In my last post, I suggested that more people should consider leaving their assets to their heirs in trust rather than as outright bequests to protect the assets from their children’s creditors and spouses (in case of divorce).
Although there are many other reasons why a trust is preferred, such as when the beneficiary has substance abuse issues or has mental disabilities, here we are assuming that the beneficiary is financially responsible and mature. An oft-raised misperception is that trusts are expensive and complex and provide unfettered control to the trustee…to the potential detriment of the beneficiary.
That’s not so—if the trust is done right. Let’s first understand that a trust is simply a contract between the grantor (the person who funds it) and the trustee (an individual or corporate entity). This contract provides legal title of assets to the trustee who in turn has a fiduciary obligation to hold the assets for the benefit of specified persons (the beneficiaries). The contract can stipulate any restrictions and powers the grantor desires as long as they are not contrary to what’s permitted by law.
For trust assets to remain protected, I generally recommend that a trust agreement provide the trustee with discretion to make or not to make distributions of income and principal to the beneficiaries. This is in contrast to those trusts that require mandatory distributions of income or principal on the occurrence of certain events (such as college graduation) or attaining a certain age. This is not to say, however, that a trustee should have unlimited discretion over distributions—there are safeguards that the grantor can build into the trust to give the beneficiary a degree of control.
One such safeguard is to designate the beneficiary as the “protector” of the trust with the power to remove and replace the trustee at will. Assuming the beneficiary appreciates the benefits the trust provides, he/she will effectively have ultimate control. Of course, this can also backfire if the beneficiary abuses this power and therefore enables a creditor to argue that the trustee is in effect the beneficiary’s agent and that the trust is therefore a sham. A more conservative version of this approach is to restrict any successor trustee to being not an individual but an institution.
Another provision to consider is to encourage the trustee to acquire assets for the beneficiary’s use and enjoyment. This could include the purchase of a home by the trust which the beneficiary can use rent free. Since the home would be owned by the trust, it could not be attached by a creditor.
To provide the same degree of control over the asset management, one can structure the trust to hold its assets through underlying entities (such as corporations or limited liability companies) and designate the beneficiary as the manager.
And to allow the beneficiary to ultimately bequeath any remaining trust assets to whomever he/she desires, the trust can grant the beneficiary a broad power of appointment whereby his/her will can specify heirs to the trust assets.
There may also be income tax savings depending on the state in which the trust is administered and the residence of the beneficiary (even more important now that the state income tax deduction is limited under the new federal tax law.) For example, if the beneficiary resides in a high tax state such as New York and the trust is governed by Delaware law (which would not be subject to state income tax if settled by a nonresident of Delaware), all capital gains realized as well as undistributed income would be subject only to federal (not state) income tax. The tax savings alone could more than make up for any additional administrative expenses.
Now, it is true that trusts carry certain costs. First, there will be the tax-return preparation fee. (Trusts generally must file tax returns.) And unless a family member is the trustee and waives his trustee commission, there will be a trustee fee. If an institution that offers money management is also providing trustee services, the incremental annual cost over the annual money management fee will likely be less than 25 basis points (0.0025) of the trust assets.
In summary, by incorporating the above safeguards into a trust agreement, you can provide your beneficiary with a substantial degree of control without significant cost or burdens.
For more information, check out Gideon Rothschild’s website.