REVOCABLE LIVING TRUSTS
Revocable living trusts are by far the most widely used type of trust. In fact, revocable living trusts have become the centerpiece for many estate plans. Thus, it is important that planners and clients understand what revocable living trusts can and can not accomplish.
Generally, a revocable trust is created by a written document and the funding of the trust. Most often the grantor and trustee are the same, and the grantor reserves the right to revoke or amend the trust at any time. The grantor is typically the primary beneficiary during his lifetime with possible discretionary distributions during the grantor's disability to individuals who are dependent on the grantor. At the grantor's death, the trust becomes irrevocable, and, after payment of taxes, expenses, and debts, the corpus is distributed to designated beneficiaries or allocated among new trusts created at the death of the grantor under the trust agreement.
The primary reasons to consider using a revocable living trust have to do with ease of administration, rather than tax planning. Perhaps the most important reason to consider a revocable living trust is to avoid probate. The property held in the trust will pass at the grantor's death free of any state probate restrictions unless the trust estate is to be distributed to the personal representative of the probate estate. Other advantages are that:
1. The trust can be amended or supplemented without the formalities associated with the proper execution of a will.
2. The trust can become irrevocable upon the grantor's incapacity or incompetency, but become revocable upon the recovery of the grantor, and, depending upon the composition of the assets in the trust, allow the avoidance of guardianship proceedings.
3. The trust can be used to segregate assets for many purposes such as second marriages where prenuptial assets can be held in the event of a subsequent divorce.
4. There may be some creditor protection for the assets held in the trust, if the grantor is given only a technical retained power, not the power to revoke.
5. Unlike a will, the trust agreement does not become a public document upon the grantor's death.
6. The trust agreement may be a more difficult document to overcome than a will or other contest.
In contrast, revocable living trusts offer few tax advantages. For income tax purposes, during the grantor/trustee's lifetime, or at least during competency, a revocable living trust is considered a grantor trust, because the grantor retains the right to revoke the trust. This means that the grantor is considered to own the assets and is taxed on any income (and entitled to any deductions) as though the trust does not exist. <1> At the grantor/trustee's death, the trust becomes a complex trust, which is a taxable entity separate from the donor/trustee and from the estate. Until August 5, 1997, the existence of the separate trust apart from the estate had some tax disadvantages, because an estate has a higher annual tax exemption and was allowed additional deductions, while a trust, unlike an estate is subject to strict rules on choosing a tax year and is required to begin making estimated tax payments in its first taxable year. <2> However, for decedents dying after that date, the trust may be treated as part of the estate, effectively eliminating these disadvantages. <3> There is one remaining potential disadvantage, however: the existence of the revocable trust may result in a decreased deduction for executor's fees by the estate, since in many states, the compensation is based on the size of the estate, and the compensation allowed understate law is one of the factors in determining the amount deductible for federal tax purposes. <4> The existence of the trust also has no effect for transfer tax purposes. The transfer to the trust is not a gift for gift tax purposes (although the transfer of the assets from a trust to a beneficiary other than the grantor may be). And from an estate and generation-skipping transfer tax perspective, the existence of the trust also has no effect. The property included in the trust is included in the estate, because the trust was revocable until the death of the grantor/trustee <5> (and the property is considered to pass directly from the decedent, so it takes a stepped-up basis). <6>
A revocable living trust may allow the trustee to engage in post-death income tax planning if it allows sufficient discretion to retain or distribute income, because this will allow some income to be taxed at the trust's own lower tax rates. However, despite this advantage, revocable living trusts generally make sense only if they make sense from a non-tax perspective.
1/ Code Section 676.
2/ Code Sections 644, 665.
3/ Code Section 645.
4/ See, e.g., Estate of Grant v. Commissioner, T.C. Memo. 1999-396.
5/ Code Section 2038.
6/ Code Section 1014.