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Use of trusts in planning for disability.

Many individuals today are concerned about the management of their financial affairs in the event they become incompetent or disabled. When an individual is disabled and unable to manage his or her own affairs, every effort must be made to ensure maximum flexibility so financial matters can be handled as smoothly as possible using trusts, powers of attorney and wills. When complex or substantial assets are involved or when a durable power of attorney may be inadequate, trusts offer the most efficient means of administering an incompetent or disabled person's estate.

Revocable trusts have major advantages, ensuring the continuity and financial security individuals desire as they face incompetency. This article explains how such trusts can be used to manage a disabled person's affairs and why a trust, rather than a will, should be considered the primary instrument for disposing of an estate.


If a person becomes disabled and has not made provisions for managing his or her financial affairs with a power of attorney or trust, family members will petition the court to appoint a committee, conservator or guardian. A committee generally is appointed by the court to oversee the person and property of someone who has been judicially declared incompetent. A conservator or guardian generally is appointed by the court to oversee the property of an individual deemed to have suffered a substantial impairment in ability to manage his or her own affairs.

For individuals concerned about disability, a revocable trust's major advantage is it provides a prearranged vehicle that becomes effective when disability occurs. Drafted properly, it can provide maximum administrative flexibility, giving the trustee far greater powers than those of a durable power of attorney, committeeship, conservatorship or guardianship.

Depending on local law, a trustee can be given broader operating discretion than the holder of a power of attorney (an attorneyin-fact). Almost all entities recognize a trustee's ability to act, while banks, insurance companies and government agencies often refuse to honor a power of attorney.

A revocable trust also can help avoid the cost and delay of appointing a committee, conservator or guardian. Questions always exist about the relationship between attorneys-in-fact and subsequently appointed committees, conservators or guardians. The holder of a durable power of attorney may be required to report to and be subject to the subsequently appointed committee, conservator or guardian's control. This is not the case with a trustee.

Major disadvantages of revocable trusts are the initial expense of creating them, the annual costs often incurred to prepare fiduciary income tax returns (required unless the grantor also serves as trustee or cotrustee) and the cost of holding title to trust property in the name of a trustee or nominee. However, such expenses generally are less than the costs of a committee, conservator or guardian proceeding.


A trust can be fully or partially funded immediately or fully funded upon subsequent disability. If an unfunded trust already exists, it should be funded immediately when the person is declared disabled. Clients reluctant to forgo control of property before disability can use a limited durable power of attorney in conjunction with a trust. The limited durable power of attorney can be drafted so the attorney-in-fact's sole power is to fund the trust. He or she merely acts as a conduit for delivering property to the trust when the client is deemed incompetent.

Executing a limited durable power of attorney before incompetency can, with a re* vocable trust, remove the need for a committeeship, conservatorship or guardianship, which has great advantages because of the weaknesses of court-supervised administration of a disabled person's affairs.

The process of appointing an administrator is time-consuming and expensive. The delay and expense at the onset of disability are troublesome, especially since state laws often require posting of surety bonds, medical testimony and extended court or administrative proceedings before a committee, conservator or guardian is appointed. Once the appointment is made, state statutes usually require periodic judicial accountings with associated delays and expense.


If a revocable trust is funded before disability and managed by the settlor (the person creating the trust) as an interim vehicle, one option is for the trust to contain a provision making it irrevocable upon incompetency. However, the gift and estate tax consequences of the conversion from revocable to irrevocable must be considered. Because the settlor retains a life interest, the trust value generally is included in his or her estate for estate tax purposes.

When the trust becomes irrevocable, the value of the remainder interest is subject to gift tax since the gift becomes a completed transfer at that point. This will occur unless the settlor retains a general testamentary power of appointment, giving the settlor the power to determine in his or her will the ultimate beneficiaries of the remainder interest at the settlor's death.

Under the newly enacted chapter 14 of the Internal Revenue Code, a completed gift's value will be 100%, with no reduction for the retained life interest value, for certain transfers after October 8, 1991. This will be the case unless the trust is a grantor retained annuity trust (GRANT) or a grantor retained unitrust (GRUNT). (For more information, see "GRITs, GRANTs and GRUNTs," by Stephan R. Leimberg, Eric T. Johnson and Robert J. Doyle, Jr., JofA, Mar.92, page 91.)


To use the revocable trust technique to protect assets during disability, the settlor creates a fully revocable and amendable trust. Generally, a power to revoke the trust must specifically be retained. The settlor even can be the initial trustee, avoiding administrative expenses before the trust becomes operational. The trust agreement typically gives the trustee the right to receive additional property from any source.

When the settlor becomes incompetent or disabled (see the sidebar on page 88 for the importance of including a definition of "disabled" in the trust), the revocable trust becomes irrevocable. All of the settlor's property is transferred to the trust, and the settlor should become disqualified to serve as trustee. He or she is replaced by a successor-trustee named in the trust,

Under the trust terms, the settlor relinquishes all previous ability to revoke or amend the trust. At that point, any disposition of trust property may be a completed gift subject to gift tax. To avoid this, a provision can be added so the settlor regains the power to revoke or amend the trust if he or she later regains competency.

Depending on state law, a court order may be required to transfer property to the trust after the settlor is incapacitated. In some states, property can be transferred using a durable power of attorney. In lieu of a durable power of attorney, a springing power of attorney, which "springs" into effect only upon a triggering event such as the principal's disability by reason of mental incompetence, may be desirable. The text of a springing power of attorney should include a mechanism for determining when the settlor is incompetent and should be coordinated with any definition of disability in the trust instrument.

The trust also can provide for a pour-over to or from the settlor's will at his or her death. A will specifically directing the testator's assets to be added to property held in an existing trust and disposed of according to the trust terms is known as a pourover will. The most typical provision provides for probate property to pour over from the will to the settlor's trust at death.

Many states, such as New Jersey and Florida, have statutes authorizing pourovers from a will to an existing trust. These statutes are versions of the Uniform Testamentary Additions to Trusts Act and provide that a trust can be amended after a pour-over will is executed. The amendments will be followed without the original will having to be revised.

Certain assets, such as personal property, cannot appropriately be transferred to a trust and should be distributed under a will. Other advantages of having assets pass under a will rather than a trust include

* Estates are permitted to select a fiscal year, allowing greater flexibility in deferring income taxes payable by a beneficiary, whereas trusts are not.

* Estates, and not trusts, may be entitled to an IRC section 642(c) charitable setaside deduction.

* Estates have a $600 exemption for fiduciary income tax purposes, as opposed to a $100 exemption for a complex trust and a $300 exemption for a simple trust.

* An estate, but not a trust, can take advantage of the limited $25,000 passive loss deduction for rental real estate.

* Losses on transactions between a trust and its beneficiary will be disallowed for income tax purposes under IRC section 267(b)(6) but will be allowed in transactions between an estate and its beneficiaries.

When there is both a will and a trust, care should be taken to coordinate provisions concerning apportionment and payment of estate taxes, especially when the beneficiaries are not the same or when there are estate liquidity concerns. If tax payments are not coordinated, one or more beneficiaries may be forced to assume a greater-than-intended share.


A trust can give the trustee the

* Authority to pay the settlor's estate taxes, debts or estate administration expenses.

* Right to lend money to or purchase assets from the settlor's estate.

* Right to borrow money.

* Ability to file tax returns on the settlor's behalf and to exercise discretion as to tax elections.

* Right to operate the settlor's business. Granting the trustee such powers also can create unwanted problems. For example, the trust operating the settlor's business could create a business trust taxable as a corporation. Local law should be considered in determining which powers to include or deny a trustee, keeping in mind the goal of flexibility.

Consideration also should be given to granting the trustee certain special powers that go beyond those described above.

* Substitution of judgment powers gives the trustee authority to make payments of income or principal to third parties, named in the trust instrument or otherwise, as the trustee believes the settlor would have made if not disabled.

* A mechanism may be advisable to provide the trustee with the power to redistribute all trust property back to the settlor in the event the settlor is no longer disabled. The same or similar disability definition and certification procedure outlined in the sidebar may be used here.

Such provisions would be consistent with the settlor's desire to retain maximum personal control over his or her affairs except during disability and may prevent adverse gift tax consequences.


As long as a trust is revocable, its assets are treated and taxed as the settlor's. A revocable trust owner reports income, deductions, capital gains, losses and credits on his or her own tax return. If the individual never becomes disabled and the trust remains revocable, the assets are includable in the settlor's gross estate at death, because a completed gift was never made for gift tax purposes. This means there are no gift tax consequences when creating a trust.

Following incompetency or disability, the settlor continues to receive some or all of the trust income or principal, making the trust fully includable in the settlor's gross estate because he or she reserved the income interest from the trust. Trust income continues to be taxed to the settlor under the grantor trust rules because of the settlor's opportunity to receive income.

Whether conversion of the trust following disability actually constitutes an irrevocable transfer for gift tax purposes depends on the trust terms. Treasury regulations provide that once the settlor parts with control over the property, the gift is deemed completed. Therefore, a gift taxable event could occur when the trust becomes irrevocable.

The regulations provide that if the settlor retains some power over the disposition of trust assets, such as a testamentary power of appointment over the remainder after death, no portion of the transfer is considered a completed gift. Thus, if the settlor retains certain powers over the trust, a completed gift on disability can be avoided.

As discussed in IRC chapter 14, a completed gift's value will be 100% in certain instances, with no reduction for the retained life interest (unless the trust is a GRANT or GRUNT). Of course, to the extent the settlor continues to enjoy an interest in the property, there is no completed gift of the income interest.


The Uniform Custodial Trust Act authorizes creation of a statutory support trust similar to the Uniform Gifts [or Transfers] to Minors Acts but primarily for the benefit of the elderly as an alternative to court administration of assets in the event of disability. The trust's most frequent use would be in response to a common need of elderly individuals to provide for management of assets in the event of incapacity. To date, nine states have adopted variations of the act: Arkansas, Hawaii, Idaho, Minnesota, Missouri, New Mexico, Rhode Island, Virginia and Wisconsin.

The statute's objective is to provide a trust that is easy to create, administer and terminate. After a custodial trust is established, the custodial trustee acts largely as an agent subject to the beneficiary's direction until he or she becomes incapacitated. Then the trustee is authorized to manage and distribute the property.

The trustee has distributive powers similar to those in the Uniform Probate Code, not only for the beneficiary's benefit but also for those supported by the beneficiary and those who may be legally entitled to the beneficiary's support. The potential for tax problems is minimized by permitting the beneficiary (in most instances) to retain control while he or she has the capacity to manage the assets effectively.

Upon the beneficiary's death, the custodial trust assets are distributable as follows:

1. As last directed in writing by the beneficiary.

2. To any surviving concurrent beneficiary (generally the surviving spouse).

3. As designated in the custodial trust instrument itself.

4. To the estate of the beneficiary if none of the preceding three designations exist.

As a consequence of the population's mobility, particularly the elderly, uniformity of laws governing custodial trusts is desirable and the act is designed to avoid conflictof-law problems between states. A custodial trust created under the act remains subject to the act despite a subsequent change in the transferor's residence, the beneficiary or the custodial trustee or removal of the custodial trust property from the state of original location.


Maintaining a revocable trust that becomes irrevocable upon incompetency is a useful estate planning tool to assist with the management of complex or substantial estates. Before such a trust is executed, however, it is necessary for clients to consult with experienced accountants and attorneys to explore the tax and other considerations of setting up such an arrangement.
COPYRIGHT 1992 American Institute of CPA's
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Article Details
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Author:Scheiner, Barbara J.
Publication:Journal of Accountancy
Date:Sep 1, 1992
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