Death and Taxes Blog

Trust terminology can be confusing, can't it? Let me take a moment to review some terms:

revocable trust: a trust that can be amended or revoked after its creation (usually by the person who creates it)

grantor: a person who creates or sets up a trust; also sometimes known as the "trustor"

declaration of trust: what a trust document (or instrument, if you prefer) is called if the grantor is also the trustee; if the grantor isn't also the trustee, the document is known as a...

trust agreement: this makes sense, doesn't it? The grantor and the trustee have an agreement about how the trust property is to be held, but if you are both the grantor and the trustee, it would be weird to agree with yourself, wouldn't it?

living trust: basically, the name given to any revocable trust of which the grantor is also (during his or her lifetime) the beneficiary; I think that, if a husband and wife each has a living trust, the trusts are also sometimes referred to as "loving trusts," but that term sort of makes me want to throw up

irrevocable trust: a trust that cannot be amended or revoked once it's executed; usually, for tax reasons, the grantor of such a trust is NOT the trustee

I didn't start my legal career doing much estate planning; for the most part, I was a probate attorney, handling Wills that had "matured" into deceased estates. I think that's a helpful experience, as you quickly figure out from a practical perspective the difference between good provisions and provisions that fail.

Let me give an example from a Will (not drafted by me, luckily) that recently came across my desk. The Will gives most property in equal shares to the decedent's three living children, which is fine. But it also makes a gift of certain jewelry to "the first of my granddaughters to marry." Setting aside the potential inequality here -- why favor the first granddaughter only? why favor only granddaughters? -- there's a problem: none of the decedent's granddaughters have married. So what now? At the time the Will was drafted, this provision failed (it didn't work), and it still fails today.

As a probate attorney, the problem is clear. I have to file with the probate court a document listing the decedent beneficiaries (legatees). Who in the world do I list from the above provision -- all of the granddaughters? someone who can hold the jewelry in trust until a granddaughter marries? somebody else?

If the draftsperson had spent five minutes thinking about the practical ramifications of this language, he or she could have easily fixed it.

I usually talk about estate planning in terms of two different approaches:

Simple: having a simple Will, where you give away all of your property outright

vs.

More involved: having what's known as a pourover Will and a separate living trust. You give your property away in your living trust -- you leave it to a trustee, who holds it for one or more beneficiaries

But there's also a middle way, which involves having only a Will, but incorporating trusts into that Will. This is known as having a Will with a testamentary trust. What's the drawback to this approach, and why isn't it more popular?

Well, when I talk about the advantages of a living trust, I address 5 of them in particular:

1. Probate avoidance
2. Control
3. Creditor protection for beneficiaries
4. Privacy
5. Estate tax minimization

If you create trusts under your Will rather in a separate document, those trusts can't be funded during your life (since your Will has no effect until death). As a result, you will need a probate. Your beneficiaries also don't get privacy, since the trust information is all located in your Will, which is a public document. But the other three advantages still exist.

This article is an interesting one on the use of strange documentary evidence in court. The last item mentioned is the relevant one for my purposes:

MISS LILLIAN PELKEY’S PETTICOAT In Los Angeles, before the Second World War, George W. Hazeltine, 86, lay ill in hospital. He wanted to make a new will and leave $10,000 to his nurses, Lillian Pelkey and Madeline Higgins. There being no paper to hand, Miss Pelkey pulled up her dress, placed a board under her petticoat, and the will was pencilled on her undergarment. The petticoat was eventually admitted to probate but the nurses were prevented from benefiting from the will because they were attesting witnesses of it.

In Illinois the rule about beneficiaries as witnesses is as follows (this is from Section 4-6(a) of the Illinois Probate Act):

If any beneficial legacy or interest is given in a will to a person attesting its execution or to his spouse, the legacy or interest is void as to that beneficiary and all persons claiming under him, unless the will is otherwise duly attested by a sufficient number of witnesses as provided by this Article exclusive of that person and he may be compelled to testify as if the legacy or interest had not been given, but the beneficiary is entitled to receive so much of the legacy or interest given to him by the will as does not exceed the value of the share of the testator's estate to which he would be entitled were the will not established.

That's a sort of convoluted way of saying this:

1. If you are a beneficiary of a Will and a witness to the Will, you can't inherit your share. Neither can anyone "claiming under" you (like a child of yours if you predecease the testator).

2. Ditto for the case where you witness a Will and your spouse is named as a beneficiary -- your spouse can't inherit his or her share.

3. There's an exception to the two above rules if there are at least two other witnesses who are NOT named as beneficiaries in the Will, who can attest to its accuracy. But under this exception, you can't inherit more than you would if the testator died without a Will. An example:

Joe Smith is a widower with three children. He does a Will leaving 1/2 of his estate to his daughter Susan and 1/4 of his estate to each of his two sons. Susan witnesses the Will along with two officials from Mr. Smith's bank. Upon Mr. Smith's death, Susan can inherit only 1/3rd of her father's property (since that is what she would receive if he had died intestate).

As I said last time, most trust funding is fairly easy but tedious. One exception: trust funding with real estate, which is tedious but not so easy. Why is that?

What we're trying to do in funding a living trust with real estate is to transfer ownership of the real estate to the trustee (or trustees -- in the case of many married couples, who own real estate jointly or as tenants by the entirety, the goal is to put one-half of the real estate into each spouse's living trust). This gets complicated because lots of entities besides the owners have an interest in their real estate. Such as...

1. Lender(s). Every mortgage I've ever seen includes a provision saying that the entire loan amount comes due upon a "transfer" of the underlying real estate. That language is intended to prevent you from selling a house but not paying off the mortgage. Obviously, there's no real concern with transferring a house from yourself individually to yourself as trustee, but in order to avoid problems, it's necessary to get lender approval for the transfer. This is made more difficult by the fact that most people employed by lenders don't understand what a living trust is, or what you are trying to do by transferring real estate to it. So you or your attorney will have to do some explaining.

2. Insurance folks. The insurance companies that provide your homeowners insurance and title insurance should be alerted to the fact that ownership of the real estate has changed.

Typically, I contact the lender, find out what they need to give their approval, and then submit it. Once approval is obtained, then the appropriate deeds conveying the property into trust are recorded. Then the insurance companies should be contacted with the information about the transfer.

A couple of years ago (here) I wrote generally about trust funding. Now I'd like to share some of the basics of how the funding process actually works for a living trust.

You start by making a list of your assets -- house, retirement accounts, non-retirement accounts, insurance, etc. The idea is that all of these assets are owned by or will pass to your living trust at the time of your death (note: there are some cases where you may not want retirement accounts to pass to your living trust, but that's beyond the scope of this post).

You will notice that I said "owned by or will pass." Basically, we're doing two different things:

1. Changing ownership of certain assets, like real estate and non-retirement accounts (investment accounts and bank accounts). The trustee immediately becomes the owner of these assets (note that the trustee of a living trust is usually the person who created the trust).

2. Changing beneficiary designations of certain assets, like insurance and retirement accounts. When the person who established the trust dies, the assets flow into the trust.

Most trust funding is pretty easy to do, but rather tedious. For re-titling non-retirement accounts, you just tell the entity how the accounts should be re-titled (your attorney can tell you "the magic words"). Typically, it would be something like a switch from "Joel A. Schoenmeyer" as owner to "Joel A. Schoenmeyer, as Trustee of the Joel A. Schoenmeyer Trust dated January 18, 2003." Beneficiary designations are changed in a somewhat similar way, without reference to the current trustee (since he or she probably won't be around when the grantor dies).

The most difficult part of trust funding involves real estate, which I'll discuss next time.

Just a few quick follow-up notes on things I've already discussed in this series:

1. As I said in Part 1, the main reason people create ILITs is to pass more of their assets on to their beneficiaries free of estate tax. But that's not the only reason -- another reason is liquidity. Let's say that you die with a taxable estate and a family business that can't be liquidated easily to pay your estate tax bill. What to do? If you set up an ILIT correctly during your lifetime, the trustee of the ILIT can purchase assets from your estate or from the trustee of your living trust, and can pay cold, hard cash for these assets (which the ILIT trustee received when he or she collected the insurance proceeds on your life). Your executor or the trustee of your living trust can then use this cold, hard cash to pay your estate tax bill.

2. In Part 3, I talked about one of the "dangers" in transferring existing whole life policies to an ILIT. Another problem -- more of an inconvenience, really -- is that those policies have a value for gift tax purposes. You can find out this value by requesting a Form 712 from your insurance company. This value will need to be included on your gift tax return, and is equal to (wait for it) the policy's "interpolated terminal reserve value" plus any premiums you've paid for a time period after the date of the gift. Fun!

3. The biggest mistakes I see with ILITs are:

(a) the failure of the grantor to understand that he or she no longer owns or has any interest in the property;

(b) the failure of the grantor to understand that "irrevocable" means "can't amend or revoke"; and

(c) the failure of the trustee to continue to administer the trust correctly, by preparing income tax returns, by sending notice of each contribution to beneficiaries, and by keeping good, clear records of what has been done.

The typical ILIT would be set up as follows:

-Grantor signs ILIT document, with grantor's spouse as trustee, and spouse and children as beneficiaries

-Grantor makes annual contributions to the ILIT, and trustee gives notice of contribution to beneficiaries

-Trustee purchases whole life insurance policy on grantor's life, and uses annual contributions to pay premiums

-When grantor dies, death benefit is paid to trust

Does an ILIT always have to work this way? Not really. Four variations on a theme:

1. Instead of setting up an ILIT, grantor gives money directly to his children, who collectively purchase a life insurance policy on the grantor's life. When grantor dies, the children split the death benefit. This variation isn't used very often, mostly (in my opinion) because it seems a little uncomfortable for all parties involved. But the big advantage: no need to have an attorney involved.

2. The trustee purchases a term life insurance policy instead of a whole life policy. The premiums will be lower, but the "danger" (is that the right word?) is that grantor may not die during the term of the policy, thereby making the value of the ILIT disappear.

3. The grantor transfers a current policy (or policies) to the ILIT instead of having the trustee purchase a new policy. This may be necessary if the grantor is now uninsurable, but the downside is what's known as the "three-year rule": if you transfer a whole life insurance policy to an ILIT and die within three years of the transfer, the insurance proceeds are included in your estate for estate tax purposes (as a gift made "in contemplation of death").

4. How about a 1/2 ILIT, 1/2 gift trust hybrid? By this I mean that (to take one possibility) one-half of grantor's contribution is used to purchase life insurance on the grantor's life, and the rest is invested by the trustee. Now you have the protection of the insurance if grantor dies in the near future, and the protection of appreciating investments if grantor doesn't.

Over the next week or two, I'm going to be talking in some depth about irrevocable life insurance trusts (often referred to as ILITs by estate planners). Today I'd like to talk generally about these types of trusts.

There are many reasons to set up revocable trusts, such as living trusts: avoidance of probate, privacy, and controlling when your beneficiaries receive their inheritance are just three. By contrast, most people set up irrevocable trusts, such as ILITs, for only one reason: to pass property to beneficiaries at your death free of estate tax. This works because an irrevocable trust is, well, irrevocable. And that irrevocability goes not only to the trust document you sign, but to any property you contribute to the trust. You no longer own it, which means you can't get it back or control it in any way. This is why property held in a correctly-drafted irrevocable trust will not be subject to estate tax when you die -- because it's no longer your property.

How does a typical ILIT work? Here's an example:

1. Grantor (Mr. Grant), a 47-year-old, signs an ILIT with his sister (Ms. Trust) as trustee.

2. The trust provisions are for the benefit of Mr. Grant's three children, and are similar to the provisions in Mr. Grant's living trust.

3. Mr. Grant contributes $15,000 per year to the trust.

4. Ms. Trust uses the yearly contributions to buy a life insurance policy on Mr. Grant, with the trust as beneficiary. (I'll talk about types of life insurance at a later time, but let's assume $15,000 per year would be enough to pay the premiums on a $1 million whole life, or "permanent," policy.)

5. Mr. Grant dies, and the insurer pays $1 million to his beneficiary (the trust). Mr. Grant has passed $1 million to his three children free of estate tax and income tax.

There's obviously a leverage aspect at work here. If Mr. Grant dies in three years, he's paid $45,000 (in premiums) to "get" $1 million (to his kids as an inheritance). Of course, if Mr. Grant dies in 40 years, he's paid $600,000 to get $1 million -- not the best return.

Next time I'll talk about ILITs and gift tax.

When I draft a living trust for a client, I make it clear that the client still needs to have a Will. "But why?" clients will sometimes ask. "Isn't the living trust taking the place of the Will?"

My answer to that question is, yes, the goal of the living trust is to replace your Will as the primary vehicle by which you dispose of your property. But we don't live in a perfect world, and it may be that all of the client's property isn't retitled in the name of (or made payable to) the client's living trust before he or she dies. Sometimes this is because of an oversight on the part of the client. Sometimes it's because the client unexpectedly acquires property (like an inheritance) right before his or her death. Whatever the reason, the issue is property that for some reason doesn't pass under the living trust upon the client's death. If you don't have a Will, such property passes by intestacy, regardless of what your living trust says. That can be a really bad result, since your property will go to your heirs under Illinois law instead of to the beneficiaries you've chosen.

Enter the "pourover Will." This is a fairly short (maybe 4 or 5 page) document designed to clean up any of your estate's "loose ends." The main provision of a pourover Will would say something to the effect of this:

I give any property I own in my own name at my death to the trustee of the Joel A. Schoenmeyer Trust dated November 20, 1970....

Why "pourover"? The idea is that your living trust is like a big bowl, and funding your living trust is like filling up the bowl. A pourover Will completes this process at your death, by pouring over -- into your living trust -- any property that wasn't placed in your living trust during your lifetime.

Today I encountered a situation where a client executed a Will (maybe 10 years ago) and, instead of seeing an attorney when she need to make changes, had (5 years later) written changes on the Will in pen. This is a bad idea for a few reasons:

1. The changes to the Will were not signed by the testator in the presence of witnesses, so they aren't valid.

2. Even if the changes had been considered valid, because they were written in (and the testator had poor handwriting), they were hard to read (thereby making it hard to understand what the testator was trying to do).

3. The changes could potentially be viewed as a revocation of the original Will. Under the Illinois Probate Act (here), a Will "may be revoked... by [the testator] burning, cancelling, tearing or obliterating it."

The best way to amend your Will is to have a new Will or a codicil prepared.

The probate of a Will is supposed to begin with the filing of the original Will with the county clerk's office.  But what if you can't find the original Will?  Then you've got problems.  But luckily, you also have a couple of good Illinois resources for dealing with this situation (although registration is required for both):

Janet's L. Grove's article in the October 2005 issue of the ISBA Trusts and Estate Section newsletter

Helen Gunnarsson's article in the October 2006 Illinois Bar Journal

If you are seeking to probate a lost Will in Illinois, you need to overcome the presumption that the lost Will was revoked by the person who created it (the "testator").  But how do you prove a negative (that the testator DIDN'T revoke the Will)?  Ms. Grove indicates that good evidence would include the following:

(1) continued strong relations between the testator and the beneficiaries,

(2) declarations by the testator of an unchanged attitude concerning the dispositions in the will, and

(3) possession of or access to the will by an adverse party.

If you are able to overcome the presumption of revocation, you aren't done -- now you have to prove that (a) the lost Will was a valid Will (i.e. properly executed) and (b) the contents of the lost Will (what did it say?).

For a Florida take on this issue, check out Juan Antunez's post here.  Professor Beyer discusses Texas law and lost Wills here.

Helen W. Gunnarsson has the cover article in this month's Illinois Bar Journal, and the title is "Should You Store Your Client's Will?"  (registration may be required for non-members)

The article gives a nice overview of the issues involved with handling old Wills.  The problem is that some attorneys -- in particular, solo practitioners and small firm attorneys -- agreed to hold original Wills for their estate planning clients.  Often this is done by the attorneys in hopes that more legal work would arise in the future (either in terms of changes to the Will, or when the Will "matures" and a probate is needed).  There's a view -- mentioned by Ms. Gunnarsson -- that this line of thinking is either unethical or morally repugnant.  I would agree with that, but then again, I don't hold original documents for my clients.  I don't safekeep documents for the same reasons I don't sell real estate (or Mary Kay products or Beanie Babies) on the side: it's not my job, and it detracts from my job.  As a lawyer, do you really want to compare yourself to attorney/babysitter/agent/bodyguard/unauthorized biographer/realtor/cobbler Lionel Hutz?

Of course, many attorneys choose not to store their clients' Wills, but wind up inheriting these types of documents from old school attorneys (many of whom did offer this service).  Now the question is, what do I do with all of these documents?  The article offers a few suggestions, like using skip tracers or checking the internet Social Security Death Index, but this can take a lot of time and/or money.  The newest idea is proposed legislation that establishes a central Will repository, which is used in a number of other states. 

I don't know what consumeraffairs.com is, but yesterday they put up an interesting post about Pennsylvania's attempt to crack down on living trust schemes (it's available here).   These schemes often involve attempts to sell (most older) people high-priced estate planning documents and annuity products.  (Unfortunately, consumeraffairs.com's affiliation with Google means that the page on which this article appears features ads from... people selling living trust schemes.  Ouch!)

The sales pitches for these schemes usually involve a lot of wild comments about the evils of probate, and how it must be avoided at all costs.  Unfortunately, as Deirdre R. Wheatley-Liss reports today on her You and Yours Blawg, myths about probate aren't limited to scammers -- even mainstream newspapers sometimes get into the act.

Living trusts can do a lot of nice things, but they are not for everyone.  What I try to do here and when I meet with clients is to discuss thoroughly the positives and negatives of living trusts and simple Wills. 

This article by Texas attorney Ronald Lipman is a really nice summary of the advantages and disadvantages of living trusts (especially compared to Wills).  I've started explaining the costs associated with the two documents in terms of timing:

A living trust has immediate costs -- you pay a little extra now, both in terms of attorney's fees and in terms of work you have to do (transferring assets by changing title and beneficiary designations). 

A Will has future costs, which must be paid when you die -- basically, the attorney's fees and court costs associated with probate (including the cost of having your executor transfer assets to the estate and to your beneficiaries).

Which is better for you, a living trust plan or a plain old Will?  That's going to depend on your assessment of the above costs.  The actual fees are pretty easy to break down, but the intangible costs are more difficult to consider -- when we talk about transfers of assets during lifetime, we're really talking about questions like:

Do you have time to transfer your assets to your living trust?

Do you have the ability to make these transfers yourself (or can someone else, like your financial planner, help with the transfers)?

Can you devote your attention to these transfers, to make sure that nothing is forgotten, and that all assets get placed into the trust?

Do you mind the "hassle" of making these transfers, and the added complexity that a living trust gives to your life?

Answers to these questions will vary among different individuals, which is why a living trust may be a bad idea for one client (an 85-year-old who hates complexity and doesn't want the hassle of asset transfers) and a very good idea for another (a 55-year-old with time and interest to spare on the transfers).

Sunday's New York Times had a nice article on incentive trusts.  The idea of an incentive trust is to make distributions from your trust to a beneficiary contingent upon the beneficiary doing (or not doing) something.  Incentive trusts can be based on things like:

-Educational accomplishments
    *the better your grades, the more money you get
    *you get money when you graduate from college or university

-Family accomplishments
    *you get money if you get married
    *you get money if you have a child

-Job accomplishments
    *you get money if you hold a full-time job
    *you get money equal to the salary you receive at your job

-"Substance Abuse" accomplishments
    *you get money only if you pass a drug test or complete drug rehab

The major knocks on incentive trusts are (1) they seem like a desperate way for a deceased person to seek control over his or her beneficiaries from beyond the grave and (2) inflexibility.  I think careful drafting can provide solutions to both of these problems.  When I've set up incentive trusts for clients in the past, I've tried to spend a lot of time determining my clients' real goals and walking them through various scenarios.  After doing so, most clients will decide to limit their use of incentives to provisions that represent their core values.  In other words, we can probably figure out a way to encourage your child to get a good education, but it may not be wise to require the child to attend your alma mater.

On Tuesday, I talked about the traditional way of structuring trust distributions (in terms of income and principal).  Because of the tension this creates between income beneficiaries and remaindermen (and the resultant headaches for trustees), practitioners and others in the estate planning community proposed a new idea: the total return trust.  Illinois' Trusts and Trustees Act now includes a provision for a total return trust (760 ILCS 5/5.3), including a procedure for converting a traditional "income and principal" trust into a total return trust.

How does a total return trust work? Essentially, income is deemed to be a percentage of the net fair market value of the trust's assets (for example, 4%).  If a trust contains $1,000,000, then the income beneficiary would be entitled to $40,000 per year from the trust (regardless of whether the "income" of the trust for purposes of the Principal and Income Act is $4,000 or $100,000).

The major benefit of the total return trust is that the trustee is no longer conflicted about investments -- he or she has the clear task of investing trust assets in a way that maximizes the fair market value of the trust assets, since this maximization will benefit all beneficiaries.

Most ongoing trusts contain language that allows beneficiaries to obtain money from the trust based on certain criteria.  Historically, trust property (and a beneficiary's right to it) has been described in terms of income and principal.  For instance, a beneficiary might have the right to all income from the trust; upon this beneficiary's death, a remainder beneficiary may receive the entire principal of the trust.

Because of the above, it's important to understand what is meant when we talk about income and principal.  The Illinois Principal and Income Act (755 ILCS 15/1 et seq.) (the "Act") defines these terms as follows:

Principal is the property which has been set aside by the owner or the person legally empowered so that it is held in trust eventually to be delivered to a remainderman, while the income is in the meantime taken or received by or held for accumulation for an income beneficiary.

Income is the return in money or property derived from the use of principal....

The Act goes on to explain which types of property constitute income and which constitute principal.  For instance, stock dividends are considered principal, while cash dividends and interest received are considered income.  The trustee is also obligated to distinguish between income and principal in the handling of trust expenses (some expenses are allocated to income, and some to principal).

As you may have guessed, there can be a fair amount of tension between a trust beneficiary with a current right to income and a remainder beneficiary.  The former wants to maximize trust income while the latter wants to grow the principal of the trust.  This tension became greater in the 1990's, with the run-up in tech stocks -- many of these stocks paid no cash dividends, but were experiencing huge jumps in share price.  As a result, tech stocks were hated by income beneficiaries and loved by remainder beneficiaries.  The opposite was true of bonds, which didn't appreciate much but which produced a fair amount of income.

Tomorrow I'll talk about a potential solution to the income beneficiary vs. remainder beneficiary fight.