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MORE THAN 40 YEARS ago, I was an agent for the Internal Revenue Service. During training, we learned about auditing individuals, corporations, subchapter S corporations, Schedule C businesses, partnerships and probably a few other areas that I’ve since forgotten. But there was one area we didn’t touch: trusts.
That puzzled me, so I asked the trainer why. His response: “You aren’t smart enough to audit trusts.” He told me that how trusts operate might change drastically based on slight differences in wording. Auditing trusts was left to lawyers who worked for the IRS.
Four decades later, I came to understand the trainer’s wisdom. I sat between my mother’s accountant and her lawyer, who were fighting over how a trust worked for tax purposes.
The irrevocable trust set up by my father’s lawyer not only didn’t save money, but also it endlessly complicated the finances of both my father’s estate and the rest of our family. The reason: all the tax law changes between when the trust was set up and when my father actually died.
To be fair, the lawyer’s actions in 1996 made sense at the time. At that juncture, anything over the $600,000 federal estate-tax exclusion was subject to tax rates ranging from 37% to 55%. But if you put the $600,000 in an irrevocable trust before you died and left it to grow, the $600,000 plus the subsequent growth would sidestep estate taxes when you died. There were other potential advantages to the trust, but this was the main selling point.
My dad died 23 years later, by which time the federal estate-tax exclusion had jumped to $11.4 million. My father’s estate and the trust were worth nowhere near that amount, so the trust no longer made sense. But the trust was irrevocable, so that was that. To add insult to injury, the stocks my dad owned outside the trust got a step-up in cost basis upon his death, but the trust’s assets didn’t.
Later, we hired a second lawyer and paid thousands to make changes to the trust. That allowed the trust’s assets to be included in my mother’s estate. This will ensure a step up in cost basis upon her death, thereby nixing the embedded capital-gains tax bill. But my mother couldn’t make this decision on her own. Instead, the change had to be approved by the trust’s beneficiaries, which included eight surviving children and 25 grandchildren.
What we were dealing with was what’s called a bypass trust. The notion: My mother could enjoy the dividends and interest kicked off by the trust, but the trust’s principal value would pass to her children and then to her grandchildren. This was all for less than $2 million in assets. Crazy, isn’t it?
Interests and dividends are about $50,000 to $60,000 a year. Do the math. With so many people involved, each beneficiary won’t get much income. In addition, either the trust or the individuals have to pay taxes on that income, and trusts are dunned on a far more punitive tax schedule than individuals.
One lawyer said he didn’t see an end to the trust. The trust was set up to flow through to the grandchildren, but he thought the intent was for the trust to eventually benefit the great grandchildren, of which there are currently 39.
This wouldn’t have meant much financially to those involved, given all the beneficiaries. But even ignoring that issue, this trust didn’t save our family money once you factored in taxes, lawyer’s fees and other expenses. In fact, it ended up costing us. There were other complications as well, but I’ll leave it there.
The moral of the story: Be careful making long-range financial decisions based on current tax law. My father’s lawyer in 1996 was also a CPA. Everything he set up in 1996 made sense. Very little of it made sense when Dad died in 2019. Sometimes, the best plans in life are the simplest.
Ken Begley has worked for the IRS and as an accountant, a college director of student financial aid and a newspaper columnist, and he also spent 42 years on active and reserve service with the U.S. Navy and Army. Now retired, Ken likes to spend his time with his family, especially his grandchildren, and as a volunteer with Kentucky’s Marion County Veterans Honor Guard performing last rites at military funerals. Check out Ken’s earlier articles.
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My rule of thumb is assume your attorney may have him/herself/firm of primary concern, not you. That includes time billed for “drafting” documents when they are actually boilerplate, then the subsequent charges for explaining in future years what the gobbledegook they wrote means. For sure trust tax rates will remain higher than individuals, so is a bright caution flag to remember. Then there is so much more.
Another anti-attorney concern is that to earn fees, many actively promote transfer of assets to then rely on medicaid and other govt programs. The vast majority of Americans who can afford it incur debts and responsibilities with the intention of honoring them. Why would we want to leave this life with questionable tactics to avoid repaying obligations? If you knew you were going to die tomorrow, would you go to neighbors and stores to steal stuff to give your children and others? Hopefully no, so remember than when you get the pitch. Spend your money on your obligations, not on attorney fees.
Ken,
I feel your pain! My parents set up a trust in the UK in 1986.It is a different set of trust laws, but I could have written a similar post to yours. The details were different but the good intentions and painful outcomes were very similar.
Intention: To avoid estate tax. Which, just like your experience, had become irrelevant at our inheritance level on both sides of the Atlantic.
Unintended consequence: my siblings and I ended up owing Capital Gains on the family home, dating back to 1986. Quite the appreciation and tax bill! Yes, I know capital gains is forgiven on inheritance. But not when the trust had made us each part owners.
Did my parents expect that by the time the trust came to pass, the three ‘kids’ would be in 3 different countries? With the extra overhead of extra countries tax and inheritance laws.? No, they did not.
Why did your father set up an irrevocable trust in the first place?
I can’t speak for Ken’s father, but irrevocable trusts do afford certain benefits (taxes, asset protection, etc.) at the expense of being…well…irrevocable. As Ken alluded to, they generally (but not exclusively) make sense for those with very large estates. (>$11.4 million currently?)
For most of us, the use of a trust to avoid estate taxes is no longer valid, and (depending where one lives) forming an revocable trust during one’s lifetime may not be worth the cost and complexity simply to avoid probate. However, there are some quite legitimate reasons to have a trust to handle one’s assets after death (grandchildren’s college education, financially irresponsible heirs, etc.). Depending upon the probate costs in the taxpayer’s state of residence, a testamentary trust (where the trust is described and funded through the will, the assets going through probate) is relatively straigtforward and inexpensive, and the assets are assured a step up at the death of the owner. The trust should be designed so that all annual dividends, interest, and (if any) distributed capital gains are distributed annually to the beneficiaries to avoid being taxed at prohibitively high trust tax rates.
While you don’t mention it, Ken, I wonder how your work for the IRS informed your thoughts here. I would think you likely encountered many instances where people thought that more complicated schemes would somehow pay off without fully understanding what they were giving up or taking on along the way. Your dad sounds like a reasonably secure, well-informed, and well-advised person whose carefully laid plans led to unintended consequences a generation later.
My understanding is that a trust is necessary when you have minor children as they cannot inherit directly. If so, it may depend on what season of life you are in! I do feel a bit of emotional loss of control though with assets being in a trust.
No, neither irrevocable or revocable trusts are necessary when there are non-adult children – but it may be advisable. Depending on amount of assets, family/relative situation simple guardianships or 529 deposits might suffice.
Trusts can be used for a variety of purposes, and some (such as a revocable living trust used to sidestep probate) involve far less of a commitment than others (such as an irrevocable trust designed to minimize estate taxes or protect against lawsuits):
https://humbledollar.com/money-guide/trusts/
Sorry, that comment was meant more to address the anti-trust comments below, not directed toward the article itself.
Do these caveats apply to revocable trusts as well?
Ken, great article on an important topic we don’t see all the time.
Good article! Your dad’s situation went from a $600k to a +$11 mil estate exemption….a pleasant experience. Unfortunately, we may be faced with the reverse situation in years to come….. going from a $1X mil exemption back to something like a $1 mil (for example) estate exemption. That will not be as pleasant a tax experience. Needless to say, it is most challenging to do long term estate planning with the constant changing federal (and now state) estate tax laws in our nation. My guess is the estate tax law could be one of the most volatile tax laws in the years ahead. That uncertain future estate tax law environment makes one think about alternatives for estate planning now. And I also do not like trusts ,if I can avoid them….for several reasons.
Ken, thanks for the interesting and well-written article. I agree with your descriptions of the complexity of trusts, it was by far the hardest course in my CFP training. When we updated our wills and POAs some years ago I spoke with an excellent estate attorney about the need for a trust. After reviewing our situation she said a test would cost far more than any probate process. We don’t have any complicating factors such as dependent children, or family with special needs. Sadly, we don’t have to worry about the federal estate-tax exclusion limit!
We set up a revocable trust for our children. Per our Maine based financial advisor NH has a terrible reputation which was confirmed when my parents died a few years ago. It took almost a year and an exorbitant amount of time for my sister to complete. With the trust our children who are very close get to divide our assets as they please and we have anonymity as to what are end assets are. The trust will save our children time and energy. It was well worth the cost!
Simpler to pay the tax than the lawyer(s) from the sound of it. Virtually everything I own will pass to designated beneficiaries or by TOD, and if tax is owed I will no longer care. While less is always better than more, avoiding taxes is not top of my list of concerns in any case. No taxes, no civil society.
I was dismayed to hear that Congress is proposing a large cut in the IRS budget. I think audits will likely be more focused on the little fish, who are easier to catch but with less wealth, rather than the whales with their complicated holdings and expensive attorneys and accountants looking for loopholes, legal or otherwise. Hope I’m wrong, but I agree with you, Kathy: Without taxes, no civil society.
Thanks so much, Ken, for your timely and clear article about trusts. I’m updating my will right now (second and likely final conference with attorney later today). Though most of my assets are beneficiary-designated and I have a good LTC policy, purchased more than 20 years ago, she was pushing me a little to put my personal property (house, car and furnishings) into a trust to “protect” these (quite modest) assets and, presumably, earn her a bit more money. Fortunately, I had read some articles here and elsewhere and had already decided that a trust didn’t make sense for me. Your article confirmed my decision and I will definitely be ready if she mentions it again today. Thanks!
Your family’s trust experiences seem like such a headache — thanks, Ken, for the cautionary tale.
My father died in 2008 in California with an unfunded living trust and a pour over will. Strange as it seemed to me at the time, I petitioned the court to transfer his assets into the trust, such that I could then distribute them out of the trust to his heirs. The process was relatively seamless, but took over a year. Needless complication and legal fees, I think. With this experience and with no need for a trust, I have just a simple will.
While there are some legit reasons for trusts, such as to benefit children with special needs, most of us mere mortals are very well served by titling our accounts as Transfer on or Payable on Death. The important thing here is to stay on top of keeping the correct beneficiaries named (in order to avoid probate). That’s also important with qualified money.
Unfortunately, my state does not allow transfer-on-death deeds, a popular tool used to efficiently distribute real property in other states. Other than our home, our only real property, all of our financial investment accounts should pass to the primary or the contingent beneficiaries via the appropriate beneficiary designations. These are further reasons for us to simplify our financial complexities to the extent possible and to review our beneficiary designations at least annually and every time a major life event occurs.
I also have started taking my RMDs early in the year to help reduce potential headaches for my beneficiaries in the event I die later in the year.
Hopefully these actions will reduce the burden on those would will have to deal with the probate of our estates.
Avoiding STATE estate taxes is a reason we have trusts. At this point, we have had our trust and POA documents executed twice, to keep up with changes in both federal and state laws. Also, our sons are no longer minors, so guardianship wording was removed and we’re not imposing a staggered age for them to receive our bounty. One and done!
Agreed. I am also in the don’t trust trusts camp due to the set up and administration fees, management complexity plus higher taxes. Our family’s probate experiences have all been easy and low or no cost – remember that the people advising us to “avoid probate” are the same ones getting paid to set up the trusts.
Further, a trust-lawyer acquaintance privately suggested that anyone with less than the $12.9 million limit most likely doesn’t need a trust. To me, trusts seem best utilized to manage the future for young, challenged or complicated beneficiary situations. More here:
https://humbledollar.com/2022/08/where-theres-a-will-2/
Good advice, another message perhaps, whatever you do set up should be reviewed every few years for relevance.