Do You Need A Living Trust?

A living trust is an estate planning tool that allows individuals to leave their assets to beneficiaries without the necessity of going through probate. Everyone, from attorneys and charitable organizations, to do-it yourself promoters have been touting living trusts as a panacea for all estate planning questions. This is an attempt to explain the basics of living trusts. It is not intended to replace sound professional advice. It should merely be used to provide you with an understanding of living trusts and why they may or may not be a desirable estate planning tool for you.

What Is A Trust?

A trust is a legal entity much like a corporation, partnership or individual. A trust is created when an owner of property called the “settlor” transfers title to the property to a trustee with instructions to the trustee that it be managed for the benefit of an individual(s) called the beneficiary.

Trusts are either “inter vivos” or “testamentary”. An inter vivos trust is a trust that is established and operates during the settler's life, conversely a testamentary trust becomes operative upon the settler's death. Additionally, trusts are either revocable or irrevocable. A revocable trust allows the settler to amend, modify or revoke the trust. If a trust is irrevocable, the settler cannot amend, modify or revoke the trust. A living trust as its name implies is an inter vivos trust and generally is revocable.

Who Needs A Trust?

The "Rule of Thumb" is, if you own any real estate and/or have a gross estate of $100,000 or more, it calls for something more than a simple will. Often the living trust is the instrument of choice.

How Does A Living Trust Work?

With many living trusts, the settler is both the trustee and the current beneficiary. When an individual establishes a living trust they, as settler, transfer to themselves, as trustee, their assets. They, as trustee, then hold the assets for their benefit as beneficiary. The trust may be amended, modified or revoked at any time while they are alive and they may withdraw assets from the trust at any time.

The following flow charts illustrate the transfer to, holding, and final distribution of a simple living trust for both a single individual and a couple.

Why Have A Living Trust?

As indicated above, the primary purpose of a living trust is to avoid probate. Probate is a legal process in which your will is proved valid (if you have a will), your assets are inventoried and appraised, your creditors are paid, and any remaining assets are distributed to the beneficiaries named in your will or to heirs determined by state law if there is no will.

This illustration exposes a dozen, no-nonsense reasons why trusts are superior to wills. Can you think of even ONE reason why you would want YOUR FAMILY to have a will over a trust?

There are two major disadvantages to probate: expense and time. When an estate goes through probate, a representative is appointed to administer the estate. This individual will usually employ an attorney to act as a guide through the process. Both the representative and the attorney receive a fee from the estate based on the gross value of the estate.

Additionally, there are other costs incurred in probate. These include filing fees, the cost of a bond, and a fee to have a probate referee appraise the value of the estate. Generally, the expense of probate can reduce the estate by 5 to 10% of its gross value.

In addition to being expensive, the process is time-consuming. When an individual dies their probate estate is frozen until such time as the representative is appointed. This generally takes 30-60 days. Thereafter, creditors must be notified, given four months to file claims, and an inventory and appraisal of the probate estate must be performed. Therefore, minimum of 6 months must pass before the probate is concluded. During this time, the representative’s actions are restricted and generally must receive court approval.

When an individual’s assets are held in a living trust, they are not subject to probate. When an individual dies, a successor trustee takes control of the trust and can immediately act and distribute the assets according to the plan set forth in the trust document. The successor trustee may need some assistance from an attorney. However, such assistance should cost a fraction of an attorney’s probate fee.

Are There Other Advantages To A Living Trust?

If an individual is unable to handle their affairs, the court will establish a conservatorship and appoint someone as conservator. The conservatorship continues under court review until such time as the individual is able to handle their affairs again or dies. The process, like probate, can be very costly and time-consuming. Furthermore, the individual appointed conservator may not be the person whom the individual would have chosen. With a living trust, if an individual becomes unable to act as trustee, a successor trustee replaces them as trustee. The successor trustee can be named by the individual prior to becoming incompetent.

Probate is a public process. If an individual’s estate goes through probate it becomes part of the public record. Anyone can review the court documents to learn of the assets, debts and disposition of the individual’s estate. Of course, unless the deceased is relatively famous or has unusually curious friends, the privacy problem may not be a concern.

Are There Disadvantages To A Living Trust?

In certain circumstances, terminating the claims of creditors or potential creditors should be one aim of an individual’s estate plan. Generally, this should be an objective of individuals in occupations or professions where liabilities arise years after the event(s) occurs. During probate, potential creditors are given an opportunity to make claims against the estate. Therefore, the conclusion of a probate insures that potential creditors’ claims have been terminated. California law does allow the trustee of a trust the ability to terminate creditor’s claims. However, the process is not automatic. Therefore, the conclusion of a trust does not insure that potential creditors’ claims have been terminated. Therefore, creditors could make claims after the assets of the trust have been distributed, unless the trustee had followed the proper procedure. While the automatic termination of creditors’ claims can be an advantage of probate, this advantage can be negated by the trustee who properly follows the process available to trusts.

The living trust, itself, as well as the cost of funding the trust, is more expensive than a will. Couples who are not concerned with estate tax planning, who desire to leave all their assets outright to the surviving spouse, will avoid formal probate upon the first spouse’s death. However, probate will occur at the surviving spouse’s death. This issue becomes one concerning the time value of money. Do you want to spend more money now to save money in the future, or should you spend less now and incur additional expenses to revise your estate plan in the future. Some couples defer establishing a living trust until the first spouse dies. They provide for their immediate estate planning needs by means of a simple will.

What Are The Income Tax Implications?

Assuming the settler acts as trustee, there are no adverse income tax implications with a living trust. Generally for income tax purposes, the trust is disregarded. The individual continues to use their social security number for the trust’s identification.

What Are The Estate Tax Implications?

Many promoters of living trusts claim that they save estate tax. While it is true that the distribution provisions of a trust can be drafted to save estate tax, identical provisions may be included in wills to provide such estate tax savings. However, planning for estate taxes can heighten a couples need for a living trust. For a discussion of why a medium-sized estate may increase the need for a living trust and other estate planning ideas for medium-sized estates see the pamphlet entitled “Estate Planning for the Medium-Sized Estate.”

Can’t Probate Be Avoided With Joint Tenancy?

Joint Tenancy is a method of holding title to property in which the joint owners have equal interests in the property. It differs from tenancy in common in that the ownership is by definition equal, but more importantly, if one joint tenant dies, the property automatically passes to the surviving joint tenant. This latter characteristic makes joint tenancy appear to be a desirable method of avoiding probate. However, there are certain pitfalls to owning property in joint tenancy.

First, for most couples, joint tenancy either provides no advantage or actually frustrates their estate plan. If their estate plan provides that the surviving spouse will receive the deceased spouse’s assets outright, formal probate will be avoided. If a couple’s estate plan provides that on the first spouse’s death all or a portion of the deceased spouse’s assets are placed in trust to save estate taxes holding assets in joint tenancy will frustrate or defeat the estate plan as the deceased spouse’s will or trust will not operate on property held in joint tenancy.

Second, there is a significant income tax disadvantage to joint tenancy. Basis is the tax term used to calculate gain on the sale of property. Basis is the cost of the property increased by the cost of any improvements and decreased by any depreciation taken on the property. Thus, if you purchased an asset for $15,000 and sold it for $100,000 your gain is $85,000. Under federal tax law, a decedent’s property receives a new basis. This new or “stepped-up basis” is equal to the fair market value of the property at the date of death. The stepped-up basis allows your heirs to immediately sell the property at no gain. Property owned in joint tenancy receives at stepped-up basis only on the portion owned by the deceased joint tenant. Thus, the surviving joint tenant receives a stepped-up basis only on a portion of the property, whereas if the beneficiary had inherited the property the beneficiary would receive a stepped-up basis on the entire property. Similarly, for couples, property owned as community property receives a stepped-up basis on the entire property. The significant effect of this difference is illustrated as follows:

John and Mary Taxpayers purchase a residence for $30,000 as joint tenants. For income tax purposes, the Internal Revenue Service treats this as if John paid $15,000 and Mary paid $15,000. 30 years later John dies and the home’s fair market has increased to $300,000. Mary’s new basis in the home is the original $15,000 she paid for it plus John’s stepped-up basis on his one-half, i.e., $150,000. Therefore, if she sells the home she will have a gain of $135,000.

Bob and Marge Taxsavers purchased an identical house for $30,000 but take title as community property. When Bob dies, Marge’s new basis in the home is Bob’s stepped-up basis on the entire house, i.e., $300,000. Therefore, if she sells the house, she will have no gain.

Third, if an individual is placed on title as a joint tenant, they become an equal owner of the property. If the original owner desires to sell or mortgage the property, the new joint tenant must consent in order to convey or mortgage the entire property.

Fourth, if someone is added as a joint tenant the original owner has made a gift of one-half of the property. If the gift exceeds $10,000 a gift tax return should be filed.

Fifth, the surviving joint tenant automatically receives ownership of the entire property at the death of the first joint tenant. If the decedent intended to use joint tenancy as a method of avoiding probate, but intended that non-joint tenants share in the property, this desire may be frustrated. The surviving joint tenant is under no legal obligation to share the property with others. Furthermore, if the surviving joint tenant does transfer ownership interests in the property to others and the value of the transferred property exceeds $10,000 per transferee, a gift has occurred and a gift tax return should be filed.

Finally, if the property is the individual’s personal residence, in any subsequent sale of the home only one-half qualifies for a rollover of gain or the one time exclusion. The new joint tenant’s portion would be subject to capital gains thus reducing the amount of cash to reinvest.

Conclusion

Although a living trust is not a panacea for all estate planning issues, it is an excellent tool to avoid probate if this is a desired goal. Furthermore, for some individuals, a living trust allows them to choose an individual to handle their affairs should they be unable to. However, a living trust is not a product to be purchased off the shelf. A living trust should result from the provision of services which have made the client fully aware of the options and alternatives involved.