Avoiding probate has been an especially important objective for many estate planning clients, mostly because of the unnecessary court costs and legal fees and because probate has become cumbersome, lengthy and frustrating. Probate is the legal process of administering a person’s estate after death. When a person’s assets pass through probate, it means that the legal representative of the estate (often called the “personal representative,” and formerly referred to as “executor”) must obtain approval from the court in order to act on behalf of the decedent’s estate.
The probate process entails court and legal fees, and can also take a considerable amount of time, especially because the pandemic has caused significant backlogs in the courts. Some of my clients have had to wait a year or longer to access their deceased love one’s financial accounts or gain authority to sell real estate.
Accessing assets and authority would not have been as arduous if those loved ones had established revocable living trusts to which they transferred their assets during lifetime. Married couples can also use revocable living trusts as an estate tax planning tool if appropriate given the size and make-up of their assets.
Trust nuts and bolts
A revocable trust is essentially a trust that can be revoked or amended by the grantor. (Someone other than the grantor can be given the power to revoke or amend the trust, but that’s beyond the scope of this article). An irrevocable trust is essentially a trust that cannot be revoked or amended, although it can be altered in many ways depending on how the trust is drafted (Again, that’s beyond the scope of this article). Therefore, a client establishing an irrevocable trust should proceed with the understanding that it cannot be revoked or amended by the grantor.
Typically, revocable trusts are used to avoid the probate process, thereby reducing court and legal fees, court oversight, and waiting long periods before beneficiaries can access the assets. In order to achieve this objective, it’s important that a grantor actually retitles his or her assets into the name of the revocable trust, or names the revocable trust as a beneficiary of the account.
Additional Reading: Unlocking the Power of Charitable Remainder Unitrusts
Revocable trusts can also include very important provisions regarding a beneficiary’s inheritance, such as whether to give the inheritance outright or whether to hold it back in trust in order to protect those assets. There are also many estate tax savings provisions that can be incorporated into revocable trusts, the benefits of which depend entirely on the grantor’s objectives and unique financial situation. All assets in a revocable trust established by the grantor are included in the grantor’s estate for estate tax purposes.
Irrevocable trusts, on the other, are used for two primary reasons: (i) minimizing estate, gift, and generation skipping transfer taxes (if applicable); and (ii) protecting assets from creditors of the grantor (especially income-only Medicaid trusts).
Added protection and comfort
Avoiding probate can be done without the use of a trust, but it’s almost always necessary to incorporate a trust if the client also wants to incorporate tax planning or protecting loved one’s inheritances. For example, a client can always deed her home to her children and retain a life estate, which avoids the probate process, but then her children would not be protected from creditors like an ex-spouse because the children would own the home outright in their own names, as opposed to in trust with properly drafted provisions that protect the assets.
Revocable living trusts have long played a part in traditional estate planning for a married couple. However, typically, each spouse establishes a separate revocable trust and both trusts must be funded with a different combination of assets. Sometimes, the assets are split and a portion is put in each spouse’s trust. What we’ve found is that many clients do not like and feel uncomfortable bifurcating their assets into separate trusts because they’ve always jointly owned most of their assets.
When a married couple expresses discomfort about splitting assets into separate revocable trusts, a joint trust may be an attractive option if the couple has the following characteristics:
- They have a long relationship with each other and divorce is not a concern.
- Neither spouse has children from a prior relationship.
- Neither spouse is exposed to creditor claims for which a creditor could collect from only one spouse.
- The couple accepts that their assets be treated as jointly owned and that the surviving spouse will have control over all of their assets when one of the spouses dies.
- The combined value of the couple’s assets does not exceed the federal estate tax exemption amount ($12.06 million per person in 2022).
- The couple lives in a state that has a state estate tax that makes trust administration overly cumbersome or impractical after one spouse passes away.
It’s important to note that different attorneys draft joint trusts very differently, so one joint trust may be very different from another joint trust. I mention this because even if a married couple does not share all of the above characteristics, depending on how the actual joint trust is drafted, it may still be a good option. Many married couples who fit well outside the above traits may still choose the joint trust structure, which is perfectly acceptable as long as they’re aware of the potential risks.
Additional benefits of joint trusts
There are other benefits to joint trusts in addition to married clients not having to separate or bifurcate their assets into two revocable trusts. First, it can be easier to administer a single trust after the death of a spouse, simply because it’s easier to administer one trust rather than two. This benefit may be curtailed, however, if the clients live in a state with a state estate tax in which the exemption is less than the federal exemption, or if the state estate tax rules make it too complicated to administer a joint trust. Lastly, depending on how the joint trust is drafted, the income tax reporting requirements could be a bit of a burden.
Second, all of the assets in the joint trust may receive a full step-up in income tax basis if the trust is drafted in such a way that the deceased spouse had a general power of appointment over all trust assets. This can provide significant income tax benefits if the surviving spouse decides to sell assets that had significantly appreciated prior to the deceased spouse’s passing. Ordinarily, with a two-trust structure in which clients separate their assets into their respective revocable trusts, only the assets in the deceased spouse’s trust would receive a step-up in income tax basis.
Third, a portion (if not all) of the assets in the joint trust could receive another step-up in income tax basis when the surviving spouse subsequently passes away.
The pitfalls of joint trusts
Although the above characteristics are the ideal ones when considering a joint trust structure, there are many couples who do meet one or more of the above conditions and still wish to implement a joint trust even after learning about the potential risks. Here are some of the situations where the risks could occur.
Spouse 1 (S1) and Spouse 2 (S2) have been married for 10 years. They both have two children from prior relationships, but they want to leave their assets equally to the four kids. Assume they establish a joint trust in which they transfer their real estate (primary residence and vacation home) and bank and brokerage accounts. According to the language in the joint trust, the four kids will be equal beneficiaries after both spouses die.
However, if S1 passes, S2 will likely have complete control over the trust assets, and could decide to distribute some of the trust assets to themself, and thereafter give the assets to S2’s children. This would reduce the amount S1’s children would receive. S1 and S2 never intended that to happen when they established the trust, but that’s what happened in this example and what I have seen several times.
Take the same example above, except that S1 and S2 unexpectedly decide to divorce. How will they separate assets from the joint trust? Some joint trusts require separate accounts be established to keep track of what each spouse contributed, but not all do. If the joint trust states that all assets owned in the trust are deemed to be contributed equally, it can be a very drawn-out process navigating a divorce settlement when one spouse contributes more to the trust than the other spouse.
If the married couple has exceptional wealth (i.e, above the current exemption amount of $12.04 million), it’s typically best for them to establish separate revocable trusts. These types of clients are usually more comfortable separating their assets anyway because chances are they have already done so with existing assets. However, some clients are adamant about having a joint trust, which can still work to utilize each spouse’s federal estate tax exemptions if properly drafted. I have heard these trusts referred to as “Joint Power of Appointment Trusts” and “Joint Exempt Step-Up Trusts” (JESTs), and I have used them (or variations) with my clients.
Reviewing the technical tax details of these techniques and whether they will or will not work as envisioned is beyond the scope of this article. The IRS has really only addressed joint trusts like these in their technical advice memorandum and private letter rulings, neither of which can be relied upon by taxpayers who were not part of the ruling. Therefore, the concern is that the IRS could audit a client with substantial assets in a joint trust and conclude that some of the tax planning elements in these trusts do not, in fact, work.
Lastly, advisors should pay particular attention to this concern if the exemption sunsets back to $5 million (adjusted for inflation) in 2026. Therefore, if advisors believe the exemption will go back to $5 million (adjusted for inflation) in 2026, then they should advise their clients that a joint trust may not be the best option if the clients are very risk averse and even the tiniest possibility of an audit gives them discomfort.
Matthew Guanci, who holds an LL.M in taxation and estate planning, established Boston-area Guanci Law in 2018 after working for several boutique law firms as an estate planning and tax law specialist. He can be reached at [email protected].