Revocable Living Trusts in Estate Planning

An Introduction to Revocable Living Trusts

Prospective clients almost universally seek to avoid probate in their estate planning, along with accomplishing other objectives. Though there are several ways to avoid probate, revocable living trusts are perhaps the most effective and safest way to do so, as well as to eliminate a financial conservatorship. A revocable living trust is sometimes referred to as simply a “revocable trust.” A revocable living trust serves as a will substitute, is effective when signed, and:

• Allows the person creating the trust (the “trustmaker”) to retain absolute and full control of the terms of the trust and the property in it;

• Distributes property after the death of the trustmaker upon the terms and conditions set out by the trustmaker;

• Creates one receptacle for all the trustmaker’s property;

• Takes care of the trustmaker and his or her named beneficiaries if the trustmaker becomes disabled;

• Offers privacy for the trustmaker and his or her loved ones;

• Is easy to create and maintain when professional advisors are used, and can be easily changed as long as the trustmaker is alive and competent;

• Has no adverse lifetime gift or income tax consequences;

• Does, in fact, avoid probate to the extent that the trustmaker’s assets are either owned in the name of the trust or pass to the trust upon the trustmaker’s death;

• Offers continuity in the trustmaker’s affairs upon disability or death;

• Is valid in every state; and

• Is difficult for disgruntled heirs to attack.

A Brief Description of the Strategy

Most individuals and their families are concerned with the publicity, cost, and length of probate. They are also vitally concerned about how their assets will be managed upon their disability. Moreover, they want to be assured that their estate planning will not be subject to unwarranted legal attack by disgruntled heirs. Using a revocable living trust as the foundation for an estate plan can more realistically address these very real fears than using an estate plan based on will and probate planning. Here is how a revocable living trust works:

The person who establishes a revocable living trust is called the trustmaker. A revocable living trust can be created for one trustmaker, or it can be for a trustmaker and his or her spouse. A revocable living trust for a husband and wife is called a joint revocable living trust.

The initial trustee is almost always the trustmaker and his or her spouse. The trust itself has provisions for successor trustees in the event one or more of the trustees cannot serve for any reason. A revocable living trust contains instructions as to how the trustmaker’s property will be administered during the trustmaker’s life, when the trustmaker is disabled, and after the trustmaker has passed away.

The trustmaker generally funds his or her trust with virtually all of his or her assets, which simply means, that legal title to most assets are transferred to the trust. However, there are some notable exceptions to this rule. Assets which are held in the name of the trust are controlled by its terms.

The dispositive provisions of a revocable living trust, which can be changed at any time by the trustmaker, can include extensive language as to how the assets are to be managed, administered, and distributed upon death. It is not uncommon for a revocable living trust to contain provisions which assure that the trustmaker’s then-current estate tax credit equivalent amount ($1.5 million in 2005) is fully and properly utilized. Provisions for the creation of trusts for children, charitable foundations, and other sophisticated planning strategies can also be drafted into revocable living trusts.

Assets in the trust avoid both a financial conservatorship (or living probate as it is sometimes called), and a death probate. An estate plan utilizing a revocable living trust should always incorporate a pour-over will. A pour-over will is a will, no different than any other; except that it simply recites that any assets in the probate estate are to pass to the revocable trust. The pour-over will acts as a safety net in case any assets are inadvertently (or intentionally) left outside of the revocable trust. Assets passing under the pour-over will are subject to probate but will ultimately be controlled by the terms of the revocable trust.

The Specifics of This Strategy

As the foundation of your estate plan, the revocable living trust is an extensive document that encompasses a number of estate planning strategies. It is a document that offers total flexibility; its terms can be changed at any time that circumstances or feelings change, as long as the trustmaker is alive and competent.

Joint vs. Individual Revocable Living Trust

Joint revocable trusts are often created for married couples who live in community property states or who hold virtually all of their assets in joint tenancy with rights of survivorship. There are several reasons why joint trusts are used.

Joint trusts are almost exclusively used in community property states. The laws of community property states consider property acquired during a marriage as being owned equally by each spouse no matter whose name those assets are in. A joint trust enables the makers to continue this community property status. A current list of the states having some form of community property includes:  Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

This continuation of community property status is important because community property receives a very special income tax advantage. When a spouse owning community property dies, all of the community property receives a step-up in cost basis to the value of the assets at the date of death. For example, if a husband and a wife own a vacation home for which they paid $100,000 and upon the husband’s death it is valued at $500,000, the surviving spouse can sell it after her husband’s death and only pay taxes on the amount received over $500,000. If this same event occurred in a non-community property state, then at best the surviving spouse would get a step-up in basis on one-half of the value of the home. If that spouse then sold the home, she would pay taxes on a substantial amount of the gain.

In non-community property states, a joint trust is used for convenience rather than for any income tax reason. It is easier to fund a joint trust – all of the property is put into one trust rather than two. Also, when one of the spouse’s dies, there are fewer trusts to administer. Each situation must be evaluated separately to determine if a joint trust or individual trusts are to be used. Care must be taken to consider all of the ramifications of using either trust alternative.

Disability

One of the most important and effective uses of a revocable living trust is for disability planning. Insurance company statistics show that almost all of us are much more likely to suffer a total disability than to simply die without having become disabled. Because of this telling statistic and the fact that Americans are living longer, disability is something that should be addressed in a proper estate plan.

Often, disability planning is accomplished with a general durable power of attorney, granting another person or persons the power to deal with our assets if we are disabled. The disadvantage of this method is that it offers no planning; there are generally no instructions in the power of attorney, making it ineffective for planning. In addition, using general durable powers of attorney can be difficult because they are not readily accepted by many third parties.

If a general durable power of attorney is not used, then the disabled individual must be declared incapacitated in a court hearing, a process that is degrading, complex, and expensive. It puts the power over assets in the hands of a court-appointed conservator, who may or may not be a family member.

A revocable living trust allows the successor trustees to continue to administer the property of the disabled trustmaker. The trust itself defines disability and contains instructions as to how the trust property is to be managed during the maker’s disability. Court intervention is difficult and highly unlikely.

A limited or special durable power of attorney is used in living trust planning. This legal instrument allows its holder to transfer property not already titled in the name of the trust to the trust. No other transfer powers are given. Thus the revocable living trust’s instructions can control this property also without giving the power holder carte blanche over these assets. We also recommend that our clients execute a general durable power of attorney which permits the agent (usually the same persons who are trustees under the living trust) to manage tax qualified assets such as IRA accounts, 401(k) accounts and pension or profit sharing accounts. This general durable power of attorney may also authorize the continuation of the client’s lifelong gifting program.

Funding

A revocable living trust is typically funded with almost all the client's assets. Funding simply means that the title of the assets will be held in the name of the trustees rather than in the individual name of the trustmaker. Generally, funding is not a difficult process, although it encompasses some administrative work. Your advisors can be of great help in the funding process.

Some assets are not held in a revocable living trust, most notable of which are third-party beneficiary contracts, such as IRAs, 401(k) accounts, pension and profit sharing accounts. A transfer of such assets to a revocable trust will cause the immediate income taxation of the monies in the accounts.  

In order to plan for these assets without accelerating the income taxation, the beneficiary designation is typically made to be the revocable trust, either as primary beneficiary or contingent beneficiary, depending on the circumstances. Because of the complex rules associated with these plans, a tax advisor should always be consulted before naming a living trust as the beneficiary.

A primary residence may sometimes be held outside of a revocable living trust. In some states, holding title to a residence in a living trust can cause the loss of certain homestead benefits. This issue should always be addressed prior to changing title of a primary residence. Certain stock options cannot be held in the name of a living trust during certain times and under certain conditions. If these are assets that you hold, you must discuss the appropriateness of transferring them prior to doing so. Severely adverse income tax consequences can occur if the transfer is not made correctly.

The Creation of Subtrusts

A revocable living trust agreement also typically creates a number of trusts within it to serve one or more purposes. Theses subtrusts come into existence upon certain events such as the trustmaker’s disability or death, or the death of the trustmaker’s spouse. Each of these subtrusts has a specific function. For example, a Marital Trust maximizes the federal estate tax unlimited marital deduction. A Family Trust (also known as a Bypass Trust, a B Trust, or a Credit Shelter Trust) makes certain that any remaining portion of the trustmaker’s $1.5 million exemption equivalent (in year 2005) is fully used.

The living trust may also contain subtrusts to provide for the management of assets for children in ways which assure that those assets are fully protected from financial management inexperience, divorce, and creditor claims. These subtrusts can also be designed to allow a beneficiary’s inheritance to pass estate tax free to his or her descendants when the beneficiary dies thereby skipping the estate tax on an entire generation of asset growth.

Selecting Who Can or Should Be Trustees

The trustmaker can be his or her own trustee. It is highly recommended by professionals that there always be two trustees acting. If this is the case, if the trustmaker becomes disabled or dies, there is another trustee immediately available to continue the trust. For married couples, both spouses are typically the trustees of their individual trusts, or they are co-trustees if they create a joint trust.

As a trustee, you can retain control of your trust assets during your lifetime. The trust’s terms allow you to use the assets in any manner you would if you owned them outright. Great consideration should be given to naming trustees upon your disability or death. It is not uncommon that the successor trustees chosen at disability are different from those chosen at death. Individual trustees can be named, including family members or professional advisors. Corporate fiduciaries such as banks or trust companies can also be named.

For most clients, the perfect trustee does not exist. Because of this reality, it is wise to choose teams of trustees. If a number of trustees are serving, each of their individual strengths can be used effectively. One trustee’s weakness can be compensated by another’s strengths.

Trustees have as their primary duty the carrying out of the terms of the trust. The trust instrument itself is the source of a trustee’s direction. A well-drafted trust document is critical to fully explain the wishes of the trustmaker. A clear trust document enables the trustees to make decisions that reflect the intentions of the trustmaker and cannot be questioned by the beneficiaries.

Planning Risks and Detriments

A revocable living trust is relatively risk-free. It can be changed, amended, or canceled by the trustmaker at any time. There are no adverse income or gift taxes associated with its creation.

A revocable trust that reflects the goals and objectives of the maker is the foundation on which a sophisticated estate plan is based. By coordinating the revocable living trust with the remainder of the planning, a flexible estate plan can be created that saves the maximum amount of administrative costs and taxes.

Other Means of Planning and Related Issues/Consequences

Every person has an estate plan, whether they realize it or not. Either they have a will or a trust that they thoughtfully created, or they have allowed the Commonwealth of Virginia to create their will. In some instances, this distinction is not important because their assets will pass by other means. The following ways to own property in Virginia will demonstrate this point:

1) Title in Your Name Alone

2) Jointly Owned with Survivorship

3) Beneficiary Designation

4) Trust Owned

Everything a person owns can be categorized into one of these four ownership options. Virtually every person has some property jointly owned with someone else, whether it’s a brokerage or bank account, real estate, or anything else. Joint tenancy with rights of survivorship, sometimes abbreviated JTWROS or simply JT, allows an asset to pass to the remaining joint tenants upon the death of any one joint tenant. Trust assets are those assets that have actually been retitled in the name of the trust. Beneficiary designation assets are assets such as 401(k) accounts, IRAs, pension plans, profit sharing plans, life insurance, etc. These are all contracts and are typically not affected by a will but instead are controlled by the contract itself.

Quite often, we are asked to review an existing estate plan, be it a will or a trust. The most artful and tax efficient trust or will is worth very little if the assets are all held jointly with someone else, or are made payable to someone else via a beneficiary designation. The manner in which assets are owned is just as important as the text on the pages of the will or trust. This fact is frequently overlooked by clients and planners alike.

As a means of evidencing the common ways in which estate plans become ineffective (virtually all of which are avoided with a revocable trust), we’ve included a link to a test called Is Your Estate Planning Up to Date? We think you’ll find this exam to be simple to take and informative at the same time.

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