Overview of Different Types of Trusts
The living trust is very popular in America. A living trust helps you avoid
the cost and delay of probate. You can also avoid the dangers from jointly
owning assets. But a revocable living trust won't protect you from lawsuits.
Though a revocable trust won't protect you, you have the comfort of
knowing that you can change or revoke your living trust as often as you
can revise your will. But can a living trust cause you to lose lawsuit
protection? Several states have ruled that a homesteaded home transferred
to a living trust loses homestead protection. Similarly, assets owned
between spouses as tenants-by-the-entirety may lose creditor protection
from this type of co-ownership when those same assets are instead titled
to a living trust.
There are trade-offs between the different ways to title assets. Without
a revocable living trust, the court will distribute your assets under
your will. This can be expensive, time-consuming, and cumbersome. (Probate
costs can consume as much as 4% of an estate and delay estate distributions.)
If you bequeath $1 million through your will, your heirs may pay $40,000
in probate costs, and wait years for their inheritances. A living trust
circumvents the probate process. Your assets immediately transfer to your
Have the best of both worlds. Title your assets to a limited partnership
(to lawsuit-proof these assets). Have your living trust (which avoids
probate) own your limited partnership. When you die, your ownership in
the limited partnership immediately transfers through the living trust
to your heirs, and avoids probate. During your lifetime your assets would
be creditor-protected by the limited partnership.
Irrevocable Life Insurance Trusts
Life insurance is another important asset. Life insurance can have a substantial
cash value or death benefit exposed to creditors. Even a term policy without
cash value can be a valuable asset in that it will provide your family
income and support after you are gone. But will your beneficiaries get
the death benefit, or will your creditors? Life insurance can also pay
your estate taxes and make funds immediately available to your survivors;
thus avoiding the delay and expense of liquidating other assets.
If you own a large life insurance policy, title your insurance policy to
an irrevocable life insurance trust (ILIT). An ILIT is specifically designed
to own life insurance. As with other trusts, the ILIT has a trustee, beneficiaries,
and terms for distributions.
Your ILIT would own your insurance policy. The insurance policy beneficiary
would be the trust. When you die, your insurer pays the ILIT trustee,
who would follow the trust instructions and distribute the proceeds to
the ILIT beneficiaries. Your estate should not be the beneficiary.
An ILIT can be funded or unfunded. An unfunded ILIT's life insurance
premiums are not fully paid. You fund future premiums (give annual premiums
to the trustee, who pays the premiums). With a funded ILIT, you transfer
to the trust a fully paid insurance policy or enough income-producing
assets to pay the future premiums. Whether you have an unfunded or funded
ILIT, your policy premiums must be directly paid from the trust. You cannot
directly pay the premiums or you'll lose both the trust's tax
benefits and creditor protection.
The ILIT is irrevocable. It protects the policy's cash value, death
proceeds, and distributions from the trust to the beneficiaries. If life
insurance is not fully creditor-protected by your state laws, then an
ILIT is essential for protection.
The ILIT — though sometimes important for protection — can
save you estate taxes. Because the ILIT owns the life insurance policy,
the policy proceeds won't be included in your taxable estate, nor
subject to estate taxes.
Assume you are single and die with a $3 million estate and $1 million of
that amount is life insurance. Assume that when you die you have a $2
million death tax exemption. Your estate would then pay an estate tax
on $1 million. If the estate tax is 50 %, your estate tax would be $500,000.
But your ILIT would remove the $1 million life insurance proceeds from
your taxable estate. Your estate would save $500,000 in estate taxes because
you reduced your taxable estate to zero.
The ILIT also gives you better control over policy distributions than insurance
owned by you personally. When you personally own insurance, your insurance
company directly pays the named beneficiaries when you die. An ILIT not
only lets you control who receives the proceeds, but also how and when
the policy proceeds will be distributed. For instance, you can specify
that the ILIT trustee pays estate taxes and other costs (taxes due on
IRAs or other retirement plans probate costs, legal fees, other debts, etc.)
before the trustee distributes funds to the trust beneficiaries. Or you can direct
your trustee to pay your beneficiaries over a period of months or years.
You can add spendthrift, anti-alienation, discretionary distribution,
and other protective provisions to protect the insurance proceeds from
your beneficiaries' creditors. The ILIT can also avoid court interference
if a beneficiary becomes incompetent. Insurance companies won't pay
life insurance proceeds to an incapacitated beneficiary. They require
court instructions. The ILIT avoids this unnecessary complication.
Do you intend to gift money to your children? Investigate an irrevocable
children's trust (ICT). It can reduce taxes as well as provide protection.
Property that you transfer to a children's trust cannot be seized
by your creditors. It also won't be included in your taxable estate.
Income from the trust would be taxed at the children's lower income
tax rates. These are the reasons for the children's trust.
The ICT (or Section 2503 Minor's Trust) by its terms, controls the
taxation and asset protection benefits of this trust. While the trust
is in effect and the beneficiary is under 21, neither the grantors nor
the child's creditors can claim the trust assets.
There is one disadvantage with the children's trust. When your child
reaches 21, your child can demand the trust assets. Since it is an irrevocable
trust, the grantor cannot withhold distributions from the trust. You cannot
thus prevent your child from receiving the assets that are then owned
by the trust. You can only extend the trust until a later age if your
child, at age 21, consents in writing. Carefully consider whether your
child (ren) at that young age can properly handle the trust assets.
Charitable Remainder Trusts
Gifting your assets to charity may seem an extreme way to gain creditor-protection,
however, our tax laws allow you to give away your property to charity,
achieve protection, and use these same assets to generate income for you
during your lifetime. For protection, as well as the tax advantages from
gifting assets during your lifetime, the Charitable Remainder Trust (CRT)
can be your answer.
Here's an overview of how the CRT works. As the grantor, you select
a tax-exempt charity as the beneficiary of your irrevocable trust. When
you create and fund the CRT, you make a charitable donation and can claim
an immediate tax deduction for the value of the assets contributed to
the trust. Although you have gifted the principal, you would be the income
beneficiary. Over your lifetime, your trust would pay you a fixed annual
income. You thus get an immediate tax deduction and future income from
the donated assets.
Assume that you have $200,000 in stocks that were purchased 15 years ago
for $60,000. If you sold the stock to invest in treasury bonds, you would
pay $21,000 in capital gains taxes on the profit (15% X $140,000 gain).
If your treasury bonds are worth $200,000 when you die, your estate may
then pay another $88,000 in estate taxes (although future estate taxes
are uncertain). Your heirs would inherit, after taxes, only $91,000 from
the original $200,000.
So, you don't sell your stocks. Instead you transfer them to a CRT.
You get the same annual income as from treasury bonds for the remainder
of your life because you could be the CRT's income beneficiary. You
deduct your $200,000 donation as an immediate charitable contribution.
The income from the tax savings from your charitable deduction can buy
a $91,000 life insurance policy to cover the $91,000 that your beneficiaries
would have received had you donated your stock to the CRT. The net result:
a large tax deduction this year, the same perpetual fixed retirement income
as with treasury bonds, you donate to your favorite charity, and the donated
trust assets are lawsuit-proof.
Do you have appreciated assets? Do you want a fixed lifetime income? Would
the CRT's fixed income satisfy your retirement needs (adjusted for
inflation)? If so, a CRT may be a good protective strategy for you —
particularly if it can help you achieve your philanthropic goals. Income
from the CRT can be seized by your creditors, but even then there are
solutions. For example, your income can be protected through a charitable
remainder annuity trust (CRAT), if your state exempts annuities from creditor
seizure. Other trusts are variations on this theme.
Qualified Personal Residence Trusts
With a Qualified Personal Residence Trust (QPRT, you transfer your residence
to the trust and retain a tenancy for ten years. At the end of the term,
your residence passes to your beneficiaries. Your objective is to transfer
your residence now at its lower value (basis), rather than when you die
and it has a greater value. The QPRT thus reduces estate taxes.
A QPRT can also lawsuit-protect your home. Your creditors can only claim
your right to use the property for the remaining term of years (or the
rental value for those years). However, your creditor cannot attach or
seize the home because it would be owned by the trust. The beneficial
remainder interest can be claimed by your beneficiaries' creditors,
unless your trust includes those important spendthrift provisions. At
the end of the term, the trustee must distribute or convert the QPRT assets
into an annuity. This is a more desirable alternative in states that creditor-protect
If you are in a second (or third, fourth, or fifth marriage), the Q-TIP
(Qualified Terminable Interest Property) trust may interest you. The Q-TIP
ensures that your spouse will receive a lifetime income from the trust.
The trust principal then passes to your children (or alternative beneficiary)
after your spouse dies or remarries.
Q-TIPs are common with second marriages because they preserve your assets
for the benefit of the children from a prior marriage, rather than the
spouse's children or family, who would become the probable beneficiaries
of an estate bequeathed outright to a surviving spouse. Q-TIPs can also
protect a spouse when the grantor believes that the spouse may waste the
assets during the spouse's lifetime. A Q-TIP is essentially a spendthrift
trust to shelter your assets from your spouse's creditors or subsequent mates.
Income from the Q-TIP trust must be used solely to benefit the surviving
spouse during the spouse's lifetime, or the trust won't qualify
for the unlimited marital deduction. Estate taxes on the principal are
deferred until the surviving spouse dies.
A Q-TIP trust won't protect your assets against your creditors, because
the Q-TIP is a testamentary trust. However, a Q-TIP trust can shelter
your wealth from a spendthrift spouse, a spouse who may have future financial
or legal difficulties, or a spouse who may wish to leave
your money to
his or her children.
The Q-TIP's trust principal will be safe from your spouse's creditors,
though the income to your spouse would not be protected. Moreover, the
trust income must be distributed as earned. The trustee cannot withhold
You can use a similar irrevocable intervivos marital deduction trust for
protection. The objective is to shift marital assets from the higher-risk
spouse to the less-at-risk spouse. This is only another form of lifetime
gifting. These transfers are also subject to fraudulent transfer claims.
A spouse who makes an outright gift must understand that the transferred
assets may be lost by a surviving spouse in a later lawsuit or in divorce.
It can also be lost to the spouse's spendthrift spending.
Land trusts, widely used in Illinois, Florida, Georgia, California, Colorado,
and a few other states can partially insulate real estate against lawsuits.
The land trust can own any real estate — including the family residence.
A bank is normally the trustee. The land trust protects the beneficiaries'
interest in the real estate only if the trust has the proper spendthrift
and anti-alienation provisions. As the trust beneficiary, you don't
directly own the real estate. The real estate is titled to the trustee.
You own only a beneficial interest in the trust. This interest is personal
property, not real property.
Owning a beneficial interest in a land trust is not sufficiently protective.
Your creditors can seize your beneficial interest. You need more protection.
One option is to title your beneficial interest to a limited partnership,
LLC or to an irrevocable trust.
Land trusts have two disadvantages. It is frequently difficult to finance
land trust property as it's necessary to temporarily re-convey the
property out of the trust to its grantors or beneficiaries to complete
the financing. Also, a beneficiary desiring a Section 1031 tax-free, like-kind
exchange, must transfer the property from the trust, since a land trust
is not a beneficial interest in real property but an interest in personal property.
Privacy, not asset protection, is the land trust's major advantage.
The beneficial owners won't appear on the public records because the
property is titled to the trustee. To the extent secrecy aids protection,
the land trust can be helpful.
Nursing home costs can impoverish you as quickly as a lawsuit. Hence, the
Medicaid trust. This special purpose trust shelters assets so the grantor
can qualify for Medicaid to pay their nursing home costs. Medicaid trusts,
of course, chiefly interest those who prefer to leave their money to their
children rather than spend it on their own long-term care.
A Medicaid trust is similar to other irrevocable trusts. The grantor (as
an individual or couple) transfers their assets to an irrevocable trust.
However, unlike other irrevocable trusts, the grantor can be the income
beneficiary. Their children or spouse would be the residual beneficiaries.
The grantor can receive income from the trust to the maximum amount allowed
by Medicaid. But the now, asset-free grantor can qualify for Medicaid
nursing home assistance.
The Medicaid trust offers about the same asset protection as any other
irrevocable trust. Medicaid trusts prohibit using the trust assets for
other health care purposes, and it also limits the beneficiaries'
income to those income limits set by Medicaid. You must create and fund
your Medicaid trust 60 months before you apply for Medicaid. That's
its one disadvantage: Few people can anticipate their long-term care needs
that far in advance.
YES, YOU CAN LOSE EVERYTHING!
You may think that your wealth is safe and that you don't need protection.
But don't delude yourself and accept reality — for every 60
minutes you spend making money, spend 60 seconds thinking about how to