The Ten
Biggest Errors in Trusts
by Frank J. Croke
Over four million Trusts are established each year, but 90% of them do not properly provide for the surviving spouse and children. Why? Because the Grantors did not use their options to adequately provide for their families. The following are the most commonly neglected options that result in the ten biggest errors found in Trusts.
Neglected
Option Number 1:
The right to state in the Trust the annual income the surviving
spouse is to receive
This
is the single most important financial right that Grantors have
in their Trusts. Yet, the majority of the Trusts neglect to state
the income requirements of the surviving spouse. As a result,
the spouse receives about half the income needed and could have
received if the Trust was properly prepared.
We recommend that the
husband's Trust state the income his wife would require from
the Trust this year if her husband died this year. Instructions
should be given to annually increase this amount by three percent,
or more if the actual inflation rate is higher in any year. This
means that if it is determined that the wife needs $30,000 from
the Trust this year and her husband were to die fifteen years
from now, she would be paid in the year of her husband's death
$46,000, ($30,000 plus the 3% annual increases). That $46,000
amount would continue to increase three percent each year thereafter.
Based on current interest
and dividend rates, most $650,000 Trusts pay only about $20,000
before taxes this year. Why? Because over 95% of the Trusts use
a standard form and those forms mistakenly include the following
phrase: "The Trustee is instructed to pay my surviving spouse
the net income from the Trust." (Source: "Family Trusts,
Good or Bad: Financial Errors in Trusts, How to Avoid and Correct
Them." ISBN 1892879123)
That "net income"
is always a low amount, one that is inadequate for the needs
of the surviving spouse. A Trust that contains this "net
income phrase" should be revised and replaced with language
that states a specific amount in today's dollars and increased
as explained in the example above.
Neglected
Option Number 2:
The right to state in the Trust how the funds should be invested
If
a Trust is silent on how the funds in it are to be invested,
many Grantors are surprised when they learn what it means. It
means that 50% will be invested in bonds.
Grantors are frequently
unaware that when bonds are in a portfolio, the value of that
portfolio, years later, is reduced.
Sufficiently knowledgeable,
Grantors, on the other hand, want a larger percent of their Trust
assets invested in good quality growth stocks, stock mutual funds,
and stock index funds. Reasonable projected returns indicate
that including such directives will produce a Trust of significantly
higher value for the children. In addition, it will support a
high income for the wife as the surviving spouse.
Neglected
Option Number 3:
The right to change the state that controls the Trust
Why
do almost 99% of the Trusts neglect to state this important option?
A person has the right to be able to change the state that controls
his or her Trust. The Grantor can make this option available
to their spouse when they die. This is accomplished by providing
in the document the power to change the state controlling the
Trust. Then attach a letter clearly indicating that the Trust
is now controlled by another state. Think of the many times people
move in their lifetime. Why must a person pay to have another
Trust prepared just because they have relocated to a different
state?
Relocation is a common
expectation for many people when they retire. There may even
be an additional move after retirement, if one of the spouses
dies. A Grantor would not want the surviving spouse who has decided
to move to be forced to hire attorneys and CPAs in another state
to prepare, file and pay annual state fiduciary taxes. This is
especially true if the state they have moved to has placed high
annual taxes on the Trust.
It is prudent to keep
in mind that cities, counties, and states are always looking
for ways to increase their income. New and higher taxes on Trusts
by these governments can be avoided by proper use of this Trust
provision.
Neglected
Option Number 4:
The right to provide in the Trust travel and living expenses
This
right is considered very important and can be the main reason
for revising a Trust. Children of the Grantor may live thousands
of miles away. Years later, the surviving parent may be seriously
ill or in a nursing home. The Grantors that anticipated this
can state that the trustee is to pay the travel expenses for
children and grandchildren, not just to visit, but to ensure
that proper care is being administered.
This right to exercise
such care giving is missing from most Trusts. And it is an unnecessary
omission. Most Trusts contain more funds than are needed to support
the surviving spouse. Why restrict visits from children who may
not be able to afford long-distance travel? If the directive
to provide for this is included in the Trust, much financial
and emotional stress on family members can be avoided.
The surviving wife
is the spouse most interested in this provision. Wives are aware
that the first to die in four out of five marriages are husbands.
It is reassuring for a women to know that her husband's trust
contains this and other important directives to benefit her in
later years.
Neglected
Option Number 5:
The right for the surviving spouse to obtain an additional $5,000
a year
Unforeseen
expenses and required income tax payments can be quickly and
properly handled if this provision is in the Trust. The IRS allows
a person to obtain up to $5,000 each year just by asking for
it without losing the tax benefits of the Trust.
As an alternative,
the IRS also allows up to five percent of the Trust to be requested
and paid. However, this provision is not required if the income
needs have been properly planned, and the provision for obtaining
annually an additional $5,000 is also included in the Trust.
If funds above the income paid are required for the proper support
of the surviving spouse, the standard provision for allowing
the trustee to determine this need should be used.
Caution: Annually allowing
an additional five percent of the Trust to be removed in addition
to providing the income needed by the surviving spouse can result
in a decrease in the value of the Trust and its future ability
to properly provide for the surviving spouse and the children.
Neglected
Option Number 6:
The right to provide for appropriate residential needs
To
obtain an individual's maximum federal tax exemption, a home
or a half interest in a home is often placed in the Trust. Again,
thinking ahead, provision should be made in the Trust for the
surviving spouse to instruct the trustee to sell the present
home and to purchase or to lease a new residence selected by
or approved by the surviving spouse.
A person may move from
a home to another residence and later move again to a retirement
community. The surviving spouse may wisely decide to rent in
an area and buy later when they are satisfied with the new locale.
Some retirement living centers require that a purchase agreement
be signed stating that the owner will only receive 90%, (or some
other figure) of the purchase price when they move from the facility.
The Trust should provide for acceptance of these types of conditions
from quality retirement living centers.
Neglected
Option Number 7:
The right to provide funds for the children
Everyone
is living longer, including parents. Surviving spouses are living
well into their eighties. Children are reaching retirement age
during the lifetime of the surviving parent. Even grandchildren
have been raised and some of them are starting their own families.
The funds in the Trust
are expected to grow in value. When that occurs, at what point
will there be surplus funds beyond those required for the surviving
spouse's needs?
Distribution of a surplus
can be accomplished by including a provision in the Trust. It
allows the surviving spouse to authorize distribution of income
and principal, under certain conditions. It is a provision that
can build strong family relationshipsthe surviving spouse during
his or her lifetime remains the head of the family with the financial
authority to assist children and grandchildren.
No longer must a widowed
mother be forced to say to her children, "I'd like to help
you buy a home, educate my grandchildren, etc., but my funds
are limited and I have no authority to access funds in the Trust.
Wait until I die. Then you'll have lots of money."
The power to distribute
income and parts of the principal should be given to the surviving
spousenot to the trustee. If a Grantor is concerned that the
surviving spouse may distribute funds she will later need for
her support, an amount can be specified for that, say one million
dollars. Funds over this amount can be distributed each year
to children and other heirs upon instructions from the surviving
spouse.
In summary, a competent
parent should have the authority to remain as the had of the
family after the death of the other spouse. In a situation where
the surviving parent is no longer competent, an annual disbursement
to all the children and heirs can be required of the trustee
when the funds are beyond a certain specified amount.
Neglected
Option Number 8:
The right to change the method of payment to heirs
Years
after the Trust has been executed and the demise of the Grantor,
there can be many reasons why the surviving spouse would not
want a child or other heir to receive a lump sum payment from
the Trust. A problematic marriage and the divorce could result
in a claim for half of the heir's assets, including funds from
the Trusts. There are other reasonsalcoholism, drug abuse, incompetence,
etc. why funds form the Trust should continue being held and
only the income from the Trust distributed to the worrisome heir.
A Grantor can give
the surviving spouse the right to require that the funds be held
in a separate Trust for a child, to state how these funds will
be invested and the income and principal to be paid to that particular
person.
Neglected
Option Number 9:
The right to change the share each heir will receive
This
is another right a Grantor has. In most cases, the grantor states
that upon the termination of the Trust, the assets are to be
divided equally among the heirs, but the Grantor can give the
surviving spouse the ability to later change this distribution.
Justification for this could be based upon circumstances: one
of the children may be well off and have no requirement for additional
funds, or a daughter may be divorced or widowed early with several
dependent children. Additional funds would be required and welcomed.
To limit the amount
of change, the Grantor can state that each person must receive
either directly, or have held in trust for them, at least 50%
of the funds they would have received prior to any distribution
change made by the surviving spouse.
In the case of second
marriages, particularly later in life, the new spouse may have
limited knowledge of the Grantor's children. In such circumstances,
Number 9 and perhaps Number 8 would not be included in the Trust
documentation.
Neglected
Option Number 10:
The right to exercise intelligent judgment in the distribution
of Trust assets
Young
adults can make mistakes and lose when they inherit. Many reasons
can be given for the losses of the funds received, bad investments,
gifts or loans to friends or just plain foolishness.
As a precaution, a
parent might state in his Trust that the children are to receive
one-third of their share when they reached age 25; one-third
at age 35 and the final one-third at age 45.
The parent might expect
his children to lose the first third of the funds they receive
and hope they would learn form that experience. It is possible
that they will also lose the second third they receive when they
are 35. When they are 45 and receive the final third, we can
only hope they'll save a little for their old age.
It is interesting to
consider the funds that would be received from this concept.
As an example, a 25-year-old with a Trust share of $1 million,
would receive $333,333 at the age of 25 and the remaining amount
of $666,667 would be held in Trust.
Therefore, even if
it was a Balanced Trust, because no investment directives were
given (50% invested in bonds and 50% invested in stocks) and
the income paid was the net income, the heir would still receive
an income each year plus the benefit of the $333,333 they received
at age 25.
At age 35, This Trust
could have increased in value to $1.2 million and the heir might
be expected to receive about $600,000 (half the value of the
Trust would represent the next third). Again, the heir would
receive an annual income from the Trust plus the benefit of the
$600,000 he received at age 35.
At age 45, his Trust
could have increased in value to $1,100,000, and he would receive
the full amount in addition to all the funds received in the
past years. This is a strong argument for distributing the funds
from the Trust over an extended time period.
If the estate planning
indicates that a sizable amount of money from a Trust may be
available to the children, serious consideration should be given
to staggering the payments to them over many years, and why not
do that? They will still receive an income from these funds that
are invested by the Trust and certain risks are avoided.
Summary
The
advice "that we cannot anticipate everything so let the
trustee decide what to do at that time" is misleading. As
the above options indicate, a Grantor can think of many things
that might happen and can give instructions to anticipate such
needs, as in Number 4 and Number 6.
Thought should be given
as well to other special circumstances for which a Grantor might
want to provide. Some very careful thinking is required about
what may happen to a surviving spouse, children, and grandchildren.
In addition, it is necessary to recognize potential issues that
may require adjustments when estate planning documents are reviewed
every three to five years. Grantors should be aware of changing
family situations.
Number 9 and Number
10 are two additional examples of items to consider. If a Grantor
does not provide for these potential events, solutions will not
be available later.
In the case of young
grandchildren, Grantors must think of their development in their
early years and other possible educational needs. Will private
or special education be necessary, tutoring or summer camps?
Provision can be made for children, for other family members,
for friends and even for beloved pets. Such needs can be recognized
in a special section of a Trust along with the name of the person
who will control and determine how the special purpose funds
are to be distributed. Giving this person the power to instruct
the trustee to make the disbursements can be included.
Conclusion
Grantors
should be aware of their options and encouraged by the legal
community to use them. Legal advice tailored to the special needs
of the Grantor's family is of tremendous benefit and is always
worth the cost. The additional legal expense is minor if the
result is a truly effective Trust document.
Editor's Note: ©
2000 Frank Croke. Excerpted from Family Trusts, Good
or Bad: Financial Errors in Trusts, How to Avoid and Correct
Them, 320 pages (Capital Management Press, 2000). Reprinted
with permission.
Family Trusts is written
in an easy-to-read style for the layperson who wants to provide
for his wife, children and other heirs through the use of little
known, seldom used, but very valuable trust options not yet taught
in law schools. The 2nd edition is now available for $26.95 at
most major book stores including Amazon.com and barnesandnoble.com.
About the author: Frank
J. Croke is an author and lecturer on Estate Planning and Trusts.
He is a member of the American Bar Association, Trusts and Estate
Planning Section. He can be reached in North Carolina at (910)
392-0070.
