1.  Trusts

2.  What is a Trust? o Trusts are a financial planning tool (legal documents) that Provide for ownership of assets Control of interests in assets Transfer of assets outside of probate o Trust has a “maker” o Trust has a trustee o Trust has a beneficiary

3.  Trust o Vests legal title for property with trustee o Beneficiaries hold equitable interest in property o Maker (a.k.a. grantor, settlor, creator, or trustor) provides assets to the trusts and instructions to trustee for managing the assets and beneficiaries interests o Maker, Trustee, Beneficiary can be the same person o Beneficiaries can be split into two types Income beneficiary Remainder beneficiary o Trustee follows the Prudent Man Rule as a fiduciary

4.  What does if mean to be a fiduciary? o One who acts in the best interest of another party Duty of loyalty Duty of care o Prudent Man Rule – act in the same manner as a prudent “person” would act if acting for their own benefit o Prudent Man Rule codified in most states into Prudent Investor Act Limits nature and types of investments a trustee can make Performance standard for trustee  Issues with appointing the trustee (when not the maker) o Skills to perform fiduciary responsibilities o Potential conflict if also a beneficiary

5.  Why use a Trust? o Managing trust property – not everyone can properly manage assets and this is a vehicle to have professional management of assets for the benefit of the beneficiaries (for example, minor or disabled individual) o Creditor protection – removes the asset title from the beneficiary and vests it with the trustee (with spendthrift clause) o Split interests in property – maker can designate an income beneficiary and a remainder beneficiary to same property o Avoid Probate – assets retitled through instructions provided to the trustee (vested owner) for beneficiaries o Avoid or postpone taxes

6.  Background on Trust life o The rule against perpetuities (never ending trust) A trust “should not” permanently remove property from commerce Case of Duke of Norfolk 1500’s Trust contained property with instructions that prevented future sale Lord Chancellor of Nottingham issued rule against perpetuities o Maximum life of a trust (varies by state) Must expire at the end of the youngest living beneficiary named in trust plus 21 years Uniform statutory rule is 90 years maximum Trusts can be perpetuity if they do not have instructions to trustee to not sell property

7.  Trusts are Hybrid Entities o Income is taxable to beneficiary, trust, or maker o Simple trusts mandate distribution of all trust income to the beneficiaries annually and thus beneficiaries pay the tax o Complex trusts can retain some income, distribute to charities or distribute principal Each beneficiary is tax on their pro rata share Income retained in trust is taxed at trust tax rates In any year all income is distributed to beneficiaries and no distributions to charities and principal distributions, trust reverts to simple trust o Transfers to irrevocable trusts are potential “gifts” o Tax rules are very complex on what is Distributable Net Income

8.  Types of Trusts o Irrevocable Trusts – Maker cannot take back property o Inter Vivos Trusts – Trusts made while maker is alive (all revocable trusts are Inter Vivos Trusts) o Testamentary Trusts – Trust made after the death of the maker o Standby Trust – Trust formed during life of maker but is contingent on an event to become hybrid entity o Pourover Trust – Trust that is created at death of maker and typically receives assets from another trust or will or untitled assets of maker o Living Trusts – Trust that serves the maker as beneficiary and the trustee is usually the maker. Primary trust for financial planning of clients with estate in excess of $2,000,000

9.  Examining the Living Trust o Fred and Wilma have accumulated $3,000,000 in their estate and have one child, Pebbles. Assets consist of home ($400,000), Life Insurance policies ($200,000 each), IRA ($350,000), Investment Portfolio ($1,800,000), Checking and Savings Accounts ($10,000) and untitled assets ($40,000). Fred and Wilma both are professionally employed and earning income Pebbles is just entering 1 st grade o Fred and Wilma make a Living Trust – Revocable Trust What assets go into the trust? What instructions should the trust have? Who should the trustee be? How should the beneficiaries be listed (both income and remainder)?

10.  Fred and Wilma’s Living Trust o Trustees – Fred and Wilma o Beneficiaries Surviving Spouse and then Pebbles (contingent) If Pebbles has not reach age of majority then contingent trust o Assets in trust Home, Investment Portfolio, Checking and Savings o Assets outside of trust Life Insurance and IRA – avoid probate by contract law o Instructions Stand-By Trust for surviving spouse (A-B By Pass Trust) Pourover Trust for all untitled assets at death of second spouse o Trust provides vehicle to avoid Probate – Becomes irrevocable at death of second maker (when surviving spouse dies)

11.  More on Irrevocable Trusts o In general, avoid probate, are private documents (not available to the public like a will), discourage contesting, property avoids creditors of beneficiaries while in trust o To the last point, large family trusts Anyone can “transfer” assets to the trust Family members can be beneficiaries of the property (income) from the trust without owning property in trust Trust pays taxes on non distributed income Kennedy’s Family Trust – property avoids creditors or others suing for injury or damages  More on Revocable Trusts o Not a completed gift and not a vehicle for avoiding estate taxes

12.  Gift Tax and Trusts o In general, a gift to a trust is a future interest and not eligible for the annual gift tax exclusion unless Beneficiary has right to withdraw the annual gift (power of appointment) Trust has a Crummey Power provision allowing withdraws (typically in the first 30 days (thus power of appointment) The 5/5 Rule for Lapsing Amounts The beneficiary has right to withdraw $5,000 or 5% annually (whichever is larger) This right can be lost each year or extended into future years on annual contributions  Life Insurance Trusts - More on these in Chapter 11

13.  By-Pass Trusts o Typically created at the death of first spouse and used to retain ability to pass on gift tax exclusions to heirs of the couple o Example – for Barney and Betty and their child Bam-Bam Barney and Betty set up Living Trust (revocable) and transfer $10,000,000 of assets into the trust with Bam-Bam as the beneficiary of the trust Note – as makers and trustees, instructions are set up such that Barney and Betty can “enjoy” the income of the trust during their lifetime Revocable trust so Barney and Betty can make changes to trust in future (remove assets, exchange assets, change beneficiaries, etc.) Trust contains a contingency for a by-pass trust at the death of either Barney or Betty for surviving spouse

14.  By-Pass Trust (continued) o If Barney (or Betty) passes – a By-Pass Trust is established for Betty (Barney) and transfers $5,000,000 of assets into By-Pass Trust with Betty (Barney) as trustee and income beneficiary Betty (Barney) can withdraw income annually and some principal (with some restrictions) for personal support At death of Betty (or Barney) all property of original trust and by-pass trust pass to Bam-Bam and one-time gift exclusion can be used by both trusts The By-Pass trust passes the property to Bam-Bam (from the first in death) and also applies one-time gift tax exclusion for the first in death The Living trust passes the property to Bam-Bam (from the second in death) and also applies one-time gift tax exclusion for the second in death

15.  By-Pass Trust (continued) Total gift tax exclusion used by Barney and Betty is $10,000,000 for estate tax purposes o Failure to use By-Pass Trust as contingency trust for Barney and Betty Assume Living Trust set up with the $10,000,000 of assets When first in death dies, surviving spouse receives all assets “gift tax” free as part of the estate of the first in death When second in death passes assets are transferred to beneficiary, son Bam-Bam Second in death uses one time exclusion and $5,340,000 of assets pass to Bam-Bam avoiding gift/estate taxes Remaining $4,660,000 is passed but incurs gift/estate taxes and potential loss is roughly $1,800,000 (current rates)

16.  By-Pass Trust during life o For very wealthy individuals on assets expected to appreciate o Difference here is a surviving spouse does not need the asset for living (retaining current life style) o By-Pass Trust receives property and one-time exclusion is used for the transferred property o Appreciated property transferred at death of trust maker and basis for estate is the original transfer value o Example – Transfer of $5,340,000 into trust By-Pass Trust is used for one time exclusion (irrevocable trust) At death of maker, asset fair market value is $15,340,000 The appreciation asset passes to heirs of by-pass trust but estate of maker is not taxed on fair market value avoiding $4,000,000 of taxes

17.  Other types of Trusts o Grantor Trusts (Chapter 7) o Estate Trusts, Surviving Spouse Trusts with Powers of Appointment (Chapter 10) o Qualified Terminable Interest Property Trusts (Chapter 7) o Qualified Personal Residence Trusts (Chapter 7) o Tangible Personal Property Trusts (Chapter 7) o Charitable Remainder Trusts (Chapter 9) o Life Insurance Trusts (Chapter 11)

18.  What are the implications for Financial Planning? o What is the most efficient way to transfer property for the client to their heirs? o What potential events to the plan may render the transfer choice ineffective or inefficient? Pre-mature death Asset value changes Cash flow needs of the donor/grantor o Changing tax laws o IRS potential challenges to the transfer o Gift tax changes (size of one time exclusion or annual exemption) o Availability of trust maker to change mind about transfer, both assets and beneficiaries and thus tax implications of trust