As families gather for vacations or to mark milestones passed during the year, it is a good time to take stock of their estate plans and, in particular, to review any trusts created during a family member’s lifetime or at death.
Families often have an assortment of trusts, created during different stages of their lives and designed to serve various purposes. Typically, they have not looked at them in a while.
Meanwhile, children have grown up, senior family members have matured, tax laws have changed and investments have prospered—or diminished in value.
If estate planners don’t stay on top of these types of changes, problems can occur. Perhaps assets appreciated so rapidly that beneficiaries are in danger of becoming financially dependent on income distributions from a trust. Or maybe there is a risk that individuals with no financial acumen will dissipate age-based payouts they are about to receive.
Many trusts are irrevocable, meaning that the grantor—the person who created them—cannot change their terms. However, depending on the provisions of the trust, the trustee’s powers and state law, there may be strategies to administer them more flexibly.
When individuals do extensive planning over many years and use different lawyers, they can end up with a patchwork quilt of trusts. Ideally, old trusts that were put in place incrementally complement one another. An inventory of old trusts should also be a prelude to drafting new ones.
Here are some common trouble spots that can arise when trusts aren’t updated:
Distribution ages are earlier than you would prefer. Take the couple that set up trusts for each of their three children a dozen years ago and specified that half the principal should be paid out when the children are age 30 and the rest at age 35. Since then, they have discovered the asset protection and other benefits of lifetime trusts. They would prefer that their children not receive large sums of money that might be squandered at a young age or fall into creditors’ hands. Moreover, they desire to ensure that the trust property passes to their grandchildren.
Sometimes, especially when trusts are funded with stock in an early-stage company, the assets appreciate more dramatically than anyone anticipated. When that happens, and the trust requires distributions at specific ages, there is a risk of substantial wealth going to beneficiaries before they are ready to manage it.
There are several strategies to consider in situations like this. One option is not to put any additional money into the trusts and instead create new trusts with extended distribution terms for any future transfers. Another choice may be to rely on the terms of the trust and state law to enable the trustees to distribute the trust property to different trusts for the benefit of the beneficiaries with a stretched-out distribution schedule.
Another popular solution is to create a limited liability company or a limited partnership—funded with other family assets—and have the trust invest in that entity. The trust would then own a percentage of the partnership. Instead of receiving property outright at the designated age—assume it is 21—the beneficiary would receive an interest in the partnership. That partnership interest, in turn, would entitle him or her to an income stream, though not nearly as much as the beneficiary would have received. Additionally, the trust, as a limited partner, would have no control over the underlying entity.
Whether a trustee can employ any of these strategies will depend on the terms of the trust and state law. Sometimes it may be necessary for the trustee to present the plan to the courts or obtain consents from beneficiaries to better meet the grantor’s wishes.
It no longer makes sense to retain assets in trust because of tax law changes. Fewer people are subject to estate tax now that the federal exemption has risen to $5.34 million ($10.68 million for a married couple). Meanwhile, federal and state income tax rates have risen and trusts are taxed at the highest marginal rates when income exceeds only $12,150 for 2014.
It may no longer make sense to hold assets in trust for a long time. Clients may prefer to distribute assets to beneficiaries who are in lower income-tax brackets than the trust. Or the trustees may wish to exchange low-basis assets in a trust for higher-basis assets or cash so that a grantor can receive a step-up in basis on the trust assets at death.
Beneficiaries often benefit from such distributions, as they may be able to use their own available estate and GST exemptions to shelter assets from transfer taxes. At the same time, their estates can obtain a step-up in basis in the assets included in their estates. If the assets had remained in trust, not only would the trust pay higher income taxes on trust income and gains than the beneficiary, but the basis of the original assets transferred would remain the same as the grantor’s, without a step-up in basis. With federal and state income and capital gains tax rates in many states now close to or exceeding the estate tax rates, it may be necessary to reconsider past strategies that preserved trust assets and consider making distributions from these trusts.
Individual trustees are not the people you would have chosen today. The trust document often offers a solution and outlines the process for the appointment of alternative trustees. For example, assume the trust provides that John and Mary are co-trustees and that if neither of them can play that role, a corporate trustee will step in. If John and Mary both resign, a corporate trustee could take over asset management, tax reporting and distributions.
In other trusts, the grantor may have appointed an individual as co-trustee along with a corporate fiduciary without specifying that the financial institution should have sole discretion over investing trust assets. If the individual does not feel qualified to participate in investment decisions, he or she may be willing to delegate the responsibilities of managing and balancing investments for current and remainder beneficiaries to a corporate fiduciary.
The interests of current and future beneficiaries are at odds. Trusts that require trustees to pay all income to current beneficiaries and preserve principal for future ones, with no power to invade principal for current beneficiaries, can set one group against the other. Lifetime beneficiaries generally want the largest possible payout, while future (remainder) beneficiaries prefer trust assets to increase in value. These trusts also inhibit trustees from investing for total return, which favors asset allocations that will produce the most growth over time, even if it means less current income.
State laws now provide ways for either beneficiaries or trustees to address the problem. The Uniform Principal and Income Act, adopted in most states, gives trustees the power to shift principal to income and income to principal, if necessary, to treat all beneficiaries fairly, even if that power is not in the trust document. Other states have laws that provide permanent solutions. Converting to a trust that is required to pay a specific amount can be very inflexible and may not preserve the inflation-adjusted value of the principal over the long term. Therefore, in old trusts that do not include the power to invade, it may be preferable to rely on the trustee’s ability to exercise a power to adjust on a year-by-year basis under state law.
Trust terms need to be changed. Sometimes trust beneficiaries need to be replaced. For instance, they may not be individuals who a grantor would currently choose, or they may have died. Or someone may want to change a trust because its terms may be too restrictive or too broad to meet the grantor’s objectives. While the trust may be irrevocable, there are ways to create flexibility.
In recent years, more and more states have enacted statutes that permit trust modifications. These laws either allow trustees to “decant” a trust, moving the assets from one trust to another, or allow grantors and beneficiaries to consent to changes.
A Florida grantor was able to modify a trust that allowed only for distributions for higher education to enable the beneficiary to receive distributions to pay for a private high school, without which the beneficiary would never have gone to college. Others have used state law and trust language to alter the trustee appointment and removal provisions, change trustees, eliminate withdrawal powers of a beneficiary or switch the tax status of the trust from being a non-grantor trust to a grantor trust, so that the grantor pays the taxes, leaving more assets in the trust for the beneficiaries.
Planning With New Trusts
Some of the problems that arise with old trusts can be avoided by making new trusts as flexible as possible.
Rather than requiring payouts at specific ages, a trustee can be given broad discretion to decide when to make distributions of income and principal. The trustee can then make this decision based on factors the grantor includes in the trust document or in a side letter.
It is important to choose trustees who are qualified to play the role assigned to them, whether making decisions about distributions or investing the assets.
As much thought should be devoted to designating successor trustees, or designing a mechanism for appointing them, as to selecting the initial ones. In addition to naming trustees, the grantor may consider appointing a trust protector (sometimes called a special trustee or trust advisor) as an independent party who can make certain key decisions or adapt various trust terms as circumstances change.
Trusts are live, dynamic documents and must be managed and reviewed as laws and family circumstances change.
Judith Saxe is a managing director and senior wealth strategist at Atlantic Trust, a private wealth management firm with 12 offices across the U.S.
