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Meador: Well so talk to us a little bit more about the taxation of trust.
Peterson: So depending on what kind of trust that you have there's going to be different
tax implications those. So if you have let's say an irrevocable trust, then the trust is
going to have a separate tax ID number and what is inside that trust is actually going
to be taxed the trust and the trust itself is going to have follow an income tax return.
Generally, if it's a revocable trust, then the trust itself is not going to pay income
tax and the income tax on whatever the assets make inside the trust are just going to be
treated on the individual grantors' tax return. So it will be on their 1040, not on a tax
return for the trust.
Often when you're giving money to a trust, an irrevocable trust, there may be gift tax
issues that arise with that. So typically, what you will see is if you are gifting money
to an irrevocable trust, there will be gift taxes, consequences as long as you get . . . if
you get over that $14,000 a year annual exclusion amount. Gifts to revocable trust because they
are revocable, there really is no gift tax consequence to that.
As far as estate taxes are concerned, remember estate taxes are something that is paid at
your death. Well, an irrevocable trust, those are created generally during your lifetime
and the transfers are made during your lifetime, so the taxes have been taken care of through
the gift tax process. So generally, there is no estate taxes due on an irrevocable trust
unless for some reason that irrevocable trust is defective. But for revocable trusts because
they are revocable, whatever is in the trust is included in your estate for state tax purposes.
So revocable trusts are not going to get you out from under estate taxes.
For generation skipping transfer tax, revocable trusts are again just like gift taxes. There's
not going to be any GST taxes on revocable trusts. For irrevocable trusts, you might
have GST taxes just like you might have gift taxes depending on who the beneficiaries are
of the trust and how much you gave to the trust in a given year. In your book, there's
actually on page 315, there's a really good chart that kind of breaks down the taxation
of trust. And so I would look carefully at that.
Meador: Great, great. Okay so-so you mentioned revocable and irrevocable trust, so tell me
a little bit more about that in terms of like when they are created, that sort of thing.
Peterson: Okay. So there's basically two main types of trust which are the revocable trust
and the irrevocable trust so just like you would expect from their name a revocable trust
can be changed, it can be amended, or it can be terminated or revoked. So an irrevocable
trust, once you set it up in general, it cannot be revoked, it can only terminate by its term,
and it usually cannot be amended or modified, and so that's kind of the main difference
between revocable and irrevocable trusts.
Meador: Okay. And then we got inter vivos which is during life and then testamentary
which is at death obviously.
Peterson: Yeah so those terms refer not necessarily to types of trusts but really when trusts
are created. So with the inter vivos trust, you are making that during your lifetime.
Testamentary trusts are trusts that you are making . . . that come in to being after your
death.
Meador: Okay.
Peterson: So a lot of times what you will see in a client's estate planning documents
in their will let's say there might be a trust for their children but that children doesn't
spring into being until that person dies and then the trust comes into being.
Meador: It will bypass trust from husband to wife type thing.
Peterson: Right. Yeah, that's typically a testamentary trust as well.
Meador: What other classes of trust are there?
Peterson: So there's a couple of different ones. One that we've talked about before is
kind of the contingent trust that we talked about in the context of wills and what you
will see there it's kind of a trust that's in waiting that may or may not ever be used.
And so if there's a beneficiary who happens to need that particular trust, and then that
trust will come into being just for that particular need. And otherwise it just kind of lies dormant.
It may never be used.
Typically, we'll see there's a lot of trusts that are called grantor trusts and so what
a grantor trust is and those generally are some form of the could be in an irrevocable
trust or a revocable trust can be grantor trust but it is usually a trust that is an
inter vivos trust that is made while you are living. And so what happens with a grantor
trust is whatever income or appreciation that the trust makes that those things still get
taxed as income to the person who makes the trust, the grantor. So that's what a grantor
trust does.
When we talk about pour over, what we are talking about is something that pours over
from one to another so you can have what's called a pour over will, or you can have a
pour over trust and what that means is that anything that gets passed through that instrument
gets poured over into another existing trust. And so we see that a lot of times in irrevocable
living trust planning, we will see pour over instruments there.
The key thing with the trust is whether or not they are funded, right? So that's always
the big issues with trusts and so what we are talking about is you could have a trust
document that's written that can be unfunded because no assets get actually passed over
into the trust. So what you are looking for when you do trusts is you want to make sure
for your clients benefit that if it's supposed to be funded that it is funded. If it's supposed
to be assets in the trust, make sure that those assets get in the trust, and help them
and their attorney do that.
Meador: Right. Which brings another question to me. What is a living trust? You will understand
why I'm getting into that in a little bit.
Peterson: Yeah. So a living trust is an inter vivos trust, so it's a trust you make during
your lifetime and it is a revocable, so it can be changed or mended or terminated during
your lifetime. So that's what a living trust is.
Meador: Well, and the only reason I ask that is because I've got clients a lot of times
that come into my office and they say, "Oh, I have a living trust so my probate is taken
care of." My first question to them is always the same which is who drew it up? Because
there are literally living trust salesman out there that . . . well I . . . the only
thing I'm going to say is if I know it was a living trust salesman that drew up, I'm
going to get them to have it reviewed by an estate attorney.
Peterson: Yeah, living trusts are kind of this area that went through a huge period
of abuse particularly in Texas. And so what basically happened in really the '80s was
kind of the hay day and lasted in the '90s and we still see it someday is unlicensed,
non-attorneys would go and have estate planning seminars and they would sell these living
trust kits. And so they would do these seminars, they would sign people up to do living trusts,
and they would sell them--sell them these living trust kits.
There were several problems with them. One, for the most part, they were not particularly
well drafted, so we have reviewed over the years many, many living trusts that pages
were missing, where it referred to paragraphs that didn't exist, that the cross references
didn't work, it was just a mess and it wasn't well drafted. Most of that was because the
sales person didn't know anything really about living trusts except whatever was in their
presentation and so they couldn't even help and since it wasn't drafted by an attorney,
just by word processor, they were real problematic.
Second is that a lot of those things were sold on a very hard sell basis and so there
were a lot of people that were really hard selling their clients. Also some of them were
really, really expensive. So I had a client not too many years ago that brought me a living
trust that they bought from a living trust salesman and I knew it was going to be a problem
the second it walked in the door because she told me she had bought it from a sales person
and she came in and the binder is literally the nicest binder I have ever seen in my life.
It's this beautiful leather portfolio. It had their client's name on it and both side
and on the front in gold foil and it was embossed. It was a terrific looking binder. Now everything
inside it was total crap but it was a really nice looking binder.
The thing that is shocking to me though is that they had paid $20,000 for this.
Meador: Ouch.
Peterson: And I don't know about you but $20,000 is really a lot of money to pay for essentially
a folder.
The problem with that kind of period of Texas estate planning history is that it kind of
put a black eye on the living trust as an instrument, and so what ended up happening
is we kind of threw the baby out with the bath water for about a good 20 year time period.
The attorney community reacted to the living trust salesman by saying basically you don't
ever . . . there's never a purpose for using a living trust.
And the truth is the living trust does have some advantages over some other estate planning
options and it should be considered as one of the options. It shouldn't just be thrown
out just because of the abuses of a group of bad apples you know. So what we are starting
to see in the industry is kind of return to the living trust as a viable estate plan.
I would say for most of our clients it's kind of the preferred option if they can afford
to do it.
Meador: Right, right. Well and we've talked about how they avoid probate and all those
other things. Talk to us just a little bit, sort of go through and give us some highlights
of some different trusts that you draw up.
Peterson: Well, let's start by turning again to the living trust so that's probably the
main one that you are going to see walk in to your office and it's the main one we end
up drawing up. So kind of the pros to the living trust when you look at is if it's funded
properly, the trust is going to completely avoid probate. So that by far and away is
the positive. Because it avoids probate and probate is a public process, it's a public
record, then the trust is going to privately.
Well, the nice thing about passing privately is that because it passes privately, it discourages
will contests and creditor claims because beneficiaries who have or potential beneficiaries
who were written out of the trust and are no longer beneficiaries, they don't necessarily
have to be informed that the trust assets are passing someone else and there's no public
filing, so they don't really have anywhere to go down and look at what the trust says.
They don't have any right to do that. And so that's a positive.
The same thing is true also of creditor claims. Often creditors their only client is against
the estate. Well, they don't actually have a claim against the trust because remember
the trust is a separate legal entity so when things pass from the trust to the ultimate
beneficiary, it doesn't go through probate which is essentially is also a creditor claims
process. The other pro is just like in wills you can do some positive things from an estate
tax claim planning standpoint. Living trusts benefit from the step up and basis in the
same way that wills do and you can do the same sort of estate tax claiming inside of
revocable trusts that you can do inside of a will, so they kind of retain those same
advantages.
The big con of living trusts is we often find that they are not funded, that assets have
not been re-titled or transferred into the name of the living trust and so just like
the lady that had the really nice $20,000 binder where the documents were not very good,
even though the documents weren't very good, the biggest problem was that they are actually
is no re-titling of assets into the trust.
So what does that look like? So her house was still in her personal name. It should
have been deeded over to the trust. Her bank accounts were still in her personal name.
They should have been deeded over to the trust. Her investment accounts were still in her
personal name. They should have been deed over to the trust. Her retirement accounts
still had beneficiary designations on them when probably what should have happened was
some of the beneficiary designations should have been in the trust. Her car was still
in her name. It should have been in the name of the trust on the certificate or title.
And so that sort of follow along work is probably the biggest problem with living trusts, it's
also the biggest opportunity from a financial planner's perspective. Because remember you
are having this annual review with clients so when they come to you and say that they
have done the living trust, then the next question should be, "Okay, what has been re-titled
into the name of the trust?"
And so you can really help them through their annual review to list when they list what
bank accounts they have on your little questionnaire that you do with them, have them list whose
name is on the bank account statement besides who is named on the beneficiary. So if you
notice that it's all in their personal name, then the next question you need to ask is
well shouldn't all this be in the name of your living trust, and they better answer
yes, and then you better work with them and with their attorney to make sure that the
stuff actually gets put in there.
If you notice that their house is still in their name, then you need to go and help them
find an attorney who can do the deed and put that in the name of trust, so there's a real
opportunity with living trust to be helpful again to your clients in this annual review
process.