Monday, April 5, 2004

The Case for Trusts in Wills

Many wills fail to take advantage of a very powerful estate planning tool – the testamentary trust (also called the will trust).

A will can leave property directly to named heirs. Alternatively, the will can direct that assets be held in trust for those heirs. Many people shy away from using a will trust because the trust seems to imply a distrust of the heirs. However, a carefully-structured will trust can provide the heirs with significant tax and other advantages.

A will trust is treated as a separate individual for income tax purposes. This means that the trust pays income tax at graduated rates – about 22% on the first $30,000 of taxable income, and progressively higher rates on higher levels of income. This can lead to income-splitting advantages.

Assume that you want to give a sizable inheritance to your child, Frank. Assume also that Frank has a good job and earns about $80,000 of taxable income in a given year. As a result, Frank is in a 40% tax bracket. If he invests his inheritance and earns $30,000 in interest income, that extra income would push Frank into a higher tax bracket. As a result, Frank would pay about $12,142 on that income, netting about $17,858 after tax.

You would be doing Frank a favor by leaving his inheritance in a will trust. If the will trust invests the inheritance and earns the same $30,000, that same income would be taxed at 22% (the lowest applicable tax rate, because the will trust would have no other income). As a result, the will trust would pay only $6,600 on that income, netting about $23,400 after tax. The will trust could later distribute that $23,400 to Frank on a tax-free basis.

By having the income earned in a will trust, Frank would save $5,542 in income tax each year that the trust is in existence.

Additional income tax savings are possible if the will trust were to include Frank’s family members as beneficiaries. Depending on the nature of the income, the will trust might be able to distribute income to Frank’s children in order to use up their basic personal exemptions (which means that no income tax would be paid on that portion of the income).

Will trusts can also have significant non-tax advantages.

For example, assume that you leave all your assets to your surviving spouse on the understanding that your spouse will leave the assets to your children. In time, however, your spouse remarries but dies in an accident shortly after the remarriage. In law, marriage automatically invalidates an existing will. Unless your spouse thought to make a new will around the time of the remarriage, your spouse would die intestate. If that occurs, a portion of the property would go to the new spouse rather than to your children. A properly-structured will trust can avoid this unfortunate result and ensure that your children eventually benefit from the property.

To some extent, a property-structured will trust can also offer asset protection advantages. The trust can be structured so that the trust property does not belong to any specific beneficiary. If a specific beneficiary gets into financial difficulty, it would be very difficult for creditors to seize trust assets. Those assets would be held in trust for other family members (possibly including future grandchildren) – not just the family member who has run into financial difficulty.

One cannot say that it is always appropriate to create a will trust. However, I have seen many situations in which the establishment of a will trust could have provided significant advantages to the heirs. When preparing an estate plan, a will trust should at least be considered. Your heirs may actually be very grateful that you did not leave your property to them directly.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.