With increasing frequency, our clients share one or more of the following estate planning objectives:
“How can we make sure that money is used for a grandchild’s education?”
“I am concerned about the health of my child’s marriage. How can we protect a child’s inheritance in case the child gets divorced?”
“My children are better off then we are. How can I minimize their taxes after we die?”
Some client dismiss the idea of managing assets after death as “ruling from the grave.” But for those clients and their advisors willing to consider a post-death trust (“testamentary trust,”) it can be an important estate planning strategy to achieve some of these stated objectives. In this month’s update, I briefly describe both the benefits and costs of a post-death testamentary trust structure for adult children.
The Benefits of a Testamentary Trust
A testamentary trust might achieve several benefits, four of which I summarize below.
- Accomplish Laudable Purposes
First, the trust assets can be earmarked for laudable circumstances. The trust could provide for specific expenses of a grandchild, such as the grandchild’s education, even while their parent is the primary beneficiary of the trust. A list of specific types of laudable distributions are included here. Depending on the life circumstances, the marginal utility of a trust transfer to a grandchild might be higher than a transfer to a child. Trust assets can be distributed to a child or a child’s children without gift tax implications.
- Protect the Assets from the Child’s Divorcing Spouse or Personal Creditors
Second, a beneficiary’s personal creditors cannot reach the undistributed assets of a testamentary trust. A child could therefore protect her inherited assets from a divorcing spouse or a personal business creditor by leaving assets in a testamentary trust. While other options exist to avoid the characterization of assets as “marital property” with a child’s divorcing spouse, a testamentary trust is a good means to characterize inherited assets as “separate” property for divorce law purposes.
- Minimize a Child’s Estate Taxes
Third, a testamentary trust that meets the definition of a “generation-skipping transfer trust” under the tax code would avoid estate taxes at the child’s generational level. The GST Trust assets are not considered to be owned by the child at the child’s death, and therefore do not add to the child’s personal estate tax liability at death.
- Direct Remaining Assets to Grandchildren
Finally, the trust could be structured so that assets remaining in the trust at the child’s death must be distributed to grandchildren. The trust creator is thereby assured that the assets “stay in the family” for the next generation.
The Costs of a Testamentary Trust
Two costs of a testamentary trust are noteworthy:
- Administrative Hassle
First, the implementation of a testamentary trust requires that the inherited trust assets be owned and managed separate and apart from a child’s individual assets. Establishing separate accounts in the trust creates more ongoing administration, including the filing of annual trust tax returns.
- Income Tax Liability
Second, based on current income tax rates, the income taxes on the earnings of undistributed trust assets are higher than the same earnings on individually-owned assets. If a trustee makes trust distributions to the child-beneficiary equal to the trust’s taxable income, the child-beneficiary would pay income taxes, not the trust. The income distribution would contravene the estate tax savings sought over the income distributed to the child. In most cases, therefore, the benefits achieved through a testamentary trust come at an increased income tax cost.
The use of a testamentary trust should be carefully considered in those circumstances when clients raise one or more of the above-referenced objectives. In an ideal scenario, we would engage multiple generations of client families in conversations about this planning tool to align legal objectives with expectations.
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