Revocable living trusts are a great estate planning tool. There is no more flexible legal instrument available to accomplish your objectives. However, a living trust also enables a person to make certain choices and take actions without realizing their consequences until it is too late.
Imagine Alan, the retired farmer. His several hundred acres are rented to son Bob. His cattle corporation Alan Bovine Co. is run by daughter Dana. Alan still owns 80% of the stock. Alan is also half-owner of a partnership with Fred, a friend. Alan has a $200,000 life insurance policy, and another $300,000 or so in personal assets—a car, home and furnishings, and some savings.
Alan creates a living trust. It says his four children will receive assets of equal value—in trust—so as to be safe from divorce, lawsuits, catastrophic illness, etc. Each of their trusts (created from within his living trust) will be controlled by the child who receives it…Alan would never control from the grave. Since the children get along well, they can decide how to divide everything. Daughter Ellen will serve as Successor Trustee.
Alan transfers all his assets to his living trust. He even made his living trust the owner and beneficiary of his life insurance, to make sure that money would also get the protection afforded by the trusts for the children. He did everything right. Then he dies.
As Trustee, Ellen claims the life insurance, sells Dad’s car and house, and deposits the proceeds into the bank account. To do so, she had to obtain a taxpayer identification number (FEIN) for the trust, an easy thing to do online. She calls a family meeting. Even free-spirited Calvin shows up. Based on land sales in the area and cattle prices, they all agree that the trust assets amount to $5,000,000. None of the children bicker about details. Each should get $1,250,000, and they agree to divide the estate as follows. Bob gladly takes farmland. Dana gets the Alan Bovine Co., worth about $600,000, plus some land. Calvin gets cash and a tract of land. Ellen gets Alan’s half of the partnership, plus some land. Within five weeks after Alan’s death, Ellen has signed Trustee Deeds conveying real estate to Bob, Calvin, Dana, and herself. She has transferred the Alan Bovine Co. stock to Dana. She’s assigned Dad’s interest in the partnership to herself, and she meets with Fred as his new partner. She’s given the cash to Calvin.
The children all agree: “We’re sure glad Dad had a living trust!”
This could really happen. So where is the danger?
Within a few more weeks, Ellen learns that Alan had $7,500 in outstanding medical bills to pay. She learns she must file his final, personal income tax return (he owed $42,000) and an income tax return for the trust for the five weeks she was winding everything up ($500 in taxes due). Then she learned about the $270,000 Illinois estate tax on Alan’s $5,000,000 estate. The total bills and taxes of $320,000 should have been paid from Alan’s trust assets before things were divided. Ellen will be personally liable if it isn’t paid.
The next family meeting doesn’t go so well. Collecting $80,000 from each of the children to pay the taxes and medical bills is uncomfortable. But the worst is yet to come.
The following year, Ellen agrees to sell Bob her share of the land. On her tax return she reports gain of $200/acre, since that is how much Bob paid in excess of the agreed value at Alan’s death. The IRS assesses a deficiency notice: Ellen must pay capital gain taxes on the full sale price, because she has not substantiated her basis. She cannot claim a “step up” because no federal estate tax return has been filed and no formal appraisal has been performed.
Could anything else go wrong?
Remember how Alan’s trust said each of the children was to receive a trust so it would be protected from divorce, lawsuits, and catastrophic illness? But Ellen didn’t transfer the land, stock, partnership, or money to any trust…she gave it directly to each child, and they accepted it that way. She didn’t seek professional advice, and none of the children knew the difference.
So, two years later, when Bob has an unfortunate accident resulting in injuries to other people, the lawsuit exceeds his liability insurance and takes his farm, including all of his inherited land. Had Ellen understood their dad’s plan, she would have been more careful to give Bob his land “in trust”…and had Bob understood it, he would have insisted that she do so!
When Dana is served with divorce papers, her land and Alan Bovine Co. could have been safe. But they aren’t, because Ellen didn’t transfer them to her in the right way.
When Calvin’s unhealthy lifestyle finally catches up with him, he will need long-term care. The inherited money has long since been spent, but he still has the inherited land. Had Ellen transferred it to him in trust, as Alan’s plan had directed, the land would have been protected to eventually be passed on to Calvin’s heirs. But it wasn’t. Instead, Calvin must sell it, pay heavy capital gain taxes, and spend the proceeds on the nursing home.
The moral of the story? When people use wills, the family is more or less forced by the probate process to get legal advice upon death. Then their attorney and the court process guide the family to follow the details of the plan. By contrast, since there are no court proceedings involved, when administering living trust a family may try the “do it yourself” approach and, like Alan’s family, unknowingly undermine key benefits of the plan.
Use living trusts? Yes. But make sure you get professional advice at every stage, including the complete administration of the trust upon death.