Matter of Tax

September 9th, 2021 by Legacy Wealth Planning

Thoughts on establishing a trust and tips for avoiding inheritance squabbles.

Reasons to Consider a Trust

Should you set up a trust? Maybe you’ve been to a seminar where they scare the life out of you, convincing you to start one. Let’s demystify this murky but very important area.

Trusts are legal arrangements that give control of assets to a person or an institution (the trustee) for the benefit of others, such as children. Trusts can save on taxes, ease inheritance squabbles and ensure that beneficiaries are treated fairly and according to your wishes. Let’s examine some uses of trusts:

To Minimize Inheritance Taxes. Some call them “death taxes,” but that term has acquired a political tinge, so we’ll try to avoid upsetting partisan sensibilities. This year, you have to own at least $11.7 million in total assets — including your house, your cars, brokerage accounts, individual retirement accounts, 401(k)s and life insurance — before the tax kicks in. Taxes are typically due upon the second spouse’s passing, not the first to die. You should also be aware that a number of states impose their own estate taxes – and several have inheritance taxes – which kick in at lower threshold amounts than the federal estate tax.

Above $11.7 million, without proper estate planning and a trust, you might pay 40% to the feds. Most people don’t have $11.7 million in assets, so they don’t have to worry about this tax, right? Maybe and maybe not.

Tax legislation seems to change every year and many state governments are looking to close their deficits. So don’t assume that because you have less than $11.7 million that you’re in the clear. Congress has always had trouble dealing with this issue. Remember when the federal estate tax expired in 2010?

To Avoid Probate. That’s a court that rules on inheritance questions if your wishes are not clear. If you don’t have a trust or a valid will, anything you own that doesn’t have a specific beneficiary designation goes through probate. Probate can be very time-consuming and emotionally draining. If your estate includes property held outside the state of residence, it may have to go through probate there as well.

If the property is outside the U.S., the situation is even more complicated. Probate can be pretty expensive. Attorneys have the right to charge either a flat percentage rate, based on the value of your total estate, or they can charge “reasonable compensation,” which is debatable, but typically not negotiable.

To Keep Your Family Finances Private. If you don’t have an estate plan properly executed by your death, your whole financial life can be public record, available to the masses. Yeah, you don’t even have to drive to the courthouse to snoop through someone’s estate. In many places, it’s available online these days.

To Look After Disabled, Young or Irresponsible Children. Having a trust makes a ton of sense if you have a child with disabilities who can’t take care of himself. Or maybe we don’t want him showing assets on paper. Also, if your estate passes to a minor, when the kids turns 18, she gets a big, whopping check for the whole thing at once. If you were no longer here, would you want your child getting your entire estate at 18? You can set up anything from basic to very creative trusts in order to protect children from themselves.

For instance, you could establish a trust in which your child would get a third of your estate at 28, a third at 34 and the last third at 38. This way, the trust can give financial support for what is absolutely needed. But your child still needs to go out, get an education, start a career and learn the value of a dollar.

There are other, more complicated trusts you can put together too, including “incentive-based trusts.” These can be established so that the child must prove (via W-2s) that she earned say $10,000 to take 1% out of the trust, $20,000 to take 2% out, $30,000 to take 3%, and so on.

To Avoid Problems Surrounding Divorced and Remarriage. Trusts are especially helpful if you and your second spouse both have kids. Trusts ensure that your estate is handled by the person you want, and that the money is given to whom you want, when you want.

To Give to Charity and Help Your Family. Through proper, creative planning, you can set up a charitable trust that will: Give money to your kids, increase tax deductions, reduce taxable income while you’re living, eliminate capital gains and dividends taxation, and then give a bunch of coin to charity at your demise – all at once.

A charitable trust pays no tax, so if you have any assets that have appreciated in value, and you put them into this trust, you get a tax deduction right off the top. Then, when you sell the asset inside the trust, you pay no capital gains tax. You retain control here, and you still benefit from the income in the trust.

A logical next step might be to use a portion of the income from the trust to buy a second-to-die life insurance policy on you and your spouse’s life. You put that policy into a different kind of trust, called an irrevocable life insurance trust (or ILIT). When you die, the government can’t put its sticky hands on the policy. Once the policy is paid up, you can increase your income again if you want, since you won’t have to pay insurance premiums any longer. Then, when you and your spouse are gone, the money in the charitable trust goes to the charities you chose, your kids collect a tax-free death benefit from the policy in the life insurance trust, and you collected a bunch of tax-free income along the way.

All of these ideas are hypothetical of course and really depend on your personal financial situation. You should talk to a financial professional to better understand if trusts are right for you and your family. Because trusts can also help you avoid one more headache: the squabbling that takes place when kids split an inheritance.

Splitting an Inheritance

Nothing ignites family arguments like inheritance. If you plan to leave money to more than a few beneficiaries, for the sake of peace and your own emotional legacy, think about how to divide the proceeds fairly.

First, you can divide your estate among however many heirs you want: three, seven, 11 or 13 and so on. Here are a few best practices for how to divide your wealth.

Dividing an estate doesn’t need to trigger taxes. Don’t try to be the financial professional of each beneficiary when you divvy the estate. Afterward, each beneficiary can decide financial and tax moves based on individual circumstances.

For example, let’s say Athos, Porthos and Aramis become heirs of a taxable account of stocks, bonds and mutual funds. The account includes:

  • 351.362 shares of XYZ mutual fund at $36.34 per share, worth about $12,768.49
  • 2,000 shares of ABC stock at $100 a share, worth about
  • $200,000 (this holding comprises two trade lots of 1,000 shares each and each trade lot has a different cost basis, or original price)
  • $85,000 face value of CorpCorp bond at $97 par value, about $82,450 (traded in $5,000 face value units)
  • $100,000 face value of MuniMuni bond at $102 par value, about $102,000 (also traded in $5,000 face value units)
  • $5,236.45 in cash.

The total account value is $402,454.94, making each heir’s share $134,151.64 with two pennies left over. To divide the account evenly:

  • The 351.362 shares of XYZ can be divided into three equal portions of 117.12 shares, leaving 0.002 shares left over. Athos and Porhos receive 117.121 shares and Aramis 117.12 shares, plus 0.001 times the closing valuation of XYZ on the day of transfer. This probably results in Aramis receiving about four cents in lieu of missing out on 0.001 of a share.
  • The ABC stock comprises two trade lots: 1,000 shares purchased one year ago at $80 a share, and 1,000 shares purchased six months ago at $105 per share. Both positions divide equally into three 333-share portions, leaving just two shares to be divided, each with a face value of $100.
  • If all three heirs are in the 15% capital gains tax bracket, the value of each share is the closing valuation on the day of transfer adjusted for 15% capital gains taxes. In large estates with many assets to distribute, divide leftover shares as evenly as possible to minimize the difference between capital gains that heirs incur.

Note that taxable assets usually receive a stepped-up basis, meaning that the asset resets to its fair market value at the date of the holder’s death. Often, however, half an estate’s assets will go into a marital trust when the first spouse in an estate-holding couple dies.

When the second spouse dies, the entire estate is settled. But assets in the marital trust might have received a step-up in basis years earlier.

In that case, potential differences in capital gains do apply when planning.

  • You can divide the $85,000 face value of CorpCorp equally only into 17 units each worth $5,000 in face value. In our example, each heir receives five $5,000 units, with two $5,000 units left over. Whoever doesn’t receive a unit receives the equivalent in cash instead.
  • The $100,000 face value of MuniMuni divides equally only into 20 units each worth $5,000 in face value. Each heir therefore gets six $5,000 units with, again, two left over. Also again, whoever doesn’t receive a unit receives the equivalent in cash instead.

(These examples assume no significant tax considerations on either bond and it might be wise to vary who receives the cash.)

Common Questions:

Why not just sell everything and split the money? Tax consequences to one or more heirs, illiquidity in one or more assets and the custodian fees to sell are all considerations to immediately selling and splitting.

What if two heirs want to sell an asset before dividing the money equally? Athos and Porthos both wanting to sell the CorpCorp bonds doesn’t need to affect Aramis. Of the 17 units of CorpCorp, you can sell 12 units and agree to split the proceeds. Athos and Porthos each receive 47.22% of the proceeds and Aramis 5.56%, plus the five unsold units.

Dividing your estate this way mitigates your need to decide on behalf of all beneficiaries what to sell and how and what transaction costs and taxes to incur.

Your Financial Professional

For most people, tax strategies can be overwhelming, especially given that the federal tax code is thousands upon thousands of pages long. Throw in the emotional toll of figuring out how to care for your kids – and when to care for them – can be paralyzing, pushing you to do nothing.

So, before you go down a path that might not be in your best interest long–term, make sure you consult with your financial professional  to help you determine how your tax decisions and changes to tax law might impact you and your family.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.

This article was prepared by Financial Media Exchange, LLC.

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