Income Tax Advantages/Disadvantage Con’t

In my previous entry, I indicated that there are, as a general rule, no income tax disadvantages to holding property in a revocable trust. Prior to that, I indicated that a revocable trust does not offer any income tax advantages. Nothwithstanding the above, there is at least one situation that Kansas City estate planning attorneys (as well as other estate planners) should be familiar with in order to avoid causing an inadvertent tax result. This trap for the unwary is titling stock of a closely held corporation in the name of the revocable trust. Under §1244 of the Internal Revenue Code, ordinary loss treatment is available upon a sale or exchange (including a deemed sale when the stock becomes worthless) for shareholders who satisfy the requirements of that Code section. Trusts are not eligible shareholders for purposes of §1244.  Unfortunately, the language of §1244 stock is broad and neither the Code nor the regulations exclude revocable trusts from its ambit.

While policy reasons would suggest that revocable trusts should not be treated the same way as irrevocable trusts under §1244, the plain language of the statute and the regulations will make it difficult to argue that §1244 ordinary loss treatment is available for stock held in a revocable trust.

For titling purposes, the stock can be held in the name of the individual with a transfer on death designation to the trustee of the revocable trust (which will become irrevocable on the death of the grantor). If §1244 loss treatment is not a major consideration (e.g., the taxpayer has a low-basis in the stock which has significantly appreciated) then stock can be titled in the name of the trust as the likelihood of loss upon a sale is quite small. In this later case, the lifetime advantages of placing the stock in the trust will likely outweigh the §1244 considerations.

Income Tax Advantages/Disadvantages to Revocable Trust Revisited

In an earlier entry, I indicated that a revocable trust does not have any income tax advantages.  But does it have any income tax disadvantages?  Generally, the answer to this question is no with a few exceptions.

For example, under prior law the benefits of the one time $125,000 exclusion under former §121 and the two-year “rollover” of gain under former §1034 on the sale of a personal residence that were available to individuals if statutory requirements were met were held to apply to sales during the settlor’s lifetime of a personal residence held under a revocable trust arrangement.  See Priv. Ltr. Rul. 9026036 (March 28, 1990) (holding the §121 exclusion applicable to a sale of a personal residence owned by a revocable trust); Rev. Rul. 66-159, 1996-1CB162 (holding the §1034 “rollover” likewise applicable). Although in 1997, § 1034 was repealed by Congress and §121 was amended to provide for a $500,000 exclusion on the sale of a principal residence ($250,000 for a single person) that can be taken every two years, the benefits of §121 as amended by the 97 Act should remain unaffected by the ownership of a principal residence under a revocable trust agreement.

Other tax areas that remain unaffected by reason of transferring assets to a revocable trust include the following:

(a)    United States Savings Bonds transferred by the Grantor/Settlor to his or her revocable trust should not trigger taxation of the accrued interest.  See Rev. Rul 58-2, 1958-C B 236

(b)   If the grantor has previously sold an asset in exchange for installment obligations, the transfer of these obligations to the grantor’s Revocable trust will not constitute a taxable disposition under § 453B of the Code so that no gain will be triggered upon such transfer.  See Rev Rul. 74-613, 1974-2 C.B. 153.

(c)    Similarly, oil and gas properties may be transferred to the Grantor’s revocable trust without causing loss of percentage depletion.  See Rev Rul. 84-14, 1984-1 C. B. 147

Next time, I will discuss what income tax advantages may be lost, or at least makes it more complicated, when certain assets are transferred to a revocable trust.

Two Additional Advantages of Revocable Living Trusts

1.         Two Additional Advantages of Revocable Living Trusts

Qualified estate planning attorneys are aware of two additional advantages of a revocable living trust, namely: asset review and avoidance of errant dispositions.

(a)        Asset Review—A fully funded revocable living trust has “the ancillary benefit of educating the settlor as to both the nature and value of assets.  It also frequently will uncover any existing title problems during the settlor’s lifetime at a time when they are easier to resolve.”  See Hood, Mylan & O’Sullian, Closely Held Businesses in Estate Planning (2d Ed) at 8-8.

(b)       Avoiding Errant Dispositions— “The titling procedure in transferring property to the revocable trust or naming the revocable trust as beneficiaries helps to insure that the estate plan is not compromised by joint tenancy ownership or errant beneficiary designations. ” Id.  Unfortunately, such a review is often not undertaken when a will is the primary testamentary instrument usually because the client is unwilling to pay for the additional fees that are likely to be incurred as a result of a review.

Advantages of Living Trust Upon Death of Grantor (Con’t)

c. Avoidance of Ancillary Administration—If an individual owns real estate in several different states and dies with these assets held in his or her own name, it will be necessary to open an ancillary administration in the foreign jurisdiction.  This could occur, for example, if an individual owned a home in both Kansas City and in Colorado titled in his name only.  Assuming that Missouri is the domicile of the individual, it will be necessary to open a main probate estate in Missouri and an ancillary administration in Colorado upon his death.

“Although a decedent’s movables typically are subject to devolution and administration under the law of the state of the decedent’s domicile at death, the decedent’s immovable assets (realty) must be administered where located, which may necessitate an ancillary administration.” A. James Casner and Jeffrey N. Pennell, Estate Planning §2.7.2 (6^th Ed, 1995) (citing Restatement (Second) of Conflict of Laws §§260, 236 (1971).

In some states, the domiciliary fiduciary (i.e., the personal representative appointed to administer the estate of the decedent where the decedent was domiciled (permanent residence) at the time of his or her death), may have limited power to act in another state and may be precluded from acting if it is necessary to open an ancillary administration in another state.  See, e.g., MO Rev. Stat. §473.675(2000).

The mere fact of opening an ancillary probate estate in another state will incur additional probate costs but if it is necessary to appoint another personal representative for the ancillary administration, inefficiencies in administration are likely to occur.  “The use of a revocable living trust can avoid ancillary administration of foreign assets as well as inefficiencies of administration provided the domiciliary personal representative of the estate and trustee are the same.”  See Hood, et. al., supra, at 8-7.

In addition, the extra probate fees that would have been incurred with the opening of an ancillary probate estate can be avoided by the use of the revocable living trust.

To achieve this goal of avoiding ancillary administration it is absolutely essential that the real estate in the foreign jurisdiction be titled in the name of the trustee of the revocable living trust during the grantor’s lifetime, or, in the alternative and if permissible under the laws of the foreign jurisdiction, a beneficiary deed must be executed by the grantor transferring the real estate to the revocable living trust upon the grantor’s death.  The beneficiary deed has become a popular non probate transfer device.  If available in the state where the real estate is located, the beneficiary deed may be an attractive alternative to titling the asset in the name of the trustee of the revocable living trust especially if the grantor is married and desires to achieve some limited asset protection by titling the real estate as tenants by the entirety with his spouse but providing, through the use of a beneficiary deed, that the real estate will be transferred to the survivor’s revocable living trust.

d. Privacy—Shortly after Michael Jackson’s death, his alleged will surfaced and was immediately placed on the internet.  Not surprisingly, he named a guardian for his children and then provided that his assets, after payment of debts, etc, are to be distributed to the trustee of his revocable living trust.  In effect this will is what estate planning attorneys refer to as a classic pour over will.

A pour over will only operates on assets titled in the decedent’s name only and if most of the assets are already in the trust, such a will will have little impact. In fact estate planners often find it unnecessary to probate a pour over will because all of the decedent’s assets are already in the trust or, if not, made payable to the trust through non-probate transfer on death designations.

Unlike a will which is a public document, “secrecy of disposition designs can be achieved by using a Revocable…[living] …trust, as the instrument normally is not required to be filed as a matter of public record other than federal estate or state death tax returns…[which have there own” set of privacy rules]…Hood, supra at 8-7.  Thus, unless the tabloid press pays someone (e.g., a beneficiary of the Jackson trust) for a copy of Michael Jackson’s living trust, the public will not be privy as to how he deposed of the assets in the trust.

e.         Avoiding Will Contests—A revocable living trust frequently is much less prone to attacks to its validity than a will.  There are several reasons why this is true.  First, the formalities for execution of a will document are much more stringent than the execution requirements for the establishment of a revocable living trust.  A quick look at the case law in this area verifies this conclusion as the overwhelming majority dealing with execution defects concern wills rather than living trusts.

Second, the revocable living trust, unlike a will, is not a public document.  Thus, if the decedent leaves out some of his or her heirs as beneficiaries under his or her living trust, the disgruntled heirs may not know about the existence of a trust, or if they do, they will not be privy to its terms and may be unwilling to incur legal fees necessary to challenge the trust especially when the attorney they hire has no knowledge as to the terms of the trust itself.

Finally, if the revocable living trust has been established through the use of a third party trustee (as distinguished from a self declaration of trust) such as an institutional trustee, many courts will be reluctant to declare the trust invalid because to do so would call into question the validity of the transactions undertaken by the trustees since the trust was first established.

Advantages for a Living Trust during Grantor’s Lifetime

 Advantages of a Living Trust During the Grantor’s Lifetime.

 (a)                Property Management—Most middle-aged grantors that establish a living trust name themselves as the trustee.  Frequently, the grantor may name his or her spouse as a Co-trustee so that the couple can operate their finances in a similar way as they did before the living trust was created.  As trustee, the Grantor operates with as much control as he or she had prior to the creation of the trust.  Thus, assets may be sold, purchased and investments may be made by the client free of restrictions, especially in light of the ability of the Grantors to change the terms of the trust or to revoke it entirely.  Alternatively, a client, especially an elderly client, may decide that an institutional trustee should be selected, either as sole trustee or co-trustee to manage the funded revocable trust.  If this option is chosen, the main motivation of the client is to shift the responsibility of the management of his or her finances to someone else especially if the client feels burdened by the financial management chore.

(b)               A Substitute for a Conservatorship Upon Incompetency.—One of the most important advantages of a revocable trust during the lifetime of the grantors is its great flexibility when dealing with the incapacity of the grantor(s).  In the event that the Grantor should become incompetent, management of assets by the grantor’s Co-Trustee or designated successor trustee is much preferable to a conservatorship.  Family members are reluctant to have a loved one (e.g., a spouse or a parent) formally adjudicated to be incompetent to handle his or her financial affairs.  Not only are such proceedings expensive, they are emotionally draining on all of the family members, especially if undesired publicity results from the proceedings.  While it is true that a durable power of attorney may be a viable alternative to a conservatorship, third parties, such as banks, are often more skeptical about their validity, especially if the instrument is several years old.  How well I remember a former student of mine informing me that a bank officer refused to honor the durable power given to him by his elderly father who could no longer handle his financial affairs.

 In summary, the use of a revocable trust has significant lifetime advantages for the Grantor and most of the time the attorney fees incurred in establishing it are more than justified considering the fees that would be incurred in establishing a conservatorship as well as the potential loss of asset value that may occur from the ineffective financial management by the client of his or her assets.

Traditional Living Trust

Traditional Living Trust

            There are two basic types of revocable living trusts. 

(a)                Self Declaration Revocable Trust─The first is the so-called self declaration of trust.  With this type of living trust the grantor in the trust document declares that he or she is holding property as trustee for the beneficiaries.  Frequently, the grantor, trustee and main beneficiary is the same person—the client who establishes the trust.  Of course, the trust provides for successor trustees upon the incapacity or death of the Grantor Trustee.  Such a self-settled trust also provides for successive beneficiaries after the death of the Grantor. 

(b)        Third Party Trustee Revocable Living Trust─The second type or revocable living trust is one in which property is transferred to another person or entity (e.g., a corporate trustee) for the benefit of the Grantor, who is the primary beneficiary during his or her lifetime with successive beneficiaries receiving the benefits of the trust upon the death of the Grantor.  Frequently, the Grantor and the Grantor’s spouse serve as the Co-Trustees in this type of third party trustee living trust arrangement.

 

During my years at the University of Iowa law school in the mid 1960s, we referred to this estate planning device merely as a revocable inter-vivos trust.  Subsequently, attorneys, including Kansas City estate planning attorneys, begin to use the term “living trust” to describe it because the trust becomes operative immediately upon its establishment during the lifetime of the Grantor (although it can still be changed or revoked during the Grantor’s lifetime assuming the Grantor has the mental capacity to do so).  In sharp contrast, a will does not become operative until after the death of the testator (the person who executed the will during his or her lifetime).

A Revocable Living Trust-An Overview

The use of a revocable trust in estate planning has two major advantages:  1) it is by far the most effective tool to assist an individual during the latter stages of his or her lifetime with the management of his or her property, especially when the individual is incapacitated; 2) it is a very effective tool, if properly funded, to avoid many of the unpleasant consequences of probate, namely, excessive probate fees and delays in accessing the individual’s assets after his or her death.

 There are several other advantages of a revocable living trust of which a qualified Kansas City estate planning attorney is well aware.  Before exploring these advantages it is necessary to provide some basic information for the uninformed.

 

1. 1.                  Revocable (Living) Trust Defined

A revocable (living) trust is created by a written agreement whereby an individual (referred to as the “Grantor” or “Settlor”) transfers property to a Trustee, either to another individual or a corporate Trustee, who holds and manages such property for the benefit of other persons who are referred to as the beneficiaries of the trust. A second type of revocable living trust is a self declaration of trust whereby the settlor declares himself or herself trustee of property owned by the settlor for the benefit of the settler and others.

 

(a)                Grantor (Settlor)—The grantor (also known as the “Settlor”) of the living trust is the person that establishes the terms of the trust agreement and who transfers property to the trust.  Clients are well aware that a will can be changed but often are worried that a trust can not be changed once established.  With a revocable living trust, however, the Grantor retains the power to alter or amend or revoke the trust.  Kansas City estate planning lawyers know that the ability to change or get rid of the document is why many clients view the living trust as an effective estate planning tool especially since it offers, as explained below, many features that a will does not.

(b)               The Trustee —When property is transferred to a trust, the person(s) or entity (e.g., a corporate trustee) becomes the legal title holder of the property.  Depending on the terms of the trust document, the Trustee may or may not have any beneficial interest in the property.  Key to the living trust, however, is the duties of the Trustee(s) who is under a fiduciary duty to manage the trust assets in accordance with the terms of the trust agreement and in the best interests of the beneficiaries.

(c)                The Beneficiaries—The beneficiaries of the Trust are those person(s) or entities (usually a charity) that are entitled to receive the benefits of the Trust in the form of income and/or principal distributions.

 

How is the Living Trust Established?

How is the Living Trust Established?

Despite the do-it-yourself books and on-line documents available on the internet, it is a very bad idea for a lay person or for that matter an inexperienced attorney to set up a living trust without hiring a qualified estate planning attorney to draft the trust agreement and to supervise the (i) execution of the document and related estate planning documents and (ii) the funding of the trust.  This latter task (funding the trust) is fundamental for a living trust to be an effective estate planning tool.  Too often an expensive estate plan is set up for a client but it is not properly funded.  In fact, some estimates indicate that more than 50 percent of living trusts are unfunded.  During the lifetime of the Grantor, only those assets placed in the trust will be controlled by the trust.  For example, absent other competing consideration (e.g., asset protection concerns or special issues concerning qualified retirement plans) titling real estate, bank accounts, CDs, mutual funds and other securities in the name of the trust is important to achieve the two principal goals of a living trust, namely (1) planning for your incapacity during your lifetime and (2) avoiding probate upon your death.  If it is not advisable to place certain assets in trust when it is established, then other techniques are available to assure that assets are placed in the trust at the death of the Grantor without utilizing probate (e.g., transfer on death designations).

Will Substitutes-Revocable Living Trust -The Best

I am taking a relative easy topic for me from my first entry into this blog:  the use of a Revocable Trust (or living trust) in estate planning as the best will substitute.

Before examining the use of a revocable living trust, it is important to dispel a few myths about this device.  Contrary to some perceptions, a revocable living trust does not have any income tax advantages during the grantor’s lifetime.  So long as the grantor still possesses the power to revoke, the income will be taxed to the grantor under the grantor trust rules in the same way it would have been had the trust not been established.  In addition, because the grantor retains dominion and control over the property transferred to the living trust, an incomplete gift has occurred upon its establishment and no gift tax consequences result upon its creation.  Furthermore, upon the grantor’s death, the property in the trust will be includable in his or her gross estate for estate tax purposes assuming the grantor dies in possession of the power of revocation or releases the power within three years of his or her death.

Notwithstanding that a revocable living trust does not provide any tax advantages to the grantor, there are a number of nontax advantages of a revocable living trust when compared to other techniques that may be used in the implementation of an estate plan for a client (e.g., using a will as the main estate planning vehicle).