An irrevocable trust has long been a key component of many estate plans. But what if it no longer serves your purposes? Is it too late to change it? Depending on applicable state law, you may have several options for fixing a “broken” trust.
How trusts break
There are several reasons a trust can break, including:
Changing family circumstances. A trust that works just fine when it’s established may no longer achieve its original goals if your family circumstances change. Some examples are a divorce, second marriage or the birth of a child.
New tax laws. Many trusts were created when gift, estate and generation-skipping transfer (GST) tax exemption amounts were relatively low. However, for 2021, the exemptions have risen to $11.7 million, so trusts designed to minimize gift, estate and GST taxes may no longer be necessary. And with transfer taxes out of the picture, the higher income taxes often associated with these trusts — previously overshadowed by transfer tax concerns — become a more important factor.
Mistakes. Potential errors include naming the wrong beneficiary, omitting a critical clause from the trust document, including a clause that’s inconsistent with your intent, and failing to allocate your GST tax exemption properly.
These are just a few examples of the many ways you might end up with a trust that fails to achieve your estate planning objectives.
How to fix them
If you have one or more trusts in need of repair, you may have several remedies at your disposal, depending on applicable law in the state where you live and, if different, in the state where the trust is located. Potential remedies include:
Reformation. The Uniform Trust Code (UTC), adopted in more than half the states, provides several remedies for broken trusts. Non-UTC states may provide similar remedies. Reformation allows you to ask a court to rewrite a trust’s terms to conform with the grantor’s intent. This remedy is available if the trust’s original terms were based on a legal or factual mistake.
Modification. This remedy may be available, also through court proceedings, if unanticipated circumstances require changes in order to achieve the trust’s purposes. Some states permit modification — even if it’s inconsistent with the trust’s purposes — with the consent of the grantor and the beneficiaries.
Decanting. Many states have decanting laws, which allow a trustee, according to his or her distribution powers, to “pour” funds from one trust into another with different terms and even in a different location. Depending on your circumstances and applicable state law, decanting may allow a trustee to correct errors, take advantage of new tax laws or another state’s asset protection laws, add or eliminate beneficiaries, and make other changes, often without court approval.
Seek professional guidance
The rules regarding modification of irrevocable trusts are complex and vary dramatically from state to state. And there are risks associated with revising or moving a trust, including uncertainty over how the IRS will view the changes. Before you make any changes, talk to us about the potential benefits and risks.
© 2021 Covenant CPA
In some cases, it may be desirable to move a trust to a more favorable jurisdiction. But moving a trust from one state to another can present significant risks, so don’t attempt to do so without considering all the benefits, limitations and risks, and obtaining professional advice.
Reasons to move a trust
There are many reasons for moving a trust to another jurisdiction, such as:
- Avoiding or reducing state income taxes on the trust’s accumulated ordinary income and capital gains,
- Taking advantage of trust laws that allow the trustee to improve investment performance,
- Extending the trust’s duration,
- Obtaining stronger creditor protection for beneficiaries, and
- Reducing fees and administrative expenses.
Many people retire to states with more favorable tax laws. But just because you move to a state with lower income or estate taxes doesn’t mean your trusts move with you.
For individual income tax purposes, you’re generally taxed by your state of domicile. The state to which a trust pays taxes, however, depends on its situs.
Can your trust be moved?
Moving a trust means changing its situs from one state to another. Generally, this isn’t a problem for revocable trusts. In fact, it’s possible to change situs for a revocable trust by simply modifying it. Or, if that’s not an option, you can revoke the trust and establish a new one in the desired jurisdiction.
If a trust is irrevocable, whether it can be moved depends, in part, on the language of the trust document. Many trusts specify that the laws of a particular state govern them, in which case those laws would likely continue to apply even if the trust were moved. Some trusts expressly authorize the trustee or beneficiaries to move the trust from one jurisdiction to another.
If the trust document doesn’t designate a situs or establish procedures for changing situs, then the trust’s situs depends on several factors. These include applicable state law, where the trust is administered, the trustee’s state of residence, the domicile of the person who created the trust, the location of the beneficiaries and the location of real property held by the trust.
The actual process of moving the trust may entail creating a new trust to which the existing trust’s assets are transferred, merging the existing trust into a new trust or modifying the existing trust to designate the new state as its situs.
Depending on the trust’s terms and applicable state law, the move may require court approval or the unanimous consent of the trust’s beneficiaries.
Understanding the risks
Depending on your circumstances, moving a trust can offer tax savings and other benefits. Keep in mind, however, that the laws governing trusts are complex and vary considerably from state to state. We can help you determine whether the benefits outweigh the risks.
© 2021 Covenant CPA
You’ve likely spent a lot of time working with your advisor to plan your estate. While documents such as your will, various trusts and a power of attorney are essential, consider adding a “road map” to your plan.
Plot it out
Essentially, the road map is an informal letter or other document that guides your family in understanding and executing your estate plan and ensuring that your wishes are carried out.
Your road map should include, among other things:
- The location of your will, living and other trusts, tax returns and records, powers of attorney, insurance policies, deeds, automobile titles, and other important documents,
- A personal financial statement that lists stocks, bonds, real estate, bank accounts, retirement plans, vehicles and other assets, as well as information about mortgages, credit cards and other debts,
- An inventory of digital assets — such as email accounts, online bank and brokerage accounts, online photo galleries, digital music and book collections, and social media accounts — including login credentials or a description of arrangements made to provide your representative with access,
- The location of family heirlooms or other valuable personal property,
- A list of important professional contacts, including your estate planning attorney, accountant, insurance agent and financial advisors,
- Computer passwords and home security system codes,
- Safe combinations and the location of any safety deposit boxes and keys, and
- Information about funeral arrangements or burial wishes.
Explain your thinking
The road map may also be a good place to explain to your loved ones the reasoning behind certain estate planning decisions. Perhaps you’re distributing your assets unequally, distributing specific assets to specific heirs or placing certain restrictions on an heir’s entitlement to trust distributions. There are many good reasons for using these strategies, but it’s important for your family to understand your motives to avoid hurt feelings or disputes.
Finally, like other estate planning documents, your road map won’t be effective unless your family knows where to find it, so it’s a good idea to leave it with a trusted advisor and a copy in a place where your heirs will likely find it.
© 2021 Covenant CPA
Traditionally, estate planning has focused on more technical objectives, such as minimizing gift and estate taxes and protecting assets against creditors’ claims or lawsuits. These goals are still important, but affluent families are increasingly turning their attention to “softer,” yet equally critical, aspirations, such as educating the younger generation, preparing them to manage wealth responsibly, promoting shared family values and encouraging charitable giving. To achieve these goals, many are turning to a family advancement sustainability trust (FAST).
Typically, FASTs are created in states that 1) allow perpetual, or “dynasty,” trusts that benefit many generations to come, and 2) have directed trust statutes, which make it possible to appoint an advisor or committee to direct the trustee with regard to certain matters. A directed trust statute makes it possible for both family members and trusted advisors with specialized skills to participate in governance and management of the trust.
A common governance structure for a FAST includes four decision-making entities:
- An administrative trustee, often a corporate trustee, that deals with administrative matters but doesn’t handle investment or distribution decisions,
- An investment committee — consisting of family members and an independent, professional investment advisor — to manage investment of the trust assets,
- A distribution committee — consisting of family members and an outside advisor — to help ensure that trust funds are spent in a manner that benefits the family and promotes the trust’s objectives, and
- A trust protector committee — typically composed of one or more trusted advisors — which stands in the shoes of the grantor after his or her death and makes decisions on matters such as appointment or removal of trustees or committee members and amendment of the trust document for tax planning or other purposes.
It’s a good idea to establish a FAST during your lifetime. Doing so helps ensure that the trust achieves your objectives and allows you to educate your advisors and family members on the trust’s purpose and guiding principles.
FASTs generally require little funding when created, with the bulk of the funding provided upon the death of the older generation. Although funding can come from the estate, a better approach is to fund a FAST with life insurance or a properly structured irrevocable life insurance trust (ILIT). Using life insurance allows you to achieve the FAST’s objectives without depleting the assets otherwise available for the benefit of your family.
A flexible tool
A FAST is a flexible tool that can be designed to achieve a variety of goals. How you use one depends on your family’s needs and characteristics. Properly designed and implemented, a FAST can help prepare your heirs to receive wealth, educate them about important family values and financial responsibility, and maximize the chances that they’ll reach their potential. Contact us for additional details.
© 2021 Covenant CPA
If you and your spouse have similar irrevocable trusts that benefit each other, it’s important to know that the trusts might be subject to the “reciprocal trust” doctrine. In a nutshell, the doctrine prohibits tax avoidance through trusts that are interrelated and place both spouses in the same economic position as if they’d each created trusts naming themselves as life beneficiaries.
Avoid this scenario
Let’s suppose that your and your spouse’s estates will trigger a substantial tax bill when you die. You transfer your assets to an irrevocable trust that provides your spouse with an income interest for life, access to principal at the trustee’s discretion and a testamentary, special power of appointment to distribute the trust assets among your children.
Ordinarily, assets transferred to an irrevocable trust are removed from your taxable estate (though there may be gift tax implications). But let’s say that two weeks later, your spouse establishes a trust with a comparable amount of assets and identical provisions, naming you as life beneficiary. This arrangement would violate the reciprocal trust doctrine, so for tax purposes the transfers would be undone by the IRS and the value of the assets you transferred would be included in your respective estates.
In this example, the intent to avoid estate tax is clear: Each spouse removes assets from his or her taxable estate but remains in essentially the same economic position by virtue of being named life beneficiary of the other spouse’s estate.
Create two substantially different trusts
There are many ways to design trusts to avoid the reciprocal trust doctrine, but essentially the goal is to vary factors related to each trust, such as the trust assets, terms, trustees, beneficiaries or creation dates, so that the two trusts aren’t deemed “substantially similar” by the IRS. Contact us to learn more.
© 2021 Covenant CPA
Now that the federal gift and estate tax exemption has reached an inflation-adjusted $11.7 million for 2021, fewer estates are subject to the federal tax. And even though President Biden has proposed reducing the exemption to $3.5 million, it’s uncertain whether that proposal will pass Congress. If nothing happens, the exemption is scheduled to revert to an inflation-adjusted $5 million on January 1, 2026. Nonetheless, estate planning will continue to be essential for most families. That’s because tax planning is only a small component of estate planning — and usually not even the most important one.
The primary goal of estate planning is to protect your family, and saving taxes is just one of many strategies you can use to provide for your family’s financial security. Another equally important strategy is asset protection. And a spendthrift trust can be an invaluable tool for preserving wealth for your heirs.
“Spendthrift” is a misnomer
Despite its name, the purpose of a spendthrift trust isn’t just to protect profligate heirs from themselves. Although that’s one use for this trust type, even the most financially responsible heirs can be exposed to frivolous lawsuits, dishonest business partners or unscrupulous creditors.
A properly designed spendthrift trust can protect your family’s assets against such attacks. It can also protect your loved ones in the event of relationship changes. If one of your children divorces, your child’s spouse generally can’t claim a share of the spendthrift trust property in the divorce settlement.
Also, if your child predeceases his or her spouse, the spouse generally is entitled by law to a significant portion of your child’s estate. In some cases, that may be a desirable outcome. But in others, such as second marriages when there are children from a prior marriage, a spendthrift trust can prevent your child’s inheritance from ending up in the hands of his or her spouse rather than in those of your grandchildren.
Safeguarding your wealth
A variety of trusts can be spendthrift trusts. It’s just a matter of including a spendthrift clause, which restricts a beneficiary’s ability to assign or transfer his or her interest in the trust and restricts the rights of creditors to reach the trust assets.
It’s important to recognize that the protection offered by a spendthrift trust isn’t absolute. Depending on applicable law, it may be possible for government agencies to reach the trust assets — to satisfy a tax obligation, for example.
Generally, the more discretion you give the trustee over distributions from the trust, the greater the protection against creditors’ claims. If the trust requires the trustee to make distributions for a beneficiary’s support, for example, a court may rule that a creditor can reach the trust assets to satisfy support-related debts. For increased protection, it’s preferable to give the trustee full discretion over whether and when to make distributions.
If you have further questions regarding spendthrift trusts, please contact us. We’d be happy to help you determine if one is right for your estate plan.
© 2021 Covenant CPA
Some of the most effective estate planning strategies involve setting up irrevocable trusts. For a trust to be deemed irrevocable, you, the grantor, lose all incidents of ownership of the trust’s assets. In other words, you’re effectively removing those assets from your taxable estate.
But what if you’re uncomfortable placing your assets beyond your control? What happens if your financial fortunes take a turn for the worse after you’ve irrevocably transferred a sizable portion of your wealth? This may be an especially pertinent question in light of the current economic downturn resulting from the novel coronavirus (COVID-19) pandemic.
If you’re married, and feel as though your marriage is strong, a spousal lifetime access trust (SLAT) allows you to obtain the benefits of an irrevocable trust while creating a financial backup plan.
A SLAT in action
A SLAT is simply an irrevocable trust that authorizes the trustee to make distributions to your spouse if needs arise. Like other irrevocable trusts, a SLAT can be designed to benefit your children, grandchildren or future generations. You can use your lifetime gift tax and generation-skipping transfer tax exemptions (currently, $11.58 million each) to shield contributions to the trust, as well as future appreciation, from transfer taxes. And the trust assets also receive some protection against claims by your beneficiaries’ creditors, including any former spouses.
The key benefit of a SLAT is that by naming your spouse as a lifetime beneficiary you retain indirect access to the trust assets. You can set up the trust to make distributions based on an “ascertainable standard” — such as your spouse’s health, education, maintenance or support — or you can give the trustee full discretion to distribute income or principal to your spouse.
To keep the trust assets out of your taxable estate, you must not act as trustee. You can appoint your spouse as trustee, but only if distributions are limited to an ascertainable standard. If you desire greater flexibility over distributions to your spouse, appoint an independent trustee. Also, the trust document must prohibit distributions in satisfaction of your legal support obligations.
Another critical requirement is to fund the trust with your separate property. If you use marital or community property, there’s a risk that the trust assets will end up in your spouse’s estate.
Understand the pitfalls
There’s a significant risk inherent in the SLAT strategy: If your spouse predeceases you, or if you and your spouse divorce, you’ll lose your indirect access to the trust assets. One way to mitigate this risk is to use dual SLATs. In other words, you and your spouse each establish an irrevocable trust using your separate property and naming each other as lifetime beneficiaries.
If you’re considering using a SLAT, or would like to learn about other estate planning strategies, contact us to learn more about the benefits and risks.
© 2020 Covenant CPA
You may have several different types of trusts in your estate plan. In general, to achieve the greatest tax savings, these trusts must be irrevocable, thus requiring you to give up control over the trust assets.
Even though you appoint a trustee to oversee distribution of the trust’s assets, you can go a step further by appointing a trust protector. This person will serve as an overseer of the trustee’s actions. Taking this step can also provide you peace of mind because the trust protector has the power to alter the trust in light of changing family situations or tax laws.
Essentially, a trust protector is to a trustee what a corporate board of directors is to a CEO. A trustee manages the trust on a day-to-day basis. The protector oversees the trustee and weighs in on critical decisions, such as the sale of closely held business interests or investment transactions involving large dollar amounts.
You can confer broad powers on a trust protector. Examples include the power to:
- Remove or replace a trustee,
- Appoint a successor trustee or successor trust protector,
- Amend the trust terms to correct administrative provisions, clarify ambiguous language or alter beneficiaries’ interests to comply with new laws or reflect changed circumstances, and
- Terminate the trust.
While it may be tempting to provide a protector with a broad range of powers, it’s important to note that this can hamper the trustee’s ability to manage the trust efficiently.
Trust protector in action
Trust protectors offer many benefits. For example, a protector with the power to remove and replace the trustee can do so if the trustee develops a conflict of interest or fails to manage the trust assets in the beneficiaries’ best interests.
A protector with the power to modify the trust’s terms can correct mistakes in the trust document or clarify ambiguous language.
Choosing the right person
Appointing the right trust protector is critical. Given the power he or she has over your family’s wealth, you’ll want to choose someone whom you trust and who’s qualified to make investment and other financial decisions.
Many people appoint a trusted advisor — such as an accountant, attorney or investment advisor — who may not be able or willing to serve as trustee but who can provide an extra layer of protection by monitoring the trustee’s performance.
Choosing a family member as protector is possible, but it can be risky. If the protector is a beneficiary or has the power to direct the trust assets to him- or herself (or for his or her benefit), this power could be treated as a general power of appointment, exposing the protector to gift and estate tax liability and potentially triggering other negative tax consequences.
Due diligence is a must
Before deciding on appointing a trust protector, contact us. It’s important to review the trusts in your estate plan to ensure they’re drafted in such a way that there are no misunderstandings regarding the protector’s role and the authority you grant him or her.
© 2020 Covenant CPA
The Tax Cuts and Jobs Act created a new program to encourage investment in economically distressed areas through generous tax incentives. The Qualified Opportunity Zone (QOZ) program relies on investments in Qualified Opportunity Funds (QOFs) — funds that can provide wealthy taxpayers with some new avenues for estate planning.
3 big tax benefits
Investors in QOFs stand to reap three significant tax breaks:
- They can defer capital gains on the disposition of appreciated property by reinvesting the gains in a QOF within 180 days of disposition. The tax is deferred until the QOF investment is sold or Dec. 31, 2026, whichever is earlier.
- Depending on how long they hold their QOF investment, they can eliminate 10% to 15% of the tax.
- After 10 years, post-acquisition appreciation on the investment is tax-exempt.
By incorporating QOFs in your estate planning, you can reduce both capital gains and transfer tax liabilities.
Estate planning implications
Proposed regulations make clear that a QOF investor’s death isn’t an “inclusion event” that would trigger tax on the deferred gains. In addition, most of the activities involved in administering an estate or trust (for example, transferring the interest to the estate or distributing the interest) won’t trigger the gain. But the sale of the QOF interest by the estate, the trust or a beneficiary would. Gifts of QOF interests also are generally considered inclusion events that make the deferred gains immediately taxable.
You could avoid this, though, by gifting your interest to a grantor trust. Both revocable living trusts and irrevocable grantor trusts qualify. However, transfers to the latter are completed gifts and therefore produce greater potential tax savings in situations where the income and gains of the trust are taxed to the grantor, in turn reducing the grantor’s estate by the amount of income taxes paid. (Note, though, that the termination of grantor trust status for reasons other than the grantor’s death is treated as an inclusion event.)
For example, you could transfer a highly appreciated asset to an irrevocable trust with no gift tax under the federal gift and estate tax exemption ($11.40 million for 2019 and $11.58 million for 2020). The trust could sell the asset and defer the gains into a QOF investment.
Another option for transferring QOF interests is the grantor retained annuity trust (GRAT), which allows you to make a gift to a trust and receive an annuity interest roughly equal to the fair market value of the gift. Any appreciation beyond the amount required to pay the annuity also passes to the beneficiaries without gift tax.
Contact us for additional information.
© 2019 Covenant CPA
The Tax Cuts and Jobs Act (TCJA) reduced individual income tax rates, but it left the 3.8% net investment income tax (NIIT) in place. It’s important to address the NIIT in your estate plan, because it can erode your earnings from interest, dividends, capital gains and other investments, leaving less for your heirs.
How it works
The NIIT applies to individuals with modified adjusted gross income (MAGI) over $200,000. The threshold is $250,000 for joint filers and qualifying widows or widowers and $125,000 for married taxpayers filing separately. The tax is equal to 3.8% of 1) your net investment income, or 2) the amount by which your MAGI exceeds the threshold, whichever is less.
Suppose, for example, that you’re married filing jointly and you have $350,000 in MAGI. Presuming $125,000 in net investment income, your NIIT is 3.8% of $100,000 (the excess of your MAGI over the threshold, which is less than your net investment income), or $3,800.
Nongrantor trusts — with limited exceptions — are also subject to the NIIT, and at a much lower threshold: For 2019, the tax applies to the lesser of 1) the trust’s undistributed net investment income or 2) the amount by which the trust’s AGI exceeds $12,751.
Reducing the tax
You can reduce or eliminate the NIIT by lowering your MAGI, lowering your net investment income, or both. Techniques for doing so include:
- Reducing this year’s MAGI by deferring income, accelerating expenses or maxing out contributions to retirement accounts,
- Selling poor-performing investments to offset the losses against investment gains you’ve realized during the year, or
- Reducing net investment income by investing in tax-exempt municipal bonds or in growth stocks that generate little or no current income.
If you own an interest in a business, you may be able to reduce NIIT by increasing your level of participation. Income from a business in which you “materially participate” isn’t considered net investment income. (But keep in mind that increasing your participation may, in certain cases, trigger self-employment tax liability.)
For trusts, you can reduce or eliminate the NIIT by:
- Structuring them as grantor trusts,
- Distributing the trust’s income to its beneficiaries (remember, the NIIT applies only to undistributed income), or
- Shifting the trust’s investments into tax-exempt municipal bonds, growth stocks or tax-deferred investments (such as life insurance).
Keep in mind that, if you use a grantor trust, its income will be passed through to you as grantor, potentially increasing your personal liability for NIIT.
Review your plan
The NIIT can affect the financial performance of your personal investments as well as your trusts. To maximize the amount of wealth available for your heirs, be sure to consider strategies for reducing the impact of this tax. Contact us with any questions.
© 2019 Covenant CPA