A living trust is a great estate-planning tool. Here’s why.
What is a Trust?
First, what is a trust? A trust is an entity, similar to a corporation or a limited liability company (LLC), used for the purpose of holding and managing a person’s property. It is formed under state law and has three essential persons: the grantor, the beneficiary and the trustee.
The grantor is the person who creates the trust (also called a settlor or a trustor). The grantor creates his/her trust by signing a written document, which explains how the trust property is to be managed and who shall benefit from the trust. The grantor then contributes property (money, stock, personal effects, and real estate) to the trust. Title to the trust property is held in the name of the trust. For example, a bank account might be held in the name of the John Doe Family Trust.
The beneficiary is a person who benefits from the use and enjoyment of the trust property. A beneficiary’s interest is called a “beneficial interest.” This beneficial interest can be either immediate or in the future or both and can be either a right to enjoy the trust income or principal or both. In contrast with a stockholder of a corporation or a member of an LLC, a trust beneficiary rarely has any voting rights.
The trustee manages and retains or distributes the trust property in accordance with the trust instrument. A trustee can simultaneously serve with another a co-trustee or later serve as a successor to another trustee who has died or has resigned his duties. A trustee can be an individual person or an institution, e.g. a bank or trust company. A trust will never fail for want of a trustee. If a successor is not named, a court will appoint one.
The trustee and successor trustees should be persons with whom the grantor has confidence. These persons should be competent and disinterested; i.e. having no present or future interest in the trust property and capable of managing the trust property and of responding to the interests of the trust beneficiaries. For this reason, some grantors will prefer a professional trustee (a bank or trust company) in order to avoid any risk of having the trust property mismanaged or worse yet, taken by a less than partial trustee, who could favor his/her own interests over the interests of other beneficiaries! An estate planning professional should offer helpful advice in selecting trustees.
Like a corporation and an LLC, a trust can exist a long time. A trust will terminate when its property has been distributed, but not later than when the trust requires final distributions be made. Unlike a corporation, most states will not permit a noncharitable trust to exist indefinitely. In Montana, a noncharitable trust can exist for at least 90 years (or even longer as permitted by Montana’s statutory rule against perpetuities, a rule far too complex to discuss in this article). For most noncharitable trusts, 90 years will be far longer than needed to accomplish the grantor’s goals.
The Living Trust v. Testamentary Trust
The living trust is a trust that exists during its grantor’s life. It is also called an inter vivos trust (means “among the living” in Latin). In contrast, a testamentary trust has life only when its creator dies, because the testamentary trust derives from the probate of a person’s will. Many estate plans will involve either a living trust or a testamentary trust, or even both. With very few disadvantages, the living trust offers some significant advantages over the testamentary trust. The remainder of this article explains why and how these living trusts can be used in estate plans.
The Revocable Trust v. The Irrevocable Trust
A living trust can be revocable or irrevocable. A revocable trust is similar to a person’s will, because it can be changed any time before the grantor dies. The revocable trust is not a device to avoid paying the grantor’s creditors. An irrevocable trust cannot be changed and is intentionally used to make permanent, irreversible gifts to individuals or charities. An irrevocable trust is typically used for making tax advantaged charitable gifts, for optimizing tax free or tax minimized gifts to heirs, and for assuring the lifetime care for a special person in need.
Neither the revocable nor irrevocable trust can be used to circumvent paying the grantor’s debts. However, both can be used to protect the interest of beneficiaries other than the grantor.
Most estate plans involve revocable trusts, as opposed to irrevocable trusts, since most people are not willing to give up ownership of their property until they die. The remainder of this article explains how the revocable trust can be used in estate plans.
The Revocable Trust - Cares for the Grantor while living & avoids conservatorships
While the grantor is alive, the grantor of a revocable trust retains total control of his/her property. While alive, the grantor is often the sole trustee and sole beneficiary of his/her own revocable trust (commonly referred to as a self-trusteed trust). While alive, the grantor of a revocable trust can always change the named beneficiaries of his/her trust estate.
When a person becomes become incapacitated (e.g., Alzheimer’s or a stroke or other illness), someone has to manage his property for him/her. States, like Montana, provide a formal judicial process, called a conservatorship, for handling an incapacitated person’s property. The revocable trust can provide a less costly alternative to the conservatorship. When the grantor of a revocable trust becomes incapacitated, his/her named successor trustee will take over managing the trust property and then use the trust income and property to care for the grantor and his/her spouse. Because the revocable trust can avoid a conservatorship, it has a significant advantage over the testamentary trust.
The Revocable Trust - Cares for the Grantor’s survivors & avoids probate
The I.R.S. disregards the revocable trust as a separate identity for tax purposes and requires the grantor to use his/her own social security number for the trust. Nevertheless, all states, including Montana, will respect a revocable trust as an entity for holding property. When a grantor dies, his/her revocable trust remains alive! On the grantor’s death, the property in the trust will simply pass free of probate to its named beneficiaries (just like insurance proceeds can pass directly to a beneficiary without going through probate). To successfully avoid probate, the grantor’s property must be held in his/her trust at the time of death. In contrast with the revocable trust, a testamentary trust cannot avoid probate, since it originates from the probate of a person’s will.
In most cases, the fear of paying extravagant probate fees may be more overblown than real. Yet, it is generally easier to account for and transfer a person’s property to a revocable trust during his/her life than through probate. Even though the cost of setting up a revocable trust and transferring property to it will be incurred while the grantor alive, the alternative of deferring those costs is likely to be outweighed by the costly burden of having to clean-up a person’s affairs in a formal judicial proceeding (probate) after he/she has died. The revocable trust is a valid mechanism for avoiding a probate.
WARNING - Probate avoidance cannot be guaranteed
Although probate avoidance is often sought-after, no professional can guarantee complete probate avoidance. For example, suppose a person dies in a car accident. There is no effective way to assign his/her estate’s wrongful death claim to his/her revocable trust. The dying man’s last dying gasp (likely out the anyone’s presence) is not likely to be: “I assign all of my right, title, and interest in my estate’s wrongful death claim to my revocable, living trust.” Or, when a person dies while reading the winning numbers on his/her lottery ticket, did he/she remember to tell the grocery clerk that he/she had purchased the winning ticket in the name of his/her revocable living trust? Or how would a person know to assign his/her inheritance to his/her trust, when coming from a great aunt that had died a few minutes earlier? In these situations, there is little that can be done to avoid a probate. The problem of a potential probate is solved by a pour-over will, as explained later in this article.
Optimizing the Estate Tax Exclusion with Revocable Trusts
The revocable trust (as well as the testamentary trust) can be used to minimize the imposition of federal estate tax. The imposition of the federal estate and gift tax[1] falls on a person’s lifetime and at death gifts. An estate includes life insurance, IRAs, pension plans, jointly held property, assets held by a revocable trust, assets passing through probate, various other nonprobate assets and all reportable gifts made prior to death. The estate tax is 40% of a decedent’s taxable estate (the total estate, including lifetime gifts, less deductions for expenses, debts, qualified marital gifts, qualified charitable gifts, and the estate tax exclusion).
For decedents dying in 2024, the life-time estate tax exclusion is increased to $13,610,000 per person,[2] which can be doubled to $27,220,000 for a surviving spouse, which will usually require the surviving spouse to file an estate tax return for the deceased spouse in order to elect portability (explained below). This will require properly planned outright spousal gifts, spousal subtrusts, and nonspousal subtrusts, (trusts within trust) and the filing of an estate tax return when the first spouse dies. In order to avoid taxation in the estate of a propertied spouse who dies first, it is important to utilize the marital deduction as well as to elect portability in order to pass all or part of the burden of taxation to the surviving less propertied spouse.
However, in 2026, the estate tax exclusion is scheduled to be cut in half. So if a person is not planning to die on or before 2025, and if there is no further adjustments for inflation, the estate tax exclusion would drop to $6,805,000 (if not increased for inflation) for a single person and 13,610,000 for a husband and wife. This legislative issue may not be addressed before 2025, when the issue comes to a head.
What is portability?
Since 2010, a deceased spouse’s unused exclusion can be “ported over” to a surviving spouse, but only if an estate tax return (form 706) is filed for the decedent’s estate (this is required even if the deceased spouse has no assets)! Portability elections are available even if a deceased spouse had no assets or where a decedent passed his/her assets to a spouse qualifying for a tax-free marital transfers.
Outright spousal gifts
Outright marital gifts allow a surviving spouse the freedom to dispose of all marital property in any manner after the first spouse dies. Outright gifts allow the surviving spouse flexibility in dealing with future but unforeseen circumstances that often arise after the first spouse dies. When a surviving spouse receives an outright gifts the entire value of these assets will be included in the survivor’s estate and the ultimate heirs will received a stepped-up basis[3] (fair market value) on the surviving spouse’s death.
Marital Subtrusts
This subtrust is for the benefit of a surviving spouse and often gives a surviving spouse and usually unlimited access to the income and principal. This property passes estate tax-free to the surviving spouse but will be later taxable in the surviving spouse’s federal estate. As with outright gifts, the ultimate heirs will receive an income tax basis in the inherited assets equal to fair market value on the surviving spouse’s death.
QTIP Subtrusts [qualified terminal interest property trust]
This subtrust gives the surviving spouse all trust income, but limited access to the principal. Depending on how the trust is drafted, these limitations may be lenient or harsh. This subtrust can qualify for a marital deduction, which will allow a deceased spouse’s property to pass tax-free into the surviving spouse’s estate. This is done by making a QTIP election on an estate tax return (form 706), when the first spouse dies. On the surviving spouse’s death, the trust will dictate where and how the left-over assets go. If the QTIP election is made, the heirs will have the advantage of a stepped-up tax basis in thein inherited assets. If the QTIP election is not made, the property will not be taxable in the surviving spouse’s estate and the heirs will not receive a stepped-up income tax basis on the surviving spouse’s death.
Disclaimer Subtrusts
This trust is for a surviving spouse who declines to accept (disclaims) an outright gift of the deceased spouse’s property. Like the QTIP subtrust, this subtrust gives the surviving spouse all trust income, but limited access to the principal. The disclaimer keeps the disclaimed property from passing into the surviving spouse’s estate, but without forfeiting the surviving spouse’s right to receive the trust income. The surviving spouse is allowed to choose whether to use this gambit. That decision will depend on whether the surviving spouse will want to minimize exposure to future estate taxes in his/her own estate. Disclaimer subtrusts often are included in estate plans as safety valves, especially in anticipation of the now scheduled post-2025 exclusion reductions.
Nonmarital Subtrusts (sometimes called a credit shelter subtrust)
This subtrust will hold property for the benefit a spouse and/or others. It often has restrictions. It sometimes holds separate funds for children of a different marriage. These funds will be taxable in the decedent’s estate, but usually without an adverse consequences, if the assets in this trust are less than the decedent’s unused exclusion. Usually trust property in excess of the decedent’s exclusion will pass estate tax-free to subtrust benefitting a surviving spouse. This trust can be useful for parking assets that might appreciate in value after a person dies. The idea is to keep all post-death increases in asset values from bulging the size of a surviving spouse’s estate. (this strategy is called asset freezing).
Revocable Trusts - protects children and grandchildren, but equal is not always fair
In a revocable trust (and also in a testamentary trust), the children’s and grandchildren’s subtrust (also referred to as a surrogate subtrust) is used to protect a younger beneficiary or beneficiaries from prematurely inheriting property. A person needs to consider what happens without a surrogate subtrust.
Often, a person without a will designates his/her spouse as the principal beneficiary of his/her life insurance and then leaves the remainder “equally to each of my children, if my spouse does not survive me.” This is a poor man’s estate plan. In some instances, the insured would be better off without the insurance. Why?
First, a young person may lack the maturity to handle large sums of money, when reaching the age of emancipation, 18 years of age. No person alive can predict how mature his/her own 3 and 5 year old children might be, when later reaching the age of 18. An unprotected gift to an inexperienced 18 year might even be used as an excuse for not having to go to college (the very reason for the gift)!
Second, if both parents die (e.g. in a car accident), “equal” is not always fair or what a person should really want. For example, assume it costs $1,000 per year to raise a child. An insured and his/her spouse die in an auto accident leaving 3 minor children, aged 13, 8, and 3 as equal beneficiaries of a single $30,000 life insurance policy. The 13-year-old will be $5,000 ahead, when he/she reaches 18, the age of emancipation (not necessarily the age of maturity). The 8-year-old will break even and the 3-year-old will be $5,000 in the hole.[4] Or suppose one child needs an expensive medical procedure. Would anyone write a will that reduced that child’s inheritance simply because his care as a child cost more than his siblings?
A surrogate subtrust (trust within a trust) can avoid a premature disbursement of funds to a beneficiary who might otherwise be a spendthrift, inexperienced, or imprudent with money. This subtrust can also provide a more equitable division of benefits among a person’s children or grandchildren, taking into consideration the diversity of the age, health and needs of all of the beneficiaries within the group (called a class). In solving these problems, the experienced estate planner must listen to his/her client’s needs and then offer choices and recommendations. Then, the client chooses which fits his/her own needs the best.
Revocable Trusts - enhanced with a pour-over power of attorney
What if a person becomes incapacitated before his/her property has been transferred to the revocable trust? This problem is solved by using a “pour-over” power of attorney, authorizing the incapacitated person’s agent to transfer his/her property to the revocable trust! The pour-over power of attorney performs the same function as a pour-over will, except it has vitality while the grantor is alive as opposed to after he/she has died. In contrast with a will, a power of attorney dies, when its principal dies.
Revocable Trusts - enhanced with a pour-over will
To protect against the unexpected possibility of a probate, a proper estate plan will include a pour-over will. The pour-over will passes all probate property into the grantor’s revocable trust. This is the essential purpose of the pour-over will and assures consistency in the estate plan.
Living Wills
A living will is not a will. It is an important component of the estate planning. However, the living will has nothing to do with disposing of property. It is simply used to direct how a person wants to be treated by his/her physician and health care providers, when terminally ill and can authorize persons (usually a spouse or other family members) to make those health care decisions. It is simple and a good idea.
Charitable Gifts - usually more advantageous, taxwise, if made during a person’s life.
Charitable trusts commonly offer the donor the opportunity “to have his/her cake and eat it, too.” Charitable trusts have created a whole new vocabulary of crazy acronyms; such as: the CRAT (charitable remainder annuity trust, CRUT (charitable remainder unitrust), CLAT (charitable lead annuity trust) and CLUT (charitable lead unitrust). Charitable trusts divide property interests in a single property between the charity(ies) and the donor, usually leaving the charity with an income interest or with a remainder interest and the donor, with the other part. These planned gifts are irrevocably made during a person’s life and are too complex to discuss in this article.
If properly made, a charitable gift can qualify for a Montana Endowment tax credit, which can offset up to $10,000 in state income taxes for a year. To do this, the credit will equal 40% of qualified gifts from individuals and 20% of any kind of a gift from entities. In addition, the donor will receive a federal tax deduction for the same gift. In addition, if the gift is of appreciated property, the donor will often be able to deduct the full value of the gift even though the donor’s tax basis is substantially lower. For example, a donor may have paid $1,000 for Microsoft stock now worth $25,000. The donor will not have to pay income tax on the $24,000 capital gain but still be entitled to deduct the whole $25,000. If the gift is structured to qualify for a Montana Endowment tax credit, a donor could end up getting a tax benefit back as much as 80% or more of the donated property!
There are other kinds of noncharitable trusts, too. The generation skipping trust or subtrust is used to bypass at least one generation of heirs and to avoid one or more generations of estate taxes. The GRIT (grantor retained income trust) is designed to downsize the taxable value of taxable gifts in very large estates. The Crummey trust (named after Mr. Crummey) is not crummy, but in fact very useful for making tax excludable gifts[5] that protect premature distributions to younger beneficiaries. The “business” trust is a legitimate entity, but is far less favored than the LLC and the corporation for conducting an active trade or business (in Montana a “business” trust is treated like, and presumably taxed like a corporation)!
Conclusion
Some people perceive the living trust to be a tool of the rich and only for those who can afford pricey lawyers. Contrary to this common misperception, most estate planners will use a revocable trust as the centerpiece of an estate plan. A good estate planner will spend time with his/her client, gathering essential information and analyzing his/her client’s needs. This process could take several meetings and will likely require the client to do some homework. Bottom line, a good estate planner will not try to fit everyone in the same size shoe. Cheap estate plans do, cookie-cutter estate plans, and online software programs will likewise fail to provide the needed wisdom and insight that an experienced estate planner can offer. A conscientious person will want to wear a “shoe that fits.” That person should give serious thought to using professional help and a living trust in implementing his/her own successful estate plan.
THOMAS C. MORRISON
J.D. & LL.M. at NYU (in taxation)
[1] The federal estate and gift tax is imposed on a person’s gifts made during life and at death. In 2023, 17 states, but not Montana, also had separate estate taxes. In 2023, 6 states, but not, Montana), had inheritance taxes, which taxes the beneficiaries of gifts.
[2] Adjusted annually for inflation. The life-time basic exclusion had previously been called an estate tax exemption. There is also an additional annual $18,000 exclusion which allows annual gifts not to exceed $18,000 per donor per beneficiary per year, beginning in 2024.
[3] It is possible for an asset to lose value and the date of death basis rule denies the heir a deduction for the loss in value.
[4] These amounts are used for simplicity of illustration and not to suggest that a $30,000 life insurance policy would be adequate to care for such a family.
[5] A person can make “tax excludable gifts” up to $15,000 per person to an infinite number of persons(called the annual exclusion), which do not need to be reported and do not diminish a person’s $11,700,000 lifetime estate tax exclusion.