For many partners at top law firms, their earnings represent the first time in that person’s family history that such wealth has been generated. With this first-generation wealth creation comes certain challenges and many opportunities. As a partner in a law firm, they now have additional financial and tax responsibilities that they may not be fully aware of. Many focus on financial planning and investment advice, but often do not spend enough time thinking about how to efficiently transfer newly accumulated wealth to children and grandchildren. Without proper planning, the accumulated wealth that that the high-income earner worked so hard for could be taxed at a 40% transfer tax rate before that wealth passes to the next generation. This article will focus on the basics of trust & estate planning, providing specific examples and case studies of how various trust structures can be utilized. Specifically, we will discuss asset protection, probate avoidance, incapacity planning, and estate & gift tax planning.
Utilizing The Right Trust Structure for You
Let’s start with the basics – while many are familiar with the terms Revocable and Irrevocable Trust, knowing when to use them and how to best take advantage of them can be tricky and requires more thoughtful planning. The main differences between a revocable and irrevocable trust are as follows:
|Revocable Trusts||Irrevocable Trusts|
|Benefits||Maintain control of the assets||Tax reduction|
|Protection in case of incapacity||Protection from creditors|
|Avoids probate||Avoids probate|
|Preserves privacy||Preserves privacy|
|Drawbacks||No estate tax benefit||Relinquish control of assets|
|No protection from creditors||Limited flexibility / subject to trustee discretion|
Lawyers know that few things are mutually exclusive – this applies to trust structures as well. Taking advantage of both structures for different assets and purposes can be beneficial. For instance, they might want to place a secondary residence in a revocable trust, allowing them to maintain control and for the home to be sold at their passing without the need for probate. However, maximizing tax savings via irrevocable trusts is also important, and should be done in conjunction with other strategies. Of course, as with any tax strategy, limitations apply, and the structures may become undesirable or ineffective if laws change. And, since there are many possible irrevocable trust structures, selecting the appropriate trust for various assets is critical. Below is a list of the most utilized irrevocable trust structures and their primary purposes.
- Credit shelter trust, also known as a bypass trust or AB trust: A trust typically used by married couples to avoid estate taxes on certain assets. After the first spouse dies, assets are moved into the credit shelter trust for the use of the surviving spouse. When the second spouse dies, the remaining assets are passed to the heir of the estate tax-free.
- Qualified terminable interest property trust, or QTIP: Divorce attorneys are likely familiar with a QTIP. This type of trust is designed to provide the surviving spouse with an income stream and use of the assets at the trustee’s discretion or for limited purposes like health, education, maintenance, and support, and at the surviving spouse’s death, QTIP trust assets remaining pass to named beneficiaries. This structure is most often used in second marriages.
- Grantor-retained annuity trust, or GRAT: A GRAT is a short-term trust designed to remove asset appreciation from the grantor’s estate to benefit heirs (typically children of the grantor) with minimal use of lifetime gift exemption. GRATs work best in low interest rate environments.
- Qualified personal residence trust, or QPRT: This structure is similar to a GRAT but is exclusively used for residential real estate. One of the advantages of this structure is that the grantor can live in the home rent-free before it is ultimately gifted to the heirs. QPRTs work best in high interest rate environments.
- Generation-skipping trust/dynasty trust: For attorneys who have amassed a larger amount of wealth, these trust structures can help insure multi-generational benefits. These types of trusts enable the grantor to gift assets to trusts for their children, grandchildren, and/or more remote descendants and keep the trust assets excluded from the taxable estates of the grantor’s descendants for multiple generations.
- Special needs trust: This trust allows a beneficiary with special needs to maintain eligibility for governmental assistance while ultimately benefiting from the trust to enhance the beneficiary’s life.
- Intentionally defective grantor trust, IDGT or grantor trust: This strategy helps reduce or eliminate estate taxes but requires the grantor to continue to pay any applicable income taxes on the assets transferred into this trust. As a result of grantor continuing to pay the income taxes, the IDGT grows tax-free.
- Irrevocable life insurance trust, or ILIT: This is a trust that owns a life insurance policy and receives the death benefit proceeds of the policy. This can be a useful tool for addressing potential estate tax liability, and subject to limited exceptions, the death benefit is excluded from the grantor’s taxable estate.
- Charitable trusts: These are trusts set up to benefit charities and gain favorable tax treatment for the grantor. Common types of this trust include charitable remainder trusts, charitable lead trusts, and pooled income trusts.
As evidenced above, there are many types of trusts that can be set up and incorporated into a comprehensive estate plan, all depending on one’s primary concerns and objectives. Working with a knowledgeable professional specializing in attorney finances who is able to coordinate the appropriate resources to address these complex planning matters is critical. If interested in learning more about these and other planning strategies, please contact us.