Estate Planning Q&A Series: Trusts

Why Use a Trust or Other Device when Jointly Owning Property Works Just as Well?

Owning property jointly, or making gifts immediately prior to death, only work for people who do not have federal estate tax problems.  Owning property jointly with another individual inhibits and prevents certain federal estate tax avoidance techniques.  As a general rule, any property that you own jointly with another person, with the right of survivorship, and any property which you give to another person but which gift is not to take effect until your death, will be fully included in your estate for federal estate tax purposes.  Thus while you will have avoided probate with respect to this property, you may not have taken advantage of methods otherwise available to legally avoid the estate tax.  Furthermore, joint ownership may cause numerous other estate and gift tax problems.  Thus jointly owning property is a tool which has certain applications, but it is far from a universal technique in estate planning.

What is a Trust?

A trust is a custody device.  In owning any piece of property, the law creates two separate types of title:  “legal” and “equitable.”  The concept of legal title involves the registration or formal ownership of property.  The concept of equitable title involves the person who is entitled to the benefits of the ownership of that property.  In most cases, legal and equitable title are vested in the same person.  For example, an automobile may have a legal title which is issued by the State of Missouri.  If the person named on the legal title is also the equitable owner as well, then that person may operate the automobile for such purposes as he or she sees fit.  If the legal owner of the automobile is a trust, however the legal owner may not necessarily be able to operate the automobile without restrictions.

1. A trust involves the separation of the legal and equitable titles with respect to the property held by that trust.  Legal title is held by a person designated as the “trustee”, but the trustee holds the property for the benefit of the beneficiaries of the trust, i.e., the person or persons for whose benefit the trust was created.  Equitable title to the trust assets is considered as being vested in these beneficiaries, and the trustee manages the assets held in trust for the benefit of these beneficiaries.  Usually the trustee may not use the assets in the trust for the trustee’s benefit.  The legal title to these trust assets is vested in the trustee, but not the equitable title.
2. A trust may be created by a variety of devices, but the most frequent method is the creation of a written document known as a “trust agreement” which is created by the person desiring to do so, who is known as the “grantor.”  The grantor executes a trust agreement, and delivers to the trustee named in the trust agreement certain assets to be held by that trustee, in trust, for the uses and purposes delineated in the trust agreement.  The creation of the typical inter vivos trust involves giving the trustee extensive instructions as to his or her duties, and as to the application of funds and assets coming into the trustee’s possession.  The trustee also is instructed as to when the trust is to terminate.  On the day of termination, the trustee must convey legal title to the trust assets either back to the name of the grantor (if the trust is revocable) or to other beneficiaries named in the trust agreement.  The trustee also has to take the other steps necessary to wind up and terminate the trust.  If a trust has not been revoked as of the date of the death of the grantor, the trust continues as prescribed by the trust agreement for the benefit of the named beneficiaries.  The successor trustee assumes the duties which were being performed by the trustee if the first trustee was the grantor.  Such an arrangement permits the assets in the trust to avoid a probate administration and to be delivered into the hands of the intended beneficiaries shortly after the grantor’s death.  Of course, the trust also can establish a federal estate tax savings scheme.
3. Upon its creation, a trust becomes a separate legal entity, but a revocable trust does not become a separate taxpayer for income tax purposes because all income is taxed to the grantor during his or her lifetime.  However, upon the death of the grantor, any income generated thereafter is taxed to the income beneficiary or beneficiaries of the trust, or to the trust itself, depending upon the provisions of the trust agreement.

What is a Revocable Inter Vivos Trust?

A “revocable inter vivos trust” is a trust which has been created during the lifetime of the person or persons who create that trust (the “grantor”), and hence is referred to as an “inter vivos” trust.  The words “inter vivos” are Latin words meaning “during lifetime.”  The adjective “revocable” as applied to this type of trust means that the grantor has retained certain powers to revoke, cancel, amend, or terminate the trust during the grantor’s lifetime.  Nevertheless, unless the trust has been revoked prior to the grantor’s death, the trust still will be a separate legal entity as of the date of the grantor’s death.  The property owned by the trust is not considered under the law as being owned personally by the grantor at the time of the grantor’s death.  Accordingly, it is not subject to the jurisdiction of the Missouri probate courts.  A substitute or successor trustee takes over the management of the trust assets upon the first trustee’s death or resignation, and this successor trustee then becomes is responsible for seeing that these assets are held for or distributed to the proper beneficiaries.  Of course, such a trust may have numerous other purposes as well, but the primary motivation behind establishing a revocable inter vivos trust instead of a will is usually the avoidance of probate.  You should note that this “probate avoidance” only works with respect to those assets owned by and titled in the name of the trust, however.  Just creating such a trust does not avoid probate unless all of your assets are conveyed to and are retitled in the name of your trust.

Does a Revocable Inter Vivos Trust Avoid Federal Estate Taxes as Well?

The answer to this question is “no” in the sense that property held by a revocable inter vivos trust  during a grantor’s lifetime is considered to be totally controlled by the grantor so long as the grantor has the power to revoke or modify the trust.  Thus property in a revocable inter vivos trust will be included, usually to the extent of its full value, in the grantor’s estate upon the death of the grantor for federal estate tax purposes.  This does not mean that a revocable inter vivos trust cannot accomplish estate tax savings purposes as well as (or better than) any other technique (such as a Will, gifts taking effect at death, etc.).
Perhaps the best way to visualize a revocable inter vivos trust and all the other techniques of transferring property at death is to recognize that a trust is merely another vehicle for the transfer of title.  Just as you may walk, drive, take a bus, or fly to a given destination, so you may choose to transfer property owned by you to another individual by any number of different means.  One method available would be by means of a revocable inter vivos trust.

What is a Testamentary Trust?

A “testamentary trust” is one which is established by a Will.  The testamentary trust comes into being after the death of the person who wrote the will that describes such a trust (the “Testator”) The personal representative of that probate estate transfers assets to the trustee named in the Will as trustee of the testamentary trust for the purposes set forth in the Will.  A common use of a testamentary trust would be for a young married couple to prescribe in their Wills that property owned jointly by them would be held by a testamentary trust for the benefit of their minor children if both parents die.

Irrevocable Life Insurance Trust:

If a donor permanently and irrevocably makes a gift, the assets given away are removed from the donor’s estate.  If an insured retains control over an insurance policy which insures his or her life, the amount of the death proceeds paid on the insured’s death will be included in the insured’s estate for federal estate tax computation purposes.  Thus owning an insurance policy in the wrong manner can have the effect of dramatically increasing the deceased insured’s estate tax liability.  One way of avoiding this expensive result is to have an insurance policy owned by an independent trustee pursuant to an irrevocable life insurance trust.  A trust of this type must be “irrevocable” (not subject to change) in order to make certain that the gift is treated as having been completed and not being subject to revocation or change.  Under these types of trusts, the donors (who usually are the insureds as well) contribute cash to the trustee of an irrevocable trust.  The trustee then uses this cash to obtain one or more life insurance policies on the life or lives of the donor or donors.  For example, a husband and wife might choose to establish a joint irrevocable life insurance trust with a “second-to-die” policy.  This type of insurance policy pays only the death of the last spouse to die.  It would only be in the event of the death of the second spouse to die that a substantial estate tax would be due in most circumstances.  This is precisely when the need for liquidity and cash is the greatest.  A “second-to-die” type of policy often can be procured relatively inexpensively.  With an irrevocable life insurance trust, the donor(s) give cash to the trustee who then buys a second-to-die policy on the lives of the husband and wife.  After the death of the second spouse, the insurance proceeds are paid to the trust, but because the gifts were made and completed before the donors’ deaths, the insurance proceeds are not a part of the estates of either spouse for federal estate tax computation purposes.  This type of trust can prescribe that in such event, the trustee of the trust would continue to hold the proceeds and use the proceeds to pay to or for the benefit of the grantor’s children.  Using an irrevocable life insurance trust avoids the result which applies in some cases where people recognize that they might have an estate tax problem and buy life insurance to provide liquidity in cash to pay this tax.  However, if they do not plan the ownership of these additional insurance policies properly, the new policies increase the size of the taxable estate, and more than 50% of the additional insurance proceeds collected has to be paid out the federal government in the form of increased estate tax.  Thus acquiring any life insurance requires a careful look at the effect this insurance will have on the potential federal estate tax payable.

Who should be named as Trustee(s) of a Trust I create?

Banks and trust companies like to be named as trustees of trusts because of the fees which are involved.  However, there is no reason for a bank or trust company to become involved in acting as trustee of a revocable inter-vivos trust while the Grantor (creator of the trust) is alive and competent., or while that person’s spouse survives.  Spouses can be each other’s successor trustee of a  revocable trust created during their respective lifetimes without adverse tax consequences and without incurring any expense.  If you need expertise from a bank or trust company with respect to investments, you can obtain this expertise with respect to “asset management” without paying for the additional costs associated with the bank acting as (and assuming the responsibility of) becoming the trustee of a trust.  A bank or trust company typically does not become a successor trustee until after the Grantor dies or becomes unable to manage the trust for himself/herself.  Sometimes Grantors consider naming one or more trusted friends or relatives as trustee or successor trustees, but their ability to do so and act fairly may be compromised by their inexperience or by personal relationships.  It may be best to name a bank or trust company as successor trustee after both of you have reached the point where the creator(s) of the trust are unable to manage the revocable trust.  On the other hand, if the trust is irrevocable, it may be necessary for a bank or trust company to be involved from the start if certain estate tax savings are one of the intended goals of that trust.  

Estate planning is a complicated area of law and there are a number of mechanisms by which an individual can transfer property at death.  If you are interested in reading more about estate planning, we encourage you to visit other articles in our Estate Planning Q&A Series:

• Introduction to Estate Planning
• What is Probate, What Occurs During a Probate Administration, and How May Probate be Avoided
• Providing Others with the Power to Make Medical and Legal Decisions

Whether you are ready to begin planning your estate, you want to amend an existing estate plan, or you may administer a decedent’s estate, the attorneys at our firm would be honored to assist you.

This article seeks to provide a summary of some common questions about estate planning in Missouri and does not address all aspects, elements, restrictions, or requirements. This article is not offered, nor should it be construed, as legal advice. You should not act or rely upon information contained in these materials without specifically seeking professional legal advice. You should consult an attorney if you have any questions about your legal matter.  Choosing a lawyer is an extremely important decision and should not be based solely upon advertisements.

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