 
TYPES OF TRUSTSCOMMON TYPES OF TRUSTS
TRUST PRIMARY PURPOSE AND GOAL
SPECIAL TYPES OF TRUSTSMINOR'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 TRUSTSIf 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 termTo 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 PROVISIONSIf 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 Totten trusts, which may be offered by banks, bank account trusts can only be offered by banks. Minors can make deposits or withdrawals without any liability to the bank. 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 TrustsIf 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 TRUSTSEXTRA PROTECTION FOR YOUR BENEFICIARIES LONG TERMMinors 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 ATTACKSObservation: 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 RULEAs you can see there are several advantages to revocable living trusts. The main drawbacks, as noted, are start-up costs and the burden of re-titling 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 CONCERNSMany 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 APPROACHAnother 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 low rated 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 other 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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