The Importance of Trusts in Estate Planning

protecting family financially

The Importance of Trusts in Estate Planning

The possibility of a reduction in the federal estate tax exemption has sent clients scrambling to fund trusts for future generations that will minimize estate tax. However, this alert’s focus is not on tax savings but on the importance of trusts as vehicles for protecting assets for your family.

As I have discussed before in previous blog posts, the benefits of gifting are that the gift, plus all future appreciation on said gift, will grow outside of the giver’s estate.

When people first meet with me to discuss preparing their wills or trusts, they often have a specific plan for the ages in which they want their children or other heirs to receive their assets.

  • Some plan to leave their assets outright to their heirs immediately upon their death;
  • Others have thought of a distribution schedule where their heirs receive property outright at a certain age, e.g., 21, or staggered distributions of principal at certain ages, e.g. one-half at age 25 and the remainder at age 30;
  • Still, others want their heirs to receive all income but forbid them from accessing the principal; or
  • Some develop an incentive plan that rewards heirs with matching distributions for employment earnings or directs distributions of specific amounts based on the professions they choose to enter.

The common problem with most of these plans is their lack of flexibility.

If life teaches us anything, it is that we can never be too prepared for its twists and turns. For this reason, I generally steer clients toward fully discretionary trusts. These trusts grant the trustee(s) flexibility to distribute trust property for an heir’s health, education, support, maintenance, or any other reason that the trustee deems appropriate. Trustees are, of course, not permitted to make any distributions to themselves and are bound to carry out the provisions of the trust—only making distributions for the trust’s beneficiaries under the trust’s authority, which grants broad discretion to the trustee.

Three primary protections that a discretionary trust affords to your children and other heirs:

1) Themselves

Should you and your spouse pass away while one or more heirs are young, a discretionary trust makes sure that your heir (a sophomore in college for example) does not have unfettered access to several hundred thousand dollars (or even millions of dollars) that such heir might squander.

With a discretionary trust, the trustee is the gatekeeper and can make a distribution to enable a child to buy a car or live in a nicer apartment, but is there to make sure that the trust funds are not wasted. The trustee’s job is to protect your child or other heirs from himself or herself. In some cases, 25-year-olds have excellent business ideas that will necessitate a large distribution, whereas in other cases 25-year-olds are not ready to take responsibility for large sums of money.

2) Potential Creditors 

If your child or heir is sued for any reason, the assets of a discretionary trust are not reachable by a creditor. Thus, if your heir is in a car accident or is sued for any reason, your hard-earned assets will not be used to pay a creditor.

3) Future Ex-Spouses

A discretionary trust protects your assets from an heir’s soon-to-be ex-spouse. Suppose your child or other heir receives assets outright (whether upon your death or upon reaching a certain age) and puts them into a joint account with his or her spouse or otherwise co-mingles the assets. In that case, they will become marital assets—subject to equitable distribution in the event of a divorce. In other words, your money may end up in your child’s ex-spouse’s hands. With a discretionary trust, the trustee is again free to exercise his or her discretion in a manner to protect your assets (or at least a large portion of them) from this scenario.

Generation-Skipping and tax exemption

If your children or other heirs are successful enough that they never need the money you are leaving them, the first $11.7 million that your estate passes in trust for your heirs ($23.4 million total from you and your spouse) can pass to their children free from estate tax (by reason of the generation-skipping tax exemption). If you leave them the assets outright, however, they cannot take advantage of this exemption.

The most critical factor in setting up a discretionary trust?

Naming the appropriate trustee(s)

You are trusting one or more individuals (or corporate fiduciaries) to step in and act in many ways like a financial guardian for each of your children or other heirs. You should thoughtfully select people who are:

  1. Close with your heirs;
  2. Financially savvy; and
  3. Likely to outlive you.

Care should also be taken to name a successor trustee(s) or put in place a mechanism for making sure there is always a reliable trustee in place.

Trustees are entitled to receive commissions for their services.

Many trustees who are relatives or friends, however, will waive their right to commissions. You are also are free to limit the commissions received or to specify that trustees serve without compensation. In such an event, trustees are free to resign if they do not agree to the financial stipulations you have put in the trust instrument.

Further, I generally advise clients to add children or other beneficiaries as additional trustees when they reach a certain age. That way, such child (or other heirs) has a learning period where they understand what the assets of the trust are and see how they are invested but do not have a say in distributing these assets.

Lastly, I typically recommend choosing an age at which each heir can obtain the power to remove the trustee. In this way, by age 40 (for example), if an heir does not get along with the trustee or believes that he or she is not fairly treated, your heir is free to remove the trustee and appoint whomever he or she wishes as successor trustee. In this manner, your heirs will gain de facto control of the assets but will still have the option of keeping the trust in place to take advantage of its benefits.

QUESTIONS? If you have questions or concerns regarding estate planning,  please contact Naim Bulbulia.