The Tools of the Trade: Basic Estate-Planning Trusts

    by Ellen J. Boling

    In our last article, we reviewed the need for an estate plan (“Reassessing Your Risk Tolerance? Don’t Overlook Estate Planning,” April 2003 AAII Journal). Once the need has been determined, implementation of a plan does not need to be difficult.

    There are several tools that can be used to maximize the benefits of the possession and use of your assets both during life and after death. One set of tools that may be helpful in achieving your estate planning objectives is trusts. However, in order to determine the correct trust tool to use, an estate planner must know not only about your assets and liabilities, but also the unique personal characteristics of family members or other potential beneficiaries of the trust. Once both the financial and personal aspects of all parties are closely examined, then the proper trust tool to use will become evident.

    Trust Basics

    Trusts involve:

    • A grantor,
    • A trustee, and
    • One or more beneficiaries.
    A grantor transfers the ownership of his or her property to a trustee, who holds it for the benefit of the beneficiary(ies).

    Trusts can provide significant advantages to all individuals, regardless of their levels of wealth. They do not have to be expensive to maintain, nor do they have to be inflexible. Moreover, trusts need not alienate beneficiaries from the decision-making process.

    Trusts are used for a variety of purposes; indeed the flexibility of trusts is perhaps the major reason they are so widely used in estate planning. Trusts can be created and funded during your lifetime (inter vivos trusts) or they can be created by the terms of a will (testamentary trusts). The terms of a trust may allow it to be changed or even revoked by the grantor, or the trust terms may be fixed or irrevocable at the date of creation. Trustees may be required to distribute all ordinary income annually, which is called a simple trust, or they may be given discretion to retain or distribute income, which is called a complex trust. The flexibility of trust terms allows the grantor to use a trust to meet his or her specific personal objectives.

    Several of the primary purposes for using trusts in estate and financial planning include:

    • Managing assets: The responsibility of making investment decisions and maintaining adequate records can be transferred to either a corporate or an individual trustee.

    • Protecting assets: In certain situations, a properly drafted trust can protect the assets in a trust from the creditors of a beneficiary. In addition, the assets may be protected from a spouse or former spouse in the event of the divorce of the beneficiary.

    • Providing privacy: The assets, terms and conditions of a trust are generally not subject to public inspection.

    • Avoiding probate: The assets that are held in a trust created and funded during the grantor’s lifetime are controlled by the terms of the trust and not by the terms of probate. In some states, avoiding probate can save time and reduce estate administration expenses.

    • Providing for multiple beneficiaries: A trust can be created for the benefit of multiple beneficiaries and can allow the trustee to use discretion in making distributions.

    • Providing for special needs: A beneficiary may have a special need related to education, health or other issues. A trust can be drafted to address special requirements.

    • Tax planning: A trust can be used to help take full advantage of the combined benefits of the marital deduction and the unified credit while assuring that all necessary assets can be available to meet the needs of the surviving spouse.
    Trusts can often achieve several of these purposes simultaneously. However, you must prioritize these purposes in order to make the trust tool work to your advantage.

    The remainder of this article will focus solely on the most commonly used, basic types of trusts, such as revocable trusts and trusts for the benefit of spouses, children or grandchildren.

    FIGURE 1. How Maximizing Marital Deduction in First Estate Can Waste Unified Credit
    Total assets of $2 million owned by spouse #1, with a simple will that passes it all to surviving spouse #2—assumes both spouses die in 2003.
      Spouse #1 Spouse #2
    Gross Estate $2,000,000 $2,000,000
    Marital Deduction (2,000,000) 0
    Taxable Estate $0 $2,000,000
    Gross Estate Tax $0 $780,800
    Unified Credit 0 (345,800)
    Net Estate Tax Due $0 $435,000
    $435,000 in tax savings results from using a credit shelter trust:
      Spouse #1 Spouse #2
    Gross Estate $2,000,000 $1,000,000
    Marital Deduction (1,000,000) 0
    Taxable Estate $1,000,000* $1,000,000
    Gross Estate Tax $345,800 $345,800
    Unified Credit (345,800) (345,800)
    Net Estate Tax Due $0 $0

    Revocable Grantor Trusts

    The purposes of a revocable grantor trust are generally to manage and protect your assets during your lifetime if you become incapacitated, and at death to eliminate the need to publicly probate the assets to transfer title to the beneficiaries.

    In this kind of trust, assets are transferred to the trust during your life. You retain free access to the assets and can choose to retain power over administration of the assets by serving as your own trustee. A successor trustee may take over the administrative duties if you become incapacitated, as defined in the trust document. Any or all of the terms of the trust may be modified at any time. You will continue to be subject to the tax on the income of these assets because of the powers retained in trust. The assets will also be included in your taxable estate at death. However, they will transfer to the beneficiaries according to the trust terms at death and not be subject to the cost or public inspection of the probate process.

    This type of trust may also be used in conjunction with your will, if the will specifies that assets not transferred to the trust during your life will “pour over” to the trust at death. While the administrator of the estate must still probate the assets to transfer them to the trust at death, this feature of a will provides simplification and uniform distribution of the assets. It also gives you flexibility in choosing when to fund the trust and what assets should be transferred if there is an administrative burden in changing the title to the asset to the name of the trust.

    Trusts to Benefit a Spouse

    Possibly the most powerful estate planning tool available is the unlimited marital deduction. When property passes to a surviving spouse, an unlimited marital deduction is allowed against the decedent’s gross estate, reducing the taxable estate by the value of the marital deduction assets. However, using the maximum marital deduction in the first estate is not always the best plan for minimizing overall taxes, as some or all of the unified credit for estate taxes may be wasted.

    Credit Shelter Trust
    If each spouse has, at a minimum, assets equal to the amount that can be transferred free from estate or gift taxes in his or her own individual name, then each spouse can establish a credit shelter trust to hold those assets and prevent them from being subject to estate tax both at their death and at the death of the surviving spouse. This is known as a credit shelter trust, because it shelters the maximum amount from estate tax, as illustrated in Figure 1.

    This trust is also sometimes called the bypass trust or “B” trust. Proper titling of spouses’ assets is critical for the success of this planning tool. If all assets are titled jointly, then they will pass by operation of law to the surviving spouse, and the credit shelter trust—or any other trust—will not be funded until the death of the second spouse. If this happens, then the couple will not utilize the unified credit of the first spouse to die. In Figure 1, if instead all assets were owned jointly, the results would be the same.

    The provisions of a credit shelter trust may vary. Typically, the surviving spouse is given a lifetime right to trust income and access to principal—at the discretion of the trustee—to provide for the spouse’s health and welfare and to support the standard of living to which the spouse was accustomed. These principal distributions are usually made only after the surviving spouse has depleted all other available assets, in order to preserve the credit shelter assets for the ultimate beneficiaries, who will inherit them estate-tax-free at the surviving spouse’s death. The surviving spouse may also be given an annual ‘5 and 5 power’ to withdraw principal—this withdrawal right equals the lesser of 5% of the principal value of the trust or $5,000 and is not subject to the trustee’s discretion.

    Under current law, the amount that can be sheltered by this type of trust is $1 million in 2003, but will escalate to $3.5 million in 2009. However, lifetime taxable gifts may decrease the amount of assets that may transfer free of estate tax at death.

    In larger estates, the grantor may give the trustee discretion to distribute income and/or principal among a class consisting of the spouse and children and/or grandchildren (often referred to as a ‘spray’ or ‘sprinkle’ power). If grandchildren will ultimately inherit these assets, then a portion of the grantor’s generation-skipping transfer tax exemption should be allocated to the trust. These trusts are usually testamentary and become irrevocable at the death of the first spouse.

    As to the ultimate disposition of the assets in a credit shelter trust, the grantor may decide in advance or grant the original beneficiary a limited power to appoint the assets to a class of beneficiaries, which may not include the original beneficiary, his or her creditors or his or her estate. A limited power of appointment may be a powerful tool to transfer assets while ultimately allowing the passage of time to determine the desired beneficiaries and, more often, the optimal terms under which the next generation of beneficiaries will enjoy the assets. For example, it allows a surviving spouse to determine the relative needs of children and their ability to be responsible for inherited assets.

    Marital Trust
    The portion of an estate that passes to the surviving spouse through the marital deduction does not have to be transferred to a trust to achieve the estate tax savings. However, for reasons of ongoing administration, investment management and the naming of ultimate beneficiaries, marital deduction assets are often placed in trust for the survivor. These trusts are called marital trusts or the “A” trusts. Two types of marital trusts are described below.

    Power of appointment trust: A power of appointment trust is chosen if the decedent wants to give the surviving spouse complete discretion over the ultimate distribution of the assets at the survivor’s death. To qualify this trust for the marital deduction, the surviving spouse must be entitled to receive ordinary income from the trust at least annually and be vested with a qualifying power of appointment that can be exercisable in his or her own favor following the death of the first spouse or in favor of her estate. However, the power does not need to be exercisable both during the survivor’s lifetime and at death. Ordinarily, the survivor is only given a testamentary power of appointment so that the assets are not depleted during the period of survival. This type of power will avoid the trust being taxed as a grantor trust during the life of the surviving spouse. If the surviving spouse is given an inter vivos general power of appointment, then the surviving spouse will have to pay the tax on the income earned by the trust.

    Qualified terminable interest property trust (QTIP): If the spouses desire to ensure who the ultimate beneficiaries of the marital trust assets will be at the death of the second spouse, then, in addition to the credit shelter trust, the estate plan of each spouse should include a qualified terminable interest property trust (also known as a QTIP trust). This type of trust was created to hold property for the benefit of the surviving spouse, while maintaining the marital deduction for these assets at the death of the first spouse and maintaining control over ultimate disposition of the assets at the death of the second spouse. Spouses in a second marriage who have children from either of the spouses’ first marriages most often choose this type of marital trust. These trusts are irrevocable. In addition, these conditions must be met:

    1. The property must “pass” from the decedent to the surviving spouse;

    2. The surviving spouse must be entitled to all of the trust income payable at least annually for life;

    3. No power must be held by any person (including the surviving spouse) to appoint any part of the property to any person other than the surviving spouse during that spouse’s lifetime; and

    4. The executor must elect that the interest be treated as qualified terminable interest property. The assets passing to this trust will qualify for the marital deduction. However, in doing so, they will also be included in the estate of the surviving spouse. A QTIP trust can be established either during life or at death.

    Trusts for Children and Grandkids

    Transfers for the benefit of children and/or grandchildren can be made during life or at death. If they are made during life, then there are ways to qualify a gift to a trust for the annual gift tax exclusion, even though the ultimate possession or enjoyment of the assets is delayed. As mentioned above, gifts that do not qualify for the annual exclusion will decrease the grantor’s remaining unified credit to fund a credit shelter trust or transfer assets outside of trusts at death.

    Minor’s Trust
    If the goal of making gifts into a trust is only to prevent the beneficiary from outright ownership of the trust assets until age 21, then the grantor may implement a minor’s trust. The trust must provide that the minor gets control over the assets at age 21 in order to qualify the gifts to the trust for the annual gift tax exclusion. It can be either a simple trust, where all income must be distributed annually, or a complex trust, where the trustee has discretion to retain the income. However, it is more likely to be complex based on the age of the beneficiary. This type of trust is not intended for long-term management of the assets. If the trust is intended for long-term management of the assets, then a trust with Crummey withdrawal rights would be a better option.

    Crummey Trust
    A Crummey trust is not a separate type of trust. Rather, it is a trust that contains “Crummey” withdrawal powers in order to permit the grantor to claim the gift tax annual exclusion for gifts made to the trust. The power is named after an individual who litigated the right to use it. Simply stated, each beneficiary must be given the right for a limited period of time (generally, 30 days) after any contribution (gift) to the trust to withdraw the lesser of his or her pro rata share of the contribution or $11,000 (current gift tax annual exclusion limit), whichever is less. This right is non-cumulative and expires after the stated withdrawal period. While the right may essentially be seen as a fiction, because actual withdrawal by the beneficiary would certainly be met with disdain by the grantor, the right must be respected and properly documented to protect the tax benefit. If the grantor intends for this trust to benefit grandchildren, then additional terms must be added, because qualification for the gift tax annual exclusion does not ensure qualification for the generation-skipping transfer tax annual exclusion.

    Characteristics of trusts with Crummey powers may vary, but they are always irrevocable. They can be either simple or complex trusts. The income tax treatment of these trusts is quite complex, because it is possible to have mixed income tax treatment based on the gift tax treatment of the contributions. As to contributions that qualify for the annual exclusion, the trust will generally be a grantor trust as to the beneficiaries. Generally, when a Crummey power holder does not exercise his or her right to withdraw assets from the trust, then he or she becomes the grantor of those assets to the trust and is taxed on future income. However, if the trust is funded with assets greater than the annual exclusion amount, then that portion of the trust will be either simple or complex. There may be additional gift tax considerations if the value of the assets subject to the Crummey power exceeds the greater of $5,000 or 5% of the trust assets. Therefore, the more complex tax aspects of these trusts should be examined before one is implemented.

    Irrevocable Life Insurance Trust (ILIT)
    An irrevocable life insurance trust is a specific type of Crummey trust, in which annual gifts to the trust are used to pay life insurance premiums. A well-designed estate plan not only minimizes estate taxes but also provides sufficient cash to pay any taxes and expenses due at death. Estate taxes must be paid in cash, usually nine months after death. This can present a liquidity problem, particularly if there is a large tax liability and additional debts. Few estates consist mostly of cash. Thus, life insurance may be used as a highly efficient method of paying estate taxes for several reasons:

    • Life insurance proceeds are received income tax free; they may also be estate tax-free, provided the ownership and beneficiary designation of the policy are properly structured.

    • Insurance premiums may be paid with funds transferred to a trust or to your heirs under the protection of your annual gift tax exclusion. However, it is important to structure the ownership of the policy appropriately.

    • Proceeds are paid promptly, providing the cash required to pay estate taxes, thereby allowing other estate assets to remain intact.
    The best way to remove existing life insurance policy proceeds from an estate is, during lifetime, to transfer ownership of the policy to an irrevocable life insurance trust and change the policy beneficiary to the irrevocable life insurance trust. When the proceeds of the policy are paid to an irrevocable life insurance trust, they can be excluded from the owner’s gross estate if the trust is structured to avoid retention of any incidents of ownership that would cause the policy to be includable under the tax code. Furthermore, in order for the transfer of the policy to be deemed a completed gift, the original owner must not retain the right to designate new beneficiaries, change the interests of the beneficiaries, or any other power that would render the gift incomplete.

    If an existing policy is transferred to an irrevocable life insurance trust, the original owner must live for three years after the gifting date to the trust for the policy proceeds to escape estate taxation. Often if this trust tool is employed, a new policy is being contemplated. In that case, the grantor would gift premium dollars to the trust and the trustee would purchase the policy in the name of the irrevocable life insurance trust. Handled in this manner, the three-year rule does not apply to the new policy.

    An irrevocable life insurance trust allows a grantor to provide a means not only to pay estate taxes but also to create a larger estate for heirs. Therefore, it is a particularly good tool if the grantor wishes to retain complete use and enjoyment of his or her assets during life, but have the life insurance to serve as a wealth replacement vehicle at death.

    Generation-Skipping Trust
    A trust that will benefit individuals who are the grantor’s grandchildren or who are more than 37½ years younger than the grantor (‘skip’ persons) will be subject to the generation-skipping transfer (GST) tax either when the trust is funded (if grandchildren are the only named beneficiaries) or when distributions are made to skip persons. A generation-skipping trust, which is sometimes referred to as a dynasty trust, is designed to benefit these individuals. Typical provisions of a GST trust are to pay trust income to the grantor’s children during their lifetimes with principal paid to grandchildren at the death of the children. A GST trust may also exclude the grantor’s children completely. These trusts are most often used in very large estates in which the individuals in the children’s generation will not have a need for the principal and/or the income of the assets that will be placed in the trust.

    A GST trust is not really a specific type of trust, but is a characteristic of a trust that prevents adverse GST tax consequences. By properly allocating the grantor’s GST transfer tax exemption, which is currently $1.1 million but is scheduled under current law to increase to $3.5 million in 2009, the grantor may protect these assets and the future growth on these assets from the GST tax. For example, by allocating GST tax exemption to the annual premiums paid to an irrevocable life insurance trust, the grantor may protect the entire future amount of the death benefit from estate tax as well as GST transfer tax. Additionally, if a generation-skipping trust is established in a state that has abolished the rule against perpetuities, meaning that the trust will never terminate, then the benefits of the trust may be enjoyed by many future generations.


    Ultimately, an estate plan should assure an individual that he or she has adequately enjoyed the fruits of labor during life and that the desired beneficiaries will be able to do so after he or she has died. Sometimes, a trust is the only vehicle that will provide a reasonable level of assurance that such a goal will be achieved. If so, then there are several trusts, such as revocable trusts or trusts for the benefit of a spouse, children or grandchildren. Each trust is simply a tool to help you achieve your vision for today and tomorrow.

    However, these tools are complex and must be structured properly in order for them to achieve your desired results. For that reason, you should consult with an advisor knowledgeable about trusts and estate planning to choose the tools that are right for you.

    Ellen J. Boling, CFP, is director of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati, Ohio.

    Tracy Tinnemeyer, JD, is a manager in Private Client Advisors for Deloitte & Touche, LLP, in Pittsburgh, Pennsylvania.

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