Trusts, Pt. 2: When should they be used?

My Comments: This comes from Hale Stewart, an attorney in Houston, Texas. He and I have spoken as a result of his interest in captive insurance companies and asset protection. He is the author of the book U.S. Captive Insurance Law and is currently working on his Ph.D.

Last week I posted Part 1 which gave you an overview of trusts. From time to time, my clients ask me whether they should employ a trust in their financial planning. Since I’m not an attorney and the penalty for offering legal advice when you are not an attorney is painful, I like to bring you an explanation from time to time. Here is Part 2. My plan is to give you Part 3 next week.

In addition, I’d like to add this cautionary word: These articles express the very basics of trusts to give the reader the appropriate tools to start talking with an attorney. If you have further questions, please contact an attorney regarding your specific situation.

Article added by Hale Stewart on April 26, 2012

First, a few more preliminary points.

It is possible to have a non-written trust. At least it is on a law school final. Here’s my advice regarding verbal trusts: don’t. Always — always — have a written document that explains the basic terms. Verbal trusts are a litigation nightmare waiting to happen.

A revocable trust is a trust that can (obviously) be revoked. This also means the terms of the trust can be changed. For example, it allows the grantor the opportunity to add or subtract a beneficiary, change a disbursement scheme, or make any other change he wants to make, including dissolving the trust.

The benefit with a revocable trust is that it prevents application of the gift tax rules because a revocable trust is an incomplete gift.

In contrast, an irrevocable trust is a trust that can’t be changed by the grantor. Additionally, once a trust becomes irrevocable, the grantor has made a completed gift, meaning we must how take the gift tax rules into consideration.

So, now that we have some of the basics down, when should we use trusts?

Trusts are very good at one thing: segregating property, placing it under professional management and controlling its manner of investment and disbursement.

For example, suppose a client wants to make sure a spouse is taken care of when they (the client) die. The client can establish a trust as part of their estate plan and make the spouse the primary beneficiary. The spouse can receive all the income from the trust on at least an annual basis and also have the right to dip into the trust’s principal for their “health, education and welfare.” After the spouse dies, the money can be distributed to their children (the grantor’s children).

The client can also write an investment policy directing the trustee to only invest in certain types of assets (for example, single “A” and above securities) and only in certain percentages (no investment can account for more than 5 percent of total trust assets).

The above stated possibilities are just that: one available possibility. The total number of possibilities are endless, depending only on creativity.

Another very common trust is an irrevocable life insurance trust, or ILIT. Life insurance is often sold as part of an estate plan. However, under the estate tax rules, the value of the life insurance policy will be included in the gross estate if “the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person.”

To prevent this rule from applying, estate lawyers write and fund an ILIT, placing the life insurance policy in the trust and taking the “incidents of ownership” out of the grantors hands. This effectively removes the face value of the policy out of the grantor’s estate.

These are but two of the most common applications of trusts. In the next topic, I’ll touch on the more advanced concepts such asset protection trusts, GRATs and intentionally defective grantor trusts.