Living Trusts: The Pros and Cons

By Ralph M. Engel, Esq., Sonnenschein, Nath & Rosenthal

The pros and cons of revocable living trusts depend upon the facts and circumstances of each case. People of moderate to substantial wealth in New York, New Jersey, and Connecticut often gain little, and could lose substantially, by using living trusts.

What is a living trust? A testamentary trust created by a will does not come into effect until an individual dies. A living trust usually starts to function during the life of its creator and can form part of an overall estate plan. A revocable living trust may be revoked by its creator (the grantor, settler, or trustor) at will, so long as he or she is legally competent to do so.

The document that creates the trust (a trust agreement, a deed of trust, or a trust indenture) names the trustee (often the grantor, so long as the grantor is able to act, or a bank, trust company, or trusted adviser) and sets forth the terms of the trust’s administration.

Taxation

All of the assets of a living trust are potentially subject to death taxes upon the grantor’s death. They are usually entitled to whatever deductions, exemptions, and credits [such as the marital and charitable deductions, the applicable credit amount (unified credit or exemption), or state death tax credit or deduction] that would be available had they been owned by the grantor personally.

So long as the grantor is living, the living trust is a grantor trust for income tax purposes, so that all of its income, including capital gains, is taxed to the grantor as though the trust did not exist. If a living trust is revocable, its funding does not incur gift taxes. If, however, the document provides that the grantor loses the right to revoke it upon a specified lifetime event, such as the grantor’s incapacity, a gift tax may be incurred at that time.

Living trusts may have adverse tax consequences. For example, if the terms of the living trust require the division of the trust’s assets into two or more portions when the grantor dies, such a division may be considered a distribution, possibly incurring capital gains taxes and eliminating the six-month alternate valuation date for death tax purposes. Under the 2001 Tax Act, which implements a carryover basis for inherited assets in 2010, if the living trust is not fully revocable by the grantor at death, its assets may not qualify for any basis step-up.

Because an estate can pour into a trust, using a fiscal year for the estate and a calendar year for the trust can result in deferral of the payment of income taxes on estate income. This benefit is available to a combination of an estate and a trust, regardless of whether the trust is a testamentary trust or a living trust, but it is not available to a living trust alone.

Protection from Creditors

Since a living trust is revocable by the grantor, the grantor’s creditors can reach its assets during the grantor’s lifetime, and the trusts’s assets are subject to the claims of the grantor’s creditors upon the grantor’s death. Some states permit creditors to go after the assets of a deceased’s living trust at any time, but limit when a creditor may file a claim against those same assets, if held in the person’s own name and passing via a will, to not more than a specified number of months (not years) after the publication of an appropriate notice to creditors. For individuals with substantial creditors, it may be detrimental to rely upon a living trust rather than a will.
Under Medicaid rules, the assets held in a grantor’s living trust are not protected, and usually must be used for medical and living expenses to the same extent as if owned outright.

Transfers to qualify for Medicaid must typically be made at least 36 months in advance of a request for Medicaid benefits. Some experts, however, believe that such a transfer, if from a trust, must be made at least 60 months in advance, or two years earlier than with no trust. Individuals should consider whether a living trust will be effective in protecting their assets.

In New York State, one spouse can create by will a supplemental or special needs trust for an incapacitated spouse. This trust can both protect the deceased spouse’s assets from the nursing home costs of the surviving spouse and allow the surviving spouse access to Medicaid benefits. The same result cannot be achieved using a living trust.

Probate Considerations

If all assets are held in a living trust or are payable to or are held jointly with one or more surviving individuals, there may be no need to go through probate. If, on the other hand, there are assets of any substantial value (in New York, substantial means in excess of $20,000) held in the deceased’s own name, or without a designated beneficiary or joint owner who in fact survives, those assets typically will have to go through probate, despite the living trust. In fact, many living trusts are never fully funded, and the creators continue to hold some assets in their own names.

Probate is a court proceeding in which an appropriate judge (or surrogate) declares a will to be valid and appoints the individual or individuals (or bank or trust company) responsible for handling the administration of the deceased’s estate as executors or personal representatives. The probate process typically takes a few weeks and sometimes just a few days. Problems with probate typically arise when distributees (heirs) are under a legal disability (e.g., minors or the mentally disabled) or cannot be found, when the will is contested or cannot be found, or when necessary witnesses cannot be located or are uncooperative.

In some states, such as Florida and Connecticut, probate requires the preparation of documents to conclude the administration of the estate, which must be signed by the estate’s beneficiaries and filed in the probate court. In other states, such as New York, no such filing at the conclusion of the administration of an estate is typically required, if all of the estate’s beneficiaries and the executors consent.

Some states that have adopted the Uniform Probate Code, such as Illinois and Missouri, offer independent administration, an informal probate process with little judicial supervision. In such states, unless unusual problems are encountered, probate incurs fewer problems and a living trust may even offer fewer savings.
Legally mandated probate fees vary by jurisdiction. In some states, such as Connecticut, they can be considerable. The fees can be even higher in California. In New York the maximum court fee for a probate filing is $1,000. The savings from avoiding probate in California or Connecticut may thus be greater than the savings in New York.

Collecting assets, paying bills, filing tax returns, paying taxes, and distributing assets occur whether a will or a living trust distributes the estate. If an estate would be required to file federal or state death tax returns, those returns must be filed even if the assets are held in a living trust. Estates have to file fiduciary income tax returns, but, after the grantor’s death, so do living trusts. The executor of an estate is responsible for collecting the estate’s assets, paying the bills and taxes, and distributing the assets of the estate. Such duties fall upon the trustee of the living trust if there is no executor to do them.

Creating and fully funding a living trust during the grantor’s lifetime avoids transferring assets from the deceased into the estate. From an administrative standpoint, in many cases little other work is avoided by the use of a living trust.

There are exceptions to the above rule. For example, people that own real estate or tangible personal property (furnishings, jewelry, automobiles) in a state other than their state of residence could be subject to probate in each of those states (ancillary probate). Transferring out-of-state assets into a living trust may save the cost of ancillary probate.

Individuals that need rapid administration of their assets upon death, such as because they are invested in speculative securities or closely held businesses, can benefit from a living trust, but only if such assets are transferred to the trust in time.

Individuals that live abroad in jurisdictions that have no probate process or where probate is not handled by a court may gain from avoiding the probate process. Such non–common law jurisdictions include much of Europe, South and Central America, and Quebec. If such individuals also have assets subject to administration in the United States, it may be highly beneficial to place their U.S. assets in a living trust.

Heirs. Incapacitated distributees (heirs), if legally necessary parties to the probate proceeding (the rules vary, but are strict in New York), must be appropriately represented. The judge or surrogate may appoint a guardian ad litem, an attorney who represents the interests of missing or legally incapacitated individuals (every minor is considered legally incapacitated, although a court-appointed guardian may obviate the appointment of a guardian ad litem). In such instances, probate can take months. The benefits of a living trust for minor children may not always justify its expense.

Probate problems are most often encountered when distributees cannot be found. Delays can be lengthy, and it may even be necessary to employ a genealogist to find the closest relatives (or to prove that no descendants still survive). A fully funded living trust can avoid the resulting delays and expense.

It is not possible to effectively designate the guardian of the person or property of a child through a living trust. Using a will to designate a guardian usually results in the same probate delays and many of the same expenses one tries to avoid through living trusts.

Costs and Fees

In New York, legal fees are usually based on the value of the gross estate, in whatever name assets are held. Accordingly, fees are typically charged on assets in the deceased’s name, assets held jointly, assets payable to designated beneficiaries, and assets held in living trusts.

In some instances, the estate (or trust) attorney will charge for time expended. Administering only a will or a fully funded living trust will normally result in a smaller legal fee than administering both a living trust and a will.

Accounting work may be the same with a will or a living trust. Final personal income tax returns will be required (unless the client has minimal taxable income) in both cases. If both a will and a living trust are involved, the accountant’s work on fiduciary income taxes could double.

The commissions of an executor or personal representative are generally charged only against the assets that go through probate. Holding assets in a living trust often avoids such commissions. On the other hand, executors or personal representatives are often family members. Because estate tax rates remain higher than income tax rates, estate tax–deductible commissions to family members can preserve assets for them.

If death tax returns are required, it typically takes two to three years to complete the administration of either an estate or a living trust. If the trustee of a living trust is not a family member, the trustee will generally be entitled to annual commissions during the administration of the trust. In addition, trustees in New York are entitled to a commission when the trust assets are distributed. Whereas the commissions to trustees of living trusts are paid annually and when the assets are distributed, the commissions paid to executors or personal representatives are paid only once. Commissions on large estates in New York are typically about 3%, whereas commissions on living trusts range from 0.5%–1.5% per year, plus 1% at distribution. If the administration of a living trust continues for two or three years, the commissions may be at least as much as for an estate of the same size.

Contests

If there is no will there can be no will contest, but it is perfectly possible to contest a living trust.

Some states, such as Florida, require witnesses for most living trusts. Other states have no formal witness requirements or only require notarization.

Because a living trust is a contract, the legal standards for entering a contract typically apply. A will, on the other hand, requires only testamentary capacity; this may require little more than the ability to know the natural objects of one’s bounty, to determine who is to receive what under the will, and to have a reasonably accurate picture of one’s assets.

Both documents can be attacked on the basis of fraud, duress, lack of mental capacity, forgery, and certain other grounds.

Because living trusts are still far rarer than wills in New York, New Jersey, and Connecticut, there is little established law on living trust contests. Those that desire to avoid contests should carefully examine applicable law to make sure that using a living trust will improve the chance of success.

In Florida, it is possible to limit the period during which a will can be challenged to three months from the publication of the notice of administration; any interested party, however, may challenge the validity of a living trust at any time during the term of the trust (unless the challenger has been party to an accounting proceeding).

Incapacity. Unless an appropriate procedure is spelled out in the trust instrument itself, a guardianship or incompetency proceeding in the applicable court may be necessary to replace the grantor serving as trustee of his own living trust with the successor trustee. A standard of incapacity in the trust document (such as the inability to manage financial affairs, confirmed by two doctors) may not be sufficient to satisfy financial institutions. Thus, a court proceeding may be required.

On the other hand, a durable general power of attorney addresses the incapacity issue directly, regardless of whether there is a living trust. One popular alternative is to create an unfunded living trust (whose grantor is not the trustee) and to use a durable general power of attorney to transfer the grantor’s assets to it in the case of incapacity.

Limitations and Clarifications

Generally, not all assets can be placed in a living trust. Certain assets pass by law to the estate and cannot be directed to a living trust. For example, savings bonds, insurance policies, retirement plans, and other assets payable upon death to a beneficiary generally pass to the estate of the owner if the named beneficiary has already died and no alternate beneficiary has been named. Rarely do such assets pass to a living trust. Joint accounts and other jointly held assets pass through the estate if the other owner is already deceased. A home, securities, and bank accounts, however, can be placed in a living trust.

The belief that going through probate means that assets will be tied up and kept from beneficiaries for years is almost always incorrect (unless there is litigation, which may also occur if a living trust is used).

In some states, the only way to privately dispose of assets is through a living trust. Most jurisdictions provide that wills are part of the public record. In some states (such as New York), however, it is possible to have the probate records sealed by the court.

Living trusts can interfere with spousal rights. For example, under Illinois and Connecticut law, it may be possible to deny a surviving spouse any share of assets placed in a living trust before the first spouse’s death. There are a few states with similar rules; some are available to nonresidents. Those interested in disinheriting a spouse should research which states currently grant this power to living trusts (New York does not). Florida, however, recently changed its law to protect surviving spouses. A professional should be mindful of conflict-of-interest rules in such a situation.

An estate plan can be included in a living trust instead of a will. A simple “pour-over” will can add to the trust whatever assets remain in the decedent’s name. An appropriately drafted living trust can include a credit shelter (bypass, unified credit) trust, a multigenerational or generation-skipping trust, a marital deduction (QTIP or QDOT) trust, various trusts for minors, supplemental or special needs trusts, or charitable remainder trusts. Identical results, however, may be achieved by using a will.

Life insurance can be held in a living trust, but without any of the tax benefits of being held in an irrevocable trust. Living trusts are sometimes created to manage the proceeds of insurance policies rather than to minimize estate taxes.

Some individuals fear that the state will not allow the appointment of the desired personal representative or executor (e.g., their accountant). Florida typically allows only close family members, residents of the state, and certain banks and trust companies to serve as executors and personal representatives. Most states, however, have no such restrictions. Almost all states, including Florida, have no restrictions when it comes to trustees of living trusts. Residents of Florida that want non-Florida persons to serve as the fiduciaries of their estate should use fully funded living trusts.

Other Uses for Living Trusts

Some individuals prefer to separate certain assets from others through living trusts. For example, inherited assets such as family heirlooms may pass more readily down the family if placed in a living trust (subject to spousal rights) and separated from other assets.

Living trusts can also provide for the management of assets for those that do not want to manage their own assets and prefer a living trust over one or more discretionary investment advisory accounts. Some people use living trusts to try out the bank or trust company that they expect to handle their estates and testamentary trusts.

In community property states, such as California, living trusts can be extremely important, particularly to segregate the various classifications of property that exist in those states (community property, quasi-community property, and separate property).

A person’s needs and desires, his assets and their location, his demands for privacy, the ability to locate his distributees, and—of prime importance—his state of residence all contribute to whether a living trust, a will, or both are the best estate strategy. Living trusts are clearly more beneficial for residents in some states than in others. For most residents of New York, New Jersey, and Connecticut (other than Connecticut individuals that wish to disinherit their spouses), however, living trusts are typically of little benefit.

©2002 CPA Journal. Legal Notices