A Guide to Complex Trusts

Complex Trusts Explained: Picking the Right Option for You

Trusts can be a key component of an estate plan. Some are designed with a simple, straightforward purpose in mind. Want your estate to be able to avoid the probate process? There’s a basic trust used for that: a Revocable Living Trust. Is there a possibility that one of your beneficiaries may be under 18 at the time they inherit from you? There’s a simple solution for that, too: a Contingent Trust for Minors. 

Other trusts are designed to take on more complex issues, such as estate taxes, blended families, or beneficiaries with special needs. To address advanced estate planning issues, complex trusts are sometimes required. This guide provides an overview of a few of the most common “complicated” trusts used in estate planning.

Qualified Terminable Interest Property (QTIP) Trusts

Estate planning for blended families, where both spouses have children from prior relationships, can present some unique challenges. One of the primary concerns is to be able to provide for the financial support of the surviving spouse, while at the same time ensuring that the children of the first deceased spouse are able to receive their inheritance after the surviving spouse’s death. 

With a typical will or living trust, after the death of the first spouse, it’s possible for the surviving spouse to change his or her estate plan to alter the way that the couple’s property will (or won’t) be left to their respective children. Qualified Terminable Interest Property Trusts (QTIP Trusts) can address this concern.

How It Works

With a QTIP trust, the surviving spouse receives a steady stream of income from the trust during his or her lifetime and has a right to distributions of the trust’s assets in many situations. Upon the death of the surviving spouse, the remaining assets are distributed to the first deceased spouse’s children. QTIP trusts are irrevocable, meaning that the provisions of the QTIP trust generally cannot be altered later on.¹

¹Source: IRC Section 2056(b): https://www.irs.gov/pub/irs-drop/rr-00-2.pdf

Trustee Considerations

Designating the trustee for a QTIP trust can be a complex decision on its own and requires careful consideration of family and interpersonal dynamics. There is inherent tension created by the arrangement: the fewer assets spent by the surviving spouse, the more that remains for the deceased spouse’s children to inherit. In some cases, designating either the surviving spouse or the deceased spouse’s adult children as trustees of a QTIP trust can exacerbate conflict.
 
To minimize potential conflicts, it can sometimes be helpful to designate the surviving spouse and the deceased spouse’s adult children as co-trustees of the QTIP trust. However, every family is different, and in other situations, this type of designation might actually increase the likelihood of problems.
 
Other possible solutions include designating another family member, a family friend or a professional trustee to act either as sole trustee or as a co-trustee. Trust companies, private banks and certain brokerage houses are the most common choices for a professional trustee. CPAs and attorneys may also be willing to act in this capacity.

Example

Lisa and Scott have been married for several years, and it’s the second marriage for both of them. Although they don’t have any children together, Lisa has two grown children—Rachel and Lauren—from a prior marriage. Lisa and Scott want to leave their property to each other, but Lisa would also like to make sure that if she dies first, Rachel and Lauren will still receive an inheritance from her.
 
In order to meet this planning objective, Lisa and Scott decide to include a QTIP trust in their estate plans. The trust is set up to come into existence upon Lisa’s death if she passes away before Scott and is to provide for Scott’s financial needs during his lifetime. At Scott’s death, the remaining trust proceeds are to be divided equally between Lisa’s children. Scott and Rachel are designated as co-trustees of the trust. The trust is set up so that all trust income is distributed to Scott each year, and distributions of principal are authorized for purposes of health, education, maintenance or support—basically, those expenses necessary to enable Scott to keep the same standard of living that he had prior to Lisa’s passing.
 

Irrevocable Life Insurance Trusts

Life insurance policies can be a great way to create liquidity for your estate, whether to pay an anticipated estate tax liability or simply to create additional funds for your heirs. Life insurance proceeds are not counted as income, and are therefore tax-free to the beneficiaries.²

However, when a person purchases a life insurance policy on their life, the policy proceeds paid out at death are included in the person’s estate for estate tax purposes.³ That means that if the overall value of the estate is high enough that estate taxes will be owed, the life insurance proceeds will also be subject to estate tax. One way to avoid this is to create an Irrevocable Life Insurance Trust (ILIT) to be the owner and beneficiary of the life insurance policy. ILITs provide a great way to leverage assets through the purchase of a life insurance policy while keeping the policy proceeds out of the grantor’s estate, allowing them to be inherited estate and income tax free.

²Source: IRC Section 101(a)(1); https://www.irs.gov/pub/irs-drop/rr-07-13.pdf

³Source: IRC Section 2042; https://www.irs.gov/pub/irs-wd/0947006.pdf

How It Works

With an ILIT, the person who creates the trust (the “grantor”):
 
1. Funds the payment of the insurance premiums; 
2. Designates the trust beneficiaries; and 
3. Specifies the way in which the life insurance proceeds are to be distributed.
 
In some cases, the insurance proceeds are paid outright to the beneficiaries. In other cases—for example, when an ILIT is created for the purpose of paying the grantor’s estate tax liability—the insurance proceeds are either loaned to the grantor’s estate or used to purchase assets from the grantor’s estate. Despite having this level of control, the insurance policy proceeds are not considered to be part of the grantor’s estate for estate tax purposes, since the policy belongs to the trust.

Policy Types and Premiums

A new life insurance policy can be purchased in the name of the trust, or alternatively, an existing life insurance policy can be transferred into the ILIT. Purchasing a new life insurance policy is usually preferred, because existing life insurance policies are subject to a three-year lookback period in which the policy proceeds could still be included in the grantor’s estate for estate tax purposes. 

Married couples often purchase a type of life insurance policy known as a second-to-die policy, which pays at the death of the surviving spouse. This type of policy is generally less expensive than an individual policy. Since estate tax liability is most likely to arise at the death of the surviving spouse, a second-to-die policy can be a cost-effective way of handling the liability. 

The premium for the life insurance policy can either be paid in a lump sum or in installment payments. Either way, the grantor must contribute the required funds to the ILIT so that the ILIT can then make the premium payment.

Example

Antonio is a widower with an estate worth $15 million, including a universal life policy that will pay $3 million at his death. He knows that his estate is in excess of the current $13.99 million federal estate tax exemption amount, and he’d like to find a way to eliminate the estate taxes that his estate will face. 

He realizes that if he could keep the life insurance policy in place, but just move it out of his estate, it would solve the estate tax problem entirely. So Antonio creates an Irrevocable Life Insurance Trust, and transfers the ownership of the policy to the trust. He designates his daughter Olivia as the trustee of the ILIT and designates his three children as beneficiaries of the trust, so that they’ll all benefit from the insurance proceeds. 

Once this arrangement has been in place for the IRS-mandated three-year waiting period, the life insurance policy is considered to be the property of the ILIT, rather than part of Antonio’s estate. For this reason, at the time of his death, his estate will be able to totally avoid estate taxes, representing a savings of approximately $404,000 ($15.0 million total estate value minus $13.99 million estate tax exemption equals $1.01 million subject to estate taxation; this amount multiplied by the 40% tax rate yields an estate tax liability of $404,000 saved by Antonio’s use of an ILIT).