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TRUSTS: WHAT ARE THEY,
AND WHEN DO THEY MAKE SENSE?

PART TWO

by Christopher G. Stoneman

In this age of acronyms perhaps the use of yet another such device may be justified as a hook on which to hang the following discussion of some of the principal, but by no means the only, uses of trusts - P.A.C.T. : protection; avoidance; control; taxation.

Protection: Three examples come immediately to mind: extreme (or even moderate) youth; physical, or, more likely, mental, handicap; the so-called "twilight" years.

Grandfather Jones has just been blessed with his first grandson and is delighted that the child will bear his grandfather's name, Ebenezer. Grandfather Jones has done well for himself, and so great is his joy that he decides that he will begin right away by giving Ebenezer $10,000, which he has every intention of continuing to do annually into the indefinite future. He is quite properly advised to set up a trust for the new arrival's benefit and to do so in a way that will ensure that no part of his, Grandfather Jones's, $625,000 gift and estate-tax exemption will be used up as a result of his generosity (much more on this in later articles). In estate-planning shorthand he establishes a Section 2503 (c) trust which will run until young Ebenezer's 21st birthday (at which time, unless he extends it, it will become his to dissipate or put to wiser use).

Tragically and unaccountably, Polly and Henry's second daughter, Melissa, succumbs to a crippling disease in her early teens, which renders her quite incapable of supporting herself. The condition is currently incurable: Polly's family is comfortably off and decide that they want to make provision for Melissa - something which her parents, with four other children to raise and educate, are quite unable to do. A trust for Melissa is probably the optimal solution.

Henry has worked all his life and has invested his savings wisely and watchfully. At 75 he decides to retire in order to "smell the roses" before his olfactory nerves capitulate and he has to settle for daisies. He also plans to travel and feels that this will make it next to impossible to continue to give his investments the care and attention which up till now he has unstintingly lavished on them. He approaches his bank and engages its trust department to "look after things" for him, also giving it detailed instructions as to what is to be done with the assets after his death. For this purpose he uses a revocable living trust.

Avoidance: Under this rubric come such purposes as probate avoidance (discussed earlier); avoidance (read, "disinheriting") of certain relatives and step-relatives, avoidance of Medicaid disqualification, (a highly technical matter beyond the scope of this Article).

As noted, the avoidance of probate through the use of a funded trust was one of the topics dealt with in Article II. By transferring one's assets to a living trust, one may in effect curtail the jurisdiction of the probate court. Such a trust will also contain directions as to how the property is to be dealt with and disposed of after the settlor's death; in other words, the trust will serve as a partial or complete substitute for the will.

From the avoidance of probate there may flow another consequence - the defeat of the surviving spouse's right to "elect against" the will. Vermont, like many other states, provides that a surviving spouse is entitled to a statutory share of the deceased spouse's probate estate. A spouse who receives less than his or her share may file an election in the probate court to have the will set aside to the extent necessary to obtain that share. Suppose that a decedent spouse leaves a will in which he bequeaths all of his probate estate to his children and omits any provision whatsoever for their mother. Provided that she acts promptly, she may obtain her statutory share of her husband's estate and the children's interest will "abate" or be correspondingly reduced. But as the law now stands in Vermont, a spouse's transfer of his or her probate property, thereby emptying out the probate estate (against which the election must be levied) will more likely than not defeat the right of election. How much longer this will continue to be the case remains, of course, to be seen. By statute or by court decisions, a number of states now thwart this approach and in effect permit a surviving spouse to "pierce the veil", so to speak, and reach the non-probate assets in order to obtain the spousal share.

Another avoidance use of the trust may be made in the case of a second marriage. Betty and Isaac were happily married for years and raised a family of three. Betty died and Isaac decides to remarry. His second wife, Martha, is herself a widow and has two adult children. Although Isaac and Martha sign a pre-nuptial agreement in which they waive all rights in each other's estates, Isaac is very keen to "take care of" Martha should he die before her. However, for all his generosity, he is pardonably reluctant to have any significant part of his estate go to Martha's children, pleasant though they are. He sets up a trust for Martha for her life which gives her a steady income and also bestows access to principal in an emergency; but at her death Martha is to have no say in what happens to the trust assets, which then go on to Isaac's and not Martha's children. As we shall see later, the tax law was changed some years ago in order to facilitate such an arrangement - by means of yet another acronym, the "QTIP" or "qualified terminable interest property" trust.

Control: Summer homes and voting trusts!

The Harbottles have a summer home on a New England lake. It came into the family when Helen Harbottle married Hector in the mid-30's and they bought the place, as Helen puts it, "for a song". Since then they have added to it several times, and winterized it, and it has become a favorite year-round gathering place for their children and grandchildren. Everyone says vociferously that it would be a tragedy to let the property pass out of the family. Helen and Hector agree but are unwilling to leave it to any particular child because of the internecine strife such a move would almost certainly engender. They place the house in a trust, together with enough cash to provide for its upkeep for the first few years, and appoint their three children as trustees with appropriate language to facilitate administration (including such essential topics as deciding how occupancy is to be determined and fiscal provisions made for continuing maintenance, etc.) Control has been centralized in a reasonably practical and democratic fashion.

The voting trust is an arrangement by which, typically, control and unified management may be indirectly maintained over a block of voting common stock.

Taxation. There are many situations in which the use of a trust is called for for taxation purposes: income tax, estate tax, gift tax and so on. In the course of these articles we will touch more deeply on some of the commoner tax-related use of trusts. For now it must suffice to give some bare-bones examples.

As we saw, Ebenezer's gift to this grandson made use of a trust which not only preserved the subject matter of the gift pending Ebenezer's adulthood but also gave his grandfather favorable gift-tax treatment.

A gift to one's spouse may of course be made without resort to the use of a trust. "I give the residue of my estate to my husband, John" would be a simple illustration. John would receive the gift regardless of his health, for example, and it would indeed qualify for the so-called "marital deduction" whereby most (but not all) gifts from one spouse to the other escape gift and estate tax in the donor's hands. But has with Isaac and Martha, the most generous intent sometimes needs to be tempered with a measure of prudence. Suppose that John is ill, or a spendthrift, or just a rather undependable person (whatever that may mean). His wife may still wish to leave him the benefit of a part (or, for that matter, of all) of her estate provided she can do so without having a tax be unnecessarily imposed at her death. May a trust be utilized without loss of the marital deduction? The answer is yes, provided that it is written in compliance with the tax law restrictions on such trusts.

In the income-tax arena there are cases where the use of a trust can prove beneficial, although this is less so now that the income tax rates applicable to trusts have been telescoped and accordingly reach the top bracket much more rapidly.

Suppose that Mark, a wealthy man and a perennial bachelor, decides that his embarrassingly improvident 23-year old brother needs an income of $800 a month in order to meet his most basic living needs. Mark, who is in the 39.6% federal income tax bracket, could send his brother a check each month out of his, Mark's, after-tax income, which would cost him $24,250 of pretax income a year and would have no annual gift-tax ramifications (12 x $800=$9600, $400 less than Mark's annual per-donee gift-tax exclusion) or Mark could take $200,000 and place it in an irrevocable trust for his brother's benefit for life, with all of the income being paid to him at monthly intervals. There would be gift-tax consequences on the transfer into the trust (depending on Mark's brother's age) but Mark would not be taxable on the income, all of which would be taxable (and, given Mark's brother's penury, in effect non-taxable). Mark could if he wished provide that if his brother died first, the trust property would come back to him, Mark, or he could designate some other person as its recipient at that time.

Christopher Stoneman

The complete list of Christopher Stoneman articles is: