Introduction
Recently a financial adviser requested that I review an insurance trust for a client. The adviser was under the impression that the trust was “pretty good,” until we actually looked at the document. Many of the issues with the trust document may be quite instructive for readers who have old trusts that may suffer from similar issues. So, the following is a case study of some of that review, along with comments as to what more generically each point might mean to you. You should use this as a guide to review your old insurance and other trusts to identify issues you might want to address. The following discussion will also help you better understand why you should put all of your old trusts under the microscope. No, its not your lawyer looking for more billing when she tells you to come in for a review of your existing estate plan. In many cases lots of concerns may be noted.
Family Members and Trustee Listing
Case Study: The trustees of the trust are Wife and Son. Daughter is the successor Trustee. Does the client realize that the remainder beneficiaries, the children, are the trustees with Wife? Is Wife really comfortable with this arrangement? Does Wife understand the conflict of interest? Might the kids, as trustees and beneficiaries, have the incentive to give less to Mom so they inherit more (they have the ability but what about the mindset)? Are you really sure? Even if Wife is sure now, can sure be sure what will happen when the kids get married? Might that new son-in-law or daughter-in-law change the attitude of the kids as trustees/beneficiaries? Millions of dollars can change lots of folks. Is this really the structure Wife is comfortable with? If not, the trust should be changed if the children are agreeable. The situation in the case study was actually worse! See below for those nuggets.
General Application: Everyone one should periodically review all of the estate planning documents, including trusts, to see who is named in what capacities. Older trusts typically only list a trustee or, as in the case study, co-trustees, and successor trustees. More modern trusts may have a list of positions including trustees, co-trustees, successor trustees, trust protectors and successors, loan directors, power holders, etc. People change, relationships change, people die, trust companies merge or even go out of business. All this needs to be considered. Take out all your old trusts now. Do you even know the cell phone number for everyone named? If not, you should really consider whether a change is in order.
And once changes, are made be certain you and your advisers (insurance agent, lawyer, successor trustees) have copies of not only the trust but the documentation that changed trustees or other roles. Also, if it is an insurance trust, be certain that any paperwork necessary to update the trustee names with the insurance carriers has been filed with them.
Is There a Conflict?
Case Study: As explained above, the trustees of the trust are Wife and son. Daughter is successor Trustee. The Trust, in Article Seventh (A) prohibits the Wife from having any discretion over trust invasion (principal payments). Does the client realize that the remainder beneficiaries, the children, are not only the trustees with Wife but only they, and not the Wife, can make principal distributions to Wife (their mom). Would anyone be comfortable with an arrangement of having to ask your children for money? So, although Wife is listed as a co-trustee, she really isn’t a “full” trustee in that she has zero power to distribute principal. The Trust provides that the Trust assets after the death of both spouse is distributed to the children. So, the less the children give their mother from the principal of the trust, the more they inherit.
General Application: There are a myriad of variations, combinations, and permutations of how distributions from a trust can be made. If the distribution provisions in the case study trust are in fact what everyone wanted, and they understood the consequences, that would be fine. But I’d bet they didn’t. Is there a legal or tax reason for the structure used? Not really. If you are both a trustee and beneficiary you can have the right to make principal distributions (see more details below), the kids did. Why so limit the Wife? Perhaps she would be more comfortable with someone independent as a co-trustee.
Out Right Distributions Are Common and Potentially Disastrous
Case Study: Trust assets after the death of both spouses are distributed to the children outright at a specified age. Once assets of the Trust are distributed outright if a child gets sued or divorced the assets will be lost. This destroys any asset protection the trust could otherwise provide. If there are tax benefits to keeping assets in the trust the requirement to distribute outright will destroy those benefits. Does the client understand the above consequences? Why would they want these results? I suspect that the conversation went something like this: Lawyer to Client: “At what age do you feel comfortable giving your kids the funds out of the trust? Client Response: “They should be mature enough to handle the money by age 30, if not, what can I do?” That could be the wrong conversation.
General Application: Having trusts end at some specified age of a child or other heir is really common, especially with older trusts. You should check yours out. If you see these types of provisions (or if you recall conversations similar to the above) visit your lawyer and inquire about decanting (merging) the old trust into a new trust that holds assets in trust for as long as possible. The decision process should not be about at what age your heir will have the maturity to handle money. If you feel the kid will have maturity you can make them their own trustee (although you might still consider a co-trustee). The conversation should be more like this: Lawyer to Client: “We can hold the assets in trust for as long as the law permits so that the assets will have protection from your kids getting sued or divorced. That might also extend potentially forever, the estate tax benefits for the trust. We can give your child lots of ways to access the money if you feel they have the maturity to do so….” Client Response: “Groovy, let’s do it.”
Final Takers (Contingent Remainder Beneficiaries)
Case Study: The Trust states that if none of the Husband, Wife or children or their descendants are alive that the trust is distributed to nieces and nephews. This is the proverbial remainder or final distribution provision in wills and trusts. The family data lists certain nieces and nephews. There is no listing in the trust of all family members. Do the nieces and nephews named constitute all nieces and nephews? Were any left out? If there is a niece or nephew to be excluded, they should be expressly listed so that they cannot claim it was a typo to omit them. Otherwise, it may be unclear if it was an oversight or intentional omission. There were two categories of nieces and nephews listed each receiving different percentages. Is that intentionally? What happens if a new niece or nephew is born or adopted? The language does not address that. What if one of the nieces or nephews dies first or disclaims (files a legal document in court renouncing their inheritance). Will their share pass to their heirs or will it lapse? In the case study different groups of nieces and nephews receive different percentages. Is that clear why? How is the above affected if a niece or nephew dies? What if a new one is born? The manner in which the provisions are written if there is a change in the status of either group of nieces or nephews the percentages won’t add up to 100% in each group. That leaves it unclear how the trust assets will be distributed. That’s not good.
General Application: Listing final persons to receive assets if all primary persons are not alive (or disclaim) makes a lot of sense. But make sure the manner in which they (and all beneficiaries) are listed is clear not only under current facts but under lots of circumstances reflecting how the current facts change. People are born, die, have kids, get divorced, etc. That’s all-common stuff and should be addressed. And any beneficiary designation should be tested to be sure it works under anticipated, and even some unlikely, scenarios. Sometimes it may be better to list the class or category of people you are naming, and then clarify that with a listing of current class members but indicate what happens if the class changes (e.g., a new niece born or adopted in the above example). Some people get impatient when their attorney asks the “what if” questions to work out these details. That’s not the attorney looking to run the clock, its your attorney doing their job right.
Can Beneficiary Be Trustee?
Case Study: As noted above, the Wife was a co-trustee but prohibited from any involvement with principal distributions. Why was the Wife, who the trust clearly said is the primary beneficiary, subject to these restrictions on her role as trustee? Why was she not made the sole trustee of the trust if it is clear she is the primary beneficiary? Why was she as a trustee unnecessarily restricted from participating in any principal distributions? This is not required to comply with tax law. The Wife can be both a beneficiary and the sole trustee so long as she is limited to making distributions to herself that are limited to what is called a HEMS or “health, education, maintenance and support” standard. Why would the clients prevent Wife from being a sole trustee of her own trust? There could be a reason and this all might have been planned intentionally, but that just doesn’t seem likely. It is possible that the attorney just “had a form” that they used for that type of trust and never really thought about the provision. Perhaps the client hired an attorney who was not a specialist in estate planning and the attorney didn’t really understand the law on these points.
General Application: The selection of trustees, other fiduciaries, and people to fill other positions in the trust (e.g., trust protector, person holding a power to add new beneficiaries, etc.) need to be carefully thought out in the context of the distribution and other powers given to each. Also, the personalities involved need to be considered as to how they will work with others named in the trust, the objectives for the trust and other factors. For example, perhaps in our case study its an intact family and mom so trusts the children that she has no worries. Perhaps the kids are already married and their spouses are saints. All that is possible. Just make certain to look at your existing trusts and evaluate not just the various people named and the roles they serve, but all of that in the context of the trust’s assets, distribution powers, investment objectives and other relevant factors. That type of holistic perspective can be valuable to administering your irrevocable trust in a manner that may meet many of the goals you had for the trust. You’ll likely be surprised, sometimes unpleasantly, at decisions made years ago, and at decisions you may now have no recollection of having ever discussed.
Grantor Trust Status
Case Study: A “grantor” trust is a trust whose income is reported for income tax purposes by another person. That other person is usually (but not always) the person who created the trust (called, “settlor,“ “grantor,” or “trustor”).” The Trustees [in our case study trust] are authorized but not directed to utilize the net income therefrom and principal thereof (i) to pay any premiums or other charges in respect of any life insurance policies held hereunder…” This might make the trust a grantor trust, but it may not be sufficient to fully do so and if there will be a sale of policies to the trust, or a swap of assets between the grantor and the trustee, additional grantor trust provisions might be advisable to assure that the trust is in fact characterized as a grantor trust.
General Application: Grantor trust status (or not) is a complex issue, and quite important to many critical tax objectives of any trust. This is hairy stuff and you really should involve by your CPA and estate planning attorney in these matters. Simply put, as explained in the preceding paragraph, the income of a grantor trust is generally taxed to the settlor who created the trust. Non-grantor trusts (also referred to as “complex trusts”) have their income taxed generally to the trust. However, trusts may benefit from a distribution deduction for income distributed to the beneficiaries. Those distributions pass trust income out to the beneficiary who then reports that income on the beneficiary’s income tax return. So, with complex trusts the taxable income may be split between the trust and one or more beneficiaries. With several important trust transactions assuring that the trust is in fact a grantor trust is critical to avoid costly and unintended income tax results. For other trusts, non-grantor trust status may be desired to save state income taxes. The decisions as to what approach is preferable may also change over time. Once you determine with your CPA which characterization for the trust is best for you it may be possible through various actions (decanting, non-judicial modification, trust protector action, relinquishment, or renunciation by various people of certain powers, etc.) to change the characterization of your trust. While this is complicated you should understand the “big picture” of what this means to the trust and to you and others potentially affected as the consequences can be Boo Koo Bucks. Some of the jargon above is just beyond the scope of this article.
Annual Demand/Crummey Power
Case Study: “Each time that property shall be transferred to the Trust Fund so as to constitute a gift by a living person, each beneficiary then living and not excluded as provided below shall have the power to withdraw from the principal.” Be certain that you and your advisors, have copies of all prior Crummey power notices to assure that this tax objective of the trust are met.
General Application: Annual withdrawal or demand powers, sometimes called “Crummey powers” after the taxpayer’s name, Crummey, in a case that approved the technique, are common in planning for irrevocable trusts. The concept is that you can make annual gifts of up to $16,000 per year (in 2022 but the amount is inflation adjusted in future years) to anyone you want and not have to file a gift tax return reporting the gift and you won’t use any of your lifetime exclusion. But if you give a gift to a trust, it won’t qualify unless the beneficiary has a right to withdraw whatever you gave to the trust up to a maximum of the annual gift exclusion amount. To make this technique work the trustee might be required to give notice to the beneficiary of the gift and power to withdraw. Many trusts require that the trustee give such notice in writing. Whatever the deal is, you need to know what your trust provides, and what steps need to be taken to comply with both the tax rules and the terms of your trust. If your trust requires annual written notices then you should be certain those have been issued and copies retained.
Mandatory Income Payments May Feel Good, But Are They Good?
Case Study: The Trust in the case study mandated that all income be paid out to the Wife (mom). “ The Trustees shall hold, manage, invest, and reinvest the Trust Property, collect the income thereof and pay over the net income to the Settlor’s wife, or apply the same for her benefit in convenient installments, but at least quarter-annually during her life.” This is actually a requirement for qualifying a trust for the unlimited gift or estate tax marital deduction, but this trust is not a marital trust. Why was this done? Mandatory income payouts undermine creditor protection and income tax planning. This might be possible to modify by decanting or merging the old trust into a better crafted new trust. However, since Wife is prohibited from participating in the distribution of principal, she might never agree to losing the mandatory income payments. Mandating that all income be paid out of a trust was very common in old style trusts and many people really want that provision. The problem is if the beneficiary getting the mandatory income payment is sued (or in the case of a child divorced) that income stream may be reachable by a claimant in a lawsuit. After all it must be paid out. In other words, it undermines one of the potentially valuable benefits a trust can offer. If instead the income payout was discretionary to the Trustee, if the beneficiary was sued that income stream could be stopped by the Trustee thereby protecting the trust assets better from the claimant.
Also, if the trust mandates that income must be paid y9out you should be sure income has in fact been paid out as required by the trust document. If income has not been paid out like in a trust like in this case study the IRS might argue that Wife made gifts to the children by leaving income in the trust that should have been paid out.
General Application: Many trusts mandate income payouts. You really should review all of the distribution provisions of your trusts and see if they make sense. In all events they need to be complied with as failing to adhere to the terms of the trust can jeopardized the independence of the trust. But if the payments are not optimal, you should explore the pros/cons of trying to change the trust. That may be feasible by decanting, non-judicial modification, or other steps. Whether or not a mandatory payment is required for tax purposes (e.g., for a marital or other special type of trust) or was just inserted into the trust document, should be determined. Are the payment and distribution provisions of the trust really beneficial? Do they create avoidable tax costs? For example, if a beneficiary lives in a high tax state, mandating income payouts assures all that income is taxed by that high tax state. Might it be better to try to change the trust and avoid income payout so that the income remains in the trust in a no or low tax state thereby saving state income tax? Talk to your CPA there can be lots of variations and considerations, but improving the overall family income tax status may be possible.
Do Termination Provisions Work The Way You Want?
Case Study: “If, for any reason whatsoever, by operation of law or otherwise, this Trust shall terminate before the death of the Settlor, the Trust Property at such time of termination, or during the lifetime of the Settlor, shall be delivered equally to Son, per stirpes, and Daughter…” This would seem to cut out the Wife who, according to the trust document, is the primary beneficiary. Was this intentional? Might this have been just a “boilerplate” provision in the trust that works for some people but not all? Does the Wife even realize this?
General Application: Trusts are usually pretty long and complex documents. But even a seemingly innocuous “boilerplate” or standard provision can have profound consequences. One suggestion is that when you are working on a trust document annotate with notes a draft copy so you have explanations of all the provisions. Then, if years later you want to look back at the trust to be sure it still makes sense, and to identify changes that might require action, you’ll have a roadmap to understand the terms of the trust.
Is Your Trust Generation Skipping Transfer (“GST”) Tax Exempt?
Case Study: The GST tax is really complicated but in very simplified terms it is a tax that applies if assets are passed, beyond the exemption amount, to grandchildren or later generations (called “skip persons” in GST jargon). The trust in the Case Study contains extensive GST tax provisions but the trust terminates when the children are age 35 which wastes GST exemption, if any were in fact allocated to the trust on the settlor’s gift tax returns (which is doubtful). The trust should be decanted into a long-term trust regardless, if GST was allocated that will preserve the benefit. However, if GST was not allocated consideration could be given to doing so as a late allocation.
General Application: The GST status of trusts is commonly confused or not planned well. To preserve asset protection, divorce protection and tax benefits of a trust it is sometimes, perhaps often, beneficial to have a trust continue on for as many years as the law permits. The combination of a long-term trust, and the benefits that may provide, will often require that the trust be exempt from the GST tax. For moderate size estates that may just require the allocation of the GST exemption on a gift tax return, or having the trust drafted so that it qualifies as a “GST Trust” to which the tax rules will automatically allocate GST exemption even if a gift tax return is not filed. Since the GST exemption amount will be cut in half in 2026 it may benefit many people with old-style irrevocable trusts to improve the trusts (e.g., by lengthening the term) and making a late allocation of GST exemption, before 2026. That might permit you to lock in benefits before the exemption is simply reduced. That is pretty complicated and you need to talk to your professional advisers on that. But for many people with estates of even less than the current tax exemption amount of $12,060,000, that may be worthwhile.
Conclusion
This article has reviewed a case study of an actual old insurance trust. Many of the issues or possible improvements of the trust in the case study are common issues that affect many older (even not so old) trusts. If you have not been meeting with your advisor team every couple of years to review all of your planning documents, it probably pays to get out copies of your old trusts, review them and see if you can identify issues and opportunities to review with your advisors.