Trusts: Questions Answered from an Actual Scenario
Trusts are very common, but can also be complicated and difficult to understand. This article offers a simple and brief description of the different types of trusts, and a quick look into how they can be taxed.
Before you read about trusts, we invite you to consider the scenario below of a typical husband and wife. You may find similarities to your personal situation. Perhaps you have some of the same questions.
We outline the specifics below and at the end of this article, we have guidance from an attorney who specializes in real estate law and estate planning.
Actual Scenario:
Husband and wife DO have an updated will. The will is set up so that the assets of the first to pass away are transferred to the surviving spouse.
Husband and wife DO NOT have a trust.
Husband and wife have two adult children who are not currently married. They do not yet have grandchildren.
Assets consist of: their residence, respective retirement plans, and investments in joint mutual funds and stocks.
The couple is planning to wait to set up a trust until one passes away. At that point, the surviving spouse will set up a trust.
Real Questions From the Couple in the Above Scenario:
Based on the circumstances above, is it okay to wait to set up a trust?
What are the downsides to setting up a trust now?
What life events, other than death, may warrant the need to set up a trust?
Can you relate?
First, let’s discuss trusts. Trusts are categorized in two ways: Revocable Trust and Irrevocable Trust.
Revocable Trust
The grantor of a revocable trust owns and has control of the trust’s assets. When the grantor passes away, the assets are based on the fair market value on the date of death. Revocable trusts always have the words “Revocable Trust” in the trust’s name.
Irrevocable Trust
The grantor of an irrevocable trust places assets in the trust, but the assets are owned by the trust. The assets are not owned or controlled by the grantor. Irrevocable trusts are intended to be permanent, so the process to dissolve an irrevocable trust is complicated and time-consuming, and involves a court-ordered judgement.
Irrevocable trusts do not always have the words “Irrevocable Trust” in the trust’s name. Following are a few examples of irrevocable trusts that are not labeled as such.
Medicaid Trust – To be eligible for Medicaid, a grantor has to be separate from assets. There is a 5 year process to determine eligibility, so the assets are placed in an irrevocable trust that allows the grantor beneficiary access to the income from the assets.
QTIP Trust – QTIP Trust stands for Qualified Terminable Interest Property Trust. It is an irrevocable marital trust that separates the income and the assets. The surviving spouse has access to the income, but not the assets as the assets are owned by the trust.
Charitable Remainder Trust – Section 664 allows assets to be held in a Charitable Remainder Trust, which allows a lifetime income distribution to a beneficiary. When the beneficiary passes away, the remainder assets are distributed to charity.
Trusts and Taxes
Taxation depends on the type of the trust: income can be taxable to the trust or it can be taxable to the grantor. A grantor trust allows income from the trust to be taxed to the individual grantor.
Revocable trusts are grantor trusts. All of the income from the trust can be reported on the personal tax returns for the grantor until the grantor passes away.
Irrevocable trusts can be grantor trusts if the language in the trusts allows income to be distributed and taxed to the grantor. Another way for an irrevocable trust to be considered a grantor trust is if the language in the trust gives authority powers to the grantor.
However, most irrevocable trusts are non-grantor trusts. Tax reporting for non-grantor trusts requires the completion of Form 1041 each year.
There are specific filing requirements for grantor trusts and non-grantor trusts. Should you have questions about this or if you would like help this taxes for your trusts, please contact me!
Now that we have given a brief overview of the different types of trusts and their taxation, let’s get back to the scenario from the beginning of the article.
Since we offered a real-life scenario with actual questions from the couple, we wanted to provide a real response from an expert. We consulted with Chris Longworth, Real Estate Law and Estate Planning Attorney with Barron Peck Bennie & Schlemmer.
In regards to wills, Chris says:
Probating an estate is a slow and arduous process. Many people have the mistaken belief that if you have a will, you can avoid probate, when the reality is that a will just tells the probate court how you want your property to be distributed, who you want your executor to be and who you would like to be the guardian of your minor children. If there is a testamentary trust in the will, it also tells the court the administration provisions and who is the trustee of the testamentary trust.
According to Chris, some reasons for a revocable trust are:
Given today’s very large federal estate & gift tax exclusion, the biggest reason for most people to have a revocable living trust is probate avoidance. As long as your house is owned with your spouse as joint with right of survivorship, your accounts are joint, and in Ohio, each spouse’s cars don’t exceed an aggregate value of $60,000, you can wait to have such a trust because you have mechanisms in place to avoid probate.
Another reason for a revocable living trust is that it can be very flexible when it comes to alternative distribution provisions. A trust gets everything in one bucket and then allows you to control the distribution to your beneficiaries beyond the grave.
For example, my trusts have “just-in-case” provisions for the case that a beneficiary has a special need or is a substance abuser (which is all too common today). It also allows you to proactively deal with a child who predeceases you, but has children when they pass.
I know your children do not have children of their own now, but they may someday and people tend to not be very diligent about making estate planning changes as their life changes. So, we try to be proactive and deal with the most common changes that occur in your financial and family life over time. This way, even if you are not staying on top of your estate planning, we have already dealt with most things that can, and will, come up.
As for the question about an example of a life event that may warrant the need for a trust:
What happens if you die simultaneously? Unless one of you has some sort of terminal condition (cancer, heart disease, covid-19, etc.), dying of trauma (car accident) is perhaps a more realistic scenario. In this case, you are probating both wills at the same time (1/2 interest in every item of property will be probated in each estate). That would be very expensive.
My usual estimate of probate for a normal middle-class couple with a net estate of $500,000 (if you own a house you are probably at least half the way there) and is usually 2-4 times the cost of having the trust prepared and funding the trust. In addition, trust administration after the death of one or both of you is immediate, you don’t have to wait for the court filings. The trustee just picks up right where the spouse or spouses died. No fuss and not having to ask the for the permission of a judge.
We hope this helped offer some clarity about trusts and maybe gave light to something that you’ve been questioning or considering.
If you have questions that you would like answered in an upcoming blog post or Q&A of the Week, please email them to us! The answers to your questions may help someone else!