To protect loved ones’ inheritances from predators, creditors, divorcing spouses and even from estate taxes in their children’s estates, I commonly advise my clients to embed continuing testamentary beneficiary trusts into their estate plan. Testamentary means after death – the trusts are written into the client’s revocable trust, but they aren’t active until the client’s death. This is different than an outright distribution that is free and clear of the client’s trust.
A typical beneficiary’s trust might name the client’s child to act as her own trustee. That child is free to invest her inheritance in whatever she wants. She can sprinkle the income or principal earned by the assets to herself or to her own children or even grandchildren yearly. She may also decide who she wants to inherit the trust assets after her death. Sounds a lot like an outright distribution, but it’s not. It has a protective shield around it.
Even though attorneys can draft a beneficiary’s trust to provide significant control, I still hear many objections to the idea:
“I don’t want to rule from the grave!”
“I want my children to do with their inheritance as they please.”
“I just want to keep things simple.”
“I heard that income taxes will be higher if their inheritance is held in an ongoing trust.”
I Don’t Want to Rule from The Grave
This objection is valid if you direct your estate planning attorney to draft a restrictive trust. In some cases, restricting access to the trust assets is appropriate. When you have a beneficiary, who will blow their inheritance in short order, have drug, alcohol, gambling, or other addictive problems, or receive government aid such as Medicaid, then you probably desire more restrictive provisions governing the inheritance. In all three examples you’ll name a third-party trustee (advisor, family member, bank or trust company) and specifically direct the trustee how to hold and distribute the funds.
For beneficiaries receiving Medicaid or other need-based assistance, the terms of the inheritance should be mindful of the severe income and asset limitations that beneficiary has before they risk losing benefits.
I Want My Children to Do with Their Inheritance as They Please
This objection can be overcome with a beneficiary’s trust. There is nothing to restrict you from naming the beneficiary as her own trustee for their inherited share of your estate. To protect the inheritance the trust must contain certain provisions, but that doesn’t necessarily thwart your beneficiaries from having freedom of choice.
A few years ago, a deceased client’s son who was a practicing physician called me to complain about his inherited beneficiary’s trust.
“I have a beef with how you drafted this trust,” he began. “My attorney told me that I can’t withdraw the money to buy a vacation condominium in Vail because the withdrawal wouldn’t qualify as necessary for my health, education, maintenance and support.”
“That’s true,” I pointed out. “But you can still purchase the condominium using trust income and assets.”
“How?” He asked, calming down a bit.
“Have the trust own the condominium.” I answered. “That way it’s exempt from estate taxes when you die, it’s also outside the reach of a divorcing spouse and safe if you get sued for malpractice or for a business deal gone bad.”
He thought for a moment, “I understand what you’re saying, but my wife expects to be on this deed. If I tell her that it’s protected from divorce, that won’t go over well. We’ve enjoyed a solid 20-year marriage.”
“Well, you can borrow the money from your trust, and record a mortgage. That protects the equity up to the borrowed amount. Since you’re a practicing physician it makes sense not so much from a divorce standpoint, as you point out, but from an asset protection standpoint.”
He was enlightened for the advice and thanked me.
I Want to Keep Things Simple
Turning to this objection, it’s true that a beneficiary’s trust appears more complicated than a simple outright distribution. Also, a beneficiary’s trust, once established, will file a Form 1041 federal income tax return and require an annual accounting, although the latter requirement can be avoided under Florida law through a designated representative.
Those are minor inconveniences compared with fighting a divorcing spouse or a judgment creditor who attempt to satisfy their claims by attacking the inheritance or keeping the IRS away from a child’s estate. Significant estate tax savings are possible when your beneficiaries already have significant assets of their own before they inherit from you.
I Heard That Income Taxes Will Be Higher if Their Inheritance Is Held in an Ongoing Trust
Finally, let’s review an income tax issue. Receipt of taxable rental income, dividends or interest requires someone to pay the income tax. That someone is usually the beneficiary who receives the income. Yet if the income is not distributed, but is instead accumulated inside a beneficiary’s trust, then the trust is the taxpayer.
When would a trust accumulate income rather than distributing it? Common examples are for beneficiaries on government aid, minor beneficiaries who shouldn’t have too much income, or those beneficiaries shielding the income from a divorcing spouse or creditors.
Federal income tax law imposes compressed brackets on trusts as taxpayers. In other words, a married couple won’t pay taxes at the highest marginal rate until they have approximately $622,000 of income. Trusts pay the highest marginal rate when they have only $13,000 of income.
The tax law penalizes trusts that accumulate taxable income. There are several work arounds. The first is to simply distribute the income if it won’t otherwise lead to adverse consequences. Another is for the trustee to invest in growth assets, which pay a lower capital gains rate. A third strategy is to distribute to other trust permissible beneficiaries, for example your grandchildren rather than your child. Yet a fourth is to include provisions in the body of the trust that treats the income as distributed even if it is not.
The power to protect the inheritance you leave your loved ones dies with you. Your revocable trust won’t protect you from your creditors, predators or divorcing spouses. Your children, likewise, can’t easily create their own protective trust.
The trust you create for them can. If you have questions about if these strategies are right for you and your loved ones, then have a family conference with your estate planning attorney. Let your children hear the advantages and disadvantages and decide together.
© 2021 Craig R. Hersch. Learn more at floridaestateplanning.com