Demystifying the World of Estate Planning: Understanding the Most Commonly Utilized Estate Planning Trusts
Cushing & Dolan, P.C.
Attorneys at Law
375 Totten Pond Road, Suite 200
Waltham, MA 02451
Todd E. Lutsky, Esq. L.L.M
Nominee Realty Trusts
General Operation and Purpose
A nominee realty trust is not really a trust at all. It is more akin to a principal and agency relationship. In this regard, the trustee of the trust is prohibited from acting on behalf of the trust unless directed by all the beneficiaries. In essence, the beneficiaries control the trust. The beneficiaries are generally listed as such on a form entitled “Schedule of Beneficiaries,” which is attached to the end of the trust. The schedule of beneficiaries is generally kept separate from the trust and not recorded at the registry of deeds. These trusts also allow you to transfer the real estate without the need to record another deed by simply changing the beneficiaries on the trust. Finally, the trustee of these trusts if often times the same as the person creating the trust or transferring the assets to the trust. However, be careful for if there is only one trustee and that person is also listed as the only beneficiary then there will be what is called a merger problem as the trustee and the beneficiary will become one and the trust will effectively no longer exist. In other words, any planning you think you may have accomplished will in fact no longer be effective.
The general use and purpose of a nominee realty trust is to hold legal title to real estate, and or investment accounts, while it transfers beneficial title to the beneficiaries listed on the schedule of beneficiaries. These trusts are often used to fund your family revocable or irrevocable trusts. For example, if an individual owned property at 24 School Street and wished to transfer it to their family revocable or irrevocable trust for estate planning purposes, they would likely utilize a nominee realty trust. In this regard, the deed would indicate that the property is being transferred to the Trustee of the 24 School Street Realty Trust with the schedule of beneficiaries being that individual’s family revocable or irrevocable trust. The name of the realty trust generally takes on the address of the property being transferred so as to help the creator remember which property is in which trust. After execution of these documents, the deed and the nominee realty trust will be recorded at the registry of deeds. However, it is important to note that the schedule of beneficiaries is not recorded as this will provide some enhanced privacy for the family. The end result of this transaction would be to place legal title to the property in the nominee realty trust while beneficial interest in the property is placed in the family revocable or irrevocable trust as the case may be. This arrangement also ensures that the family’s revocable and or irrevocable trusts are not recorded at the registry for all to see, as these documents typically have all the families wishes and desires regarding the disposition of their assets.
Probate, Creditor Protection Issues and common misunderstandings
When a nominee realty trust is properly utilized the assets placed inside it will avoid the cost associated with the probate process. However, a common mistake occurs when people transfer their real estate into these trusts and then name themselves individually as the beneficiaries. For example, a husband and wife transfer their home to a nominee realty trust and then name themselves as 50% beneficial owners on the schedule of beneficiaries. This type of arrangement has in essence accomplished nothing as the real estate transferred to the trust went from the husband and wife as joint tenants by the entirety, passed right through the trust, then right back to the husband and wife as tenants in common in their own name. The end result of this transfer would not even avoid the probate process. The proper way to transfer the real estate would have been to make the schedule of beneficiaries be a family trust or, in essence, someone other than the individuals transferring the property to the nominee realty trust. Finally, these nominee realty trusts by themselves generally do not provide any credit or protection for the individual and in some cases can actually increase the creditor exposure as will be explained below.
Another common mistake that people make when using these trusts are that they end up giving away the property put in the trust to the beneficiaries completely and without even realizing they have done that. For example, many people establish a nominee realty trust then transfer their home or vacation home to it and then name the kids as beneficiaries. This transaction would result in a completed gift of the property in the trust to the kids, and since they are the beneficiaries they would control that property leaving the parents completely vulnerable to the kid’s demands. More importantly, this arrangement would expose the property in the trust to the children’s creditors including but not limited to future divorces, etc. It is very important to remember when using these nominee realty trusts that you fully understand the ramifications of naming the particular beneficiary that you are considering.
Massachusetts has recently modified their homestead statute to allow people to receive the homestead protection even if their property is owned inside a trust. The old statute did not provide for trust ownership. The homestead laws will essentially allow you to receive $500,000 of creditor protection on your primary residence. A complete discussion of the homestead rules are beyond the scope of this article.
However, there are several problems with the way the new law is written. More specifically, it appears that if you transfer real estate to a nominee realty trust with another revocable family trust serving as a beneficiary that you will not receive the homestead protection. This is because the beneficiary of the trust must intend to use and occupy the property as the primary residence in order to receive the homestead protection and a family revocable trust as beneficiary of the realty trust cannot do that. Therefore, if you want to put property in your family revocable trust and avail yourself to the homestead protection then we suggest transferring your home directly to the revocable trust and recording a trustee certificate.
Another recent development comes into play when using a nominee realty trust with the beneficiary being an irrevocable trust to protect assets from the nursing home. The state seems to be challenging these types of arrangements since the realty trust is a revocable trust even though the beneficiaries are an irrevocable trust. Here again, the safest conclusion is to simply transfer your home, or any real estate that you want to protected from the nursing home directly to the irrevocable trust, file a trustee certificate and forget about using nominee realty trusts.
Income, Gift and Estate Tax Planning Issues
These nominee realty trusts are known as grantor trusts and will not result in any adverse income tax consequences when using them. In fact, since they are in essence flow through trusts, which means the assets in them flow through to the schedule of beneficiaries, it is generally the beneficiary who would file the income tax return and not the nominee realty trust. With regard to estate tax planning, these nominee realty trusts by themselves do not reduce or eliminate an individual’s estate tax liability. These types of trusts are generally used for funding purposes of the individual’s family trusts. It is those family revocable type trusts that offer the estate tax planning benefits and in the case of irrevocable Medicaid trusts will also offer asset protection benefits in addition to the estate tax reduction benefits. However, if, as mentioned above, the person who created the trust also named the children as the beneficiaries, this would result in a completed gift and may require the filing of a gift tax return.
Revocable Family Type Trusts
General Purpose, Use, and Operation of the Trust
The generally purpose and use of these family revocable trusts are to help an individual avoid the costs associated with the probate process, reduce and in many cases eliminate federal and state estate taxes as well as ensure the proper disposition and control of their assets to their family members following their demise. The donor of the trust is generally the individual who creates the trust and often times is the same person who will be the trustee on the trust. The trustee of the trust is the individual who would control the operations of the trust and the assets transferred to it. For example, in a husband and wife situation and assuming the use of 2 trusts, the husband would be the donor or creator of his trust while the wife would be the donor or creator of her trust and both of them would serve as co-trustees on each of their trusts. Upon the death of the first spouse the surviving spouse would then serve as sole trustee on both trusts, the only difference is that the deceased spouses trust is now irrevocable since the only person who could revoke it is deceased. Since these trusts are revocable and the husband and wife are the trustees, there is absolutely no loss of control over the assets transferred to the trust during the donor’s life. In this regard, the trustee of the trust can manage and invest the trust assets in any way they wish. In other words, there is no investment limitation associated with having assets owned inside the trust. Furthermore, the trustees of the trust can sell trust assets including real estate without any increased complexity or adverse income tax consequences versus owning them in their own name. You are also free to spend or save the money inside the trust anytime or anyway you wish. In essence, there is no operational downside to having a revocable trust and placing your assets in them.
Funding the Trust
It is imperative that once the trust is created that you transfer or re-title your assets to the trust, which is known as funding the trust. If the trust is not funded, then it is not working to accomplish your goals. In order to re-title your real estate to the family trust, you would need to prepare a deed transferring the title to the nominee realty trust mentioned above, which would name each of the family trusts as 50% beneficial owners. You can also simply file a deed transferring it directly to the family trusts but make sure you use something known as a trustee certificate and put that on record at the registry of deeds instead of the family revocable trust for all the privacy issues mentioned above. If you already have a trust and are concerned as to whether or not your real estate has been transferred to it, one way to check is to look at the real estate tax bill to see if it comes in the name of the trust, and if so then it has been transferred. If the real estate tax bill is still coming in your own personal names then it is very possible that it has never been transferred to the trust, and you still own it in your own names which means you are likely not accomplishing your estate planning objectives.
With regard to re-titling your investment and or bank accounts, you need to contact your financial advisor or go to your respective bank or financial institution and ask them for a change of name or change of ownership form. When completing the form, it may read something like this, “Todd Lutsky, Trustee, Todd Lutsky Family Trust”. That in essence would be the new name on the account. Then that financial institution would be looking for a tax identification number to go along with that new account, and that would simply be the individual’s social security number. Also remember that the funding of these trusts with bank or investment accounts does not require that the account be liquidated or anything be sold, so there will not be any taxable event upon the funding of the trusts with these accounts. The funding process is simply a name change on the account. Again, it is imperative that once these trusts are created that they are funded, as it is the funding of these trusts that helps you to avoid the costs associated with the probate process as well as reduce or possibly eliminate your estate tax liability.
For example, if you are married and continue to own all of your assets jointly or with each other listed as designated beneficiary, which is not uncommon, then on the death of the first spouse all of the assets would avoid probate but pass directly to the surviving spouse. This results in no federal or Massachusetts estate tax but would also have wasted that spouse’s estate tax exemption amounts, currently $5,340,000 for the Federal estate tax and $1,000,000 for the state of Massachusetts. However, it is now possible under current law for the federal exemption to be carried over to the surviving spouse, and this is known as portability of exemptions. However, there are many problems with portability. First of all, it is not automatic and requires an election be made on the death of the first spouse by filing a timely estate tax return even though one is not due, and if you do not then you will not have the carried over election. Secondly, the portable exemption is not indexed for inflation, so in essence all the assets left to the surviving spouse would be growing estate taxable instead of estate tax free, which would be the result if the exemption amount were instead utilized by sheltering that amount inside a trust on the death of the first spouse to die. Also, there is no portability election for Massachusetts, so the rule remains if you do not use your exemption on or before your death then you loose it and the surviving spouse will be left only with the single $1,000,000 exemption amount. The result is that the surviving spouse could end up with all the assets, and if that total is more than $1,000,000 for Massachusetts then there would be estate tax liability due to the state and the tax would be on the full amount not just the amount over the exemption.
Finally, the only asset that you cannot currently place into one of these trusts is your IRA, 401K or other qualified plan account. If you were to put this type of assets into the trust it would require that you withdraw the assets from the IRA, which would result in an adverse income tax consequence. If you have a large IRA or other qualified plan account, consider making the contingent designated beneficiary the participant’s own trust as this may be helpful in reducing estate tax consequences. This arrangement allows the surviving spouse make use of a disclaimer which allows the IRA to pass to the deceased spouses’ trust for the benefit of the surviving spouse if that will help utilize deceased spouses’ federal and Massachusetts exemptions, which in turn will help to reduce the surviving spouse’s estate tax liability. For a more detailed discussion of estate tax issue and IRAs please contact Todd E. Lutsky, Esq. L.L.M at 617-523-1555.
Creditor Protection and Income and Estate Tax Consequences of These Trusts
It is important to note that generally assets owned inside a revocable trust do not provide any protection from creditors, nor do they offer any protection from the costs associated with long-term care. There are however other trusts known as Irrevocable Medicaid Income Only Trusts that are specifically designed for protecting assets from the nursing home and other creditors, and these will be addressed in detail below.
From an income tax standpoint, these trusts will not result in any adverse income tax consequences. The assets owned inside a revocable trust are, as mentioned above, listed in your own individual social security number and are known as wholly owned grantor trusts in which the donor and the trustee are often times the same person, and thus do not require the filing of a separate income tax return. You will continue to receive your 1099s and report all of your income on your individual tax returns, Form 1040, and pay taxes at your lower individual rates just like you used to prior to establishing this trust. Finally, since these assets are included in your gross estate for estate tax purposes they will receive a step up in basis for capital gains tax purposes. This means that if you bought your home for $50,000 many years ago and put another $50,000 of improvements into it over the years your total basis for sale purposes is $100,000. If you gave it to your children during your life they would get your cost basis of $100,000. When they go to sell it say for $500,000 there would be a $400,000 gain that would be taxed at a total rate of 28.8% consisting of 20% for the Federal and 5% for Massachusetts and 3.8% for the new Obama Care tax that would result in a total tax of about $115,200,000. If instead the kids inherit the property through the trust, then the kids basis would equal the fair market value on the date of death, which in our example is $500,000 and the gain would then be eliminated thereby saving approximately $115,200,000 in capital gains tax. This result is obtained because transfers of assets to revocable trusts are not completed gifts and includable in the estate thereby getting the step up in capital gains tax basis discussed above and also no gift tax issues will be incurred.
With regard to estate taxes, these trusts are designed to enable each individual to more fully utilize both their current $5,340,000 federal and the current $1,000,000 Massachusetts estate tax exemption equivalent amounts. Remember, the new tax legislation that was passed in late December of 2012 has reset this federal exemption amount, and indexed it for inflation, and set the rate at 40%. However, it is safe to say that this is far from permanent as the 2014 Obama budget proposal is already seeking to reset this exemption amount back to $3,500,000 and raise the tax rate to 45%. An exemption equivalent amount is the dollar value of assets that an individual can leave to the next generation without the need to pay estate taxes. For example, if the federal exemption amount were to remain at the $5,340,000 level and you are a married couple, these trust would enable you to shelter $10,680,000 of assets from federal estate taxes while these same trusts would only enable you to shelter up to $2 million from Massachusetts estate taxes. Federal and state estate taxes can be truly voluntary for many families provided they are worth less than $2 million dollars and provided however that they do estate planning. For estates worth well over these amounts there may be a need to do more sophisticated planning which is beyond the scope of this article.
For example if a family is worth $2,000,000, even though the federal estate tax would not be a problem the Massachusetts exemption amount remains at $1,000,000. With no planning the result will be approximately $99,600 of Massachusetts estate tax due on the death of the second spouse. This is because all of the assets would have likely passed to the surviving spouse after the first death leaving the surviving spouse with an estate worth at least $2,000,000. In Massachusetts the whole amount of the estate would be taxed, and not just the amount over, which results in the tax due mentioned above. By using the trusts and funding each one with half the estate, upon the first death the trust would break down into shares that are designed to shelter or hold assets for the benefit of the surviving spouse without leaving them outright to the surviving spouse. The surviving spouse would be the trustee and the beneficiary of the deceased spouse’s trust, but this arrangement would cause the assets to be taxed on the first spouse’s death while paying no tax but instead using the deceased spouse’s exemption amount. Upon the death of the surviving spouse the assets in the first spouse to die’s trust are not owned by the surviving spouse, and thus are not subject to taxation regardless of how much they may have grown over the years. The result is that the surviving spouse’s estate consists only of the other half of the assets which is not over her exemption amount and results in no estate tax due to the state. If this trust planning is done then there would be no federal and or Massachusetts estate tax due, thereby making estate taxes at both the federal and Massachusetts level voluntary in many cases. Finally, by planning for Massachusetts estate tax you will also be planning for the federal estate tax as well since the federal tax law seems to be in a constant state of flux.
While a full technical explanation of how the trusts accomplish this tax savings is beyond the scope of this article, it is important to note that without the use of proper trusts it is likely that individuals will not utilize their estate tax exemptions on the first death. In essence, if you do not utilize these exemptions on the death of the first spouse, it generally results in enhanced estate tax liability on the second death. Finally, depending on the value of your estate, it may become clear that for many people, estate taxes are voluntary as they may be easily eliminated through the use of proper family revocable trust planning. For a more detailed explanation of the use of trust for estate tax planning please contact Todd E. Lutsky, Esq. L.L.M at 617-523-1555.
Irrevocable Medicaid Income Only Trusts
General Purpose, Use and Operation of these Trusts:
The general use and purpose of these trusts are to avoid the costs associated with the probate process, when needed be used to reduce and or eliminate estate taxes, ensure the proper distribution and control of your assets following your demise, and serve to protect the assets from the cost of long-term care and general creditors. The donor of the trust is generally the person who creates the trust. The trustee of the trust is the person who is in charge of the trusts operations, which can in Massachusetts, be the same person. However, since many people move and the states are looking closer and closer at these trusts, this author’s suggestion is that a child or other family member serve as trustee while the donor retains the right to remove and replace the trustee at any time for any reason or no reason. This replacement power allows the donor to retain control over the assets in the trust while continuing to protect the assets from the costs of long term care.
Funding and Control Issues Associated with the Trust
Like with the revocable family trusts mentioned above, it is imperative that these Medicaid irrevocable trusts be funded. In this case the funding not only helps you reduce the costs associated with the probate process, it is what effectively starts the five year look back period running in order to protect these assets from the cost of long-term care. This look back period is the time it takes from the date the assets are transferred to the trust, until they fully protected form the cost of long-term care.
With regard to real estate, these trusts may be funded by preparing a deed transferring the property sirectly into the irrevocable trust and then filing a trustee certificate. As mentioned above you should not use nominee realty trusts in conjunction with these trusts. These trusts can also hold bank and investment type accounts. Remember, IRA and or other qualified plan accounts cannot be transferred to the trust during life without incurring an adverse income tax consequence and generally should not be put into the trust. In order to re-title these accounts, you simply go to either the bank or the financial institution and ask for a change of name or change of ownership form. The new name on the account would read for example, “Todd Lutsky, Trustee, Lutsky Family Irrevocable Trust”. Then the financial institution will request a tax identification number to go along with this new account. It is important that you obtain a tax identification number from the internal revenue service to be associated with this irrevocable trust. In addition, you may invest in any type of asset you could ordinarily invest in as if these assets were not inside the trust. Furthermore, there is no taxable event upon the transfer of the assets from a bank or brokerage account to these irrevocable trusts as nothing needs to be sold or liquidated but only retitled. Finally, since the donor retains the right to change the beneficiaries of these trusts through a limited power of appointment the transfer is an incomplete gift, and thus there will not be any gift taxes associated with these transfers either.
With regard to maintaining control, by you retaining that right to remove and replace the trustee on your own irrevocable trust helps to keep you in control of the assets placed inside it. In other words, as donor, you can continue to manage and invest the trust assets just like you did prior to transferring them to the trust. You are also entitled to all of the income ( i.e. interest, dividends or rent) generated from those assets just like you were prior to transferring them to the trust. The income from the trust can be set up to automatically be transferred to your personal account without the need to deal with the trustee, and then you spend it anyway you would like just like you did prior to establishing the trust.
With regard to principal, the trust must prohibit distributions of principal to the donor as this is what protects it from the costs of nursing home care. However, the donor can always tell the trustee to cut a check out to the kids, siblings, nieces or nephews as the case maybe, who can then give it back to the parent or donor of the trust. While many of us may not entirely trust our children or family members we allow the parent or the donor to reserve a limited power of appointment, which means they can even change who they wish to leave the trust assets to following their demise. The class of beneficiaries is generally set at the time the trust is created and usually includes children, grandchildren of all generations and charities. This is the ultimate control because you keep the children in line by always letting them know if they do not cooperate they may find themselves removed from the trust entirely. For folks without children you could use nieces nephews, siblings etc..
With regard to your home, which is also considered principal, or any other real estate transferred to the trust, you can continue to live there as long as you wish, pay all the bills, fix the roof, rent it, kick out tenants, raise the rent, and yes, even sell the property any time you wish without the need to acquire any permission from the children even if they are serving as trustee. While it is true that the trustee, i.e. child, would be the one who would have to sign the Purchase and Sale agreement and the deed out of the trust to the buyer, remember, if they decided not to cooperate, you as the donor would simply remove them as trustee and appoint someone who would cooperate. Also remember, your retained limited power of appointment which essentially would enable you to completely remove that non cooperative child as a beneficiary all together. That being said, I think you as the donor parent have all the control you will ever need and more. Finally, once the sale of real estate has been completed, the trust would receive the proceeds from the sale, which you could either use to purchase another home or any type of property, maybe downsize after the loss of a loved one, or simply invest in the stock market or in any financial investments that you see fit. Finally and most importantly, these sale transactions within the trust do not reset the five-year look back period mentioned above.
Income and Estate Tax Concerns Associated with these Irrevocable Trusts
With regard to income tax filings, as mentioned above these trusts do have their own tax identification number associated with them and are required to file a separate income tax return, Form 1041, each year. However, these trusts are grantor trusts and do not pay any income tax, but instead generate a Form K-1 or Grantor Letter, which reports all of the income and expenses earned by the trust assets and is sent to the donor or creator of the trust. The donor or creator of the trust then takes those numbers from the K-1 and places them onto his or her individual income tax return and pays taxes at his or her lower individual rates just like they used to prior to establishing the trust. In other words, there are no adverse income tax consequences associated with these irrevocable trusts. In addition, with regard to the sale of your home from these irrevocable trusts, you would continue to retain your capital gains tax exclusions associated with the sale of your primary residence in the amount of either $250,000 if you are single or $500,000 if you are married.
With regard to estate taxes, the most frequently asked question we receive is can these irrevocable trusts also provide estate tax planning in addition to the asset protection planning described above. In this regard, for people with assets less than $1 million only one irrevocable Medicaid income only trust would be required. By itself that would not provide any estate tax planning nor would such a person need any such estate tax planning. I only mention this because so many folks think that just because they may not have an estate large enough to require the payment of estate taxes that somehow this means they do not need to do any estate planning. Nothing could be further from the truth as folks in this position while maybe not concerned about estate taxes are generally worried about loosing assets to the nursing home and the avoidance of probate; thus the use of a single irrevocable Medicaid trust maybe right for them as the use of this type of trust can accomplish both of these goals.
However, for those couples worth over $1 million, which is the current Massachusetts exemption amount or that exceed the federal exemption amount in effect at the time of death, they should consider the use of two irrevocable Medicaid trusts, one for the husband and one for the wife. Then by funding these trusts, as described above, and dividing their assets between them, the trusts will help them to utilize their current federal or Massachusetts exemption amounts in a similar fashion as described in the revocable trust section of this article, thereby reducing and possibly eliminating their estate tax exposure while at the same time serving to protect their assets from the costs associated with long term care.
For example, for a married couple with assets of $1,800,000, these two irrevocable trusts would enable them to shelter up to $2 million in assets thereby effectively eliminating their Massachusetts estate tax liability and also their federal estate tax liability even assuming the exemption falls to $1 million sometime in the future. As mentioned in the revocable trust section, the technical explanation as to how this tax savings is accomplished is beyond the scope of this article but in essence these trusts enable a couple to double whatever the federal and state estate tax exemptions are in effect on the date of death. In addition, the assets in these trusts will be included in the individuals’ gross estate and thus get a step up in basis to help reduce and maybe eliminate capital gains taxes when the property is sold by the beneficiaries. For an example of the benefits of this step up in basis see the revocable trust section of this article as it works the same for these irrevocable trusts as it does with revocable trusts. With proper use of these Medicaid trusts it is possible to do both estate and asset protection planning at the same time.
Special Needs Trusts
General Use, Purpose and Operation
These special needs trusts are generally utilized when the family has a special needs child who may be receiving some kind of governmental benefits. The family’s concern is generally that they must disinherit their special needs child in order to ensure that they continue to receive the governmental benefits they may be entitled to. However, this is just not the case. Instead, when the family is doing estate planning and creating either their family revocable trusts or family irrevocable trusts, as the case may be, they should inform the planner of their special needs child and discuss the implementation of a special needs trust. This special needs trust can be built directly into their family revocable or family irrevocable trust. Other planners may establish a separate special needs trust all together, but this is not always needed and should be discussed, on a case by case basis.
Operationally, upon the death of the surviving spouse, the trustee of either the family revocable or family irrevocable trusts would divide and allocate the property into as many equal shares as there are children of the donor then living and children of the donor then deceased leaving issue then living. In the case of a share allocated to a then living child of the donor, with the exception of the special needs child, the trustee may likely distribute out the assets to those other children free and clear of all trusts or in any manner they dictate. However, the share of trust assets allocated to the special needs child would be held in a special needs trust for the benefit of that child. This way the special needs child could enjoy the benefits of the assets held in the trust while continuing to receive any governmental benefits in which he may be entitled. The trustee of the special needs trust, who is often times a sibling or other family member of that special needs child, can then use the assets in the trust to enhance the life of the special needs child. Therefore, it is important to realize that if you have a special needs child, you do not have to disinherit that child and in fact can provide benefits to him through this type of trust while ensuring that he retains his governmental benefits he may be entitled to.
Funding and Income Tax Issues
If these trusts are built into the family revocable or irrevocable trusts then they would not be funded generally until both parents die and would be funded with the assets that are in these trusts. Since these types of special needs trusts really do not exist until the parents die there would be no separate income tax returns needed until such a time. If separate special needs trust are created then they are going to be funded during the life of the parents; such funding would be the same as mentioned in the revocable trust section. However, there will be a separate income tax return, form 1041, needed to be filed by these trusts every year. These trusts will generally not be grantor trusts and will have to pay income taxes at the trust level.
Sole Benefit Trusts
General Use, Purpose and Operation of this Trust
These trusts are generally used when you have a situation where a loved one is going into a nursing home and there has been no other advanced planning in place. The individual may have a house or money that they want to protect from the nursing home and also has a disabled person that they would like to have these assets. Generally this person is a family member but it can be anyone under 65 years of age and disabled. For Example, say a grandfather is entering a nursing home and would like his disabled granddaughter to have his home and some of his money. He could create one of these trusts and transfer these assets into that trust. This transfer would not be a disqualifying transfer as to the grandfather and would not result in a five year waiting period for him to qualify for Medicaid benefits. The result is that these assets would be protected from the nursing home and not subject to being paid back for grandfathers care and he would be eligible for Medicaid benefits.
The assets of the trust could then be used for the sole benefit of the disabled person, or granddaughter in our example. The assets can be used for any reason for her benefit and can even be paid out over her life expectancy. Furthermore, this trust will not prevent the disabled person from continuing to receive any governmental benefits that they may have been already receiving. However, to the extent this grandchild receives governmental benefits of her own the trust will need to pay them back following her demise. In the event there are trust assets remaining in the trust following the death of the granddaughter in our example then the assets can go to family members as the trust directs.
Estate, Gift and Income Tax Issues
The assets transferred to this trust will be treated as completed gifts as subject to gift tax. However, the federal government currently allows people the ability to gift up to $5,340,000 of assets without paying any gift tax. While a gift tax return, form 709 will need to be filed by April 15th following the year of the gift, there will not need to be any gift taxes paid unless the amount given exceeds this exemption amount mentioned above. The taxpayer simply reduces the exemption amount by the amount given each time. From a state perspective, there are no state gift taxes in any state except CT.
With regard to income taxes these trusts would need to file a separate income tax return each year and would need a separate tax ID number for the trust. These trusts are not grantor trusts and will have to pay the taxes at the trust lever. The tax return they file federally is a form 1041. However, if the income is paid out to the beneficiary, disabled person then that person would pick up the income on their personal return and pay the taxes while the trust would get an income tax distribution deduction. Finally, this is not a trust that is done for estate tax reduction purposes but nevertheless could end up saving a lot of assets for either the disabled family member and or ultimately the family in general for if it were not utilized the assets would have been likely taken by the nursing home.
General Use, Purpose and Operation of this Trusts
These trusts are generally used as a last minute way to save some of the assets from the costs of nursing home care and generally for folks in which a last minute annuity technique will not work due to advanced age. The folks that use these trusts are also generally single or who do not have a healthy spouse. However, these should be considered on a case by case basis.
Operationally, Pooled trusts are established by certain non-profit organizations for the benefit of disabled individuals. Funds transferred to a “pooled trust” account are held for the sole benefit of the beneficiary but are pooled for investment purposes. The advantage of a pooled trust is that persons total assets would be available for their supplemental needs (generally everything except for food and shelter) for the remainder of their life and not depleted at all to pay any nursing home costs while they are living. However, upon the individuals death the non-profit agency has the right to keep a portion of the funds for its non-profit endeavors and MassHealth has the right to be reimbursed to the extent of the amount of benefits paid on behalf of the individual. The amount that goes to charity depends on how long the assets were in trust. If the individual lives less than 2 years after creating the trust then the charity will receive 10% of the balance of the trust after the state is paid back, otherwise the charity would receive 20% of the balance. Any funds remaining after these amounts have been satisfied would then be paid to the individuals listed on the application to establish the pooled trust.
Remember, even though assets need to be repaid to the nursing home having all the assets available for the loved one during his or her life is a significant benefit and the assets maybe growing during her life which may enable there to be assets left over for the family. In this regard, the growth on the assets during the term of the trust can serve to offset the amount that must go to charity. The additional benefit is the leverage obtained by being on Medicaid as the Medicaid rate is approximately $6,000 per month the while the private pay rate of a nursing home is approximately $12,000-$14,000 per month. Therefore, the Medicaid lien on the assets inside the trust will be substantially reduced and thus possibly preserving more assets for the family while at the same time retaining all the assets for the loved ones use during his or her lifetime.
First to Die Irrevocable Life Insurance Trust
General Purpose of this Trust:
These irrevocable trusts are generally designed to hold either life insurance or any other asset that an individual would like to exclude from taxation in their gross estate. These trusts are often referred to as gifting trusts as folks can gift any assets to them. These trusts have become a popular estate planning technique due to the recent law changes that have given everyone a $5,340,000 gift tax exemption. This means that anyone can gift up to this amount without paying gift tax but keep in mind that such gifts will also reduce their estate tax exemption by a corresponding amount. A complete discussion of the tax ramifications associated with gifting is beyond the scope of this article.
The donor is the creator of the trust and generally the person transferring assets to it. The trustee is the person in charge of the trust. However, in this case the trustee cannot be the donor otherwise the assets in the irrevocable trust would be includible in the estate of the donor and thus taxable. The trustee must be someone independent of the donor; the donor’s spouse or children are independent enough and can serve as initial trustee to these trusts. The donor, however, can retain the right to remove and replace the trustee during his life. However, the replacement trustee can now not be anyone related or subordinate to the donor, otherwise it would again cause the assets of the irrevocable trust to be includible in the estate of the donor. However, having the spouse serve as trustee and or retaining this trustee removal power does help to ensure that the creator of the trust maintains some degree of control over the assets in the trust. It is a way of giving assets to family members without actually giving it to them, while also protecting it from their creditors.
Funding the Trust, Gift Tax Issues and Types of Assets to be Used for these Trusts
With regard to funding these trusts, unlike the revocable trusts mentioned above, you would not put all of your assets into these trusts, but only certain assets that you would like to have pass outside of the estate for estate tax purposes. However, transfers of assets to these trusts, unlike the trusts mentioned above, are considered taxable gifts as they are meant to be future gifts. In order to avail yourself of the current $14,000 present interest exclusion, which is the amount a person can give to another person each year without paying a gift tax or eating into the $5,340,000 gift tax exemption mentioned above, the trustee must send a crummy notice to each beneficiary which converts this future gift to the trust into a present gift just long enough to qualify it for this present interest exclusion. This letter in essence tells the beneficiaries of this trust, generally the children and grandchildren, that a gift has been made to the trust and that they have 30 days to take it out. However, you tell them not to touch it or bad things will happen. At the end of this period the gift will have qualified for this present interest exclusion and will be gift tax free and will not even require the need to file a gift tax return.
For example, if the donor has three children and three grandchildren, then that individual could gift up to $84,000 ($14,000 x 6) each year without the need to file a gift tax return. In the event they wish to utilize their spouse’s $14,000 exemption amount per beneficiary of the trust, then they would need to file a gift tax return, Form 709, in which the spouse consents to split all gifts made by the donor. It is important to note that the spouse is not making a gift to this trust. If this is done, then the husband and wife would be able to gift up to $168,000 a year in assets to this irrevocable trust, which in turn could grow and grow and be outside the estate for estate tax purposes and be protected from creditors. Therefore, when funding this trust, the ideal assets to put here would be assets that may significantly grow over time in the future but have a high basis to start with.
However, when gifting assets to this trust, the husband and wife must remember that they will have little control and little or no access to the assets once gifted. Also, since the assets gifted to this trust will not be includible in the estate for estate tax purposes, they will also not receive a step-up in basis for income tax purposes. In other words, in the event you were to gift low basis stock to the trust that is expected to significantly grow in value over the years, the capital gain built into that particular asset would remain built into that asset when it is transferred out of the trust to the beneficiaries. For example, if you bought $1,000 worth of stock, transferred it to the trust and then at the date of distribution from the trust that $1,000 worth of stock is worth $50,000, there would be a $49,000 gain built into that stock in which the beneficiaries would have to pay once they sell that stock. The trade off is generally to agree to pay the capital gains tax say at 28.8% verses the estate tax at say 40%. However, caution must be used when thinking about gifting since the laws have changed and one can see that the rate differential is not that great any more. In addition, for many with the federal exemption set at $5,340,000 there may already be no federal estate tax to avoid by gifting, thus the only tax to avoid is the Massachusetts estate tax. In many cases this may be less than the capital gains tax that would be trapped in the assets gifted away due to the loss in the step up in basis that results from the lifetime gifting. Therefore, it is important to seek tax advice prior to making any such gifts and keep in mind that high basis assets are generally better to gift than low basis assets.
Generally these trusts are funded with life insurance policies, as they usually have a very low value during the insured’s life, known as the cash surrender value, and a significantly higher value when the insured dies. This generally results in little or no gift tax upon funding. This is important since the biggest misunderstanding of life insurance is that people think that they are tax free and that is not always the case. While it is true that the proceeds are income tax free to the individual who receives them, the death benefit is very much estate taxable to the insured upon his death if he died owning the policy.
In order to fund the trust with life insurance you would need to request a designated beneficiary change form and a change of ownership form from the insurance company. It is important that you change both the owner and the beneficiary to the irrevocable life insurance trust. The result of this transfer is to make the proceeds from the insurance flow into the trust upon the death of the insured both income and estate tax free. If the life insurance policy is worth $1,000,000 that can make a significant difference in the amount of estate tax an individual might owe. Remember the Massachusetts estate tax exemption amount is $1,000,000 and often times this one asset alone can make a families estate taxable when otherwise it would not have been. However, for life insurance that you already own the insured must live at least three years following the transfer of an existing policy to one of these irrevocable trusts, otherwise the death benefits would be included in the estate of the insured. If you are considering the purchase of life insurance then consider having the trust purchase it from the get go for this way the three year rule does not apply.
Additional Estate Tax Planning Benefit
Operationally, the initial trustee of this first to die irrevocable life insurance trust can and is often times the donor’s spouse. The language of the trust then would permit the donor’s spouse to enjoy the income generated from the proceeds of the life insurance that now fund the trust following the death of the insured as well as utilize the principal as needed to maintain her standard of living that she enjoyed when her husband was alive. That small restriction over the use of the principal is what will ensure that whatever assets are left in this irrevocable life insurance trust upon the surviving spouse’s demise will also not be includible in her estate for estate tax purposes. In other words, this irrevocable life insurance trust will ensure that the life insurance proceeds avoided estate taxes on the death of the insured, were available for the benefit of the surviving spouse, and then pass to the children or family members estate tax free again following the death of the surviving spouse. Finally, this trust can provide direction and control of the distribution of trust assets to your family in any manner you desire as well as provide creditor protection for your children.
Income Tax Issues
These trusts do require a separate tax identification number and to the extent there is income generated, would require the filing of a separate income tax return for income tax purposes. This is known as Form 1041. However, during the donor’s life, the trust would be considered a grantor trust for income tax purposes, which means that all of the income would simply flow through and be reported on the individual donor’s income tax return, thereby enabling the donor to continue to pay income taxes on any income earned inside the trust at his or her lower individual rates just like they used to do prior to establishing this trust. Generally, if the only asset in this irrevocable trust is life insurance, then there is no taxable income being currently generated and therefore no need to file an income tax return. From an estate tax planning standpoint, as mentioned above, these trusts help to reduce the donor’s estate tax liability by ensuring that the assets transferred to these irrevocable trusts are not includible as part of the donor’s estate for estate tax purposes upon his/her demise.
Second to die Irrevocable Life Insurance Trust
General Purpose, Operation, and Use of Trust
The second to die irrevocable life insurance trust is very similar to the first to die irrevocable life insurance trust mentioned above, except that it generally holds life insurance policies that cover both the life of the husband and the wife and does not pay out until the death of the survivor of the two. All the same funding, gift, estate and income tax rules apply to this trust as they applied to the first to die irrevocable life insurance trust mentioned above. Most importantly the life insurance proceeds that pay to the trust will be estate and income tax free just like the first to die life insurance trust mentioned above.
The significant difference between this irrevocable life insurance trust and a first to die life insurance trust is that the trustee of this trust can be neither the husband nor the wife, but can be initially a child. The donors would also retain the right to remove and replace the children as trustees, but any such replacement trustee must also not be related or subordinate to the donors. The other difference is that since both the husband and the wife would be the donors of the trust they can both gift and each utilize their $14,000 present interest exclusions per beneficiary without the need to file a gift tax return. In other words, they could gift $28,000 per beneficiary per year to the trust without the need to file a gift tax return. Finally, these second to die irrevocable life insurance trusts can also own other assets just like the first to die irrevocable life insurance trusts mentioned above could do.
Revocable or Irrevocable Trusts Control How You Leave Your Assets to Your Family Including Protection From Future Creditors and Divorces:
Since the passage of the new tax laws, many folks are now considering the use of trusts not only to reduce the probate costs and reduce state estate taxes but with more assets getting to the next generation they are concerned about how and when the kids get such assets. If children get large sums of money all at once it can cause them to be less productive, wasteful and or simply cause more harm than good. These trusts can be designed in any number of ways to ensure assets are distributed to children at a time when they are at an appropriate age and demonstrating some level of responsibility so that they are ready to handle the assets.
For example, you could set out ages when they can get assets. It is common to stagger the ages of distributions such that the children can have one third at age 30, one third at age 35 and the final portion at age 40. The trust would generally allow the trustee discretionary distributions to the children prior to them reaching these ages for such things as their health, education, welfare and support. Also it is a good idea to provide that if a child dies prior to reaching the age of distribution but after the death of the parent, then that child’s assets would go to his or her own children (your grandchildren) rather than to that child’s spouse. This helps to keep the assets in the blood line and prevents the surviving spouse from remarrying and spending your assets on someone else’s family. You can use any age that works for your family and some folks even hold assets in trust until the children reach retirement age to ensure they can afford their retirement.
Some trusts provide that the assets be held for the child’s entire life. This protects assets from creditors, including future divorces, while also taking advantage of generation tax skipping rules. The trust might state that the assets are to be divided into equal shares for each child but then held in trust for their lives with income and principal being paid out to such child in the trustee’s sole discretion. Generally, you can have the children serve as trustee but that child could not exercise discretion over his or her own share. Generally a sibling would be appointed to do that. This way they can get the money to each other when they need it but if there is a divorce down the road and the other side wants half of the assets in that child’s share they would not be available unless the sibling trustee wanted to make a distribution. The sibling trustee, in all likelihood, would not be agreeable to such a distribution and, because the trust is a third party trust with sole discretion given to the trustee, the trust assets would not be available under those circumstances. The end result of the divorce would be that the child got to keep the assets in the trust and maybe half of the assets they acquired together. Finally, if the children never actually use up all the trust assets during their life then at the child’s death they will pass to that child’s children and avoid estate taxation in that child’s estate thus successfully skipping a generation for tax purposes.
Finally, folks can set up trusts with incentive language so that children have to work to get some of their assets and these are called incentive trusts. For example, if the child produces a W-2 at the end of the year the trustee could require the trust to make a distribution that would match it. Some folks set up trusts to protect against drug addictions and or simply because they know that their children cannot handle money very well. There are an endless number of ways to design a trust to protect assets for the family. Again, this is becoming more and more important as the value of assets being passed down to the next generation increases as a result of the federal estate tax exemptions being so high. It is worth thinking about how you would like your wealth to be distributed to your children. It seems some of the examples discussed above, limiting the terms of asset distribution, provide a better alternative to the creation of an instant windfall.
Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Cushing & Dolan and The Securities America Companies are unaffiliated. Representatives of Securities America Inc. do not provide legal or tax advice. The scenarios provided are for illustrative purposes only and not intended to represent client experiences of Armstrong Advisory Group or the Securities America companies. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. AT 937994 June 2014