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A Question about Trusts

June 12, 2019

Are the use of Trusts the best way to leave money to your heirs?

I was recently asked a question about putting money into trusts to help pass things “tax free” to someone’s kids or other heirs.  Given the number of misconceptions out there about trusts, I thought I would expand on the question a bit.

FIRST, please note this is a general discussion. Every person’s situation is different. I could say “95% of people don’t need this,” and you could be in the 5% who do. So, don’t ever make personal investment or estate planning decisions based on an online post, CONTACT AN ACTUAL INVESTMENT ADVISOR OR ATTORNEY — most will have initial conversations for free (I do).  Most questions can also be answered fairly easily.

Why do trusts even exist though?  Traditionally, trusts have served four primary purposes. (Yes, there are others, but these, historically, have been the big four):

Avoiding probate. Probate is seen as a “big, long, expensive, painful” process. It takes court filings, hearings, money, etc.  Most people think they have to pay a lawyer for it.  Going to court is “scary.”  The general consensus among advisors and estate planners for years has been to put all of a person’s assets into a trust or have a pour-over will that moves things to a trust when the person dies to avoid probate. (A pour over will simply has a provision in it that says something to the effect of “when I die all my stuff goes into Trust ABC”).

Depending on the state where someone lives, this may or may not still be valid. I don’t know the probate process in all of the states. (I’ve only probated wills in two states). In Texas, this concern is vastly over-blown. The process of probating a will is not that expensive and comes with some benefits over a trust (particularly if the estate has debts).

Further, if an estate is too small for a normal probate process, there’s even something called the “small estate affidavit” that allows heirs to “skip” most of the formal probate process. I personally think, in Texas anyway, the use of a revocable/pour-over trust for purposes of avoiding probate is unnecessary, particularly when you consider that most property can be transferred outside of the probate process (such as designating a beneficiary to your IRA or a payable on death benefit on your checking account).

Avoiding taxes. Depending on the year, the estate tax exemption has ranged from $0 to $11m for couples and everything in between. This means if someone had as little as $500,000 (which I realize for a lot of people is a TON of money, but there are millions of people that have more than that in this country), that person’s heirs could (again depending on the year), find the government taking upwards of 33% to 40% of that when they inherit.  So if your parents die, leave you $500,000, the government might take as much as $200,000 of it. (Note: this is NOT the current law, but laws in this area change quickly depending on who is in Congress.)

This is particularly problematic if a large amount of real property (land) is included in the inheritance because land isn’t particularly liquid. For example, should a family own a ranch worth $5m.  When parents die, the children inheriting the ranch will have to either come up with $2m cash or sell the property to pay the 40% tax. The other option would be for the parents to set up trusts to transfer outside of estate taxes years ahead of their demise. (It is more complicated than that, but that is the general premise.)

Since the estate tax exemption is currently around $11m for couples, this is much less of a problem today than it was in the past. Of course, there are democratic candidates calling for the elimination of the exemption and taxing estates at 100%…so this could go back the other way. I refer to the constant changing of the estate laws as the “Estate Lawyer Employment Acts.” Anytime the estate tax exemption gets too low or the estate tax rate too high, the use of trusts to pass assets goes up (until laws are passed about those, then something else will be created to deal with avoiding those taxes legally).

A great example of this occurred toward the end of 2012 when there was a chance the exemption was going to $0. Quite a few estate planners and lawyers were extremely busy in November and December preparing for the anticipated change.  Of course, that change did not occur and the planning proved unnecessary – but until laws actually exist, the smart move is to react according to the actual existing laws;

Protecting Minors. For parents who have a lot of money or who may have life insurance policies with large payouts, upon their deaths, they don’t necessarily want their 12-year-olds to have a million dollars at their disposals. A trust continues to be a good way to help manage the funds until any children are old enough to manage the funds independently.  Even most wills have provisions in it that provide for the creation of trusts for under aged children;

Liability Protection. If a person moves assets to an irrevocable trust in which that the person is not the named trustee, the assets can be shielded from liability. Meaning I have the right to income and “expenses to maintain my standard of living” but NOT the right to the principal of the trust, and I get sued for $10m, that trust, if setup correctly and in advance, might protect my assets from judgment or from creditors. Ensuring this is properly setup necessitates the use of a lawyer and the understanding of judgment and trust law in whatever state you reside in.

This is still a legitimate use of trusts, but I personally prefer investment companies, particularly in Texas with how strong the corporate liability shields are and/or the difficulty (if not impossibility now) of piercing the corporate veil in the state.  LLC’s also can have certain tax advantages not always available to trusts.

Of course, there are some MAJOR disadvantages to passing assets via a trust:

No step-up in basis. To me, this is the number one reason to be cautious about using trusts (living trusts aside). A step up in basis means the heirs don’t have to pay capital gains tax. For example, if a trust includes stock ABC that was bought at $100,000 for $1 per share that is now worth $10 per share (so $1m total), without a step-up in basis, that’s a $900,000 capital gain the heirs will have to pay in taxes when the trust sells the stock.

Whereas, if you get a step-up in basis by inheriting the stock via a will, you don’t have to pay that tax.  You only pay on gains after that point in time you inherit.

This very situation happened to my wife.  Her grandfather set up a trust for the grandkids decades ago and put a few hundred shares of Coca-Cola stock in it.  The stock split adjusted purchase price was actually less than $1. When he passed away, she got the stock from the trust – when it was worth about $45/share.  That means she had a $44 capital gain when she sold the stock and had to pay capita gains taxes on the $44.

During the years the stock was in the trust, the dividends were also taxed at a higher rate than his personal income was taxed.

Whereas, if he had held the stock in his own name, he would have paid less in taxes on the stock while owning it, and when he left it to her in his will, she would have owed $0.00 in taxes when she sold it.

Tax inefficiencies. During the lifetime of the trust creator, trusts are tax inefficient, particularly irrevocable trusts. LLC’s, if you have real estate, tend to be a much better vehicle from a tax rate perspective (particularly given the Trump tax code changes). Why put something into a trust that’s going to get taxed at over 33%, when if it is put into an LLC, the tax rate could be lower on the property? (TALK TO YOUR ACCOUNTANT/LAWYER ABOUT THIS AND WHETHER IT ACTUALLY HELPS IN YOUR SITUATION – it may not).

Also note as a general rule, this discussion applies to irrevocable trusts – not all trusts are taxed the same;

PODs. For many assets, it’s just as easy to pass them via a POD (payable on death)/beneficiary designation. IRAs, bank accounts, insurance, brokerage accounts, etc, all allow holders to designate beneficiaries upon death. This happens as soon as upon death — no need for probate, trusts or anything else. MOST assets can be passed this way, which eliminates the need for paying for a trust).

The answer to the question “Are trusts the best way to leave money to heirs” is “it depends.” Why are you using one? What state do you live in? How much do you have in assets? What KIND of assets are they (real property, cash, stocks?); How old are you? How much life insurance do you have? Do you have kids or young heirs? Do you care what your heirs do with the money?

No matter what people decide for dispersal of wealth after death, it is better to make these plans when young, than when on death’s doorway. Doing it later in life removes options. Trusts aren’t as necessary as they used to be — which doesn’t mean they aren’t necessary — it just means people need to have discussions with their attorneys and advisors.

And everyone should have this talk with an attorney, investment advisory, or Certified Financial Planner at some point – that’s why they’re around after all. 

Christopher Welsh is a licensed investment advisor and president of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Strategy and the Lorintine Capital Blog.


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