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The KRASA LAW, Inc. Estate Planning Blog

Monday, February 25, 2019

Protecting Inheritances Through an Irrevocable Trust

Introduction

Under California law, as in most states, Trust-Makers cannot establish asset protection for themselves by creating their own trusts with their own assets for their own benefit (CA Probate Code §15304). Such a trust is commonly referred to as a “self-settled trust.” However, under California law, as in most states, Trust-Makers are able to establish asset protection for third-parties by creating irrevocable trusts for the benefit of third-parties (CA Probate Code §15303). Such a trust is commonly referred to as a “third-party trust.” 

The concept of the “Beneficiary Controlled Trust” (“BCT”) is to take advantage of the rule permitting the establishment of creditor protection for third-parties by utilizing a third-party trust to transfer either a lifetime gift or a gift upon death to a third-party. The BCT is designed to give the beneficiary complete control over an inheritance or a gift while at the same time providing a degree of asset protection.

A BCT may be established as a stand-alone trust or as a sub-trust that is created under a living trust after the death of the Trust-Maker(s). 

Trustee 

The beneficiary of the BCT will typically serve as Trustee, either immediately at the creation of the trust or upon attaining a specified age of maturity.

Some BCT’s are structured to designate the beneficiary as the sole Trustee. Under such circumstances, tax laws require that the Trustee be given an “ascertainable standard” as guidance for appropriate distributions of trust assets to the beneficiary (i.e. “trust spending”). The most common and most liberal “ascertainable standard” is known as “HEMS”: the Trustee may distribute income and principal to the beneficiary for the beneficiary’s “Health, Education, Maintenance, and Support.” The beneficiary / Trustee has complete discretion to determine whether a particular distribution meets this standard and thus the beneficiary / Trustee is not practically limited in how he/she decides to spend trust assets. 

Although it is convenient for the beneficiary to serve as his/her own Trustee, such a scenario does not provide the strongest degree of asset protection. Because the beneficiary / Trustee has the ability to not only manage the trust assets, but can also control whether or not to spend trust assets, under certain circumstances, a creditor could “step into the shoes” of the beneficiary / Trustee and force a trust distribution to satisfy a claim. To establish a stronger degree of asset protection, a BCT might be structured to bifurcate the role of the Trustee by naming the beneficiary as the “Administrative Trustee” and an independent third-party as a “Distribution Trustee” (also known as a “Spending Trustee”). 

For example, a BCT might name beneficiary Sally as the Administrative Trustee and might require that Sally appoint an independent third-party to serve as the Distribution Trustee. Sally, as Administrative Trustee, would be solely on title to all trust assets and would have complete control investing trust assets. However, before spending any trust assets on herself, the Distribution Trustee would be required to approve or deny trust spending in writing. Records of spending requests and approvals / denials should be kept in the trust binder. By giving an independent third-party the power to approve or deny trust spending, there is less of a chance that a creditor could force trust spending to satisfy a claim. 

Unlike the scenario of a beneficiary serving as sole Trustee, the Distribution Trustee is not limited to a HEMS standard. Instead, the Distribution Trustee is free to approve or deny trust spending for any reason. This coupled with the fact that the beneficiary does not have the power to unilaterally decide how to spend trust assets gives the BCT stronger asset protection. 

Often the beneficiary is given the power to replace the Distribution Trustee at any time for any reason. The Distribution Trustee must not be “related or subordinate” to the beneficiary (i.e., should not be a parent, child, spouse, or sibling of the beneficiary). 

Although a BCT structured with a Distribution Trustee provides stronger asset protection than a BCT that names the beneficiary as a sole Trustee, both structures provide significantly greater asset protection than a gift or an inheritance that is free of trust.  

Flexibility

A BCT is technically an irrevocable trust, meaning that the beneficiary cannot amend or revoke the trust in the same manner that a Trust-Maker can amend or revoke a typical revocable living trust. However, a well-drafted BCT will include many tools that give the beneficiary flexibility in updating the trust in a variety of circumstances. 

A BCT will often allow the beneficiary to appoint successor Trustees in the event that the beneficiary becomes unable or unwilling to serve as Trustee in the future. This is important, especially if the beneficiary becomes mentally disabled or dies. A beneficiary of a BCT should exercise his/her right to appoint successor Trustees and should review successor Trustee appointments on a periodic basis. 

A BCT will often give the beneficiary the power to remove a Trustee for any purpose if the beneficiary is not serving as his/her own Trustee. As mentioned above, if the BCT is structured to include the use of a Distribution Trustee, often the beneficiary is given the power to replace the Distribution Trustee at any time for any reason. 

A BCT names contingent beneficiaries to inherit whatever might be left in the trust after the beneficiary dies. Often a BCT will give the beneficiary a “testamentary power of appointment,” the ability to name alternate contingent beneficiaries to inherit the remaining trust assets upon the beneficiary’s death. A beneficiary of a BCT should exercise his/her right to name alternate contingent beneficiaries of the trust and should review such contingent beneficiary designations on a periodic basis. 

The power of appointment can either be “limited” or “general.” The distinction between the two different types of powers of appointment can have significant tax implications. Often a BCT will be structured to allow a power of appointment to be converted from a “limited” power to a “general” power. Upon the establishment of a BCT, the beneficiary should consult an attorney or CPA to determine the type of power of appointment and whether or not it can and should be modified. 

As circumstances change and as the law changes, it might be necessary to modify the administrative or tax provisions of a trust. Because the BCT is irrevocable, the beneficiary cannot have the power to make such trust modifications directly. However, a BCT is often structured to include provisions for the appointment of a “Trust Protector,” an independent third-party who has the power to make changes to the administrative or tax provisions of the trust. In some circumstances, the Trust Protector will have the power to terminate the trust and transfer the trust’s assets directly to the beneficiary if the BCT is no longer desired. Often, the beneficiary of the trust has the power to appoint an independent third-party as Trust Protector when needed. 

Many years into the future, the BCT might be completely out of date and a new trust might be in order. A BCT can include “trust decanting provisions” which allow an independent third-party Trustee to “decant” the assets of the BCT into a new, updated trust. If the beneficiary is serving as Trustee, the beneficiary should appoint an independent third-party as Trustee before utilizing the trust decanting provisions. 

Retirement Plans

A BCT might be named as the beneficiary of certain retirement plans including IRAs. Trusts and IRAs involve many nuanced rules that must be navigated carefully in order to ensure that the beneficiary can maximize tax benefits. Often a BCT will include “conduit provisions” that mandate that all “Required Minimum Distributions” (“RMDs”) from the IRA be distributed out of the trust to the beneficiary individually. If a BCT is named as a beneficiary of an IRA, the beneficiary should consult with an attorney or CPA about the proper management of RMDs. 

Tax Returns

A BCT is its own taxpayer and must file federal and state income tax returns under its own Taxpayer Identification Number (“TIN”) each year. The Trustee will often have the discretion to either keep the trust’s net income in the trust each year or to distribute the trust’s net income to the beneficiary individually. 

For any income that remains in the trust at the end of the year, income tax will have to be paid by the trust on the trust tax returns. For any income that is distributed to the beneficiary during the tax year, the trust will issue a K-1 to the beneficiary and the beneficiary will pay income tax on the beneficiary’s personal income tax return. 

The trust tax rate is usually significantly higher than the individual tax rate. As a result, in a typical year where there is no threat of a creditor, it is often better for the beneficiary to distribute all of the net income out of the trust and to the beneficiary individually in order to enjoy a lower tax rate. While the income that is distributed will lose asset protection, the principal will remain protected. In a year in which there is threat of a creditor, it might be prudent to keep the income in the trust and pay the higher income tax rate. 

The beneficiary should consult a CPA at the end of each year to determine whether it is advantageous to keep trust income in the trust or to distribute the trust income out to one’s self by the end of each year.

Keep it Separate 

The basis for creditor protection of a BCT is the fact that a third-party created and funded the trust for the benefit of the beneficiary. A trust that is funded with the beneficiary’s own assets does not enjoy asset protection. As a result, a beneficiary should not under any circumstances transfer his/her own assets into the BCT. It is of paramount importance that the inherited or gifted assets of the BCT not be comingled with the beneficiary’s personal assets.


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KRASA LAW assists clients with Estate Planning, Elder Law, Pet Trusts, Asset Protection, Special Needs Planning and Probate / Estate Administration in Pacific Grove, CA(93950), Monterey (93944, 93940, 93943, 93942), Salinas (93901, 93905, 93906, 93907), Hollister (95023,95023) Pebble Beach (93953), Carmel By The Sea (93921), Seaside (93955) and Carmel (93923, 93922) in Monterey County and San Benito California.

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