Tuesday, August 9, 2016

Do You Need A Living Trust?

Every so often a client asks me to take a look at their living trust. You’ve probably heard how a living trust allows a person to transfer all of their assets into a trust to avoid costly probate proceedings and to keep their assets private. Where the living trust is revocable, the Internal Revenue Service generally ignores the living trust for tax purposes and treats the assets as being owned individually by the trust maker.

Despite these advantages, I typically discourage clients from using living trusts, especially where both spouses want to transfer their assets into a single trust. Managing one’s assets within a trust can be more complicated than most folks realize, and holding both spouse’s assets within a single trust can have unintended tax consequences.

Setting Up A Living Trust

Living trusts are usually created by signing a lengthy trust agreement, in addition to a will, a power of attorney, a living will, and other estate documents. (I have yet to meet a client that understands these lengthy living trust agreements.) Once the living trust document has been signed, the trust maker must then transfer all of his or her assets to the living trust. In the case of a joint living trust, the assets of both spouses must be transferred into the trust. To completely fund the transfer, new deeds, bills of sale, and vehicle transfer records will have to be drafted by an attorney and signed, and new bank and stock brokerage accounts will have to be opened. Depending on the size of the trust maker’s assets, this process can take quite a bit of effort and expense. If any substantial or important asset is missed, the executor or executrix of the first spouse to die will likely have to probate the deceased spouse's estate anyway, thus defeating one of the main reasons for having a living trust.

Joint Living Trusts

Significant tax issues can arise where spouses comingle their assets in a joint living trust, and this may jeopardize certain federal tax advantages and exemptions. For example, if the tax basis of each asset is not tracked separately for each spouse, a surviving spouse might not be able to claim a “step-up in basis” for any appreciation in the deceased spouse’s capital assets, such as real estate and stocks. Under Section 1014 of the Internal Revenue Code, the tax basis of a beneficiary in a decedent’s appreciated capital assets is usually the fair market value of the assets as of the date of death. (But there are always exceptions in the Internal Revenue Code.) It is difficult to claim this step up in basis if the surviving spouse has inadequate records and doesn’t know which spouse contributed which asset to the living trust and what they paid for each asset.
The IRS might also treat a transfer of assets of unequal value into a joint living trust as a taxable gift between spouses that does not qualify for the unlimited marital gift tax deduction. Further, where assets are commingled in a joint living trust, the IRS might choose to disregard a credit shelter trust and assign all of the assets in the living trust to one spouse or the other.

Credit Shelter Trusts

In estate planning, “portability” is the ability of a deceased spouse’s personal representative or executor to make an election on the decedent’s estate tax return (IRS Form 706) to transfer the “deceased spouse’s unused exclusion” (the “DSUE”) to the surviving spouse. For married couples, one of the main goals of estate planning is to maximize each spouse’s estate tax exclusions. Before Congress adopted portability of the marital estate exclusion in the American Taxpayer Relief Act of 2012, maximizing estate tax exclusions was usually accomplished by creating a credit shelter trust upon the death of the first spouse, because the deceased spouse’s estate tax exemption did not transfer to the surviving spouse along with the deceased spouse’s assets. With a credit shelter trust, the deceased spouse’s assets were held in trust during the life of the surviving spouse up to the amount of the federal estate tax exclusion, thus providing the surviving spouse with some benefit from the decedent’s assets without those assets actually being transferred to the surviving spouse’s taxable estate. However, the heirs of the surviving spouse lost any "step up in basis" on assets held in a credit shelter trust because the assets technically were never owned by the surviving spouse.
Many joint living trusts drafted before 2012 included credit shelter trusts to preserve the estate tax exemption upon the death of the first spouse. However, with the passage of the new portability rules, and the substantial increase in the federal estate tax exemption that occurred in late 2010, currently set at $5,450,000 per spouse, credit shelter trusts have largely become unnecessary except for couples with very large estates. However, many living trusts formed before 2012 still require the creation of a credit shelter trust upon the death of the first spouse, even for trusts with a relatively small amount of assets. This can create hardship for the surviving spouse -- not to mention the loss of any step-up in basis for the heirs of the second spouse for assets in the credit shelter trust -- because upon the death of the first spouse all of the assets in the living trust must be allocated into either the credit shelter trust or the trust for the surviving spouse. And given that assets in the credit shelter trust will typically be restricted, having a substantial portion of the surviving spouse's assets tied up in a credit shelter trust can increase the difficulty of managing those assets, and might also lead to a shortage of funds for the surviving spouse if a third party trustee or co-trustee has to approve whether or not the surviving spouse is allowed to have access to those funds.

Do You Need A Living Trust?

Unless spouses have a great and unusual need for privacy in order to shield their assets from disclosure in probate proceedings, living trusts are usually more trouble than they are worth. Probate proceedings become expensive when family members fight among themselves, and that can happen whether you have a living trust or a will. The expense of setting up a complex living trust, and then transferring all of your assets into the trust, and then managing all of your assets from within that trust, can greatly exceed the relatively simple modern process of probating one's estate after your death. And if the living trust has been drafted poorly, or if a joint living trust has been used, or if the surviving spouse does not maintain careful records, heirs can frequently find themselves with a host of tax problems that would not have existed had they used a simple will.