WILLS V. REVOCABLE TRUSTS

The Advantages and Disadvantages of Using a Funded Revocable Living Trust for Basic Estate Planning

Introduction

The goal of basic estate planning is to insure the orderly management and disposition of assets upon an individual’s death. For estates in excess of the applicable exclusion amount (which is presently $2,000,000, including such assets as life insurance, joint tenancy property and retirement accounts, but will increase to $3,500,000 on January 1, 2009), another important objective may be estate tax planning.

The appropriate means for accomplishing these basic estate planning objectives will vary somewhat depending upon the size of an individual’s estate, the composition of his or her assets, the nature of his or her ultimate beneficiaries, and other factors. However, in California, the “flagship” for most basic estate plans is a funded revocable living trust. The funded revocable living trust permits the management and disposition of trust assets during an individual’s lifetime if he or she should become incompetent, and after the individual’s death, at which point the revocable trust will establish the terms for the distribution of the trust assets to family members or other beneficiaries, to continuing trusts, or to charity.

The purpose of this brief discussion is to highlight some of the advantages and disadvantages of a funded revocable living trust for basic estate planning, as compared to a Will or an unfunded revocable living trust.

This discussion describes a revocable living trust created by a single individual. Married couples in California frequently create joint revocable trusts. A joint revocable trust operates in a similar manner to a single settlor trust, except that both spouses serve as Co-Trustees and the trust becomes irrevocable at the first death only as to the deceased spouse’s share of the trust estate. The survivor’s share of the trust (including any assets passing outright to the survivor under the deceased spouse’s estate plan) continues in revocable form until his or her subsequent death.

 
How a Will Works

When an individual dies, property held in the deceased person’s name (other than property passing by right of survivorship, such as joint tenancy property, or by beneficiary designation, such as life insurance or retirement accounts) passes under the deceased person’s Will.

To carry out the terms of a Will for all but the most modest estates (under $100,000 of gross value and no significant real property interests), an Executor must be appointed by the Probate Court and the Will must be offered for Probate. The Executor then takes possession of the deceased person’s property, holds that property during the administration of the estate, and pays debts, taxes and administration expenses. The Executor must file an inventory with the Court of all of the deceased person’s assets and liabilities, and must publish in a newspaper of general circulation a notice to creditors so that they may file claims against the estate.

The Probate of an estate generally takes at least a full year to complete, but for large estates or estates with substantial creditors’ claims, disputes among the beneficiaries or other complications, Probate can take up to two years or even much longer. At one time, almost all of the Executor’s actions affecting the assets of the estate during this period required a petition to the Probate Court and formal Court approval. Fortunately, California law now includes an Independent Administration of Estates Act. As a result, many actions of the Executor only require written notice to the affected persons. If proper notice is provided and no objections are received within a statutory time frame (typically 15 days), the action may then be taken. Certain actions, however, such as distributions to beneficiaries, still require advance Court approval.

Generally, distributions from a Probate estate are not made until the conclusion of Probate administration. To insure that the deceased person’s family is taken care of during Probate, however, a “family allowance” may be paid from the estate to the surviving spouse and/or children. In addition, it may be possible to make preliminary distributions from the Probate estate if the Executor and the Court believe the remaining assets would be sufficient after the distribution to cover any possible taxes, expenses or other claims against the estate.

 
Wills that Create Testamentary Trusts

In many cases, upon the conclusion of a Probate proceeding, the estate is not distributed outright to the beneficiaries named in the Will. Rather, the estate may be distributed to trusts that will continue to hold property from the Probate estate for the benefit of the beneficiaries. The terms of these trusts are set forth in the Will itself. This type of trust is referred to as a “testamentary trust.”

 
How an Unfunded Revocable Living Trust Works

A revocable living trust is a trust that is fully revocable and amendable by the person or persons who create it. (The person who creates the trust is called the “Settlor.”) The trust generally becomes irrevocable, however, at the Settlor’s death, at which time the assets held in the trust are either distributed outright to the beneficiaries or they are retained in trust to be managed and administered by a successor Trustee for the beneficiaries’ benefit.

An unfunded revocable living trust is a revocable living trust that holds only enough assets to make the trust a valid trust under California law. (This amount can be very small, such as $100.) However, in creating such a trust, it is usually anticipated that the trust will receive substantial assets following the Settlor’s death, either from the Settlor’s estate or from insurance proceeds. Thus, other than amounts passing to the trust by beneficiary designation (such as life insurance), assets must pass through Probate administration before they can be distributed to the trust. In fact, the only advantage of an unfunded revocable trust over a Will which creates a testamentary trust is a very limited amount of additional privacy: the public record in the estate proceedings will still show the nature of the assets of the Probate estate and will indicate that the estate was distributed to the Trustee of the revocable trust, but, in most cases, it would not reveal the actual terms of the trust agreement.

 
How a Funded Revocable Living Trust Works

A funded revocable living trust is a revocable trust to which substantial assets -- often the bulk of the Settlor's wealth -- have been transferred during the Settlor's lifetime. During the Settlor’s lifetime, the Settlor is usually the sole Trustee of the trust with complete control over the management and use of the trust assets. So long as the Settlor is serving as Trustee, the trust has no separate tax identity and all income, gain, loss and deductions associated with the trust assets are included on the Settlor’s tax returns as though the trust did not even exist.

Upon the death of the Settlor of a funded revocable living trust, the assets of the trust do not pass under the Settlor’s Will. Rather, the trust assets are held, administered and distributed after the Settlor’s death by a successor Trustee under the terms of the Trust Agreement.

A funded revocable trust is never a complete substitute for a Will, since it is almost a certainty that a Settlor will own some property in his or her own name at death. Therefore, a “pour-over” Will is used with a funded revocable trust to insure that assets not held in the trust during the Settlor’s lifetime are distributed to the Trustee of the trust at the Settlor’s death. (In California, so long as these assets have a collective gross value of $100,000 or less, and do not include any significant real property interests, the “pour-over” to the revocable trust can be accomplished without a Probate proceeding.) The Will also directs the Executor to make certain tax elections and, where there are minor children, nominates a guardian or guardians for those children.

 
Advantages of a Funded Revocable Living Trust Over a Will

Asset Management in the Event of Incapacity. The successor Trustee of a funded revocable trust can continue to manage trust assets and apply the income and principal of the trust for the benefit of the Settlor in the event of incapacity without the need for a Court-appointed guardian or conservator. This can avoid expense, restrictions, delay, and invasion of privacy.

For persons doing estate planning with a Will, similar benefits can be secured by executing a Durable General Power of Attorney that appoints an agent with respect to an incompetent person’s assets until he or she regains capacity. It is often more difficult to get third parties to accept the validity of a Durable Power of Attorney than a trust agreement, however.

Note that even an individual with a funded revocable trust is well advised to execute a Durable General Power of Attorney which appoints an agent to act with respect to non-trust matters. For example, the agent, rather than the successor Trustee, would have the authority to deal with such non-trust assets as retirement accounts, could take such actions as filing tax returns for the incompetent individual or acting with respect to the estates or trusts of other persons in which the incompetent individual has a beneficial interest, and could even transfer assets to the revocable trust in order to avoid a probate of those assets upon the incompetent person’s death. The agent under the Durable General Power of Attorney may be the same person appointed successor Trustee of the revocable trust, or may be a different person.

After the Settlor's death, the funded revocable trust has the following advantages:

Privacy. Unless there is litigation concerning the trust or the Trustee wishes Court instructions concerning the administration of the trust, neither the trust agreement nor the assets of the trust must become a matter of public record. Current law, however, requires that certain beneficiaries and heirs be notified of the death of a Settlor, a change in Trustees, and certain other events, and offered an opportunity to receive a copy of the terms of the trust.

Prompt Transfer of Income. Until the Executor of a Will has been appointed and has had time to assemble the estate assets under his or her control, neither income nor principal is customarily available to the beneficiaries of a Will. The funded revocable trust, however, exists immediately at the death of the Settlor. It is therefore possible for the Trustee to make income payments to the beneficiaries when that income is received by the trust. As a general rule, there is also substantially less delay in making principal distributions to the beneficiaries from a revocable trust after the Settlor’s death.

Streamlined Sale of Real Property. The Trustee of a revocable trust usually may sell real property without obtaining an appraisal, publishing notice, or seeking Court confirmation. Even in Probate estates that qualify to be administered under the Independent Administration of Estates Act, the Executor must give notice of the proposed sale to the affected beneficiaries; if they do not object within a specified time frame, the sale may go through. If any beneficiary objects, however, Court confirmation must be sought. The uncertainty created by this procedure can have a chilling effect upon prospective purchasers of real property held by the Executor of an estate in Probate.

Investment Protection. After the death of the Settlor of a funded revocable trust, there need be no interruption in investment supervision and no delay in taking whatever action the successor Trustee may consider appropriate to preserve the assets of the trust. For estates disposed of under a Will, however, an Executor must be appointed by the Probate Court and the assets of the estate must be inventoried before even routine investment actions can be taken. Even after the Executor has been appointed, certain kinds of investment decisions require Court approval, whereas others (such as the sale of listed securities) normally require 15 days advance notice to beneficiaries. Some types of investment actions may not even be permissible to Executors, such as continuing to run certain types of businesses that are part of the deceased person’s estate.

 
Disadvantages of a Fully Funded Revocable Trust

Changing Legal Title to Your Assets. The Settlor of a funded revocable living trust must actually transfer legal title to each asset to himself or herself as Trustee of the trust. This requires the preparation and execution of deeds, stock certificate transfers, beneficiary designations, assignments and other legal documentation. When trust assets are sold and new assets acquired, care must be used to take title in the name of the Trustee and to take actions incidental to property ownership, such as making the Trustee an additional insured under a homeowners policy when a home is added to the trust. Stock transfer agents may demand to see (but not to retain) a certified copy of the Trust Agreement. (California legislation requires third parties to honor an affidavit of the Trustee concerning his or her powers to act for the trust, thus simplifying this aspect of the transfer procedure.)

An attorney can assist the Settlor in transferring assets to the revocable trust. In addition, there are administrative services who will assist in the transfer of assets to a revocable trust for a relatively modest fee.

Additional Record Keeping. Separate books of account should be kept to verify the existence of the trust and the identity of its assets. Income must be received by the Trustee and deposited into the trust's account. The Trustee, in turn, will distribute to the Settlor so much of the trust's income (and principal) as the Settlor requests.

Possible Extra Tax Returns. So long as the Settlor serves as Trustee, a separate tax return is not required for the trust. If the Settlor does not serve as Trustee, however, the Trustee must file a income tax return for the trust (a “fiduciary” return). Since the funded revocable trust is, in effect, ignored for income tax purposes during the Settlor's lifetime and all of its income is taxable to the Settlor, the fiduciary income tax return will be blank except to state that all income is reported on the Settlor's personal return.

Lack of Court Supervision and Potential for Mismanagement. Perhaps the most important potential disadvantage of a funded revocable trust is the possibility for mismanagement by a Trustee because of the lack of Court supervision that would otherwise apply to the Probate of a Will. Careful selection of successor Trustees and requiring regular and detailed accountings to the beneficiaries under the terms of the trust agreement can minimize the risk of fiduciary mismanagement or malfeasance. It is also advisable to design the trust to allow beneficiaries at least a limited power to remove and replace successor Trustees after the Settlor’s death in order to avoid the need for court intervention in the event of concerns over mismanagement or other disputes.

Greater Up Front Costs. Legal fees for drafting the trust instrument and assisting in funding the trust are likely to exceed those for drawing a Will. However, the modest additional cost of creating and funding a revocable living trust are often recovered several times over in a more simplified and streamlined administration of the Settlor’s affairs in the event of incapacity or death. Further, most of the fees for creating and funding a revocable living trust, unlike those for drawing Wills, would appear to be deductible for income tax purposes to the extent that these fees, combined with the taxpayer's other miscellaneous deductions, exceed 2% of the taxpayer's adjusted gross income.

Circular 230 Notice: In accordance with IRS Treasury Regulations, we are required to notify you that any tax advice given herein (including attachments) is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding any penalties that may be imposed by any governmental taxing authority or agency or (2) promoting, marketing or recommending to another person any tax related matter.