Many estate planners believe that their job is done when the beneficiaries avoid probate and receive their inheritance. However, when beneficiaries receive their inheritance in their name outright, that needlessly exposes the legacy you leave to the claims of creditors, lawsuits, divorce, the loss of governmental benefits they might otherwise receive and even a second estate tax when they die. "Outright" distributions from the trust to the beneficiary in his or her name should rarely occur for large or even relatively modest estates.
A better approach is for each beneficiary's inheritance to go into his or her own Beneficiary Controlled Trust. If properly drafted and funded, the beneficiary can control, use and enjoy the inheritance with fewer risks than outright ownership. A Beneficiary Controlled Trust will help protect your loved ones from the bad things in life that may occur without any fault of your loved ones. For example, divorce, lawsuits, creditor claims, bankruptcy or even estate tax upon their death. Sadly, bad things happen to good people. On the other hand, a spendthrift trust is traditionally intended to be used for beneficiaries who are not trusted to make good financial decisions. A spendthrift trust is similar to a spigot on a hose. The trustee in his or her discretion can open the spigot to permit spending or close the spigot to restrict or prevent spending by the beneficiary.
Asset Protection with Plenty of Control
A Beneficiary Controlled Trust refers to a trust where the beneficiary may also be the controlling trustee. The beneficiary can be provided virtually the same control as he or she would have with outright ownership. For example, the beneficiary, as the controlling trustee, could make all investment decisions. Investments such as a home or brokerage account would be held in the name of the trust and would be better protected from lawsuits, divorce, creditors or predators.
After they inherit, the primary beneficiary could alter the level of control or protection if greater risks arose. They could appoint a co-trustee to control distributions or even investments. If the risk is very high, the primary beneficiary could even resign as trustee and appoint their best friend, trusted family member or professional to act as Trustee. We represented a beneficiary who was going through a contested divorce at the time she was inheriting funds from her mother. She designated her son to be the Trustee to further separate her inheritance from the divorce proceedings. We had a similar situation where a client was being sued regarding a car accident that resulted in a death. In that case, the client designated his best friend to act as the Trustee.
An HEMS Trust: Estate Tax Protection Comes with Vulnerability
If the primary beneficiary wants to act as the sole trustee with control over investments and administration, distributions can be limited to the beneficiary’s health, education, maintenance and support (“HEMS”) to avoid estate tax (the “HEMS Trust”). This structure is designated by the Grantor (or trust creator) in the trust instrument or document created. However, some states permit certain creditors, such as a divorcing spouse or health care providers, to pierce through the trust and access assets up to the HEMS standard.
If they obtain a judgment against the beneficiary, the price to be paid for the beneficiary's additional control is potentially weaker creditor protection. A better approach, from a creditor protection standpoint, may be to empower the trustee to make discretionary distributions not tied to any specific standard.
Going with an Independent Trustee Instead
If the primary beneficiary of a Beneficiary Controlled seeks even greater asset protection, then they can appoint an independent trustee who acts as the distribution trustee. The independent trustee is authorized to make distributions to the beneficiary in such amounts and at such times as may be determined in the sole discretion of that Independent Distribution Trustee (the "Discretionary Trust"). The Discretionary Trust generally provides greater asset protection irrespective of the beneficiary's state of residence.
Considering what happened to Brittney Spears, the beneficiary may be concerned about giving such discretion to the Independent Distribution Trustee. This issue can be minimized by providing the primary beneficiary with the right to remove and replace the Independent Distribution Trustee. While the beneficiary does not have direct control over distributions, the beneficiary can select who does hold the power, so long as the person selected is not a related party or subordinate person.
2 Ways to Deal with the Tax Consequences of Trusts
Careful consideration must also be given to the trust income tax rules. The highest marginal federal income tax rate for ordinary investment income is now 37%. In 2021 the highest federal income tax rates are triggered with income for a single individual of $523,601 or more. For married taxpayers, the highest federal income tax rates are triggered with income of $628,301 or more. The highest marginal tax rate for a trust is also 37% in 2021 — but it is triggered with income of only $13,050. The difference in tax liability can be substantial.
To help deal with that tax issue, the Beneficiary Controlled Trust can be drafted in some cases to be a "Grantor Trust." A Grantor Trust is a trust that is "disregarded" for income tax purposes. Income is taxed to the beneficiary without regard to whether the income is distributed to the beneficiary. A Grantor Trust will avoid application of the higher tax rates for a trust.
Alternatively, the Beneficiary Controlled Trust can be drafted as a "Complex Trust" for income tax purposes. The Complex Trust files a separate tax return. Income actually distributed to the beneficiary is taxed at the beneficiary's lower individual tax rates. Only income not distributed by the Trust will be taxed at the higher trust income tax rates.
There is no single best approach, and careful analysis of the client's goals, concerns and situation should always be analyzed. The Trust may, in some circumstances, have an ability to toggle, or switch, between a Grantor Trust and a Complex Trust.
As a general rule, a client with a substantial estate should always consider the protective features of a Beneficiary Controlled Trust. If you have any questions about this topic. Please contact the Goralka Law Firm.
Founder of The Goralka Law Firm, John M. Goralka assists business owners, real estate owners and successful families to achieve their enlightened dreams by better protecting their assets, minimizing income and estate tax and resolving messes and transitions to preserve, protect and enhance their legacy. John is one of few California attorneys certified as a Specialist by the State Bar of California Board of Legal Specialization in both Taxation and Estate Planning, Trust and Probate.
Ford Recalls 45,000 Cars Over Faulty Door Latches
The Ford recall follows its 2020 recall for the same issue. Here's what to know.
By Jamie Feldman Published
Scammers Are Pretending to Be From Your Utility Company. Here's How To Shut Them Down
With scams in the utility sector on the rise during cold winter months, companies are spreading the word for customers to be on the lookout for fraudsters.
By Joey Solitro Published
Why More Retirees Might Come Out of Retirement
It’s often not solely because of financial reasons, but because of a lack of purpose in retirement. This financial expert can relate.
By Chris Blunt Published
What Would Accreditation Change Mean for Real Estate Investors?
Investors determined by a test to be ‘financially savvy’ would be allowed to invest in ways that they can’t now without having a certain level of assets.
By Edward E. Fernandez Published
Five Simple Year-End Tax Tips to Set Up a Successful 2024
If you wait until the new year, you may miss out on some valuable tax planning strategies. Here’s what you need to know before closing out 2023.
By Julie Virta, CFP®, CFA, CTFA Published
Six Estate Planning Tips for Younger Generations
Millennials and Gen Zers are taking their estate planning seriously. These tips can help make the process seem less daunting.
By David Weinstock, CFP®, AEP®, CPA Published
Year-End Tax Planning for a Financially Healthier Retirement
Getting your tax ducks in a row for the end of the year can decrease your tax liability and make the most of your income, now and in retirement.
By Ryan Marston, Investment Adviser Representative Published
Where to Start Financially After a Life-Changing Diagnosis
Dealing with an illness, yours or your child’s or that of another loved one, is hard enough without adding financial duress. Here are some considerations and suggestions for covering expenses.
By Stephen B. Dunbar III, JD, CLU Published
Six Ways to Prepare for Widowhood and Protect the Surviving Spouse
No one wants to have to plan for losing their spouse, but having plans in place and knowing what to do when the time comes can alleviate at least some of the stress.
By Tyler Hill, Investment Adviser Representative Published
Creating a Blended Family? Three Key Steps to Consider
Blended families can make your finances and estate extra complicated, but you can head off some of those issues with careful planning.
By Adam Frank Published