Determining whether lifetime gifts should be made in trust.

Facts: Gill Bates, a multibillionaire, is considering creating a trust to hold his esteemed art collection, some stock and real estate.

Issue: Bates asks his tax adviser for the pros and cons of holding all (or some) of his property in a trust structure.

Analysis

Lifetime transfers of property can be grouped into two categories: (1) transfers in trust and (2) nontrust transfers. Transfers in trust can be revocable or irrevocable. Nontrust transfers can include outright gifts and transfers of partial interests (such as life estates and remainder interests).

In general, if a client's estate planning goals and objectives can be met without using a trust, trusts should be avoided. Nontrust transfers are simpler and more economical, while transfers in trust require preparation of a trust instrument, trustee fees, tax return preparation fees and, possibly, accounting fees. A client should understand the benefits provided by trusts in conjunction with his goals and objectives; if no special reason exists to use a trust vehicle, the transfer should be made outright to the donee.

Advantages of Using a Trust

The client's unique circumstances usually determine the value of using a trust. In some situations, the need for a trust may be obvious; in others it may not be so clear. Clients may be aware of only some of the advantages and disadvantages, so a certain amount of client education may be necessary before the plan is finalized.

Advantages of using a trust for lifetime transfers include the following items.

1. Professional management of assets. A trustee manages the property on behalf of the beneficiaries. The donor can specify whatever powers and duties he wishes to confer on the trustee. Professional management is a necessity in some situations, such as when the donee is incapable of managing the transferred property. A transfer in trust may also be appropriate when the property owner does not want to deal directly with the burdens of property ownership (e.g., an elderly widow who owns rental real estate). The trust can be revocable or irrevocable. For transfers to minor children, an alternative is a gift under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act, which would allow the donor to act as custodian of the property until the minor reaches majority.

2. Flexibility in making dispositions of property over time. The donor can set the parameters for distributions of income and principal to beneficiaries. The trustee can be granted broad powers, or his discretion may be limited. For example, a trustee may be given the power to determine the appropriate distributions among a grantor's children, depending on all the facts and circumstances that exist at the time. Such powers are sometimes referred to as sprinkling powers.

3. Shifting income for income tax purposes. This advantage is not as significant as it once was (due to the compressed income tax rate structure currently applicable to trusts). However, a trust still allows a limited amount of income to be taxed at a lower rate (in 1999, up to $1,750 is taxed at 15% and the next $2,300 at 28%) than it might be if the grantor retained the income. To receive income tax saving's, the trust must be irrevocable and not considered a grantor trust. However, there are situations in which grantor trust status is preferable. Some trusts are intentionally designed to qualify as grantor trusts for income tax purposes (e.g., when the grantor might be in a lower income tax bracket than the trust) and are referred to as income tax defective trusts.

4. Reducing Federal estate taxes. Irrevocable life insurance trusts are often set up during an estate owner's lifetime, so that insurance proceeds will not be subject to estate tax. In addition, an irrevocable trust that provides for successive life interests in several beneficiaries can be established to avoid estate taxes on the death of each successive income beneficiary. Consideration should be given, however, to transfers to grandchildren or other skip persons that would result in imposition of the generation-skipping transfer tax. Another consideration is the loss of the annual gift tax exclusion for transfers into trust of future (rather than present) interests in property. However, many estate tax advantages that can be achieved using trusts can also be accomplished with nontrust transfers.

5. Creditor protection. Depending on state law, transfers of property to irrevocable trusts may insulate that property from claims by creditors of the donor and beneficiaries. Such trusts are sometimes referred to as spendthrift trusts.

6. Continuity of management and avoidance of probate. A trust can be used to achieve continuity of asset management on a client's incapacity or death, and to avoid probate and other expenses of estate administration. A revocable living trust is a favorite nontax estate-planning tool. The trust becomes irrevocable on the estate owner's death and provides for disposition of the owner's property in the same manner as in a will. The "up front" and annual fees incurred in maintaining the trust should be weighed against the estimated expenses of probate and estate administration before this approach is adopted. In addition, clients should be counseled that other advantages of the probate process may be overlooked if only costs are considered.

Another frequently used tool to simplify estate administration is the Totten trust, which is a joint bank or savings account with right of survivorship maintained under the owner's control (and, thus, revocable until death) that ultimately passes to a designated beneficiary independent of the decedent's will. The client should be advised that holding any property in the form "joint with right of survivorship" could prevent the client's estate from taking full advantage of his unified credit. Because the assets would automatically pass to the survivor on the joint owner's death, they would not be controlled by the decedent's will and are thus not available to fund a bypass (credit shelter) trust. If the estate does not have other assets available to fund the trust, part of the decedent's unified credit would not be used.

Editor's note: This case study has been adapted from "Guide to Tax Planning For Individuals," 3rd Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and James F. Reeves, published by Practitioners Publishing Company, Fort Worth, Tex. 1998.