7 Trusts That Could Enhance Your Estate Plan

To optimize your estate plan, you should be able to talk the basics of trusts with an estate planner.

Last month, I reviewed key trust terms and concepts and described some basic types of trusts.

This month, I describe some specialized trusts that solve particular problems or achieve certain goals.

Estate plans of married couples often include a classic: the bypass trust, also called the B trust (part of the A-B trust estate plan) or the credit shelter trust.

The primary purpose of the bypass trust used to be to reduce estate taxes, even for modest estates, but it has important nontax benefits.

First, here’s how the bypass trust helps reduce estate taxes. Suppose we’re back when the estate tax exempt amount was $1 million. Max Profits has an estate worth more than $1 million and is married to Rosie Profits.

Max bequeaths $1 million to a bypass trust and the rest of his estate directly to Rosie.

The bypass trust provides for Rosie for the rest of her life. Then, the trust remainder goes to the Profits’ children, as does Rosie’s estate.

Max’s lifetime federal tax-exempt amount shelters the $1 million bequeathed to the bypass trust. The unlimited estate tax marital deduction shelters the amount bequeathed to Rosie. So, Max’s estate pays no federal estate tax.

When Rosie passes away, her lifetime exemption shelters up to $1 million of her estate, and the money in the bypass trust isn’t included in Rosie’s estate.

The result is at least $2 million eventually passes to the Profits’ children free of estate and gift taxes.

Few families are concerned about estate taxes now, but the bypass trust still should be considered for its nontax benefits.

A good trustee protects trust assets from bad investment decisions, scams and similar concerns. Trust assets also are protected from the beneficiaries’ creditors.

A bypass trust guarantees the children eventually receive the trust remainder. There’s no possibility the surviving spouse over time might be persuaded to leave the assets to others.

The tricky part now is determining how much of the estate should go into a bypass trust. In the old days, the will bequeathed an amount equal to the federal estate tax exempt amount to the trust. Today, that simple formula would transfer the entirety of most estates to the trust, leaving the surviving spouse with no assets in his or her name.

The amount to bequeath to a bypass trust now is a personal one to be discussed with the estate planner and your spouse.

Married couples also should consider the QTIP, or qualified terminal interest property trust.

The surviving spouse receives income from the trust for the rest of his or her life but can receive only income from the QTIP. After that spouse passes away, the remaining assets go to the final beneficiaries, usually the couple’s children.

When the first spouse passes away, all assets that go to the QTIP qualify for the unlimited marital deduction and avoid estate taxes, provided the surviving spouse is a U.S. citizen.

When the surviving spouse passes away, all the trust assets are included in that spouse’s taxable estate.

You don’t have to finalize the amount that goes into the QTIP trust when the will is written. The estate executor determines how much of the estate goes into the trust. That makes it a flexible tool for reducing taxes and managing the transfer of wealth.

The QTIP provides the same nontax benefits as the bypass trust.

A potential disadvantage of the QTIP is the surviving spouse receives only trust income. He or she can’t touch the principal, so other assets might be needed to maintain the standard of living.

The irrevocable life insurance trust (ILIT) is another classic.

An individual creates an irrevocable trust, usually naming the individual’s children and, perhaps, grandchildren as beneficiaries.

The trustee buys a permanent life insurance policy on the individual’s life. The individual transfers cash to the trust to pay the insurance premiums. The premiums might be due in a lump sum or annually, depending on the policy. In most cases, the transfers are free of estate and gift taxes.

When the individual dies, the insurance benefits are paid to the trust free of income, estate, and gift taxes.

Estate taxes are avoided because the policy was owned by the ILIT. If the individual exercised ownership rights over the policy, the benefits are included in his or her taxable estate.

The trustee invests and distributes the trust assets as directed in the trust agreement.

An ILIT can become a dynasty trust that provides wealth to several generations of a family. A dynasty trust can pass on more after-tax money and make it last longer through its spending and investment policies.

One feature that makes the ILIT and dynasty trust work is the Crummey clause, also known as a Crummey trust, which also can be used in other trusts. The name comes from a court case that established the rule.

A Crummey clause allows beneficiaries to withdraw any gift made to the trust, up to the annual gift tax exclusion amount ($18,000 in 2024). A time limit, such as 30 days, can be set. If the gift isn’t withdrawn by the deadline, the right to withdraw expires.

The clause qualifies gifts for the annual gift tax exclusion. Without a Crummey clause, gifts to the trust could be taxable or reduce the lifetime estate and gift tax exempt amount.

With the Crummey clause, you take the risk that a beneficiary might withdraw the gift. Most trust creators accept this risk and reduce it by letting it be known that if a gift is withdrawn, there won’t be future gifts.

The charitably inclined often consider two types of charitable trusts.

The charitable remainder trust (CRT) pays regular income to the trust creator, or other named beneficiaries, either for life or a period of years. After the income period, the property remaining in the trust goes to a charity or charities designated by the trust creator.

The CRT avoids taxes on appreciated property. When the property is transferred to the trust, the donor owes no capital gains or other taxes on the appreciation. Because the trust ultimately benefits charity, it is tax exempt. The trustee can sell the property tax free and reinvest the entire sale proceeds.

Another bonus is the trust creator receives a current income tax deduction of the estimated present value of the amount the charity eventually will receive.

The annual income to the beneficiary can be a percentage of the value of the trust assets each year, known as a charitable remainder unitrust (CRUT). Or the trust can pay a fixed annual amount, known as a charitable remainder annuity trust (CRAT).

CRTs are very flexible and can be used in many ways. See the July 2020 episode of my Spotlight Series of online seminars for more details.

A charitable lead trust (CLT) is sort of the opposite of a CRT.

The CLT pays income to the charity for a period of years. After that, the non-charitable beneficiaries (usually the trust creator or the creator’s children) receive a series of payments or receive the trust balance.

The trust creator qualifies for a charitable contribution deduction when the trust is created.

But a CLT is not exempt from income taxes. Either the trust or its creator will be taxed on the annual income, depending on the terms of the trust.

Either type of charitable trust can be created during the creator’s lifetime or in the will.

Review the different types of trusts discussed in this issue and the last one. You’ll be ready to have a fruitful discussion with your estate planner.