Living trusts: Myth vs. reality

Editor's note: The content of the following article was presented to the MACPA's Personal Financial Planning Study Group on Sept. 10, 2002. The author, Edwin G. Fee Jr., led the discussion that day and has allowed us to reprint this article.

By Edwin G. Fee, Jr.
Whiteford, Taylor & Preston, LLP

Seminars and articles about revocable living trusts have become prevalent in recent years. Many people, however, do not need living trusts. Some of the claims concerning these estate planning vehicles are discussed below.

Saving taxes, time and money

Myth: Living trusts reduce taxes.

Reality: Living trusts do not save estate, inheritance or income taxes.

During the lifetime of the grantor (the person who creates the trust), the grantor is treated as the owner of the trust assets. Therefore, all of the income earned by the trust is included in the grantor's income. Similarly, when the grantor dies, the assets of the trust are included in the grantor's estate for federal estate tax purposes. All of the traditional methods of minimizing the federal estate tax (such as use of the unified estate tax credit, the unlimited marital deduction, and charitable deductions) may be incorporated into a will or living trust. Thus, despite the claims of some living trust advocates, there is no income or estate tax advantage to establishing a living trust.
The Maryland inheritance tax actually may be due sooner if a decedent has used a living trust rather than a will. The inheritance tax on non-probate assets held in a living trust generally is paid shortly after filing the information report, which is due within three months of the appointment of the personal representative. In contrast, the inheritance tax on probate assets generally is paid with the administration account, which is due within nine months of the appointment of the personal representative.
After the death of the grantor, living trusts have several disadvantages for income tax purposes. Although an estate may select a fiscal year, a trust must have a calendar year. In addition, the federal income tax exemption is $600 for estates, but only $100 or $300 for trusts. These disadvantages may be minimized if the personal representative elects to treat a revocable trust as part of the decedent's estate for federal income tax purposes.

Myth: Living trusts save time and money.

Reality: Living trusts often cost substantially more than a will.

Proponents often argue that living trusts save the time and money associated with probate, including court costs and legal fees. In many situations, however, the decision whether to use a living trust comes down to whether a person wants to "pay now or pay later." There are legal fees for setting up the trust and transaction costs involved in transferring assets (such as fees for preparing and recording a deed to transfer real estate into a living trust). In the worst case scenario, the result is "pay now and pay later." If all of the assets have not been transferred to the trust prior to death, the person's individually owned assets will have to go through probate, anyway. The only person who is better off in this situation is the attorney who gets to set up the trust and administer the estate.
More important, a grantor must spend his or her own time and money in order to establish a living trust. Any potential savings through avoidance of probate would only benefit his or her beneficiaries in what may be the distant future. In real economic terms, the initial costs may be greater than any savings that ultimately are achieved. For example, if a person pays $2,000 to establish a living trust at age 50 and dies at age 75, the real cost of the trust is what an investment of $2,000 would have earned during the intervening 25 years. Assuming a 5 percent rate of return, the $2,000 would have grown to more than $6,700. Thus, the person's beneficiaries would have to save $6,700 in probate costs just to break even.
Even if someone sets up a living trust, he or she still must have a will to transfer any assets that have not been transferred to the trust prior to death. Also, in some states, a living trust must be executed with the same formalities and witnesses as a will. In addition, a person who establishes a living trust still should have a power of attorney. In the event of incapacity, the power of attorney would allow someone else to manage assets that have not been transferred to the trust prior to the incapacity.
Some advocates argue that a trustee may distribute the assets of a living trust on the day of the grantor's death, whereas an estate cannot be distributed until after the period allowed for creditors' claims has expired. Nevertheless, immediate distribution of trust assets generally will not be possible if, for example, the trust is responsible for paying the grantor's debts, funeral expenses, legal fees or death taxes, or if assets of the trust must be appraised for the federal or state estate or inheritance taxes.

The evils of probate are greatly exaggerated

Myth: Probate must be avoided.

Reality: Probate in Maryland is relatively uncomplicated.

Probate is the process whereby a court determines the validity of a will and supervises the distribution of the assets that a person owns individually, as opposed to assets that pass automatically upon death to beneficiaries, such as life insurance proceeds, retirement plan proceeds and jointly owned assets. Although advocates of living trusts stress that probate must be avoided at all costs, the evils of probate are greatly overstated. Certainly there are court costs and legal fees associated with probate, but these future costs may be less than the immediate costs of setting up a trust.
In addition, many of the costs associated with estate administration, such as preparation of the federal estate tax return and fiduciary income tax returns, will be incurred in administering a living trust as well.
Probate provides certain benefits that living trusts do not. The probate process allows supervision of estate administration by the probate court and provides notices to beneficiaries, who are given an opportunity to object. In contrast, a beneficiary of a living trust may have to sue a trustee in order to challenge the trustee's actions.
In some states the probate process can be time-consuming and expensive, and in those states a living trust may be advantageous. In addition, if a Maryland resident owns real estate in another state, a trust may allow his or her estate to avoid additional probate proceedings in states other than Maryland.
In Maryland, however, the probate process is relatively uncomplicated. Maryland allows a streamlined probate procedure for "small estates" — i.e., a net estate of $30,000 or less ($50,000 or less if the surviving spouse is the sole legatee or heir). Maryland also permits a less burdensome modified administration if the intestate heirs or the residuary beneficiaries consist only of the decedent's spouse, children or personal representatives. These options reduce the costs and administrative burdens that often are associated with probate.
In fact, in most states the actual probate fees are nominal, compared to other costs of estate administration, such as preparation of the federal estate tax return. In Maryland, for example, the probate fee for an estate between $500,000 and $750,000 is $750. The cost of preparing a federal estate tax return and a fiduciary income tax return could be several times the cost of the probate fee. For extremely large estates, however, the probate fee could be substantial. For estates of more than $5 million, the probate fee in Maryland is $2,500 plus .02 percent of the excess over $5 million. For such large estates, the savings from avoiding the probate fee may justify the cost of establishing a living trust.
Proponents of living trusts argue that a grantor may establish maximum trustee commissions that are lower than Maryland's statutory personal representative commissions. Unlike in New York and some other states, personal representative commissions in Maryland are not mandatory. Instead, they are optional and are subject to a statutory cap (9 percent of the first $20,000 and 3.6 percent of the balance of the probate estate). Furthermore, in certain situations it makes sense for a personal representative who is also a beneficiary to elect to receive the greatest commission possible. This may result in overall tax savings, because an estate may deduct the commission at the federal estate tax rate (up to 50 percent) but the personal representative pays taxes on the commission at his or her personal income tax rate (which may be as low as 15 percent for federal income tax purposes).
If a person wishes to avoid probate, a living trust is not the exclusive method of doing so. Probate property generally includes only those assets that a person owns individually. Jointly owned property passes automatically to the surviving joint owners without going through probate. Similarly, life insurance proceeds and retirement benefits pass directly to the designated beneficiaries. A life estate deed also will pass property to the remainder person without going through probate. So will other forms of ownership, such as a "pay on death" account.
If a person decides to utilize a living trust, he or she must transfer all of his or her assets to the trust in order to avoid probate completely. If any assets have not been transferred to the trust prior to death, the estate will have to go through probate, anyway. Even if all assets have been transferred to a living trust, some assets may come back to the estate after death (such as an income tax refund or a refund of a deposit at a retirement community). In some situations, the value of the assets may be low enough to permit use of the small estate procedure. Nevertheless, an improper or incomplete transfer of assets to the trust may result in full-scale probate in any event.

Avoiding creditors and courts

Myth: Living trusts can be used to avoid creditors.

Reality: Living trusts cannot be used to avoid creditors.

During the lifetime of the grantor, assets in a revocable trust are treated as owned by the grantor and, therefore, are subject to the grantor's creditors. A grantor may place a spendthrift clause in a revocable trust so that a beneficiary's interest in the trust cannot be attached by the beneficiary's creditors. Nevertheless, the same clause may be used in a will. Thus, a revocable trust provides no additional protection from creditors. In fact, when a person dies with a will, creditors have six months from the date of death to make a claim against his or her estate. The statute of limitations for making a claim against a trust is three years, and it is not always clear when the three-year period commences.
Maryland also provides special protection for certain assets owned by a husband and wife as tenants by the entirety. For example, a creditor of only one spouse may not be able to seek satisfaction of the debt from assets owned in tenancy by the entirety. This protection is lost if the couple splits the property into tenancy in common interests in order to transfer the property to their respective living trusts.
Advocates also argue that living trusts may be used to decrease the amount that a surviving spouse is entitled to receive from the deceased spouse. In Maryland, a surviving spouse is entitled to a portion of the deceased spouse's probate estate and may also be entitled to a portion of the property over which the decedent maintained dominion and control during his or her lifetime. Because a grantor of a revocable trust may alter or revoke the trust at any time prior to death, such assets may be subject to the right of election of a surviving spouse.
A living trust may be more advantageous than a will if the grantor's estate would be subject to a Medicaid lien. If a person receives Medicaid, then in some instances the state will have a lien against the person's estate in order to recapture some or all of the payments provided by Medicaid. On the other hand, such a lien may not apply to assets held in a living trust.

Myth: Only living trusts can be used to avoid guardianship.

Reality: A durable power of attorney may avoid guardianship.

Some living trust proponents argue that a living trust saves the cost and time involved in getting a guardian appointed. A living trust may be useful if a person who is in poor health or who does not want to be bothered with investment decisions wants someone else to manage his or her assets. Nevertheless, a durable general power of attorney may be used to manage the financial affairs of an incompetent person in lieu of a living trust or a guardianship. A power of attorney certainly is less complicated and less costly than a living trust.

Myth: Living trusts ensure privacy.

Reality: Living trusts do not ensure privacy.

With probate, the terms of a will and the decedent's probate assets become a matter of public record. Living trusts do not guarantee that a person's assets will remain free from public scrutiny. For example, in order to open an account for the trust, a bank or brokerage firm may require that the grantor provide a copy of the trust agreement. In addition, if a living trust is subject to the Maryland inheritance tax, a schedule of the trust assets and beneficiaries must be filed with the Register of Wills, and thus becomes public record. It may be possible, however, to keep the trust document itself from becoming a matter of public record.

Conclusion

In certain situations, living trusts may be useful estate planning vehicles. This may be the case if a person owns real estate in more than one state or desires to have someone else manage his or her assets currently.

Nevertheless, in most cases the immediate costs and administrative burdens involved in setting up a living trust and transferring assets to it outweigh any potential savings that may be realized by avoiding probate in the future.

This content has not yet been Rated.

To Rate content, please Login.