictions is that a beneficiary’s creditor can get what the beneficiary can force from the trust, and no more.  However, purely discretionary distributions from a trust cannot be reached by a beneficiary’s creditors in most situations.  Creditors can arise in a number of settings, including successful plaintiffs in personal injury or breach of contract lawsuits, bank loans, and divorces.  If a creditor tries to force money from a lifetime discretionary trust, the trustee will be duty bound to refuse to make distribution. The creditor will also be powerless to force the distribution against the trustee’s will.

For many families, the risk of divorce is a primary concern.  A lifetime trust is like a prenuptial agreement that does not need to be discussed or negotiated.  Instead, the new spouse has no choice but to accept the restrictions and terms of the trust.  Upon divorce, assets in a lifetime discretionary trust should be off the table when the marital property is divided (with obvious differences from state to state).

A frequent secondary concern is asset management.  Especially for families with significant wealth, the burden of management can be both overwhelming and often beyond the beneficiaries’ technical abilities.  In addition to preserving the family’s wealth, a lifetime trust can also increase the beneficiaries’ well-being by relieving them of the unwanted stress of financial management. If the trust owns a closely-held business or engages in a sophisticated hedging strategy, centralized management can be crucial.  A lifetime trust can help to ensure continuous, long term professional management.

Pure Discretion vs. a Distribution Standard

When a trustee’s distribution power is described in terms of certain purposes, it is said to be governed by a “standard” for distribution.  Typical standards are health, maintenance, support, and education.  Sometimes the phrases “customary,” “reasonable,” and “in the manner to which accustomed” are used to further modify the standards.  Every distribution must be justified by a reason that fits within the standard.  A standard arms a beneficiary against an unreasonable trustee.  However, it can also limit a trustee’s ability to benefit a wealthier beneficiary – if the beneficiary has plenty of assets to meet her health, maintenance, and support needs, then it is harder to justify a distribution.  More troubling, it could enable a creditor to force a distribution under the “support” standard.

The alternative to a distribution standard is a pure discretionary distribution power.  With this type of power the trustee’s decision to distribute — or not to distribute — cannot be measured against any objective standard and therefore cannot effectively be challenged.  This can be bad news for a beneficiary who disagrees with the trustee.  But it is good news when a creditor tries to force assets out of a trust.  A pure discretionary distribution power allows distributions to be made even if the beneficiary is relatively well-off and does not technically “need” the distribution.

Building in Flexibility

A substantial concern regarding irrevocable lifetime trusts is the loss of flexibility to adapt to an uncertain future.  We address these concerns through tools such as limited powers of appointment, powers of termination, powers of substitution, and trustee removal powers, and by appointing an Administrative Power Holder who has specific powers to reform and adjust the trust.

A limited power of appointment allows a beneficiary to direct the trust assets to a prescribed group of individuals or trusts, either at death or during life.  This power gives the holder the ability to hit the “reset” button to meet unforeseen family circumstances or changes in tax law. Because it is limited, this power will not result in taxation to the power holder.

Powers of termination permit people other than the beneficiary to terminate the trust in favor of the beneficiary.  Because the beneficiary does not hold this power, it  will not result in taxation to the beneficiary.  This is also a form of “reset,” albeit somewhat more radical.  This power is often vested in a beneficiary’s siblings or adult children.

Powers of substitution permit the grantor to swap assets of equivalent value.  If closely held stock is transferred into the trust, it can later be swapped out for cash.  This power can make the otherwise permanent transfer of assets less troubling and provide powerful income tax planning benefits.

Trustee removal powers allow the beneficiary (typically) to replace the named trustee.  This can be very beneficial if the trustee relationship deteriorates, perhaps due to changes in the corporate trustee (such as through an acquisition) or the aging or changing family relations with an individual trustee. A removal power is an important check on the trustee’s powers.

An Administrative Power Holder can be given broad or narrow powers to change key aspects of the trust, usually without tax consequences to the grantor or the beneficiaries.  Key powers are the ability to amend a document to correct drafting errors or to conform with the law.

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