A family trust is a “complex” trust for tax purposes. It is designed, in part, to achieve traditional “credit shelter” or “bypass” trust objectives.
There are two (2) types of non-grantor trusts: simple or complex. A simple trust (i) must distribute all income to beneficiaries, (ii) cannot distribute principal, and (iii) cannot make distributions to charities. Conversely, a complex trust can do any one or more of these. In other words, it can accumulate income, distribute principal, and/or make distributions to charity.
This form of trust (a family trust) can help keep assets out of the surviving spouse’s estate (thus reducing potential estate tax liabilities upon his or her death), while still making the trust assets available to support the surviving spouse. As described below, in a coordinated plan, the deceased spouse uses his or her unified credit amount against estate and gift tax (the “Coupon”), to create a third-party created, asset protections “spendthrift” family trust. This trust can do for the surviving spouse what he or she cannot do for himself or herself – that is, shield the trust assets today from threats that may arise tomorrow (including lawsuits, divorce, and the need for long-term care in a nursing home).
Asset Protection and Estate Tax Advantages
The family trust is necessarily an irrevocable trust, as the trustmaker is deceased and can therefore no longer revoke it. However, its assets are set on a path to be held for the benefit of the decedent’s loved ones during the life of, and then upon the death of, the surviving spouse.
An estate tax is imposed on all assets transferred from a decedent’s estate unless a tax exemption or tax exclusion applies. That said, any part of the estate that is left to a surviving spouse is exempt from tax (pursuant to the marital exemption). Conversely, a family trust transfers the assets in a way that does not qualify for the marital exemption. However, the assets may still be available to benefit the surviving spouse and other beneficiaries.
All income generated from assets left outright to a surviving spouse (or in a marital trust) will belong to the surviving spouse, whereas income from the family trust may be sprinkled among multiple beneficiaries, including those who may be in lower tax brackets. Assets left in the family trust, instead of outright, will be governed by the terms of the trust on the death of the survivor. Thus, the deceased spouse still has the ability to control where the remainder will pass on the surviving spouse’s death. Income may be left to accumulate in the family trust, and this income will remain outside of the surviving spouse’s estate. Moreover, as stated above, assets of the family trust are protected from life risks of the surviving spouse, while assets left outright would not be. Therefore, income of the family trust can remain protected from life risks of the surviving spouse, while income from a marital trust or outright assets will not be.
As such, leaving assets to the family trust at the first death uses up that much of the Coupon of the first to die, but keeps those trust assets, and any growth on them, from being included in the taxable estate of the surviving spouse. And any unused Coupon can still be ported to the surviving spouse as the “deceased spousal unused exclusion amount” or DSUEA.
How a Family Trust Works
As stated, the family trust is necessarily an irrevocable trust, created by the deceased spouse’s estate assets in an amount up to his or her Coupon. The trust assets can be made available for the benefit of the decedent’s loved ones during the life of, and following the death of, the surviving spouse. Essentially, those assets held in a trust may continue to benefit the surviving spouse, but then be passed on to the next beneficiaries in line (without a second potential tax liability when the surviving spouse dies).
The goals of a family trust may include keeping assets in the blood line, benefiting the surviving spouse, and saving estate taxes. The beneficiaries of the family trust may be the surviving spouse, children, other descendants, named individuals, or others.
Further, the surviving spouse can be named as the trustee, and can even have the power to make distributions to himself or herself, provided that this power is limited by ascertainable standards related to health, education, support, or maintenance. Discretion must always be limited to amounts that will not exceed those ascertainable standards.
The surviving spouse can also be granted a power of appointment over the family trust assets, which is a power to transfer the assets from the trust. By law, powers of appointment can be exercisable during life; on specified conditions, events or dates; or upon death (that is, a testamentary power). However, to prevent inclusion in the surviving spouse’s estate, the power of appointment cannot be a general power of appointment, but must instead be a limited power of appointment. A general power of appointment is the power to direct assets to any one or more of the following prohibited beneficiaries: (i) the powerholder (that is, the surviving spouse to who the power of appointment is granted), (ii) the powerholder’s estate, (iii) the creditors of the powerholder, or (iv) the creditors of the powerholder’s estate. A limited power of appointment is a power to direct assets to any person or party other than the four (4) described prohibited beneficiaries.
The Benefits of Family Trusts
What makes a family trust a “complex” type of trust is the fact that it can accumulate income for the beneficiaries. Income does not need to be distributed. It can be retained in the trust, and thereby remain protected in case of a potential threat.
A family trust may also enable the deceased spouse to specify when beneficiaries can receive distributions, and under what circumstances (such as, a specific age and/or education level, i.e., not less than 21-years old and graduated from college).
Because family trusts—and estate planning in general—can be so complex, it is recommended that you work with an experienced accountant, financial advisor and estate planning attorney to assist you in your planning, and to assist your spouse and beneficiaries in the future.
For help in designing a family trust and developing a sound estate plan, contact me today.
