Tax and Non-Tax Advantages of Trusts

Trusts are traditionally used for minimizing estate taxes, and can offer other benefits as part of a well thought-out estate plan.  AAFCPAs advises clients to think about the benefits of establishing a trust as a method to control your wealth, protect your legacy, and avoid probate.  We have provided the below overview, and summary of the different types of trusts and their unique benefits.

What is a Trust?

A trust is an agreement between the person forming the trust (the “Grantor”) and the person managing the trust (the “Trustee”) as to how the assets held by the trust will be managed and disbursed to the beneficiaries of the trust.  The trust agreement itself lays out the rules for how the trust is to operate, what it is to do, and when to do it.  When forming a trust, a Trustee is appointed who will have the job of managing the trust assets and following the trust’s rules.  Often times the Grantor and the Trustee can be the same person.
Once the trust is created it needs to have assets.  Often times the Grantor (the person forming the trust) will transfer assets to the trust, to be managed according to the terms of the trust by the Trustee.  Once a trust has assets, the Trustee invests those assets according to the rules of the trust.  The trust will then have principal (the original amount gifted to the trust) and income (the money earned from the principal).  The rules of the trust will then determine who ultimately gets that income and principal (the beneficiaries).
While traditionally trusts have often been used to maximize estate tax savings, there are also many non-tax advantages to the use of trusts.

Types of Trusts and Benefits

Revocable Trust.  A revocable trust (also called a living trust) has largely become the main document in many traditional estate plans.  This trust is designed to provide for the management of the trust assets for the benefit of the Grantor during his or her lifetime and then provides what happens to the trust assets after the Grantor’s death.  The advantage of a revocable trust is any assets held by the revocable trust avoid the probate process (which can be long and expensive).  In addition, the terms of a revocable trust can be changed at any time during your lifetime, should life situations change, such as divorce or death of a spouse or children, or remarriage to a new spouse.
Some people think that holding all their assets jointly is a way to avoid probate.  While it does avoid probate, it may not be the most tax-efficient way to hold assets.
Life Insurance Trust.  A Life Insurance Trust is an irrevocable trust that cannot be revoked or changed once it is created.  These types of trusts are used to own life insurance policies so that the insurance proceeds are not subject to the estate tax.  Instead of paying the insurance premiums themselves, they make a gift to the trust so that the trust pays the premiums each year.  The trust is the beneficiary of the life insurance policy and the trust dictates when the beneficiaries of the trust will receive the proceeds.
Testamentary Trust.  A Testamentary Trust is set up to take effect at death.  It is referred to in a will, with a separate trust instrument.  Once the estate is settled, the estate assets pass to the trust and are distributed according to the rules of the trust.  The trust may also call for the creation of other types of trusts such as a Credit Shelter Trust, Spendhrift Trust or Special Needs Trust discussed below.
Credit Shelter Trust.  A Credit Shelter Trust may also be known as a Bypass Trust.  The trust is designed to allow a married couple to maximize the use of the estate tax exemption and avoid the payment of state and federal estate taxes.  With the advent of “portability” these trusts are not as necessary as they once were for the federal estate tax but still can be important for state estate tax reasons.
Qualified Personal Residence Trust (QPRT).  The QPRT Trust is designed to reduce estate taxes while maximizing the use of the estate tax exemption.  They may be set up for your personal residence and a vacation home.  An example of how the QPRT works is the Grantor may gift his/her home to a QPRT that says he/she may use the home for a ten year period.  At the end of the ten year period the trust provides that the house passes to his/her children (or perhaps another trust).  At the end of the ten years the gift is completed but at a lower gift value because of the right to live there for the specified number of years.  The children or second trust would own the home, but the parents could stay in it if they pay rent at fair rental value.
Medicaid Qualifying Trusts.  A Medicaid Qualifying Trust is designed to allow you to qualify for Medicaid if confined to a nursing home without losing all of your assets.  This is a complicated issue, and one has to be careful giving gifts within 5 years of going into a nursing home.  It may be necessary to private pay a few months or years of nursing home care in order to get into a good one.  Long term care insurance is an alternative, but needs to be purchased at a time in one’s life when there are not too many medical issues.  In addition, many long-term care insurance companies have quit issuing policies because people are living longer in long-term care facilities.
Spendthrift Trust.  A Spendthrift Trust is designed to protect your heirs from creditors and divorce.  Instead of giving money directly to the heir you put it into trust and the trustee would then distribute the money to the heir according to the terms of the trust; perhaps when the beneficiary reaches a certain age, or for specific expenses such as college or medical expenses.
Special Needs Trust.  A Special Needs Trust is designed to provide support to a disabled individual without causing them to be disqualified from governmental benefits.
The non-tax advantages of trusts may include professional management of the assets, so that a beneficiary of the trust does not have to worry about how the assets are invested.  A professional trustee and a family member trustee may be the best trustees.  The professional trustee can help prevent family squabbles, and the family member trustee knows the needs of the family members.  Tax rates can be high on income kept within a trust so it may be tax efficient to distribute most of the income, but keep the principal within the trust.  Trusts also can be worded to avoid assets going to spouses of family members during a divorce.
When preparing wills and trusts, it is essential to have good professional advice.  Wills and trusts need to be updated as circumstances and tax laws change.  AAFCPAs and our affiliate AAFCPAs Wealth Management can work collaboratively with your lawyer, investment advisor, and insurance agent to arrive at the best solution.  Our multi-disciplinary team includes Certified Public Accountants (CPAs), estate planning & tax strategists, Certified Financial Planners (CFPs), as well as Personal Financial Specialists (PFSs) with comprehensive knowledge of financial planning and extensive tax, estate, retirement, investment, and risk management experience.