TRUST TYPES
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COMMON TYPES OF TRUSTS
TRUST PRIMARY PURPOSE AND GOAL
Revocable Living Trust Avoid probate
aka Living Revocable Trust
aka Family Living Trust
(or a mixture of the words)
Keep assets in friendly hands in
case of incapacity
Minor's trust Give assets to your children
Provide for education
Reduce income and estate tax
Preservation trust Provide security for loved ones
Protect assets
Q-TIP trust Provide lifetime income for a
surviving spouse
Direct assets to chosen heirs
Defer estate tax
Life insurance trust Reduce estate tax
Provide liquidity for heirs
Charitable remainder trust Provide retirement income
Provide income for surviving
spouse
Avoid capital gains tax
Transfer assets to charity
Credit shelter trust Reduce and defer estate tax
Provide lifetime income for a
surviving spouse
Retained interest trust Reduce estate tax
Provide income during trust term
Personal residence trust Reduce estate tax
Provide use of a house during
trust term
S corporation trust Reduce estate tax
Facilitate transfer of a family
business
Generation-skipping trust Reduce estate tax
Keep assets in your family for
future generations
Asset protection trust Safeguard personal wealth
Reduce estate tax
SPECIAL TYPES OF TRUSTS
MINOR'S TRUSTS
If you're a parent, there may be several reasons for giving money
or other assets to your children:
* Shifting money to children may mean income-tax savings, which,
for example, can help you build a college fund faster. Children up
to age 14 are eligible for a tax break on up to $1,200 of unearned
income, based on 1994 rates. The first $600 is untaxed while the
second $600 is taxed at only 15%. Thus, a child can have $1,200 of
interest from a bank account, say, and owe only $90 in taxes.
* Children age 14 or older get an even better tax break. Their
income will be taxed at only 15%, up to $22,750 in 1994.
Therefore, a parent in the 28%, 31%, 36% or 39.6% tax bracket can
save substantially by transferring taxable investments to teenage
children.
* You may want to give your children some money, a little at a
time, so they'll have some funds when they go off to live on their
own.
* If you're concerned about estate taxes, you can trim your taxable
estate by giving some assets to your kids.
* In these increasingly litigious times, transferring assets to
your children may keep them out of the reach of any future
creditors or claimants.
Observation: If tax rates are increased on high incomes, as many
suspect the Congress will do, the advantage of shifting investment
income to your children will be even greater.
CUSTODIAL TRUSTS
If you decide on transferring assets to your children, you have a
decision to make. Although your child, as a minor, can have assets
in his name, he generally cannot make decisions on how they will be
handled. Therefore, the money must be held in a custodial account
or a trust.
Custodial accounts: quick and easy. Probably the most common
vehicle for transferring assets to minors is the custodial account,
authorized by the Uniform Gifts to Minors Act (UGMA) or, in some
states, the Uniform Transfers to Minors Act (UTMA). Essentially,
these acts permit you to set up bank accounts or register
securities in the name of an adult, acting as custodian for a
minor. For tax purposes, the income from these accounts goes to
the child, rather than to the parent.
A custodial account is not considered to be another pocket for you,
the parent. Instead, once the money goes into the child's account,
it belongs to the child. The custodian is not entitled to use the
principal or the interest, except when he is acting on the minor's
behalf. What's more, the parent can't use the money for ordinary
custodial expenses, such as food and clothing. The money, if used,
must go for extraordinary expenses, such as private school tuition
or a home computer.
Custodial accounts are cheap and simple. You can have one set up
at virtually any financial institution, in a few minutes, at no
charge. Then you can put money in and take money out at
will--although withdrawals will be taxed to you unless they are
made to cover extraordinary expenses. Assets in custodial accounts
are outside the reach of your creditors and they don't go through
probate. If you die, a successor custodian will take your place.
Note:
* In some states, there is little investment flexibility in
custodial accounts, with options essentially limited to stocks and
bank accounts.
* If the income generated is used for ordinary support and the
person who created the account is legally obligated to provide for
the minor, that income will be taxed to the donor.
* A problem arises if you're the donor as well as the custodian and
you die before your child reaches majority: Your gifts will be
pulled back into your taxable estate. Therefore, if you make the
gifts, your spouse should act as custodian, and vice versa. In
case of joint gifts, from you and your spouse, a third-party should
be named as custodian.
* The custodian is liable to the child for negligence in handling
these accounts. If the child so requests, the custodian must make
a complete report of transactions concerning the account.
Important: Custodial accounts remove you of control over the assets
you give to your children. These accounts automatically terminate
when the minor reaches majority, at age 18 or 21 depending on state
law. Whatever is in the account then passes to the young adult,
with no strings attached.
This ultimate loss of control is a major drawback. When your child
is "emancipated" or comes of age, all the money must go to the
child. If your 17-year-old daughter gets married--thus becoming
emancipated--and there's a $50,000 in her UGMA account, she gets to
do whatever she wants with it. There's nothing to stop her from
spending that $50,000 on a car or a trip to Australia or anything
else.
Trusts for the long term. To cope with this lack of control, many
parents prefer setting up a minor's trust. There are two ways to
do this. The "official" minor's trust, established under Section
2503(c) of the Internal Revenue Code, can extend your control over
the assets you give your kids until they reach age 21. To qualify
for the gift-tax exclusion on donations to Section 2503(c) trusts,
the assets must be payable to the beneficiary when he or she
reaches 21. But the trust term can run beyond age 21 if your child
consents to the extension--which the child is likely to do if he or
she is still dependent on you or is savvy enough to perceive the
tax advantages. You, or you and your spouse, usually can act as
trustees, in control of all the assets.
Caution: Some authorities suggest that parents not act as trustees
of minor's trusts. Check your state's rules.
If you want to be sure that the trust runs longer and you also want
to take advantage of the gift-tax exclusion, you'll have to set up
a trust with "Crummey power." This refers to a landmark court
case, in which a taxpayer triumphed over the IRS. "Crummey power"
provides the beneficiary with the right to demand distributions
from the trust each year, up to some specified amount--for example,
$1,000 or 3% of the trust's value.
The beneficiary (in the case of a minor, the beneficiary's legal
guardian) must be formally notified of this right each year.
Frequently, this right has a limited time period, such as 30 days
after receipt of notice. If no demand is made in this period, the
right lapses, until the next year's notice is sent out.
What's the point of this exercise? If this right is extended after
a gift is made to the trust, and the beneficiary or guardian has
the right to withdraw the gift, then the gift qualifies as a
present interest. As such, it's eligible for the $10,000 or
$20,000 gift-tax exclusion, but the trust can last for as long as
you like.
If you're concerned about long-term control of the assets, this may
be a better choice for you than a Section 2503(c) trust. However,
if you're after absolute control, you'll have to pay the price and
forgo the gift-tax exclusion.
Trusts are flexible. You can hold virtually all types of assets in
trust, not just cash and stocks. You can also put any number of
provisions in the trust documents. The payout of the trust to a
beneficiary child could be contingent on enrolling in college,
keeping up a certain course load, attaining a certain grade
average, passing from one level to the next, graduating, or so on.
Irrevocable (Permanent) Trusts have their own tax bracket; a
situation that offers tax planning opportunities. For example, you
could set up both a trust and a custodial account. Each year, the
trustee might distribute just enough to a custodial account to
fully utilize the child's lower tax rate. After that distribution,
the first portion of trust income is taxed at the lower rates.
Paying the price. While custodial accounts are virtually
cost-free; trusts are more expensive. Start-up costs for the
simplest trusts start at $500, but you can spend thousands of
dollars to create a complex minor's trust. In addition, there are
ongoing expenses for trust administration and tax return
preparation.
Note: If you do set up a 2503(c) trust, keep in mind that it must
be irrevocable.
Whether you use a trust or a custodial account, gift-tax rules
apply when making gifts to minors, unless you retain total
control. There's no tax on gifts of up to $10,000 per year per
recipient. If your spouse consents, by signing a gift-tax return,
the two of you can give up to $20,000 per year per recipient
tax-free. Larger gifts will eat into your $600,000 individual/$1.2
million spousal estate tax exemptions.
Because gifts to trusts are considered gifts to trust
beneficiaries, you're not allowed to double dip. Example: With
spousal consent, you give $20,000 this year to a trust set up for
your son. If you also give money to a custodial account for him,
you'll incur gift tax.
SPECIAL PROVISIONS
If you leave property directly to a minor at your death, you're
leaving yourself open to interference from the probate court. In
every state, the court will set up a custodianship to supervise how
that property is handled. Fees will have to be paid, transactions
will be on the public record, and the custodian may not have the
child's best interests at heart.
You're better off setting the terms yourself. Property left to a
minor should be left in trust, with a trustee of your own choice.
These trusts can be drawn up so that the trustee has the discretion
to distribute the principal to the beneficiary at any given age, if
you are uncomfortable about turning over the assets when your child
reaches 21.
Some minor's trusts include provisions to achieve certain goals:
* Present interest trusts. Here, the trust documents assert that
the trust funds and the income may be spent for the beneficiary
before age 21, any remaining trust assets will pass to him or her.
These stipulations make gifts to the trust "present interests,"
under the tax code. As such, they qualify for the gift-tax
exclusion.
* Totten trusts. Named for a 1904 court decision, they're also
called tentative trusts or bank account trusts. Essentially, these
trusts are similar to the POD bank accounts described in the first
chapter. You put money into a savings account, naming yourself as
trustee of the account while a minor is the beneficiary. At your
death, the funds pass directly to the beneficiary (or to the
management of the beneficiary's guardian), without going through
probate.
These trusts, unlike those mentioned above, are revocable. You can
pull out the money at any time. Thus, the interest is taxable to
you, the donor, and the funds will be included in your taxable
estate. The advantage of the Totten trust is that you can name a
successor to your bank account without the time and expense of
drawing up a will and without the disadvantages (inflexibility,
loss of control) of joint ownership.
* Savings account trusts. Unlike n trusts, which may be offered
by banks or savings and loans, savings account trusts can be
offered only by S & Ls. Minors can make deposits or withdrawals
without any liability to the S & L.
Wait and see. Which works best--trusts or custodial accounts?
Many families use custodial accounts. Although the loss of control
is troubling, most parents can exert enough control over dependent
children to "persuade" them to use the money for college. If your
child is the exception who'll turn 18 and spend money wildly,
rather than use it for college, you'll see the signs a few years
earlier. In that case, you can set up a trust then. However, if
there are large amounts of money involved or you question your
ability to influence your children, a minor's trust is probably the
better choice.
Education Trusts
If you give assets to your children, either in trust or in a
custodial account, you'll reduce your chances of qualifying for
college financial aid. Here's why: When evaluating what a family
should contribute to the student's education, the standardized
financial aid forms require both parents and the student to list
their assets and income. Under the standard formulas, the student
is expected to contribute a higher percentage of his or her assets
and income than the parents are. If the parents were expected to
contribute a portion of their assets and income, the child might be
expected to contribute matching funds. Therefore, shifting assets
to the child increases the required "family contribution" and
decreases the amount of financial aid that will be awarded.
Note: You're better off having the assets available than having to
depend on the college and the various student loan programs to come
up with the amount you need. The available funds are constantly
changing, and there's no guarantee that what you need will be
available when your child is ready for college.
IN BRIEF;
* There are several reasons why you might want to transfer assets
to your children, but minors generally can't legally make decisions
on how those assets will be handled.
* If any significant sums are involved, minors' assets should be
held in trust or in a custodial account.
* Custodial accounts are simple and cheap.
* Trusts, though more expensive, enable you to exert more control
over the assets you give your children.
* Bequests to children should be in trust, if they're sizable.
* The larger the amounts involved, and the greater your doubts
about a minor's behavior upon coming of age, the more you should
lean towards trusts rather than custodial accounts.
* When making gifts to trusts or to custodial accounts, be sure to
consider the gift-tax limits.
PRESERVATION TRUSTS -
EXTRA PROTECTION FOR YOUR BENEFICIARIES LONG TERM
Minors aren't the only ones who need help handling their funds.
Some people, young or old, have problems with large sums of
money--perhaps because of too-trusting natures or a lust for good
living. In any event, you may want to protect such people from
themselves, especially if they're loved ones. You may be able to
exercise this restraint while you're alive and able, but not after
you're dead or incompetent.
Alternatively, you may have some very young relatives you'd like to
provide for, but you just don't know how responsible they'll be
when they mature. Or, you may be perfectly comfortable with the
sense of responsibility your children or grandchildren display, but
you're not sure about their spouses or as-yet-unidentified
spouses. Or, you may be quite certain that a marriage is headed
for disaster. Again, you want to provide for your descendants, yet
keep assets out of the reach of future divorce negotiations.
These are the kinds of situations for which common, garden-variety
trusts were designed, and for which they're still commonly used.
Assets are placed in a trust, with the income to be distributed to
the beneficiaries either on a regular basis or as needed. Usually,
the beneficiaries are not automatically entitled to all the trust
income; the trustee holds onto the purse strings. Thus the
beneficiary can't squander the principal, and the assets are
generally out of the reach of creditors, including spouses in
divorce negotiations. In essence, these trusts preserve the assets
so they'll be there over the long term.
Sometimes, though, a vanilla trust won't do. When that's the case,
you can use a sprinkle trust or a spendthrift trust to provide even
more protection to beneficiaries.
MEDICAL TRUSTS PROTECT ASSETS FROM FINANCIAL ATTACKS
Observation: There is one specific area in which a revocable trust
can be used to provide asset protection: It may shelter your house
from a Medicaid lien. Although, as usual, the details will vary
from state to state, this is the basic scenario:
* Because neither Medicare nor private health insurance covers
nursing home costs, many people are forced to reduce their assets
to poverty levels so that Medicaid will pay for their long-term
nursing home care.
* You generally can hold onto your personal residence, no matter
its value, and still qualify for Medicaid.
* Some states, however, will attach a Medicaid lien on your house
in this situation. That is, when the house is sold--either while
you live or after your death--Medicaid will demand restitution from
the sales proceeds. In case of long nursing home stays, tens of
thousands of dollars will be involved.
* Transferring your house to a revocable trust will forestall a
Medicaid lien in some states. Yet you retain control of the house
and the various tax advantages that come with home ownership. In
the case of married couples, transferring the home to a revocable
trust may permit one spouse to enter a nursing home, paid for by
Medicaid, while the other spouse remains in the house, lien-free.
Such a transfer may mean a wait for Medicaid eligibility of up to
30 months, however.
AVOIDING THE THREE-YEAR RULE
As you can see there are several advantages to revocable living
trusts. The main drawbacks, as noted, are start-up costs and the
burden of retitling assets. Another negative relates to estate
planning.
The Internal Revenue Code allows you to give up to $10,000 per year
to anyone you choose, free of gift tax. Such giveaways can help
you reduce your taxable estate. However, under the code, gifts you
make from revocable trusts within three years of your death are
thrown back into your taxable estate and subject to estate tax.
Suppose you transfer virtually all of your assets into a revocable
trust to avoid probate. But you also want to give away assets and
reduce estate tax. How can you make gifts yet avoid the three-year
rule? Recently, the IRS and the Tax Court have spelled out of the
do's and don'ts of making gifts from revocable trusts.
TAX CONCERNS
Many trusts have their own tax bracket and file their own income
tax returns. The 1993 tax law created the following tax brackets
for trusts:
Taxable Income Rate
0-$1,500 15%
$1,500-$3,500 28%
$3,500-$5,500 31%
$5,500-$7,500 36%
$7,500+ 39.6%
Note: Tax brackets will adjust slightly each year, to keep up with
inflation. Previously, trusts were a popular tool for shifting
income. By putting investments in trust, where tax rates were low,
parents could build up a college fund for their children. The
income-shifting advantages have been substantially reduced now.
TAXWISE APPROACH
Another solution is for the trustee to adopt an investment policy
that minimizes current taxes.
* High-quality municipal bonds can provide steady income. But, if
you switch from Treasuries or investment-grade corporate bonds into
lowrated or unrated munis, you take on a lot more risk for a little
extra yield.
* Low-divided growth stocks can generate substantial long-term
appreciation. No taxes will be due until any gains are realized
and those gains likely will be taxed no higher than 28%. If the
trustee prefers mutual funds to individual stocks, funds with a
history of paying low taxable distributions can be selected.
Gifts to a trust may qualify for the gift-tax exclusion if the
trust is irrevocable and you give the trust beneficiaries a
"present interest" in the trust assets--that is, the opportunity
for some present benefit from them (for example, by giving them a
Crummey power; see page 25). If your gift is to a charitable
trust, you'll be able to deduct the "present value" of the gift
from your income tax as a charitable contribution.
State laws are important, too, especially for taxes. If you have a
trust set up in New Jersey and a beneficiary who lives in New York,
you might buy New York municipal bonds, or "munis," instead of New
Jersey munis, so the beneficiary can avoid in-state income taxes.
(The trust likely will avoid the tax by paying out the interest.)
From an estate planning standpoint, many trusts can remove assets
from your estate, thus from the estate-tax assessment. Estate tax
is a wealth tax imposed at death. It's payable on all of the
decedent's assets. A federal tax credit exempts the first $600,000
of assets from tax. After that the rates range from 37% to 55%,
with an added 5% surcharge imposed on estates valued at $10 million
to $21 million.
In one case that was the subject of an IRS "letter ruling," a
revocable trust's documents allowed the trustee to make
distributions only to the grantor, during the grantor's lifetime.
All gifts, thus, were considered to have been made to the grantor
and then to the gift recipients. (This was the case even though
the gifts were made directly to recipients.) In this case, the IRS
ruled, the assets given away were not brought back into the
grantor's estate.
In another case, a revocable trust's documents allowed the trustee
to make distributions to another recipients as well as to the
grantor. The IRS letter ruling went against the estate in this
case. The gifts made from the trust within three years of the
grantor's death were brought back into his taxable estate.
In 1991, the Tax Court gave its interpretation of this issue in the
Estate of Jalkut case. Here, a revocable trust's trustee could
make distributions only to the grantor, as long as the grantor was
competent. However, after the grantor was no longer capable of
managing his own affairs, the trustee could make distributions to
others.
Gifts were made from the trust, within three years of Jalkut's
death, before and after his incompetence. The IRS assessed estate
tax on all the assets given away in this three-year period. Since
the IRS's actions in this dispute contradicted its own letter
rulings, the case was appealed to the Tax Court. The Tax Court's
ruling was in line with the letter rulings. All gifts made while
the grantor was still competent were deemed two-step transactions,
trust-to-grantor-to-recipient. Therefore, they were not subject to
estate tax. However, gifts made from the trust after the grantor's
incompetency within three years of death, were thrown back into the
taxable estate.
These rulings show that you can avoid estate-tax problems if you
draw up a revocable trust that restricts the trustee to making
distributions to you, the grantor. For even more protection,
actually go through a two-step process when making gifts of assets
held in a revocable trust. First, formally remove the assets from
the trust and take title in your own name. Then, give them away.
There will then be no question about the procedure, and the gift
won't be subject to the three-year rule.
Observation: Even some sophisticated estate planning attorneys
aren't aware of this pitfall. So don't assume your lawyer is up to
speed. Check to be sure that your trust documents restrict the
trustee to making distributions to you, the grantor.
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