Not All Inheritance Trusts Are Created Equally
When it comes to inheritance, some clients are convinced that their parents have made proper arrangements on their behalf. Even when parents have used qualified lawyers and other advisors to do this, we always recommend “double checking” to make sure that any inheritance that might be received will be under an appropriately-drafted trust to protect the client and his or her descendants from creditors, federal estate tax, divorce, and undue influence in the event of incompetency. Although many clients respond by saying that this type of planning is already in place, we often find that one or more elements of proper inheritance trust planning is missing or deficient.
The list below provides the components that we would hope to see in a properly drafted “inheritance trust,” which would provide the client with many of the rights and powers that he or she would have if the inheritance was received outright, while affording protection offered by the inheritance being held under a trust structure:
1. The client (the person who is receiving the inheritance) is named as a trustee of the trust, and has the right to designate the successor trusteeship to apply in the event of his or her resignation, death or incapacity.
An inheritance trust will likely be a trust that can benefit a client for his or her lifetime, and can then be passed into separate trusts for his or her children after the client’s death. There might be a period of time during the client’s lifetime that he or she cannot serve as trustee, so the trust document will permit the client to name co-trustees or successor trustees. These trustees are subject to all limitations that are deemed appropriate, such as limiting the client’s prospective successor trustees to his or her spouse, children, or a trust company, to ensure that no one outside of the family would be able to overtake the trust.
2.Typically, the client will have the power to direct how the trust assets will pass upon his or her death.
An inheritance trust likely provides that, on the client’s death, the trust will divide into separate trusts for his or her children, or will go outright to his or her children. Typically, the client will be given a “testamentary power of appointment,” which gives the client the ability to direct how the trust assets will pass upon his or her death. Most often, this will be exercisable solely in favor of descendants or his or her parents, but, to some extent, there are instances where it may also be used in favor of charity, or in favor of any individual deemed appropriate by the client (other than the client, the client’s estate, the client’s creditors, or the creditors of the client’s estate). Nevertheless, a well-drafted inheritance trust might also provide for a committee of independent persons (i.e., non-beneficiaries) to have the ability to give the client the power to appoint assets to the creditors of his or her estate upon his or her death to allow for a step-up in income tax basis (i.e., the assets under the trust would receive income tax basis equal to their fair market value upon the client’s death) of the assets held under the trust, if the client does not have federal estate tax concerns.
3.The client is given a “lifetime power of appointment.”
In addition to a “testamentary power of appointment,” which would be exercisable only at the time of the client’s death, an inheritance trust can give the client a “lifetime power of appointment.” This allows you to transfer assets to trusts for the client’s children and other descendants while you are living.
4.Provide for Trust Protectors when drafting inheritance trusts.
The inheritance trust should provide for Trust Protectors to be appointed, who are individuals that are not beneficiaries of the trust, that may alter the trust if there are significant changes with respect to family circumstances, the tax law, or applicable state law. Trust Protectors are typically given the authority to make changes to the trust document for the benefit of the beneficiaries, which might include the ability to modify the trusteeship, the ability to modify the dispositive terms of the trust, and the ability to change the situs of the trust.
5.Request that the exact language used for the client’s children’s trusts be provided for under the inheritance trust in case the client does not survive his or her parents.
The parents of many clients find the process of drafting the inheritance trust to be too burdensome or complicated, and sometimes the lawyers for the parents are not fluent in all aspects associated therewith. For those clients, we commonly draft a separate irrevocable trust that our client signs, and then the parents make that separate irrevocable trust the beneficiary of their plan instead of the child. A separate irrevocable trust will contain provisions which benefit the client’s children, which will apply on the client’s death if he or she did not exercise his or her power of appointment, or the client does not survive his or her parents.
Once a client signs an inheritance trust, which covers everything he wanted, his parents now only have to change their will or living trust to provide that the client’s inheritance will pass to the irrevocable inheritance trust, rather than to the client directly or otherwise under the parents’ last will and testament or living trusts.
These tips are useful for anyone to consider, and can help assure that whatever inheritance the client might receive will not be subject to federal estate tax at his or her level. While many trusts achieve this objective, some have more desirable features than others. There certainly is a great amount of detail to review here, but it is worthwhile to do everything reasonably possible to assure that all bases are covered where assets values are appreciable, and in light of potential creditor claims and detrimental tax consequences that might result from neglecting proper planning.
While the above items and methodology may seem inconvenient and expensive to implement, lawyers who specialize in this type of work will have forms and knowledge that can make this process easy and protective. Shortcuts can result in lost assets, adverse tax consequences, and significant inconvenience.