This memo answers some important questions about basic estate planning. This discussion is very general. The idea is just to give you the big picture. Also, please bear in mind that the law changes from time to time; what is true one week may not be true the next—particularly if Congress is in session. (As one wise guy put it, if “pro” is the opposite of “con,” what is the opposite of “progress”?)
What is a trust?
A trust is the legal relationship that is created when a person transfers “stuff” to a trustee with the understanding that the trustee will manage it for the benefit of one or more beneficiaries. We use the term “stuff” to mean any kind of property you can own. It includes both real property—such as land and buildings—and personal property—such as bank accounts, stocks and bonds, and personal effects. The person who transfers the stuff to the trustee is called a trustmaker. This person is also known as a settlor, grantor, or trustor. Usually, the trustmaker is also the trustee (or perhaps co-trustee) and the initial beneficiary of the trust. For the reasons explained below, a married couple will usually want to create two revocable living trusts instead of just one. It is not uncommon for husbands and wives to be the co-trustees of both of their trusts during their joint lifetimes, and then, after the death of one spouse, to have the survivor serve either as sole trustee or co-trustee with one or more other individuals or a trust company.
A trust is controlled by a document called the trust agreement (sometimes called the trust instrument). The trust agreement sets out the rules about how the trust will be run. We often refer to a client’s set of estate planning documents as their “rule book,” and the trust agreement is the part of the rule book that controls the trust.
If the trust agreement says that the trustmaker can revoke it or change it, the trust is what we call a revocable trust. If the trust agreement does not allow the trustmaker to change or revoke it, we have what is called an irrevocable trust. Irrevocable trusts are also used in many estate plans. They allow trustmakers to make gifts but keep the recipients from having complete control over the gifted assets. Irrevocable trusts play an important part in many estate plans. They can help provide tax savings, creditor protection, and expert management of assets.
A living trust is one that you create and fund (transfer stuff into) during your lifetime. It can be revocable or irrevocable, depending on how much control you want to maintain over the trust and its assets. A revocable trust gives you complete control, whereas an irrevocable trust gives you limited or no control. A testamentary trust is one that goes into effect and is funded following your death because it is governed by your last will and testament.
Will I lose control of my assets when they are transferred to the trustee?
NOT IF YOUR TRUST IS REVOCABLE. The trustee is bound by the trust agreement. You have final say over what the trust agreement says, and failure to abide by the trust agreement can make the trustee personally liable to the beneficiaries, including yourself. This means that if the trustee messes up, that person may have to pay for the mess out of his or her own pocket. Most often, the trustmaker of a revocable living trust is the initial trustee. In that situation, the trustmaker does not have to worry about anyone questioning his or her management of the trust for two reasons. First, the trustee is usually granted very broad discretion to favor the trustmaker as the initial beneficiary. Second, the trustmaker of a revocable living trust has the power to amend the trust agreement or to revoke the trust and get the trust assets transferred back into the trustmaker’s name. Thus, no one else is in a very good position to challenge what the trustmaker/trustee does with the trust. In fact, potential beneficiaries have a vested interest in not doing anything that might cause the trustmaker to revoke the trust or change the trust agreement in order to exclude a troublemaker. This is a simple demonstration of the “golden rule” of estate planning:
The One who hath the Gold maketh the Rules
If your kids are good kids, they won’t stick their noses into what you do with your trust. If they are bad kids, hopefully they are smart kids and will at least act like good kids as long as you’re alive because they won’t want to be disinherited. If you do not have any children—or don’t have any that you like—don’t assume that revocable living trusts are not a good idea for you. There are many good reasons for creating trusts, and some of them may apply to your situation. One reason that many people create revocable living trusts is so that their stuff will not go through probate after they are gone, or through conservatorship if they become incapacitated.
How does a revocable living trust avoid probate?
Once assets are transferred to the trustee, the trustmaker no longer holds legal title to them—even if the trustmaker and the trustee are the same person. Thus, if the trustmaker dies, the trust continues, and the successor trustee (who is named in the trust agreement) takes over administering the trust. Since a trust can’t die the same way a person can, the trust assets will not be subject to probate upon the trustmaker’s death. Title to the trust assets simply remains in the trust, and the trust agreement tells the successor trustee (that is, whoever the trust agreement identifies as next in line to serve as trustee) exactly what to do with them. Any assets not transferred to the trustee, however, will be subject to probate upon the trustmaker’s death.
What is probate, anyway?
Probate is the court proceeding to transfer a dead person’s assets to the people who are supposed to get them. Simple in concept, but humbug in practice. Probate can easily take a year or more to complete, and the attorneys’ fees and other costs associated with probate could easily eat up 5% or more of a decedent’s gross estate. (“Decedent” is lawyer talk for someone who has assumed room temperature—i.e., a “dead person.”) If a decedent owned assets located in more than one state or country, it may be necessary to have a probate in each jurisdiction where the decedent’s assets are located. If one probate is bad, you can bet that more than one probate is worse. In almost every case, probate is an awfully good thing to avoid.
In addition to the money and time that probate can consume, another reason people try to avoid probate is that the court’s probate files are public records. Nosy people can go through the court’s probate files and gather all kinds of information that may be profitable to them—and detrimental to decedents’ families. This is a growing concern, especially as we see more and more cases of identity theft.
What other benefits do revocable living trusts provide?
A revocable living trust can avoid a conservatorship proceeding (sometimes called a “living probate”) in the event the trustmaker loses the ability to handle assets. Ordinarily, if a person becomes incompetent, a court must appoint a conservator to administer the person’s assets on his or her behalf. The conservator must then account to the court every year or so, and the whole conservatorship process can end up being extremely costly and time consuming. Not only that, but the documents in the court’s file are a matter of public record. Think about it. If you were to become incapacitated (and you currently have more than a 50-50 chance of doing so), anybody who so chooses could go down to the courthouse and find out personal information about you (such as the specific diagnosis of your incapacity). Even worse, that person can find out information about your assets and your family members that would best be kept private. On the other hand, if your assets had been held in trust, upon your incapacity the successor trustee could have stepped in—without court action—and picked up the administration of the trust where you left off.
Trusts also allow you to have control over your estate even after your death. If one of the beneficiaries of your trust after your death is a minor, you will want your trust to hold on to that beneficiary’s share of your estate until the beneficiary reaches the age when you believe he or she will be mature enough to handle it. Think back to when you turned 18. What would you have done if all of a sudden you had more money than you knew what to do with? Would your little munchkins do any differently? If you don’t plan for that possibility, you could be setting up one of your loved ones to blow his or her inheritance. If this does not appeal to you, your trust agreement could provide, for example, that the share of any beneficiary under the age of 25 will stay in trust until the beneficiary turns 25. In the meantime, the trustee can make distributions to or for the beneficiary, but the beneficiary cannot demand that any distributions be made until he or she turns 25.
There is no magic to the age of 25; you could postpone a beneficiary’s control over his or her inheritance to any age you wish. You could also use an event besides a birthday to trigger a distribution from your trust. For example, your trust agreement could call for a distribution when a child either turns 25 or graduates from an accredited college or university, whichever happens first. You could also have the trust assets distributed to a beneficiary in increments—say a third of the trust principal at age 25, half of the remaining assets at 30, and the rest at 35. You could even set out different terms for each beneficiary. One beneficiary might be quite capable of handling an inheritance at the age of 21, whereas another might never have that ability. You can tailor your trust agreement to include appropriate provisions for each situation.
Many clients choose to leave children’s inheritances in trust during the children’s entire lifetimes to provide them with creditor protection and to avoid estate taxation upon their deaths. Depending on how much control the trustmaker wants to give a beneficiary, the trust agreement can (but does not have to) say that each beneficiary gets to pick the trustees of his or her individual inheritance trust, and each beneficiary can be given the power to say where his or her remaining trust assets go when the beneficiary dies. Thus, the beneficiaries can be given virtually all of the control of outright ownership, while at the same time being spared two important disadvantages of outright ownership: vulnerability to creditors and susceptibility to predators. If the trusts are set up and administered correctly, most creditors (including ex-spouses) and questionable characters can be prevented from walking away with your children’s inheritance. If that wasn’t good enough, consider this: the trust assets will not, at your children’s deaths, be counted as part of their estates and subjected to estate tax. Even the IRS goes away disappointed. The technical term for this kind of trust is a “generation-skipping trust.” Children are understandably suspicious of the name, but they are not actually skipped—unless you want them to be.
Revocable living trusts can also be used to provide incentives for beneficiaries. For example, you could say in your trust document that the Trustee will make distributions to a beneficiary only if he or she earns a college degree. Another type of incentive provision might be that the Trustee will match the income earned by the beneficiary, as evidenced by the W-2 forms provided by the beneficiary’s employer for income tax purposes. The point is that your trust can cover a vast array of different situations. You are limited only by your own creativity and that of the professionals who help you design your trust.
Do I have to do anything to make my trust “work”?
Remember that the trust agreement will govern only those assets which you actually place in your trust. The process of putting property into your trust is called funding. If you have a trust but fail to fund it fully by placing all of your assets in it, whatever assets remain outside the trust upon your death or incapacity may be subject to probate and/or conservatorship proceedings. Funding is simply a matter of changing title to your real estate, your bank accounts, and whatever else you own so that it is held in the name of your trustee. Usually, your attorney will prepare the deeds for your real estate and can help with transferring the rest of your assets. If you want, you can handle a good part of the funding yourself and possibly save yourself some legal fees. You just have to make sure that the funding is done correctly. If you are going to pay your lawyer to double-check your funding, it might make sense to have your lawyer take care of it in the first place.
If I have a revocable living trust, do I still need a will?
YES. First, what if you fail to have all of your assets transferred into your trust before your death? This could happen for a variety of reasons, some of which are beyond your control. Unless you have a so-called “pour over will” (one that says “please put everything into my trust”), your non-trust assets will pass according to whatever law is in effect for people who do not have wills. Dying without a will is called dying intestate. The laws that govern how an intestate estate is passed on to the decedent’s survivors are called intestate succession statutes. The intestate succession statutes that cover your estate may actually frustrate your overall estate plan by requiring that assets pass in ways that you would not want them to pass. Also, remember that each State in the Union has its own intestate succession statute, so if you have assets in more than one State, different rules may apply to different assets. So why not go for the certainty of having a safety net to catch your non-trust assets and pour them into your trust?
Another reason to have a will even if you have a trust is that your will is where you typically name guardians for minor children (or incapacitated adult children or an incapacitated spouse). If you fail to name a guardian, the Court will pick somebody, and that somebody may not be your first choice. Your will also names your personal representative (also known as an executor), who is the person who will deal with claims by or against your estate. There may be no need for a guardian or a personal representative to be named after you are gone, but nobody will know that until after you are gone; and then it will be too late to do anything about it. Again, why not go for the certainty of stating your choice rather than leaving these important matters to chance?
Will a revocable living trust help to avoid taxes?
In and of themselves, trusts do not avoid estate taxes, but they help to carry out good estate tax planning. As far as income taxes go, revocable living trusts are “tax neutral.” During your lifetime, your trust will not need to file its own income tax returns. The taxpayer identification number for your trust is your Social Security Number, and you simply report all trust income on your individual Federal and State income tax returns.
What is the current status of the estate tax?
The federal estate tax has been in flux since 2002, and Congress has yet to agree on a form of the tax that will be somewhat predictable for the indefinite future. As of January 1, 2012, a 35% tax is imposed on all estates valued at more than $5,120,000. It is as if Congress gave each of us a coupon that our loved ones can use to shelter the first $5,120,000 worth of our assets. Quite clearly, the coupon as it now stands is big enough to protect most estates from the estate tax.
If you are waiting for the other shoe to drop, here it is: unless Congress does something to make the size of the coupon permanent (at least, as “permanent” as tax rules ever are), on January 1, 2013, the coupon will drop down to $1,000,000, and the tax rate will jump up to 55%. It is difficult to say whether Congress will allow that to happen, but the current state of our economy and the runaway federal budget deficit do not give us much reason for optimism. Now, more than ever, it is important to establish a plan to minimize the potential tax bite that awaits, and to keep your estate plan current. People with larger estates should consider ways of using all or part of their coupons as soon as possible, before Congress either reduces them or sits on their hands until the scheduled changes (i.e., the drop in the coupon and the explosion of the tax rate) take effect.
Once my spouse and I set up our trusts, how should we hold title to our assets?
We recommend that assets be split between two revocable living trusts, one in the husband’s name and the other in the wife’s. You should not be concerned that you will lose control over those assets, as husband and wife can be co-trustees of both trusts. Alternatively, they can also be the sole trustees of their respective trusts, if they prefer.
Splitting the assets may seem unusual to you, since it is very common for married couples to own all of their assets jointly. Holding assets jointly makes a great deal of sense on one level, since joint tenancy assures that, at the death of the first spouse to die, title to the joint assets will vest in the survivor without probate (by virtue of the way title is held) and without tax (by virtue of the unlimited estate tax marital deduction). However, in many cases, joint tenancy is a trap waiting to be sprung. It makes you lose the opportunity to build significant tax and asset preservation components into your estate plan, and it sets up the surviving spouse’s estate for probate.
Can a married couple own assets in a way that protects from creditors?
Yes. Among other things, a married couple can protect assets by holding property as tenants by the entirety. Notwithstanding all the bad stuff we just reviewed about joint tenancy, there is a very special kind of joint tenancy between spouses which has important benefits. It is called tenancy by the entirety. Among the characteristics of property owned in tenancy by the entirety are that: (1) one spouse, acting alone, cannot convey any interest in the property (in other words, both spouses have to sign a deed in order to transfer the property to someone else); (2) the property automatically passes to the surviving spouse upon the death of the first to die; and (3) the creditors of one spouse cannot reach tenancy by the entirety property.
The latter characteristic was defined in the Hawaii Supreme Court case of Sawada v. Endo, 57 Haw. 608, 561 P.2d 1291 (1977). In that case, the defendant, Mr. Endo, had been involved in a car accident; he was sued, and a judgment requiring him to pay money to the plaintiffs was entered against him. At the time of the accident, Mr. Endo and his wife owned their home as tenants by the entirety. When the plaintiffs tried to force the sale of the Endos’ home in order to collect their judgment, the court refused to allow them to do so. The court reasoned that, since one spouse, acting alone, cannot convey away an interest in tenancy by the entirety property, the creditors of one spouse cannot satisfy their claims out of such property. The court said that
by the very nature of the estate by the entirety as we view it, and as other courts of our sister jurisdictions have viewed it, “[a] unilaterally indestructible right of survivorship, an inability of one spouse to alienate his interest, and importantly for this case, a broad immunity from claims of separate creditors remain among its vital incidents.”
Sawada v. Endo is actually a bit more convoluted than explained above, but the bottom line is that the case upholds a very important benefit of tenancy by the entirety – creditor protection.
Can my spouse and I own property as tenants by the entirety in our trusts?
Yes, you probably can by including language in your trust agreements that is designed to preserve the protections afforded by tenancy by the entirety. One implication of Sawada is that, when spouses divide their property between their trusts, they may lose the creditor protection afforded by tenancy by the entirety. If one spouse were to have a car accident or a business setback or otherwise incurred substantial debt, the property in that person’s trust might be subject to creditors’ claims. This result might have been avoided if the couple had held all of their property in tenancy by the entirety. Thus, there may be a serious downside to dividing tenancy by the entirety property between a husband’s and wife’s trusts. Accordingly, if you transfer tenancy by the entirety property into your trust, you should try to preserve the kind of protection afforded by tenancy by the entirety through provisions in your trust agreement that track the spousal rights inherent in tenancy by the entirety.
Is there a downside to tenancy by the entirety?
We offer TWO WARNINGS about tenancy by the entirety:
First, tenancy by the entirety protects assets only against creditors who are unknown, and whose claims are not clearly foreseeable, at the time that the tenancy was established. You cannot put assets into tenancy by the entirety after a debt or liability arises and expect those assets to be safe from being consumed by the debt or liability.
Second, the creditor protection afforded by tenancy by the entirety can backfire if the non-debtor spouse dies first. In other words, if you have a huge debt, the person you owe money cannot get at property you hold in tenancy by the entirety with your spouse, but only as long as your spouse is alive. If your spouse should die before you, you would end up as sole owner of the (formerly tenancy by the entirety) property, and your creditor would be in a position to try to take it away from you.
Can I own assets other than my home in tenancy by the entirety?
Hawaii law allows you to hold any kind of property in tenancy by the entirety—not just real estate. Thus, if tenancy by the entirety protection is appealing to you, you can probably use it to shelter a lot more than just your house from potential creditors. The reason we say “probably” here is that a recent Bankruptcy Court decision indicated that tenancy by the entirety protection, for bankruptcy purposes, may extend only to a primary residence.
What about protecting my other beneficiaries?
In an age of a 50% divorce rate and liability seemingly waiting around every corner, it makes sense to wonder whether the things you leave behind to children, grandchildren, and other beneficiaries might be snatched away from them. Trusts are very effective in protecting your loved ones in these situations.
One approach is for your trust agreement to provide that, after you are gone, your trust divides up into as many trusts as you would like. In other words, rather than passing assets to your beneficiaries, you pass them trusts that contain the assets. This way, you can achieve significant creditor protection without sacrificing the beneficiaries’ enjoyment of their inheritance. The beneficiary for whom each trust is created may be given the power to choose the trustee of his or her trust, and each of them can be given a certain amount of discretion as to when and whether to withdraw assets from his or her trust. When each beneficiary dies, he or she can have the power to direct where the assets go, or, if the power is not exercised, your trust agreement can say that the assets go to that person’s children.
Is there a kind of trust will protect my assets from my own creditors?
Yes. As of July 1, 2011, Hawaii law allows you to create an asset preservation trust that will keep your creditors at bay. There are very specific rules that govern these kinds of trusts, and those rules must be followed carefully. However, if you create and fund one of these trusts at a time when you do not have any creditors nipping at your heels, that trust can prove to be a very effective means of protecting whatever is in the trust. These trusts provide a variety of other important features that can make them very attractive in the right situation.