Attorney & Counselor at Law
ROBERT M PHILLIPS
“Put not your trust in money, but put your money in trust.”
Oliver Wendell Holmes (1809-1894)
In the first part of this series on trusts, I introduced and explored what a trust is, briefly reviewed how a trust is created, defined who the players involved in a trust are, and explained what the major differences are between several common types of trusts, including “living trusts” versus “testamentary trusts,” “revocable trusts” versus “irrevocable trusts,” etc.. In this article, I review a two common types of irrevocable trusts, Life Insurance Trusts and Charitable Trusts, and how these types of trusts may benefit you and your beneficiaries. A third article will explore Personal Residence Trusts and Grantor Retained Annuity Trusts.
You may recall that an irrevocable trust is a trust established by a settlor that cannot be revoked. Once a person creates an irrevocable trust and gives property to the trustee to manage, the property is no longer owned by settlor/donor-it is owned by the trust. Aside from reducing the value of their estates (and, hence, any estate taxes that may be assessed against these assets or the future growth of these assets), most people give away property to accomplish some other purpose, either during their lifetime, or after their death, or both. An irrevocable trust is often the vehicle of choice for such gifts and purposes. Let’s explore two of these purposes as we look at trusts created by Ivan and Cathy.
Life Insurance Trusts
Ivan owns a $1,000,000 life insurance policy on his life, payable on his death to the beneficiaries of his choice. During his lifetime, the policy permits Ivan to change the beneficiaries of this policy whenever he desires. When Ivan dies, the $1,000,000 will be distributed, in cash, to his designated beneficiaries. They will not have to claim any of that money as income on their federal or state income tax returns. They will receive the entire proceeds income tax free!
However, there could be a “hidden” tax on these proceeds…not to the beneficiaries directly, but to Ivan’s estate. Ivan’s estate could be required to pay an amount, up to about one-half of the value of the life insurance proceeds, to the government in federal or state estate taxes. This is because the life insurance proceeds will be included in Ivan’s estate (the IRS deems these proceeds as “property” that Ivan owned) along with all of the other assets that Ivan owned, and if the total value of all of this property is more than a certain amount, his estate could be required to pay these taxes.
To avoid this outcome, Ivan could have created an irrevocable trust, sometimes called an Irrevocable Life Insurance Trust (or “ILIT”). Instead of applying for and acquiring the life insurance himself, Ivan could have the trust acquire the $1,000,000 life insurance policy on his life. The trust would apply for the policy, pay the premiums (from cash gifts that Ivan makes each year to the trust), and eventually receive all of the proceeds of the policy on Ivan’s death. Then, according to the terms of the trust (that Ivan chose when he created the trust) the proceeds could be distributed outright, income and estate tax-free, to Ivan’s beneficiaries. Or, if Ivan so desired, the proceeds could be held in trust until some time in the future (say, when the beneficiaries reach certain ages, go to college, or have other needs).
Why is there no estate tax on the proceeds? Because when Ivan died he did not own the policy. Estate tax is only assessed against persons. Here, the trust owned the policy, and trusts do not “die” or pay estate tax!
Now, there are a few tradeoffs that Ivan must give up to receive these tax-free savings. For example, Ivan cannot change the beneficiaries of the life insurance policy once he establishes the trust, nor can he receive any dividends from the policy or borrow money against the policy value. However, a well-drafted trust agreement and careful selection of trustee can reduce some of these concerns. And, if Ivan ever wanted to cancel the life insurance policy, all he has to do is stop making gifts to the trust. If the trustee is unable to pay the premiums, the policy will lapse.
What if after creating the trust, the estate tax laws are dramatically changed, or even repealed? Was establishing the trust a waste of time and money? Not at all. Ivan can still be comforted by knowing that the proceeds of his ILIT will be held and managed in trust, thus affording them the usual benefits of an irrevocable trust, including significant asset protection, deferred distribution of the proceeds, and continuing fiduciary management of the funds that would not be available or could not be ensured if the proceeds were made outright to his beneficiaries. This is particularly important if the beneficiaries are minors or disabled.
Charitable Trusts
There are so many flavors of charitable trusts, each with differing purposes and benefits. To understand one such type of charitable trust, the Charitable Remainder Trust, let’s consider the situation of Cathy.
Cathy is a benevolent person and would like to make a gift to one or more charitable organizations of her choosing. She has an asset that she acquired many years ago that has appreciated quite nicely in value and is paying her a modest amount of income. Cathy has three options:
Her first option is to give the entire asset to the charity. This is simple and would provide Cathy with the largest income tax deduction (equal to the full fair market value of the asset). But after making the gift, Cathy would lose the income that the asset had provided. She wants to keep that income.
A second possibility is that Cathy sell the asset, pay income tax on the gain she realizes on the sale, and then make a cash gift to the charity of a portion of the remaining proceeds. This way she could retain some of the cash proceeds to supplement her loss of the income. Cathy likes this option except that she does not like the fact that she will have to pay income tax when she sells the asset. Giving the government a portion of the asset means there will be less funds remaining to generate income for her or to benefit the charity. Is there a way to avoid paying taxes to the government and yet still retain an income stream? There is.
Cathy could establish a irrevocable Charitable Remainder Trust and give the asset to the trust. The trust could hold or sell the asset, and in most cases pay no income tax on the sale. Cash, equal to the full fair market value of the asset, would remain in the trust and be reinvested. The trust would pay Cathy an income stream for the rest of her life, and on her death the remaining trust assets would be distributed to the charitable organization(s) that Cathy designated.
With the Charitable Remainder Trust, the income tax payable upon the sale of the asset can be avoided, the income stream can be retained, and Cathy can still get an immediate income tax deduction for the gift to the trust (although the deduction will be less than if she had made an immediate outright gift to the charity). This is the best option for Cathy.
An advantage to making the gift during Cathy’s lifetime: Charitable gifts made during one’s lifetime, whether outright or in trust, reduce the value of one’s taxable estate at death, but because they are made during a taxpayer’s lifetime they also permit the donor to enjoy an immediate income tax deduction when the gift is made. Charitable gifts made after death will reduce the value of the donor’s taxable estate, but the income tax deduction for making a charitable gift is lost-there is no income tax deduction in the decedent’s estate.
If Cathy really want to get fancy, she could take the income stream from her Charitable Remainder Trust and use it to pay the premium on a life insurance policy on her life (held in an ILIT, of course) equal to the value of the asset that she gave to the Charitable Remainder Trust. This way, her beneficiaries receive the same size inheritance as if she had done nothing, the charity receives a nice gift at Cathy’s death, Cathy gets an income tax deduction during her life, and she continues to receive an income stream for life. The only loser is the government; it will not receive the income tax when Cathy’s asset is sold, or the estate tax on the value of the asset or the estate tax on the life insurance proceeds! That’s a win-win-win!
Conclusion
Trusts can be the most creative and flexible instruments that lawyers can prepare. When I teach trusts to law students, we collect, over the course of the semester, a list of the different types and names of trusts that we have examined. In any semester, we may collect thirty or more types. If I had time, we could review two or three times that many. Creative people continue to find ways that trusts can be of benefit. So I suppose Holmes was right. More and more people are putting their money in trusts.
© 2005 Robert M. Phillips.
All Rights Reserved.
Oliver Wendell Holmes (1809-1894)
In the first part of this series on trusts, I introduced and explored what a trust is, briefly reviewed how a trust is created, defined who the players involved in a trust are, and explained what the major differences are between several common types of trusts, including “living trusts” versus “testamentary trusts,” “revocable trusts” versus “irrevocable trusts,” etc.. In this article, I review a two common types of irrevocable trusts, Life Insurance Trusts and Charitable Trusts, and how these types of trusts may benefit you and your beneficiaries. A third article will explore Personal Residence Trusts and Grantor Retained Annuity Trusts.
You may recall that an irrevocable trust is a trust established by a settlor that cannot be revoked. Once a person creates an irrevocable trust and gives property to the trustee to manage, the property is no longer owned by settlor/donor-it is owned by the trust. Aside from reducing the value of their estates (and, hence, any estate taxes that may be assessed against these assets or the future growth of these assets), most people give away property to accomplish some other purpose, either during their lifetime, or after their death, or both. An irrevocable trust is often the vehicle of choice for such gifts and purposes. Let’s explore two of these purposes as we look at trusts created by Ivan and Cathy.
Life Insurance Trusts
Ivan owns a $1,000,000 life insurance policy on his life, payable on his death to the beneficiaries of his choice. During his lifetime, the policy permits Ivan to change the beneficiaries of this policy whenever he desires. When Ivan dies, the $1,000,000 will be distributed, in cash, to his designated beneficiaries. They will not have to claim any of that money as income on their federal or state income tax returns. They will receive the entire proceeds income tax free!
However, there could be a “hidden” tax on these proceeds…not to the beneficiaries directly, but to Ivan’s estate. Ivan’s estate could be required to pay an amount, up to about one-half of the value of the life insurance proceeds, to the government in federal or state estate taxes. This is because the life insurance proceeds will be included in Ivan’s estate (the IRS deems these proceeds as “property” that Ivan owned) along with all of the other assets that Ivan owned, and if the total value of all of this property is more than a certain amount, his estate could be required to pay these taxes.
To avoid this outcome, Ivan could have created an irrevocable trust, sometimes called an Irrevocable Life Insurance Trust (or “ILIT”). Instead of applying for and acquiring the life insurance himself, Ivan could have the trust acquire the $1,000,000 life insurance policy on his life. The trust would apply for the policy, pay the premiums (from cash gifts that Ivan makes each year to the trust), and eventually receive all of the proceeds of the policy on Ivan’s death. Then, according to the terms of the trust (that Ivan chose when he created the trust) the proceeds could be distributed outright, income and estate tax-free, to Ivan’s beneficiaries. Or, if Ivan so desired, the proceeds could be held in trust until some time in the future (say, when the beneficiaries reach certain ages, go to college, or have other needs).
Why is there no estate tax on the proceeds? Because when Ivan died he did not own the policy. Estate tax is only assessed against persons. Here, the trust owned the policy, and trusts do not “die” or pay estate tax!
Now, there are a few tradeoffs that Ivan must give up to receive these tax-free savings. For example, Ivan cannot change the beneficiaries of the life insurance policy once he establishes the trust, nor can he receive any dividends from the policy or borrow money against the policy value. However, a well-drafted trust agreement and careful selection of trustee can reduce some of these concerns. And, if Ivan ever wanted to cancel the life insurance policy, all he has to do is stop making gifts to the trust. If the trustee is unable to pay the premiums, the policy will lapse.
What if after creating the trust, the estate tax laws are dramatically changed, or even repealed? Was establishing the trust a waste of time and money? Not at all. Ivan can still be comforted by knowing that the proceeds of his ILIT will be held and managed in trust, thus affording them the usual benefits of an irrevocable trust, including significant asset protection, deferred distribution of the proceeds, and continuing fiduciary management of the funds that would not be available or could not be ensured if the proceeds were made outright to his beneficiaries. This is particularly important if the beneficiaries are minors or disabled.
Charitable Trusts
There are so many flavors of charitable trusts, each with differing purposes and benefits. To understand one such type of charitable trust, the Charitable Remainder Trust, let’s consider the situation of Cathy.
Cathy is a benevolent person and would like to make a gift to one or more charitable organizations of her choosing. She has an asset that she acquired many years ago that has appreciated quite nicely in value and is paying her a modest amount of income. Cathy has three options:
Her first option is to give the entire asset to the charity. This is simple and would provide Cathy with the largest income tax deduction (equal to the full fair market value of the asset). But after making the gift, Cathy would lose the income that the asset had provided. She wants to keep that income.
A second possibility is that Cathy sell the asset, pay income tax on the gain she realizes on the sale, and then make a cash gift to the charity of a portion of the remaining proceeds. This way she could retain some of the cash proceeds to supplement her loss of the income. Cathy likes this option except that she does not like the fact that she will have to pay income tax when she sells the asset. Giving the government a portion of the asset means there will be less funds remaining to generate income for her or to benefit the charity. Is there a way to avoid paying taxes to the government and yet still retain an income stream? There is.
Cathy could establish a irrevocable Charitable Remainder Trust and give the asset to the trust. The trust could hold or sell the asset, and in most cases pay no income tax on the sale. Cash, equal to the full fair market value of the asset, would remain in the trust and be reinvested. The trust would pay Cathy an income stream for the rest of her life, and on her death the remaining trust assets would be distributed to the charitable organization(s) that Cathy designated.
With the Charitable Remainder Trust, the income tax payable upon the sale of the asset can be avoided, the income stream can be retained, and Cathy can still get an immediate income tax deduction for the gift to the trust (although the deduction will be less than if she had made an immediate outright gift to the charity). This is the best option for Cathy.
An advantage to making the gift during Cathy’s lifetime: Charitable gifts made during one’s lifetime, whether outright or in trust, reduce the value of one’s taxable estate at death, but because they are made during a taxpayer’s lifetime they also permit the donor to enjoy an immediate income tax deduction when the gift is made. Charitable gifts made after death will reduce the value of the donor’s taxable estate, but the income tax deduction for making a charitable gift is lost-there is no income tax deduction in the decedent’s estate.
If Cathy really want to get fancy, she could take the income stream from her Charitable Remainder Trust and use it to pay the premium on a life insurance policy on her life (held in an ILIT, of course) equal to the value of the asset that she gave to the Charitable Remainder Trust. This way, her beneficiaries receive the same size inheritance as if she had done nothing, the charity receives a nice gift at Cathy’s death, Cathy gets an income tax deduction during her life, and she continues to receive an income stream for life. The only loser is the government; it will not receive the income tax when Cathy’s asset is sold, or the estate tax on the value of the asset or the estate tax on the life insurance proceeds! That’s a win-win-win!
Conclusion
Trusts can be the most creative and flexible instruments that lawyers can prepare. When I teach trusts to law students, we collect, over the course of the semester, a list of the different types and names of trusts that we have examined. In any semester, we may collect thirty or more types. If I had time, we could review two or three times that many. Creative people continue to find ways that trusts can be of benefit. So I suppose Holmes was right. More and more people are putting their money in trusts.
© 2005 Robert M. Phillips.
All Rights Reserved.
TRUST ME (Part 2 of 3)