The revocable living trust has been a significant estate-planning tool for many years, and remains the foundation upon which most estate plans are based. For that reason, it is important for people to understand how a revocable living trust works, the advantages of the arrangement and, most importantly, whether the advantages are applicable to their particular circumstances.
A trust is an agreement between individuals who establish the trust, called the trustors, settlors or grantors, and the individual(s) or company who will manage the trust’s assets, called the trustee. The individuals or organizations who receive the benefit from the assets in the trust are called the beneficiaries. A trust is called a living trust if it is a trust established between a trustor and a trustee while the trustor is still alive, as opposed to a testamentary trust which is established pursuant to a person’s Last Will and Testament and becomes effective upon the person’s death.
A living trust can either be revocable or irrevocable. If it is a revocable trust, the trustor can change the terms of the trust and/or revoke the trust completely at any time during his/her lifetime and competency. However, if the trust agreement provides that the trust is irrevocable, the trustor is not legally entitled to amend or revoke the trust. While irrevocable trusts are utilized in estate planing to some extent, the vast majority of trusts are revocable living trusts.
While a revocable living trust has a number of advantages, the three primary reasons for establishing trusts of this type are: (1) saving estate taxes; (2) establishing a manner of distributing assets to beneficiaries, and (3) avoiding the probate of the trustor’s estate.
ESTATE TAX SAVINGS
The Internal Revenue Code provides an “unlimited marital deduction” for the taxable estate of a decedent which allows an unlimited amount of assets to be transferred to the decedent’s spouse without any federal estate taxes. Therefore, in the case of a married couple, if the entire estate of the first spouse to die passes outright to the surviving spouse, no federal estate taxes would be due by the deceased spouse’s estate. However, upon the death of the surviving spouse, all of the couple’s assets would then be included in the surviving spouse’s estate.
Every individual is entitled to have a certain amount of assets in his or her estate without incurring any federal estate tax. This amount is called the “exclusion amount”. Historically, one of the primary functions of a revocable living trust is to permit the estate of the first spouse to die to utilize his or her exclusion so that, upon both spouses’ deaths, assets of both spouses, up to the exclusion amounts of both spouses, may pass estate tax-free to the couple’s beneficiaries. This was accomplished by placing a portion or all of assets of the first spouse to die in a trust that would be held for the benefit of the surviving spouse, without causing those assets to be included in the taxable estate of the surviving spouse.
Over the last several years, the exclusion amount was increased from $1,000,000 to $3,500,000; and by using a revocable living trust for this purpose, married couples were able to utilize both of their exclusion amounts and protect joint assets. initially of $2,000,000 and eventually up to $7,000,000, from federal estate taxes.
On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Tax Relief Act”) which increased the exclusion amount to $5,000,000 for 2011 and 2012. Unfortunately, if Congress does extend these provisions, the exclusion amount will return to $1,000,000.
In addition to increasing the exclusion amount, the 2010 Tax Relief Act introduced a concept of the “portability” of a married decedent’s unused exclusion amount. Under this provision, if a decedent is married and his/her estate does not fully use his or her exclusion amount, the unused portion is available for use by the surviving spouse. Therefore, if portability is available to a married couple, it would not be necessary to establish a revocable living trust for the sole purpose of utilizing both spouse’s exclusion amounts.
Unfortunately, there are many aspects of portability that individuals of significant wealth should consider before making a decision not to establish a revocable living trust for the purpose of protecting each spouse’s exclusion amount. First, as currently enacted, the portability concept is only applicable to married couples who both die in 2011 or 2012. Second, a remarriage by a surviving spouse may impact the availability of the unused exclusion amount. Third, the revocable living trust provides the additional benefits of (i) protecting the appreciation on the decedent’s assets from estate taxes on the surviving spouse’s death, (ii) protecting the decedent’s assets from creditors of the surviving spouse, and (iii) ensuring that the assets of the decedent pass in the manner that the decedent intended.
Therefore, it is our belief at this stage that married individuals with joint estates in excess of the exclusion amount should still establish a revocable trust for the purpose of protecting the exclusion amount of the first spouse to die.
There are two primary types of revocable living trusts which generally accomplish this result, namely: an “A/B” Trust and a “QTIP” Trust. The primary differences in these trusts are discussed below.
THE REVOCABLE “A/B” TRUST
Upon the first spouse’s death, the assets in the trust divide (as the attached “A/B” trust diagram indicates) into two separate trusts, namely: the “Survivor’s Trust” and the “Bypass Trust”. The Bypass Trust will generally hold the deceased spouse’s assets which equal the available exclusion amount; and the Survivor’s Trust will hold the balance of the deceased spouse’s assets, if any (together with all of the surviving spouse’s interest in the trust’s assets).
The estate receives a marital deduction for the deceased spouse’s assets which are allocated the Survivor’s Trust. The assets allocated to the Bypass Trust are included in the deceased spouse’s taxable estate; however, since the amount of assets allocated to the Bypass Trust does not exceed the federal estate tax exclusion amount, the deceased spouse’s estate does not have any federal estate tax liability.
The surviving spouse has the right to receive all of the income from the Survivor’s Trust during his or her lifetime; and he or she may withdraw such amounts of the principal of the Survivor’s Trust at any time as he or she wishes.
The Bypass Trust generally provides that the surviving spouse will receive so much of the net income and principal thereof as the Trustee deems necessary or advisable for his/her proper health, maintenance and support.
Because the Bypass Trust becomes irrevocable upon the first spouse’s death and the surviving spouse’s rights to the assets in the Bypass Trust are limited to the rights granted to the surviving spouse by the trust agreement, the assets of the Bypass Trust (regardless of their value in the future) are not included in the taxable estate of the surviving spouse upon the surviving spouse’s death; but rather these assets are held, along with any assets remaining in the Survivor’s Trust, for the benefit of the couple’s children (and/or other beneficiaries).
THE REVOCABLE “QTIP” TRUST
A “QTIP” (Qualified Terminable Interest Property) Trust is generally recommended when the wealth of one of the spouses exceeds or is likely to exceed the exclusion amount.
Upon the first spouse’s death, the assets in the trust divide (as the attached “QTIP” Trust diagram indicates) into three separate trusts, namely: the “Survivor’s Trust”, the “Bypass Trust” and the “QTIP Trust”.
The Bypass Trust will generally hold the deceased spouse’s assets which equal the available exclusion amount; the QTIP Trust will hold the balance of the deceased spouse’s assets, if any; and the Survivor’s Trust will hold the surviving spouse’s interest in the trust’s assets.
The assets allocated to the Survivor’s Trust are the surviving spouse’s assets and, therefore, are not included in the deceased spouse’s estate. The assets allocated to both the Bypass Trust and the QTIP Trust are included in the deceased spouse’s taxable estate; however, since (i) the amount of assets allocated to the Bypass Trust does not exceed the federal estate tax exclusion amount, and (ii) the assets allocated to the QTIP Trust qualify for the marital deduction and will not be subject to estate tax until the surviving spouse’s death, the deceased spouse’s estate does not have any federal estate tax liability.
The provisions of the Survivor’s Trust and the Bypass Trust established for the benefit of the surviving spouse in a QTIP Trust are the same as those discussed previously for an A/B Trust.
The assets of the QTIP Trust are held for the benefit of the surviving spouse for so long as he or she lives. Generally the QTIP Trust provides that the surviving spouse will receive all of the net income from the QTIP Trust, plus so much of the principal thereof as the Trustee deems necessary or advisable for his or her proper health, maintenance and support.
Upon the surviving spouse’s death, the assets which remain in the QTIP Trust are included in the surviving spouse’s taxable estate, although any estate tax which is attributable to these assets will be paid from the QTIP Trust’s assets.
The net assets which remain in the QTIP Trust after the payment of estate taxes in the surviving spouse’s estate are combined with the assets then remaining in the Bypass Trust (as well as the assets remaining in the Survivor’s Trust, if the surviving spouse has not otherwise changed the dispositive provisions relating to those assets), and held for the benefit of the couple’s children (and/or other beneficiaries).
MANNER OF DISTRIBUTION
Without some type of trust provisions, each adult heir will receive his or her entire inheritance outright, and each younger heir will receive his or her entire inheritance upon reaching the age of majority. Many people believe that the receipt of a substantial inheritance will have a significant adverse impact on younger beneficiaries if these younger beneficiaries receive the inheritance outright; and therefore, most couples desire to delay the distribution of the principal of their estates until their children reach certain “older” ages. The provisions of a revocable living trust permit a trustor to specify when, to what extent, and under what conditions, the trust’s assets are distributed to or used for the benefit of their children and other beneficiaries. A delayed distribution scheme avoids the potential wasting of family assets by immature beneficiaries, while still providing for the beneficiaries’ health, education, maintenance and support. Further, even for an older child, it is advisable to leave the child’s share in a trust and thereby protect the assets from the child’s creditors. In those instances, the child may be given the ability to act as the trustee of his or her trust and control the distribution of his or her share of the trust assets.
AVOIDANCE OF PROBATE
With just a Will, the assets of a decedent’s estate will have to detour through probate court before those assets are distributed to the decedent’s beneficiaries. In very general terms, a probate is designed to ensure that a decedent’s debts are paid, and that the decedent’s assets pass to his or her beneficiaries in accordance with the decedent’s Will (or if the decedent did not leave a Will, then in accordance with Arizona’s intestate succession laws). Although probate in Arizona can, in most cases, be finalized quicker and with less formalities and therefore, with less expense, than in many other states, it generally requires the services of an attorney and takes a number of months to complete. However, if a person is diligent in transferring the title to all of his or her assets to a revocable living trust prior to death, there would not be any assets titled in that person’s name at his or her death and, as a result, there would not be any assets of the decedent required to go through the probate proceeding.
Please note that in order to avoid a probate proceeding, the trustor must transfer the title to all of his or her assets to the living revocable trust during the trustor’s lifetime, and ensure that all life insurance proceeds and retirement plan assets which pass according to beneficiary designations upon his or her death are not payable to his or her “estate”. This transfer process generally requires the actual recording of new deeds for real estate, changing the name on bank and stock brokerage accounts, partnership interests, etc., and reviewing and possibly changing beneficiary designations on insurance and retirement assets. Following the transfer of assets, the trustee (which is normally the same individual as the trustor) transacts business involving the trust’s assets in the name of the revocable living trust. However, the revocable living trust does not have to obtain a separate federal identification number (unless the trustee is not the same person as the trustor), nor does it need to file separate income tax returns, since all of the income of the trust is simply reported by the trustor under the trustor’s social security number.
While probate proceedings can be avoided in this manner, it is important for individuals with substantial estates to understand that even if a trust is fully funded with all of the decedent’s assets, there will still be professional fees incurred for the preparation of the estate tax returns, the administration of the trust, and the allocation of the trust’s assets to the subtrusts which are established following the trustor’s death.
In addition to the primary benefits of a revocable living trust discussed above, there are other features of this type of trust which may be beneficial to trustors. For instance, in the event a trustor becomes physically or mentally incapacitated, the revocable living trust may eliminate the need for a conservatorship proceeding, and thereby permit the uninterrupted management of the trustor’s assets by the named successor trustee(s) without any court interference. Further, when a Will is probated, the contents and distribution scheme of the Will, as well as a list of the decedent’s assets, may become a matter of public record. In contrast, the provisions of a revocable living trust and a disclosure of its assets are not filed with the probate court (regardless of whether or not there is a probate). And finally, since the revocable living trust is simply an agreement between the trustors and the trustees, which are often the same individuals, it is very easy to make modifications or changes, or revoke the agreement entirely, without the formalities required by statutes for other testamentary documents.
CONTACT US FOR ADDITIONAL INFORMATION
The foregoing discussion gives you a brief overview of what a revocable living trust is, the advantages it offers, and how it works. This trust can be tailored to meet various special needs within the family, and it allows trustors the ability to specifically direct how, when and under what circumstances their property will be distributed. It is a valuable estate planning tool for both married couples with taxable estates, and for others who wish to take advantage of the specific benefits such a trust has to offer.
Santerre & Vande Krol, Ltd. devotes a substantial part of its legal practice to estate planning, and if you have questions concerning the revocable living trust or its application to your specific situation, please contact us to discuss your questions.
To contact Santerre & Vande Krol, Ltd. by phone, please call (480) 991-3990.
The offices of Santerre & Vande Krol, Ltd. are located at:
7920 E. Thompson Peak Parkway Suite 150
Scottsdale, Arizona 85255
*The content of these articles shall not be interpreted or construed as legal advice. These articles are not routinely updated, so if you have any questions or concerns relevant to any topic referenced herein, please contact an attorney.