By Eva Stark, JD, LL.M.
Most clients are aware that leaving a child's (or later descendant’s) inheritance in trust for life can better protect the inheritance from creditors, an ex-spouse, or from the beneficiary's own mismanagement. But in spite of such benefits, some clients may be averse to such planning due to a lack of understanding how a trust might work or the options available to establish one.
A trust can provide for descendants and may even give them some control over trust assets, if desired. A trust for descendants may be set up through:
|(i)||The client's will (known as a "testamentary trust"),|
|(ii)||The client’s revocable living trust, or|
|(iii)||An irrevocable trust created during the client’s lifetime.|
Typical Trust Features
A trust is a legal entity created under state law. It involves three parties: (i) the settlor, who establishes the trust, sets the terms of the trust, and typically funds the trust; (ii) the trustee, who holds legal title to trust property and manages or distributes that property under the terms of the trust agreement; and (iii) the beneficiary, who receives trust benefits, typically in the form of cash or property distributions.
Inheritances of children and later descendants that are left in trust may enjoy enhanced protection from creditors, an ex-spouse, or from the child's own mismanagement. The level of protection varies widely by jurisdiction and the trust’s terms, so individuals should discuss with their estate planning attorney how their children’s inheritances left in trust can and would be best protected.
Many clients feel confident that their adult children can manage their inheritances but still desire the enhanced protection of trusts. In such a case, beneficiaries can be given a level of control over their trust share by allowing them to serve as trustee. Trusts are often structured to require a third-party trustee while the child is very young, but to allow the beneficiary to become a co-trustee or sole trustee of his or her own separate trust share upon attaining a somewhat more mature age, such as 35 or 40.
If the beneficiary serves as a trustee, he or she cannot have unlimited discretion over distributions from the trust or creditor protection is lost. A beneficiary-trustee's ability to make distributions to him or herself must typically be limited to an "ascertainable standard" such as "health, education, maintenance and support." He or she must also typically be prohibited from discharging a legal obligation to support others with trust distributions.
If distributions beyond health, education, maintenance or support may be desirable, the document could give an independent trustee unlimited discretion to distribute any, all or none of the trust assets. An independent trustee is typically an individual or a corporate trustee who is not "related" or "subordinate" to any beneficiary within the meaning of applicable laws. Trusts are often structured to allow for a beneficiary to serve as trustee under some circumstances while providing a mechanism for an independent trustee to be appointed for discretionary distributions. A fully discretionary trust, which allows for distributions in the sole discretion of an independent trustee, may offer a higher degree of insulation from creditors in some circumstances.
Options to Create a Trust
A trust that protects inheritances may be established to take effect at the client’s death or during the client’s lifetime. The client’s specific goals will determine which structure is appropriate.
Trusts that take effect at death
TESTAMENTARY TRUST. One method for leaving an inheritance in trust for descendants is to incorporate provisions for the trust into the client's will. Such "testamentary trust" does not come into effect until the client dies. The client continues to own the assets intended for the trust during his or her lifetime and the assets are transferred to the trust at the client's death, either through the probate process or by the designation of the testamentary trust as beneficiary of non-probate assets. The terms of the trust may be changed during the client's lifetime by executing a new will or a "codicil" (i.e., amendment) to an existing will.
While the steps involved to create the trust are minimal (only the execution of a will is required), a testamentary trust is usually costly and burdensome to administer after death. Testamentary trusts are subject to probate court supervision and periodic reporting to the probate court may be required.
REVOCABLE LIVING TRUST. The second method for leaving an inheritance in trust is to incorporate provisions for the trust into the client's own revocable living trust. During the individual's lifetime, the trust remains revocable and amendable. The settlor (i.e., the client) retains access to trust property by being beneficiary of the trust and by retaining the right to withdraw trust assets. If the settlor becomes disabled, the trustee (or successor trustee) continues to manage trust assets and may make distributions for the benefit of the settlor and, typically, for the settlor's spouse and dependents. At the settlor's death, the trust for beneficiaries takes effect. The trustee simply continues to manage trust assets, privately, outside of the probate process, as specified in the document for the benefit of descendants.
Trusts that take effect during lifetime
IRREVOCABLE TRUST. The final method for creating a trust for beneficiaries is to set up and fund an irrevocable trust for their benefit during the client's lifetime. Generally, gifts to the trust constitute completed gifts and will no longer be accessible to the client or be available for his or her support. In most states, the settlor cannot be the beneficiary of his or her irrevocable trust, because such a "self-settled" trust does not offer creditor protection, and assets in such a trust are includible in the settlor's taxable estate. Because gifts to the trust are usually completed gifts, such gifts are also subject to gift tax. However, the client may be able to apply annual gift tax exclusions or his or her lifetime exemption so that no gift tax is due. Assets in the trust, and any post-contribution appreciation of the assets, are typically removed from the client's taxable estate for estate tax purposes. Trust assets also are typically protected from the creditors of the client while he or she is living, in addition to the creditors of the beneficiaries.
The table below summarizes the typical features of the three methods for creating an irrevocable trust for descendants.
|Can protect assets from descendants' creditors|
|Exists during settlor's lifetime|
|Amendable during settlor's lifetime|
|Settlor retains access to assets|
|Can protect assets from settlors' creditors|
|Transfers to trust are subject to federal gift tax during settlor's lifetime||N/A|
|Can remove assets from settlor's taxable estate at death|
|Subject to court supervision|
|Typical reason for choosing the method||
A trust for children or later descendants can better protect inheritances. Clients may wish to explore with their estate planning attorney and other professional advisors the various features that may be available and the advantages and disadvantages of the three methods for creating such a trust. Creditor protection afforded varies widely by jurisdiction and the specific trust terms selected, which must be explored with the client’s attorney so that descendants' inheritances will receive protection from creditors.
Eva Stark, JD, LL.M.,joined The Nautilus Group® in 2014 to assist with the development of estate and business plans. She also performs advanced tax research. Eva graduated summa cum laude with a BS in economics and finance from The University of Texas at Dallas. She earned her JD, with honors, from Southern Methodist University, where she served as a student attorney and chief counsel at the SMU Federal Taxpayers Clinic. She received her LL.M. in taxation from Georgetown University Law Center. Prior to joining Nautilus, Eva worked in private practice in tax controversy, business law, and litigation.