From the Archives: Don't Get Rid of That Trust!
Hints at a future cottage industry?
Intro
A while back, I faced a situation where a CPA told several siblings in a family that it would be better to terminate the trusts set up for them by their parents, because the trusts caused “unnecessary complications” in the form of “more tax returns to prepare every year and higher tax rates.” They took the CPA’s advice and terminated the trusts.
Later, I explained on a conference call with the family and CPA what benefits had permanently been lost by the termination. Needless to say, the family was not happy with the CPA.
While it is mostly educated-yet-unscientific theory on my part, I have previously discussed the tension that is to come as part of the “wealth wave” or “silver tsunami” through which we will see the largest intergenerational wealth transfer in history. At the top of the bell curve, I predict the following:
Most clients who have visited a somewhat-competent estate planning attorney in the last 20-30 years are going to have estate plans that create lifetime trusts for at least the next generation, and possibly multiple generations.
We are accustomed to a world of individual ownership of wealth. Inheritors expect individual ownership of wealth, and many wealth managers and tax advisors are trained primarily to deal with individual ownership of wealth. This will create bad feelings on the part of inheritors, and a sudden (at least partial) obsolescence of the skillsets of wealth managers and tax advisors.
In response to this dynamic, I anticipate that we will see a cottage industry of “trust busters” - not in the tradition of Teddy Roosevelt but instead on the private wealth side. Like with my opening story, this creates a temporary way to illustrate (on paper) numerical proof of certain “benefits,” while also scratching an emotional itch of a client who does not like having the restrictions of a trust forced upon them.
(As an aside, while controversial, I am a firm believer in giving some unrestricted wealth to beneficiaries to allow them to make their own mistakes and learn their own lessons - a possibility that could prevent the bad feelings described above. I have previously spoken about a small amount of wealth I inherited. I learned valuable lessons from spending some of it, but I also learned regretful lessons that are more impactful - one being that if I had invested in Apple, Amazon or Google at the time that I would be retired by now.)
So, I am here today to warn you not to fall into this trap if you are a professional advisor representing clients who have inherited wealth in trusts. There are certain benefits gained by keeping trusts intact. While not a complete discussion, this article highlights some of the common benefits of trusts - especially trusts for descendants.
Creditor and Divorce Protection
(Note - this discussion is intended to be a general discussion and does not represent a complete representation of all states’ laws. Protections, or lack thereof, are subject to judicial or legislative changes.)
In many states, a beneficial interest in a trust is treated as personal property that can be transferred - whether voluntarily or involuntarily. But, this right to transfer one’s interest in trust is limited by a spendthrift clause. Generally, a spendthrift clause prevents the voluntary or involuntary transfer, pledge, or encumbrance of one’s interest in a trust. There are state-by-state exceptions, under which certain claims (for example, unpaid child support for which a beneficiary is liable) can be satisfied from a trust notwithstanding the spendthrift clause due to public policy. But, as long as initial transfers to the trust are not subject to fraudulent or voidable transfer laws (which can allow claims against the transferor and not beneficiary to be satisfied from the trust), the spendthrift clause should protect beneficiaries from themselves.
Once property leaves the trust in the form of a distribution to a beneficiary, however, it loses this protection. You cannot put the toothpaste back in the tube.
Depending on the state, guaranteed distributions from the trust may also lack protection - even before the toothpaste leaves the tube. While a spendthrift clause can protect property held by the trust or trustee, creditors may be able to make claims against future distributions from the trust depending on the state. Classic examples of such “guaranteed” distributions might include:
Distributions of all trust income according to a predetermined frequency, such as quarterly or annually;
Distributions of determinable pecuniary dollar amounts (such as matching W-2 income); and
Tiered distributions at certain ages, such as one-third of trust principal at age 25, one-half at age 30, and the rest at age 35 - a classic structure in older trusts (and sometimes newer trusts drafted by those accustomed to that structure).
Generally, guaranteed distributions are avoided by giving the trustee the discretion to determine when and where to make distributions. This discretionary distribution power may, depending on the state, prevent the beneficiary’s interest in the trust from being treated as “property” for purposes of certain judicial and equitable claims (including divorce claims) which would otherwise supersede the protections of a spendthrift clause. (Note that support distributions may receive different treatment under an ascertainable standard than distributions for which an independent trustee has full and absolute discretion - see the recent article by Steve Oshins for more info on these differences.)
Long story short, there are several other factors such as choice of trustee, independence of trustee, etc. that come into play, but at the top of the bell curve we usually see that a trust containing (1) a spendthrift clause, and (2) discretionary distributions, should provide a baseline level of protection against claims of judgment creditors, and claims in divorce (property settlements, and sometimes determination of maintenance and spousal support). These protections only exist so long as the toothpaste is still in the tube.
As angry as someone might be at their parents or ancestors about burdening them with a trust, they are going to be even more angry at the loss of their inheritance due to a claim that might have been avoided had they just left the trust alone. You do not want to be the advisor who is forced to answer that call based on your suggestion to get rid of the trust.
Taxes
Funding a trust comes at a cost to the settlor. The settlor usually uses applicable credit against federal gift or estate tax when the trust is funded, or exchanges value that will later use such applicable credit. The settlor may also allocate exemption against future federal generation-skipping transfer (GST) tax when the trust is funded. As long as the toothpaste stays in the tube, the trust is the owner of assets, income, and appreciation in the trust - meaning that these transfer taxes will no longer apply so long as the trust stays intact (subject to certain legislative proposals to limit the period of exemption for a GST-exempt trust) because these taxes generally apply to individuals. State-level death or inheritance taxes might have also applied (after exemptions), or may have been deferred so long as the trust stays intact.
While trusts do have higher income tax rates, these rates generally are most impactful for ordinary income. And, where ordinary income is distributed out to a beneficiary during a calendar year (or within 65 days of the end of a calendar year with an election on Form 1041), the trust can take a deduction which has the effect of “shifting” taxation of this income to a beneficiary - usually at lower tax rates (due to broader individual income tax brackets). Capital gains are usually taxed to the trust and get the same benefits as for an individual, but with a more compressed 0% rate bracket. Nonetheless, a trust-level election on Form 1041 may also allow trustees in most states to treat distributed capital gains as “income,” the taxation of which is also shifted to beneficiaries.
Trusts do have higher accounting compliance, in the form of (1) annual Form 1041 filings, with a possible additional filing for state income tax, and (2) the requirements of maintaining accounting of the assets, sales/exchanges, income, and distributions of the trust. But, these added burdens are often table stakes compared to the increases in transfer taxes that can occur when trusts are terminated, not to mention the other benefits highlighted in this article. (Note also that the termination of a trust itself can result in GST tax and sometimes federal and/or state income tax.)
Protecting Beneficiaries From Themselves
I can’t speak for you, but if I had received unfettered access to thousands or millions of dollars as a young adult, my decisions would not have been sound. Personally, I would have used the wealth to mask insecurities by (1) trying to impress others and/or buy their approval, and (2) purchasing luxuries in order to feel like a “king.” Even in the face of sound personal values, I can’t say my decisions would have been productive or made with consideration of long-term implications.
Social media is like gasoline being poured on the fire of this tendency to overspend when we get sudden access to wealth. I am not here to cast blame, but it is human tendency to (1) blow large windfalls in a short amount of time, or (2) read stories about other people blowing windfalls while assuming we would not do the same. (I have a future article coming out about how family values are not as impactful as we think in an environment where many of us were raised by substitute “parents” - broadcast media, video games, reality television, image-based social media, and now video-based social media - all of which can affect our macro views of wealth.)
Long story short, one often has no idea how they would react to a sudden and acute increase in wealth - regardless of age. Even when one chooses to live frugally, we don’t know how they would react to the sudden pressures from family members and friends to provide financial “assistance” or support certain causes when and if sudden wealth is received. When compounded with the current isolation many people of all ages currently experience, it is more likely that they would be unduly influenced by someone with nefarious motives due to a lack of positive counterinfluences.
Creating a trust does not completely avoid these outcomes, but it does provide some limitations and protections. The need to go through a trustee to receive access to wealth can at least cut off some impulsivity a beneficiary may otherwise experience with individually-owned wealth. It also allows a beneficiary to make the trustee the “bad guy” when faced with undue influence, in order to reduce some immediate social pressure.
And, in many cases, modern trusts allow a beneficiary to either (1) become a trustee at a certain age, or (2) control the selection of a trustee at a certain age. This gives some “hope” of gaining control in the future, while also tempering the sting and regret of short-term decisions. As I will later explain in an upcoming series, this also gives advisors some different ways to add value without just getting rid of the trust wholesale.
Entity Protections
While this is not acknowledged as often as the other protections, trusts for various children and descendants (especially those with a common trustee) have an enhanced ability to co-invest wealth through business entities. While there are restrictions on diversification and investment mix to consider, added liability protection may be in play.
How? To start, the classic way to ruin entity protection is where a creditor can “pierce” the limited liability veil. Most often, veil-piercing outcomes occur when there is individual ownership of business entities. With trust ownership, a trustee has more of an incentive and fiduciary duty to observe entity formalities and create belt-and-suspenders protections for a trust. This can enhance some of the creditor protections discussed above.
In addition, the effects of family infighting may be reduced when an unbiased trustee is charged with voting and managing equity interests held by a trust. Depending on the state, access to information about the entity may also be limited if the trustee’s duty to provide an accounting is relaxed. (Contrast this with individual entity ownership, where owners’ rights to access the entity’s books and records usually cannot be restricted.)
There is, however, a catch - or two common catches.
One, there is no trust income unless or until the entity makes distributions to the trust as an equity holder. This can create a tension between (1) beneficiaries who passively participate in a business or investment through their trusts, (2) the director or managers of the entity who control distributions versus reinvestments of net cash flow, and (3) the trustee who controls whether to distribute income received by the trust from the entity.
Two, if distributions must be made, this may require either (1) distribution of equity interests in-kind, leading to a beneficiary becoming a direct equity holder (exacerbating the tensions highlighted above), or (2) full or partial redemption or liquidation of the trust’s interest in the entity (which can affect the economic interests of all other equity holders - especially other trusts).
What is a Termination?
Note when I criticize a “termination” of the trust, I am not talking about a natural termination that occurs according to the terms of a trust or a beneficiary’s powers - which sometimes results in a continuation of the trust as separate subtrusts for the next generation. Instead, I am talking about an early “termination” of the trust - possibly by the appointment of a sympathetic trustee, combined with a consent to terminate the trust by the beneficiaries under a non-judicial settlement agreement or pursuant to a court order. And, while the trust codes of many states prohibit termination if doing so would violate a settlor’s material purpose in creating the trust, this can be overcome by a (sometimes spurious) argument that the trust is “uneconomical” to administer.
Generally, the existence of a spendthrift clause is not by itself a “material purpose” for maintaining a trust (see UTC 411). And, a beneficiary’s consent to trust termination often does not invoke the protections of the spendthrift clause - at least as long as the trustee also consents. But, the effect of terminating a trust is usually an outright distribution to the income beneficiaries of the trust. Where there are beneficiaries in multiple generations, this distribution pattern may require actuarial calculations which are quite complex and thus easy to mess up.
Note that in lieu of distributions, certain types of transfers may be made that do not violate a spendthrift clause. On the beneficiary side, this can include a qualified (or sometimes nonqualified) disclaimer, or the exercise of a lifetime or testamentary power of appointment granted by the trust. On the trustee side, this can include a decanting of the trust, or possibly a modification of the trust - both of which are subject to fiduciary duties and other state-law limitations.
On that note, by consenting to a trust termination, the trustee is putting themselves at risk. Above, I noted that an advisor should not want to answer to a client whose inheritance was later jeopardized due to termination of the trust at the advisor’s urging. Likewise, many trustees don’t want to answer to that beneficiary.
While releases and indemnifications at the time of termination may provide some protections to a trustee, they cannot protect a trustee who acts (1) in bad faith, (2) with reckless disregard for the trust instrument, or (3) without providing adequate information to allow each beneficiary to make an informed decision about trust termination. Further, consent of minor or unborn beneficiaries may not be properly obtained (by virtual representation or otherwise), and these are the beneficiaries who could come back and sue a trustee for breach of fiduciary duty if and when their parent or ancestor wastes or loses the inheritance they would have received had the trust stayed intact.
Conclusion
It is easy to fall into the trap of thinking you can be a “hero” to a client by getting rid of that pesky trust they do not like. This may win you business in the short term, and may even be encouraged in the future by guidance in your industry. But, the long-term implications of such a decision can come back and bite you.