Living Trusts Taxation

The following is an excerpt from a recent California Court of Appeal decision:

"Before Beckwith presented the will to MacGinnis, he called Dahl to tell her about the will and e-mailed her a copy. Later that night, Dahl responded to Beckwith's e-mail stating: `"I really think we should look into a Trust for [MacGinnis ]. There are far less regulations and it does not go through probate. The house and all property would be in our names and if something should happen to [MacGinnis] we could make decisions without it going to probate and the taxes are less on a trust rather than the normal inheritance tax."

Beckwith v. Dahl (2012) ___ CA4th ___

The phrase in italics is a common fallacy held by many people. A revocable trust is a tax neutral document, i.e. it will neither increase nor decrease taxes.  Dahl was acting under this erroneous belief when she emailed Beckwith above. Regardless if the decedent wrote a will or revocable trust, the taxation of their estate would be unaffected by the drafting of either instrument. The principal reason for this is because reducing or eliminating the estate tax, "inheritance tax" is a colloquialism, is determined by the recipient of the property, e.g. a spouse or a charity, as opposed to what instrument is used.

However, it should be noted that other types of trusts are created to avoid or reduce taxes. For example, a disclaimer, A/B and charitable trusts are all examples of trust specifically designed for such. Still, each of these trusts utilize beneficiaries that are considered allowable deductions for estate tax purposes. For example, if a person passes away with a $100M estate, they can devise it entirely to charity and their estate will not have any estate tax liability.

Testamentary Trust

The colloquial phrase "living trust" is used commonly by attorneys and non-attorneys. The correct legal terminology for a living trust is an "inter vivos trust." Inter vivos is Latin for among the living. Now you can express your friends at the next cocktail party when somebody asks about your knowledge of Latin. Trust me, it will happen.

Since death is the natural consequence of life, one might ask if they can create a trust at their death. The answer is yes. A trust created at death is called a "testamentary trust." Since the trust is created at death, a will is the instrument used to create a testamentary trust.

To create a testamentary trust, the following five elements must be present:

1. The intention to create a trust
2. Trust property 
3. A trust beneficiary 
4. A trust purpose neither illegal nor against public policy  and
5. A trust purpose that is ascertainable with reasonable certainty

The main reason why testamentary trusts are not as popular as living trusts is because all wills must be probated. Since a principal advantage of a trust is that it exempts trust assets from being probated, a testamentary trust negates this advantage because a will needs to be probated in order for the testamentary trust to come into existence. Hence, testamentary trusts are generally disfavored by most people. 

The following language is excerpted from the will of Joseph Clementi, Jr. that created a type of testamentary trust, a charitable trust. The California Court of Appeal held that the following did in fact create a charitable trust despite the ostensibly incomplete language. Clementi's heirs tried to invalidate the will on the premise that there was no intent to create a trust. The ruling emphasized that charitable trusts are generally favored and courts are reluctant to strike them down, so its validity was upheld on appeal.

Estate of Clementi (2008) 166 CA4th 375

"3. I give the balance of my assets to a charitable foundation or trust in my name to be run by Richard Weisz. If Richard Weisz is not alive when I die, then I appoint his son, Frank Weisz[,] to run my charitable foundation or trust."

Modifying an Irrevocable Trust

The Berkeley Court handles probate matters in Alameda County

Though the name suggests otherwise, an irrevocable trust can be modified through a number of ways. A previous post discusses how to amend a revocable trust. The following are permitted methods to change a California irrevocable trust. Most of the methods do require court approval.

1.  All trust beneficiaries consent. Prob C §15403.

This method is generally allowed provided that neither of the following apply (1) "the continuance of the trust is necessary to carry out a material purpose of the trust, the trust cannot be modified or terminated unless the court, in its discretion, determines that the reason for doing so under the circumstances outweighs the interest in accomplishing a material purpose of the trust.the modification will not" or (2) the trust contains a spendthrift clause.

If neither (1) or (2) apply, the beneficiaries can petition the appropriate probate court for modification. 

One of the problems with this method is that sometimes beneficiaries do not live in the same area or there are beneficiaries that are minors or unborn. Thus, obtaining the consent of all beneficiaries can be a challenge.

2. All trust beneficiaries and the settlor consent. Prob C §15404(a)

Generally speaking, no court order is needed for this method. 

3. At least one beneficiary and the settlor consent. Prob C §15404(b)

This method is allowed provided that the interests of the non-consenting beneficiary or beneficiaries is not substantially impaired.

4. Principal is uneconomically low. Prob C §15408

Following the submission of a petition to the court, if it "determines that the fair market value of the principal of a trust has become so low in relation to the cost of administration that continuation of the trust under its existing terms will defeat or substantially impair the accomplishment of its purposes," modification is permitted.

Or, if the trust principal is $40,000 or less, the trustee is empowered to terminate the trust immediately.

5. Changed circumstances. Prob C §15409

This is most common with charitable trusts as a settlor might name a charity as a trust beneficiary but the charity merges with another charity or dissolves prior to death. For example, assume that Samuel Settlor designates an animal shelter in Los Altos, CA as the sole trust beneficiary. Prior to Samuel's death, the animal shelter dissolves for lack of funds to operate and donates its remaining assets to the animal shelter in Mountain View, CA. Upon Samuel's death, the Mountain View animal shelter would petition the probate court to modify the trust whereby it would become the trust beneficiary because of its connection to the Los Altos animal shelter. 

The legal term for substituting one charity for another to fulfill the settlor's intent in a trust modification case is called "cy pres." Try to incorporate that term into your conversations to either (1) impress your friends, co-workers or family (2) confuse them or (3) raise their ire by using legal jargon in an every day conversation.  

6. Conform the trust to tax laws. Probate Code §§21520-21526

Since a principal reason to write a trust is consideration of tax laws, a trust can be modified to achieve the tax objective the trust was intended to fulfill.

Types of Irrevocable Trusts

The majority of trusts that are drafted are known as revocable or living trusts. However, some people write irrevocable trusts as well if the situation dictates the necessity for such. The following are some of the more common irrevocable trusts:

Life Insurance Trust (commonly known as a ILIT)

In this type of trust, parents gift money to their children to pay the life insurance policy premiums, which are taken out for the parent's lives, and the parents then designate the children as the policy's beneficiary. An ILIT provides the benefit of reducing the parent's taxable estate for Estate Tax purposes and provides the children with liquidity to satisfy Estate Tax obligations. For example, the parents might gift $26,000 to their children annually to purchase the largest life insurance policy they can obtain. When the parents pass away, the proceeds from the policy will not be included in his or her gross estate for Estate Tax purposes. In turn, the children will reap sufficient liquidity to pay any Estate Tax liability. Generally speaking, the IRS requires prompt payment of the Estate Tax, hence access to large quantities of cash is needed to pay it. Unfortunately, you cannot barter services with the IRS as a form of payment so money is needed to pay them off not your impressive karaoke skills.  

Crummey Trust 

This type of trust allows a parent to gift the maximum annual exclusion amount, $13,000 in 2012, to their child's trust. The name is derived from the court case which recognized its validity, Crummey v Commissioner (9th Cir 1968) 397 F2d 82. Basically, a parent tells their child that they are gifting their Crummey Trust $13,000 and the child has the right to withdraw said funds within a specified time period if they so desire. Invariably the child will not withdraw the funds whereby the funds become part of the child's trust. If this seems like a big charade to you, then you can think prudently. 

Charitable Trust

Since the Estate Tax allows a charitable deduction, a wealthy individual might write a trust which benefits a recognized charity to offset the Estate Tax. There are two types of these, a charitable remainder trust ("CRT") and a charitable lead annuity trust ("CLAT"). In a CRT, individuals are designated as beneficiaries for a specified period of time, with the remainder interest passing to charity. In a CLAT, the formula is reversed, the charity is the initial beneficiary for a specified period of time, with the remainder interest passing to named individuals. 

Special Needs Trust (commonly known as SNTs)

A SNT is a trust designed for individuals who are disabled with the goal of retaining the individual's public benefits such as Medi-Cal and Supplemental Security Income while simultaneously allowing them to receive property. There are two types of SNTs, a First-Party Specials Needs Trust and a Third-Party Special Needs Trust. In a First-Party SNT, the disabled individual themselves creates the trust. For example, the individual is awarded a substantial judgment for a personal injury claim and creates the First-Party SNT to maintain eligibility for public benefits. Conversely, with a Third-Party SNT, some person other than the disabled individual, almost always the parents, creates the trust for the individual. 

Qualified Domestic Trust (commonly known as a QDOT)

In the case of a couple, the Estate Tax is not an immediate concern should one spouse away. The reason for this is because one spouse is allowed to transfer to the surviving spouse an unlimited amount of property upon their passing. IRC §2523. For example, if Jack and Jill were collectively worth $250M and Jack suddenly passed away in a tragic hot air balloon accident, Jill would have no immediate concern of paying the Estate Tax since Jack could leave his entire to her absent Estate Tax liability. Although Jill's estate would have to pay the Estate Tax once she passes away. Regardless, the major qualification for the unlimited marital deduction is that the surviving spouse be a U.S. citizen. IRC §2056(d).

If the surviving spouse is not a U.S. citizen, the couple can write a QDOT to take advantage of, albeit partially, the marital deduction for Estate Tax purposes. The nuances of a QDOT are beyond the scope of this brief post because the requirements are rather technical and more importantly for you the reader, quite boring. However, a prior post is dedicated to this topic.   

There are many other types of irrevocable trusts. I focused on the above trusts because I see them in use most frequently.