Here are some types of estate planning trusts that are key to many estate plans. To learn more, contact us at 415-235-9162 to arrange a complimentary consultation. Let us help design an estate plan that will provide you with the lasting peace of mind that comes from knowing you and your loved ones are protected in case of an unexpected event.
We start with a classic: the bypass trust, also called the B trust (part of the A-B trust estate plan) and the credit shelter trust. The bypass used to be used primarily for tax reduction, even by middle class families. If the estate tax exemption declines in the next few years, more people will need it again for tax reduction.
But it also has important nontax benefits.
Let’s say we’re back in the days when the estate tax exempt amount was $1 million and say Max Profits has an estate worth $2 million and is married to Rosie Profits.
Max bequeaths $1 million of his estate to Rosie and $1 million to a bypass trust that will provide for Rosie for the rest of her life. After Rosie passes away, the trust remainder goes to the Profits’ children, as does the rest of Rosie’s estate.
The amount left to the bypass is sheltered from estate taxes by Max’s lifetime federal tax exempt amount. The unlimited estate tax marital deduction shelters the amount bequeathed to Rosie.
When Rosie passes away her lifetime exemption shelters up to $1 million of her estate, and the money in the bypass trust isn’t included in Rosie’s estate.
The result is at least $2 million eventually passes to the Profits’ children without any estate and gift taxes.
In addition to potential tax reduction, the bypass trust protects the assets from bad investment decisions, scams, creditors, and similar concerns.
The bypass trust guarantees the children are the eventual recipients of the assets. There’s no concern the surviving spouse might be persuaded to leave the assets to others. That’s why the bypass is useful when this isn’t the first marriage for at least one of the spouses or in case the surviving spouse remarries.
The tricky part is determining how much of the estate should go into a bypass trust. In the old days, the will simply stated that an amount equal to the federal estate tax exempt amount was transferred to the trust. Now, that simple formula would leave most surviving spouses with no assets outside the trust. The amount to transfer to the bypass trust is a personal one to be discussed with the estate planner and your spouse.
A similar trust is the QTIP, or qualified terminal interest property, trust.
The first spouse to pass away leaves some or all of the estate to the QTIP trust.
The surviving spouse receives the income from the trust for the rest of his or her life. But only the income from the trust assets is available to the surviving spouse. After that spouse passes away, the assets go the final beneficiaries, who usually are the couple’s children.
The estate of the first spouse to pass away isn’t taxed on the assets transferred to the QTIP trust because of the unlimited marital deduction, provided the surviving spouse is a U.S. citizen.
When the surviving spouse passes away, all the assets in the trust are included in that spouse’s taxable estate.
A flexible feature of the QTIP trust is the estate executor of the first spouse to pass away can determine how much of the estate goes into the trust. You don’t have to finalize the amount when the will is written.
The QTIP provides the same nontax benefits as the bypass trust.
A potential disadvantage of the QTIP is the surviving spouse can receive only income from the trust. He or she can’t touch the principal. Other assets might be needed to maintain the standard of living.
The irrevocable life insurance trust (ILIT) is another classic.
An individual creates an irrevocable trust, usually naming the individual’s children and perhaps grandchildren as beneficiaries.
The trustee buys a permanent life insurance policy on the individual’s life. The individual transfers cash to the trust to pay the insurance premiums. The premiums might be due in a lump sum or annually, depending on the policy.
When the individual dies, the insurance benefits are paid to the trust free of income, estate, and gift taxes. The insurance benefits are excluded from the taxable estate of the insured individual, because they are owned by the ILIT. If the individual exercised ownership rights over the policy, the benefits are included in his or her taxable estate.
The trustee manages the benefits as directed in the trust agreement. The benefits might be invested and distributed to the beneficiaries over time, or they could be distributed to the beneficiaries soon after they are received.
The trust protects the benefits from creditors of the insured and the beneficiaries. Also, the trustee invests and distributes the money, potentially avoiding wasteful spending, poor investments, scams, and more.
An ILIT can become a dynasty trust that provides wealth to several generations of a family at greatly reduced tax cost.
If the same amount of money were passed down directly through generations of a wealthy family, the transfers would be subject to gift or estate taxes in each generation. With the current maximum 40% estate and gift tax rate, the wealth would be reduced fairly quickly.
A dynasty trust can pass more after-tax money, and then make it last longer through spending and investing policies in the trust agreement. The trust can last for generations.
One feature that makes the ILIT and dynasty trust work is the Crummey clause, also known as a Crummey trust. The name comes from a court case that established the rule.
A Crummey clause allows beneficiaries to withdraw any gift made to the trust, up to the annual gift tax exclusion amount ($15,000 in 2020a and 2021). A time limit such as 30 days can be set. If the gift isn’t withdrawn by deadline, it remains in the trust subject to its rules.
The clause qualifies gifts for the annual gift tax exclusion. Without a Crummey clause, gifts to the trust wouldn’t qualify for the exclusion and could be taxable or reduce the lifetime estate and gift tax exempt amount.
With the Crummey clause you take the risk that a beneficiary might withdraw the gift to spend today. Most trust creators accept and reduce this risk by letting it be known that if a gift is withdrawn, there won’t be future gifts.
The charitably inclined should consider two types of charitable trusts.
The most commonly-used is the charitable remainder trust (CRT). The CRT pays regular income to the trust creator or other named beneficiaries for life or a period of years. The property remaining in the trust goes to a charity or charities designated by the trust creator.
The CRT is a great way to avoid taxes on appreciated property. When the property is transferred to the trust, no capital gains or other taxes are due on the appreciation. Because the trust ultimately benefits charity, it is tax exempt. The trustee can sell the property tax free and reinvest the entire sale proceeds.
Another bonus is the trust creator receives a current income tax deduction for the estimated present value of the amount the charity eventually will receive.
The annual payments to the beneficiary can be a percentage of the value of the trust assets each year, known as a charitable remainder unitrust (CRUT). Or the trust can pay a fixed amount each year, known as a charitable remainder annuity trust (CRAT).
A growing use of the CRT is to overcome the restrictions the SECURE Act placed on inherited IRAs. A CRT is a way to create the equivalent of a Stretch IRA.
A charitable lead trust (CLT) is sort of the opposite of a CRT.
The CLT pays income to the charity for a period of years. After that, the non-charitable beneficiaries (usually the trust creator or the creator’s children) receive a series of payments or receive the trust balance in a lump sum.
The trust creator can receive a charitable contribution deduction when the trust is created.
But a CLT is not exempt from income taxes. Either the trust or its creator will be taxed on the annual income, depending on the terms of the trust.
Either type of charitable trust can be created during the creator’s lifetime or in the will.
These trusts are very flexible but also have some detailed requirements and restrictions.