Many estate planners believe that their job is done when the beneficiaries avoid probate and receive the inheritance. However, when beneficiaries receive their inheritance in their name outright that needlessly exposes the legacy you leave to the claims of creditors, lawsuits, divorce, the loss of governmental benefits they might otherwise receive and even a second estate tax when they die. "Outright" distributions from the trust to the beneficiary in his or her name should rarely occur.
A better approach may be for each beneficiary's inheritance to go into his or her own Beneficiary Controlled Trust. If properly drafted and funded, the beneficiary can control, use and enjoy the inheritance without the risks of outright ownership.
A Beneficiary Controlled Trust refers to a trust where the beneficiary is also the controlling trustee. The beneficiary can be provided virtually the same control as he or she would have with outright ownership. For example, the beneficiary, as the controlling trustee, could make all investment decisions. Investments such as a home or brokerage account would be held in the name of the trust and would be better protected from lawsuits, divorce, creditors or predators.
The primary beneficiary could alter the level of control or protection if greater risks arose. A co trustee could be appointed to control distributions or even investments. If the risk is very high, the primary beneficiary could even resign as trustee and appoint their best friend, trusted family member or professional to act as Trustee.
If the primary beneficiary wants to act as the sole trustee with control over investments and administration, distributions can be limited to the beneficiary's health, education, maintenance and support ("HEMS") to avoid estate tax (the "HEMS Trust"). However, some states permit certain creditors such as a divorcing spouse or health care providers to pierce through the trust and access assets up to the HEMS standard. If they obtain judgement against the beneficiary, the price to be paid for the beneficiary's additional control is potentially weaker creditor protection.
If the primary beneficiary seeks even greater asset protection, then the primary beneficiary can act as the investment trustee and control or make all investment decisions. This primary beneficiary can appoint an independent trustee who acts as the distribution trustee and is authorized to make distributions to the beneficiary in such amounts and at such times as may be determined in the sole discretion of that Independent Distribution Trustee (the "Discretionary Trust"). The Discretionary Trust generally provides greater asset protection irrespective of the beneficiary's state of residence.
The beneficiary may be concerned about giving such discretion to the Independent Distribution trustee. This issue can be minimized by providing the primary beneficiary with the right to remove and replace the Independent Distribution Trustee. While the beneficiary does not have direct control over distributions, the beneficiary can select who does have the power so long as the person selected is not a related party or subordinate person.
Careful consideration must also be given to the trust income tax rules. The highest marginal federal income tax rate for ordinary investment income is now 37%. The highest tax rates are triggered with income for a single individual of $500,000 or more. The highest marginal tax rates for a trust are triggered with income of only $12,500. The difference in tax liability can be substantial.
The beneficiary controlled trust can be drafted in some cases to be a "Grantor Trust." A Grantor Trust is a trust that is "disregarded" for income tax purposes. Income is taxed to the beneficiary without regard to whether the income is distributed to the beneficiary. A Grantor Trust will avoid the higher tax rates applicable to a trust.
Alternatively, the Beneficiary Controlled Trust can be drafted as a "Complex Trust" for income tax purposes. The Complex Trust files a separate tax return. Income actually distributed to the beneficiary is taxed at the beneficiary's lower individual tax rates. Only income not distributed by the Trust will be taxed at the higher trust income tax rates.
There is no single best approach and careful analysis of the client's goals, concerns and situation should always be analyzed. The Trust may, in some circumstances, have an ability to toggle or switch between a Grantor Trust and a Complex Trust.
As a general rule, a client with a substantial estate should always consider the protective features of a beneficiary controlled trust. If you have any questions about this topic, please contact the Goralka Law Firm.