Thursday, April 22, 2021
A common question that I receive from individuals interested in creating an estate plan is whether a trust should be a part of the plan. More specifically, the question typically is whether a revocable living trust should be used. That’s a difficult question to answer because there are many factors to consider when determining whether to include a revocable living trust as part of an estate plan. Clearly, one valuable use of a revocable trust is to provide a management vehicle for property of older individuals at a time when they may not be capable of providing active management effort. But are there others?
A revocable living trust – what is it? How does it work? What are the pros and cons of utilizing it as part of an estate plan. These matters are the focus of today post.
The revocable trust can be valuable as a basic instrument in an estate plan for some persons, particularly where management of an individual's assets is needed. The passage of property to one's beneficiaries at death requires the same detailed and careful planning as does the accumulation of the property during lifetime. There is no legal device which will solve this problem on a "one size fits all" basis. As with all estate planning tools available, the use of a revocable trust should be done only after a complete analysis of the individual's assets, stated desires and overall family goals.
The grantor creates the trust by executing a trust agreement and funds the trust by transferring property to the trust during life. Asset titles must be changed into the name of the trustee of the trust. The grantor retains the power to amend, modify or revoke the trust. Frequently, the grantor retains the right to receive the income for the grantor's life.
Estate and gift tax aspects. Because the grantor reserves the power to revoke the trust, the transfer of property to the trust does not constitute a gift. Treas. Reg. §25.2511-2(c). However, whenever income or principal is applied to the benefit of a third party, the grantor may be deemed to have made a gift to the beneficiary. Treas. Reg. §25.2511-2(f). Subsequent termination of the power to revoke, other than by death, completes the gift for federal gift tax purposes. Id.
Because of the powers the grantor retains over the trust, the property in the trust is subject to federal estate tax. I.R.C. §§2036-2038. See, e.g., Estate of Bell, 66 T.C. 729 (1976); Treas. Reg § 20-2038-1(a). There is also a “three-year within death” rule that pulls some transfers that a decedent makes within three years of death. Indeed, for deaths before August 6, 1997, the position of the courts had been that gifts of trust income or principal within three years of the grantor's death were included in the grantor's estate if the donees were potential trust beneficiaries. I.R.C. § 2035(d)(2). See also Estate of Collins v. United States, 94-1 U.S.T.C. ¶60,161 (E.D. Mich. 1994); Estate of Jalkut v. Commissioner, 96 T.C. 675 (1991), acq., 1991-2 C.B. 1. However, for deaths after August 5, 1997, any transfer from a grantor (e.g., revocable) trust is treated as a transfer by the grantor. I.R.C. § 2035(e), added by TRA-97, Sec. 1310.
Claims against a decedent’s estate give rise to a deduction for the estate. But, are those claims limited to the value of assets included in the decedent’s probate estate? If so, then claims arising from assets in a decedent’s revocable trust would not create a deduction because the assets in the trust are not included in the decedent’s probate estate. However, the U.S. Tax Court has held that a deduction for claims against the estate under I.R.C. § 2053 is not limited to the value of assets in probate estate. Estate of Snyder v. United States, 99-2 U.S. Tax Cas. (CCH) ¶ 60,357 (Fed. Cl. 1999). The Tax Court noted that the statute makes no distinction between probate and non-probate assets).
Income tax aspects. A revocable living trust is disregarded as a taxable entity because it is treated as a "grantor trust" with all trust income taxable to the grantor. I.R.C. § 676(a). Form 1041 is required to be filed with a separate statement attached showing income, deductions and credits attributable to the grantor from the trust. Treas. Reg. § 1.671-4. But, if an individual is both the grantor and the trustee and all items of income, deduction and credit are treated as owned by the grantor, it is not necessary for the individual to file a Form 1041. The information is reported on the grantor's individual return. Treas. Reg. § 1.671-4(b). Generally, the trust is to obtain a taxpayer identification number. I.R.C. § 6109. But, if the grantor is also the trustee and is treated as the owner of all assets held by the trust, there is no requirement to obtain a taxpayer identification number. Treas. Reg. § 301.6109-1(a)(2).
Also, a qualified revocable trust may elect under I.R.C. §645 to be treated and taxed as part of an estate, and not as a separate trust, for all tax years of the estate ending after the date of the decedent’s death and before the applicable date that terminates the election period. The applicable date for decedents dying on or after December 24, 2002, is set by Treas. Reg. §1.645-1(f)(2)(ii), effective on that date, where an estate tax return must be filed. The IRS has announced that qualified revocable trusts for decedents dying before December 24, 2002, may use the Treas. Reg. §1.645-1(f)(2)(ii) dates if Form 1041, U.S. Income Tax Return for Estates and Trusts, has not been filed treating the Section 645 election period as terminated. Notice 2003-33, C.B. 990.
Note: Because transfers to a revocable living trusts rarely include all of the transferor’s assets, the plan often includes a "pour over will." This will assures that property not needed in estate settlement for payment of debts and taxes would be transferred following estate settlement into the trust.
Other Particular Issues
The residence. Transferring the principal residence to a revocable living trust does not make the residence ineligible for exclusion gain on sale under I.R.C. § 121, See Ltr. Rul. 8007050, Nov. 23, 1979. The principal residence is eligible for the exclusion to the extent the owner is treated as the owner of the trust under I.R.C. §§ 671-677. See, e.g., Priv. Ltr. Rul. 8239055 (Jun. 29, 1982). But, the residence may be ineligible for preferential credit or exemption from property tax under state law.
Depreciation. Expense method depreciation does not apply to trusts. I.R.C. § 179(d)(4). But, the IRS acknowledges that this rule only applies to non-grantor trusts, such as irrevocable trusts. Because a revocable trust is a grantor trust, property transferred to the trust that is eligible I.R.C. §179 property remains eligible. Depreciation deductions, in general, are apportioned between the trustee and income beneficiaries as trust income is allocated. Treas. Reg. §§ 1.611-1(c)(4)(1973), 1.167(h)-1(b).
Estate planning. From an estate planning standpoint, the transfer of closely-held business assets to the trust could terminate installment payment of federal estate tax unless the transfer is merely a change in organizational form. But, if that hurdle is cleared, property interests contained in the trust at death are not made ineligible for installment payment of federal estate tax simply by virtue of being held in trust. See, e.g., Priv. Ltr. Rul. 7747007 (Aug. 19, 1977); Priv. Ltr. Rul. 8132027 (May 1, 1981); Priv. Ltr. Rul. 200529006 (Apr. 11, 2005).
Recapture of special use valuation (I.R.C. §2032A) benefits could occur unless all beneficiaries are qualified heirs and consent to personal liability for recapture tax.
Conveyance of joint tenancy property to a revocable living trust could result in a severance of the joint tenancy characteristic. Black v. Commissioner, 765 F.2d 862 (9th Cir. 1985). But the Tax Court has held that the transfer of jointly owned property to trust with retained right to jointly revoke transfer does not constitute severance, and §I.R.C. 2040 remains applicable to tax a decedent's estate to the extent of the decedent's proportionate contributions. Estate of May, T.C. Memo, 1978-20.
Pros and Cons of Revocable Living Trusts
There is a lot of information available about the supposed benefits of a revocable living trust. Much of this information is peddled by those desiring to profit from the selling of the trust. That doesn’t mean that the information is inaccurate. It does mean that a person considering the use of a revocable trust needs to do their “homework” and discern carefully the information that is provided.
The following is a straightforward discussion of the go things and not-so-good things about a revocable trust with comparison to the probate process when a decedent dies with a will.
Probate avoidance. Avoiding probate is a reason often cited for the use of a revocable trust. But, what is "probate"? The answer to that question is tied to state law. Probate can be more complex, and costly, in some states as compared to others. It is not costless to create a revocable trust, and it is not costless to administer a revocable trust at death. There simply is no clear-cut answer as to whether a revocable trust is better than a properly drafted will from an economic standpoint. However, probate is a public process and trust administration is not. Privacy may be an important aspect of a trust that some place a high priority on. But, the public nature of the probate process also puts in place a judge to administer the process, deal with creditor claims and handle disputes that might arise. That administrative supervision is not there to the same degree with a trust.
Estate tax savings. Many times, the impression is erroneously given that a revocable trust is the only way to avoid estate taxes. A revocable trust does not avoid more taxes associated with death than does a properly drafted will. Avoiding probate by using a trust does not mean that taxes are avoided. The tax results for an estate where the decedent has a revocable trust should be the same as for an estate where the decedent had a will.
Distribution of assets. Assets are generally not tied up in probate for a long period of time. With most state probate systems, assets are available to a personal representative five days following the decedent's death. Any delay in distributing assets to the beneficiaries should be no greater in probate administration than when a revocable trust is used. A trustee as well as a personal representative must make sure that the creditors are paid, taxes are computed and properly paid and all other distributions are proper. Partial distributions can be made for those beneficiaries in need of assets.
Fees and costs. The cost of preparing and funding a revocable trust is greater than the cost of having a will prepared that accomplishes the same testamentary disposition. Upon death, estate settlement costs are either hourly or a percentage of the estate. The settlement process (administration of assets, payment of debts, tax filings and asset distributions) is virtually the same regardless of whether a trust or a will is used. A bank, if named as trustee, will most likely have a settlement fee for closing a trust estate. Fees for settling the estate through a trust, whether legal or administrative, just do not disappear.
Privacy. As noted above, a revocable trust does maintain family privacy to some degree. This is a desirable feature of the revocable trust to many people, although some limited disclosure must be made for inheritance tax purposes in states that have an inheritance tax.
Creditors rights. Present and future creditors of the grantor can reach trust assets. Transfers to a revocable trust to avoid creditors will not, typically, be allowed. Probate proceedings statutorily provide for the elimination of some claims when the statutory notice provisions are followed. However, in most instances, legitimate claims are allowed against the estate and probate should not be viewed as a method of avoiding all creditors. The probate process, however, does provide an ability to terminate creditors' rights in the probate assets.
Note: Assets held in a revocable trust that was created by a deceased spouse for the discretionary use and benefit of a surviving spouse can be counted as available resources (as can the income from the trust) for Medicaid eligibility purposes. On the other hand, a trust created by the deceased spouse's will (a testamentary trust) for the benefit of the institutionalized spouse, if drafted property, may possibly not be treated as an available resource.
Disinheriting a spouse. While it has been possible in some states in the past, to my knowledge, no state remains where assets can be transferred to a revocable trust, with the grantor’s spouse not being named as a beneficiary, and effectively disinherit the spouse. The rights of a surviving spouse to a statutory elective share of a deceased spouse's property are not avoided by using a revocable trust rather than a Will.
Challenges. Both revocable trusts and wills are susceptible to challenge by unhappy heirs. Precedent is perhaps better established in the probate format. A revocable trust may create greater suspicion on the part of the heirs. This could mean that challenges are more likely in the context of a revocable trust as compared to a will administered through the probate process.
Trust language interpretation. There is a large body of caselaw that has developed around interpretation questions for wills. This law does not automatically apply to the interpretation of a revocable trust when there may be uncertainty as to the actual intent of the grantor. Even though the considerations might appear to be the same, that has not always been the case when applied by the Courts.
A revocable trust is clearly not advised for everyone. Each person has unique goals and needs that must be considered in light of the benefits and burdens inherent in any type of estate planning arrangement that might be utilized. There is no legal device which will make the basic personal decisions which must be faced for constructive estate planning, and there is no substitute for good counseling in the preparation and implementation of one's estate plan.