This guide is intended to define certain terminology and explain structural concepts within an estate plan that may pop up during your own research or when talking with your estate planning attorney.
Probate and Last Will and Testament
It is a common misconception of many clients that drafting a Last Will and Testament (“Will”) will allow their estate to avoid Probate. In fact, when clients draft an estate plan centered around distribution of property through their Wills, a probate is required – as all Wills are admitted to Probate post death, and any assets of a person’s estate that passes through a Will are subject to the probate court jurisdiction.
Therefore, in order to administer a Will and make distributions to your beneficiaries, a Will must be admitted to Probate. Probate is the court driven process by which Wills are administered. One of the most common misconceptions we see is the presumption that having a Will avoids Probate. In fact, having a Will guarantees that a Probate will occur. A brief summary of the Probate process is: (1) your Will is admitted to court and notice is given to all interested parties; (2) a Probate judge appoints and authorizes the personal representative (also known as the executor) nominated in your will; (3) your assets are inventoried with the court; (4) a public notice is published to all potential creditors; (5) the remaining assets are then reconciled with the court; (6) a final accounting is filed with the court; and then (6) assets are distributed to your beneficiaries. This process takes somewhere between 9 and 18 months, depending on cooperation of your family members, creditor claims, the efficiency of the court, and whether there are any challenges to your Will. The process can become expensive due to court fees, attorney’s fees, asset transfer fees, and many hours devoted to completing the Probate. On average, Probate costs range between 3% and 6% of the Probate estate’s value.
Many clients do not like the public nature, burdensome court process, time investment, or cost associated with Probate (a court governed, public process). Often, they feel this is an unnecessary burden on their loved ones to have to administer their estate. Some do not like how their beneficiaries and assets passing through that process can be found simply by search Wisconsin’s CCAP website.
In an effort to avoid probate and simplify administration of their estate, many of our clients choose to create a Living Trust instead of a Will.
The Living Trust is an estate planning tool that, among other benefits, can eliminate the requirement of a Probate for your estate and consolidate the administration of your estate and distribution to your beneficiaries. A Living Trust also typically allows for a more efficient administration of your estate post death and can provide for any inheritance received by your beneficiaries to be protected from potential creditors or divorcing spouses in the future. This strategy involves creating the trust now and coordinating assets with this trust to allow the entire estate to avoid probate (see the discussion of Funding in Section I). This strategy also allows for additional flexible options in designating beneficiaries and how they are to receive any inheritance.
The Living Trust and its potential use in an estate plan is further referenced throughout this addendum and discussed in more depth in the Recommendations Section and in the supplementary documentation provided.
The Survivor’s Trust is for the sole benefit of the surviving spouse of a married couple, and the surviving spouse serves as the Trustee of the Survivor’s Trust, meaning he or she has full control and access to all assets. This does allow for maximum flexibility, control, and ease of administration for the surviving spouse. However, notably, this also means that the surviving spouse can completely revoke, amend, or otherwise alter the distribution provisions of the Survivor’s Trust to disinherit a child, provide for a new spouse, or make other changes. Depending on your asset structure, family structure, and planning goals, this may or may not match your intentions. This is an aspect of the plan that could be discussed further if you thought you wanted to change this distribution in any way, or simply wanted to weigh the pros and cons of various options.
The Family Trust, if used in an estate plan, is irrevocable upon funding at the first spouse’s death, meaning that the ultimate beneficiaries at the date of death of the second spouse cannot be changed by the surviving spouse. The surviving spouse cannot change the terms of the Family Trust, and has limited access to income and principal, at the discretion of the Trustee of the Family Trust. This means that to access principal or income from the Family Trust, the surviving spouse must gain permission from the Trustee. If a third party (non-spouse) is named as the Trustee or Co-Trustee, this typically indicates some desire for restriction on the surviving spouse or protection against disinheriting the children. This structure is common when there is a concern about the surviving spouse remarrying and leaving assets to a new spouse, or otherwise disinheriting the children.
By contrast, if the surviving spouse is the sole Trustee, there really isn’t any real restriction, since they have full control and access as Trustee and beneficiary. This indicates the structure was likely created initially for estate tax planning purposes only, which may no longer be relevant in today’s tax environment. In 2022 the amount an individual is able to pass estate tax free is $12.06 Million, per person, and is portable between spouses – meaning that a married couple can exempt $24.12 million in assets without paying any estate tax. These exemption amounts are set to sunset on 12/31/2025, with the estate tax exemption being reset to $5M per person (indexed for inflation) on 1/1/2026. The past two years there have been talks of lowering the exemptions further, but nothing took shape. This is something we have been keeping our eye on here.
The appropriateness of such elements of a plan depends largely on a client’s goals, asset structure and size, and family structure, and can often be better determined through a review of the assets and a conversation regarding goals and objectives. While the Family Trust structure maximizes the amount that can be passed on exempt from estate tax, it is not the ideal structure relative to another tax – capital gains tax. Capital gains tax is the tax levied on the appreciation in property from the original cost basis paid to acquire the property. If a client paid $100,000 (their cost basis) for a piece of property and later sold it for $300,000, they would have $200,000 of taxable gain. When a client passes away, all assets in their estate get a “step-up” in cost basis to the date of death value, meaning if instead of selling the property referenced above during lifetime, the client passed it on at death, the cost basis the beneficiaries would have in the property would be $300,000. Therefore, when the property is sold immediately after death, there would be no taxable gain. The problem created by the Family Trust structure is that property allocated to the Family Trust would receive a cost basis adjustment at the first death only, and not when the second spouse passed away. If there was a significant period of time or significant appreciation in assets between the first and second spouse’s deaths, this could incur taxes that could have been avoided. By contrast, any assets of the Survivor’s Share would receive a step-up in cost basis at both the first death and the second death. Therefore, if there aren’t other reasons motivating the Family Trust structure, it may not actually be the ideal tax vehicle in your planning. That said, if your estate is likely to incur estate taxes, then the Family Trust structure is still preferred as the potential estate tax rate (up to 40%) is much more significant than the capital gains tax rate (up to 23.8%). Tax legislation is always subject to change, and if our government hemorrhages from the spending during 2020-2022, so too may our analysis above.
Due to the factors highlighted above, we would recommend any client with a Family Trust structure at least review the pros and cons to such a structure to determine whether it is the best vehicle and structure for their estate plan. Your family, goals, assets, and the law may have changed enough since your documents were executed that there would be reasons for a change to this structure.
The Marital Trust, if used in an estate plan, is irrevocable upon funding at the first spouse’s death, meaning that the ultimate beneficiaries at the date of death of the second spouse cannot be changed by the surviving spouse. The surviving spouse cannot change the terms of the Marital Trust, and typically receives all income and has discretionary access to the principal at the discretion of the Trustee. This means that to access principal from the Marital Trust, the surviving spouse must gain permission from the Trustee. If a third party (non-spouse) is named as the Trustee or Co-Trustee, this typically indicates some desire for restriction on the surviving spouse or protection against disinheriting the children. This structure is common when there is a concern about the surviving spouse remarrying and leaving assets to a new spouse, or otherwise disinheriting the children, or where one spouse has significantly more property than the other spouse. The benefit of the Marital Trust (or QTIP Trust) is that you can leverage the unlimited marital exemption for estate tax purposes, but still create restrictions or protections on the assets funded here for the surviving spouse.
Some estate plans distribute certain dollar amounts or specific property to a beneficiary “off the top”, prior to the residuary distributions – these are called Specific Distributions. This may be a specific dollar amount to a charitable beneficiary or to a family member with financial need (i.e. a parent, sibling, cousin, nephew, etc.), or it may be a gift of a particular asset (i.e. cabin, vehicle, etc.) to a child or other individual. Specific Distributions should always be reviewed within the context of an overall estate plan, to make sure they are still relevant and to make sure they are sensitive to the size of the current estate.
After the death of the second spouse, the remaining trust property is distributed to your children, in equal shares, and each child’s share is held in a trust for his or her benefit, managed by the Trustee you have named, until the age stated in the document. This means that prior to that age, the child must request distributions from the Trustee, who has the discretion to approve or deny any requested distribution. Your trust may have specific guidelines outlining what purposes distributions should be approved for, including purposes such as education, medical, housing, travel, wedding, family related, or other specific uses that are meaningful to you. Even when there are particular guidelines, the Trustee still typically has discretion to approve additional distributions if he or she determines it is appropriate. As discussed further below relative to the selection of a Trustee, you should consider what the relationship might be like for the Trustee and your children if it is a friend or family member, and make sure the person you have selected will be comfortable with this dynamic – one of the benefits of a corporate or professional Trustee is that they don’t sit at the Thanksgiving table with your children, so any frustration with a Trustee does not come between family members.
Once a child reaches the age stated in the trust document, the Trustee is typically directed to distribute the remaining trust property to the child, outright and free of trust. While many clients initially believe this matches their goals, there may be good reasons to allow the property to stay in trust at that age and simply allow for the child to take over as the Trustee of his or her separate trust. The potential benefits of continuing to hold the inherited property in trust, from a restriction and/or protection perspective, are discussed in more detail in Section H below.
Step-Distributions versus Withdrawal Rights
Many older estate planning documents create “step-distribution” trusts, meaning that the Trustee is required to pay out certain amounts at certain ages, typically including a final age at which all remaining inherited assets are distributed outright to the child or other beneficiary.
At age 25, one-third of his or her share is distributed to them outright.
At age 30, one-half of his or her share is distributed to them outright.
At age 35, the balance of the trust property is distributed to them outright.
Because these distributions are mandatory and are made outright to the beneficiary, they must be paid or distributed immediately upon the child reaching the stated age. This means that regardless of what is happening in the child’s life at that time (i.e. divorce, bankruptcy, creditor problems, lawsuit, substance abuse, etc.) the distributions will be made and will be immediately subject to any of these liabilities.
In general, if a step-distribution strategy is desired, we would advise clients to use a withdrawal right strategy rather than a mandatory distribution, giving the child the option to take the funds out but not requiring it. This way, if it is not an ideal time to receive the distribution or the child simply wants to delay the distribution, they can. In addition, adding language to give the Trustee the ability to withhold the distribution if the child is incapacitated or otherwise subject to an immediate liability referenced above can provide additional flexibility. In addition to not being mandatory distributions, the child is given maximum flexibility to determine the best timing to exercise the withdrawal rights, once they have attained the requisite ages. The withdrawal rights are typically cumulative, and can be exercised at the date they are earned, or at any point thereafter.
Inheritance Protection and/or Restriction
Many of our clients that have sought to protect their children’s’ inheritance from creditors and divorce, have opted to create separate Asset Protected Beneficiary Trusts for each child to ensure the protection of any inheritance distributed. They have the ability to be sole trustees of their own trust at a predetermined age, and you decide now what the inheritance may be used for – whether you decide that they may use the assets for anything, for health, education, maintenance or support, or as a back-up to their normal standard of living, or as otherwise directed. You can give them the choice whether to keep the assets in trust to receive the protection, or allow them to withdraw the assets for a down payment on a house, help with their own children’s education, or whatever else you choose or direct. The inheritance protection structure is an option that we could discuss further at an initial consultation.
In addition, some beneficiaries require specialized planning if it is possible that they will not be able to manage their own inheritance at their current age – or in some cases, at any age. This may be due to age, financial maturity, substance abuse, or special needs that impact their ability to effectively or safely manage money. If this is the case, additional planning options exist that would continue to use trust-based concepts to oversee the management of the property for the beneficiary to a later age, or indefinitely. If the beneficiary has special needs that qualify him or her for government benefits, additional protections may need to be drafted in to create a Special Needs Trust to ensure they can benefit from their inheritance and not lose access to important government benefits. Depending on the nature of the need for any beneficiary, customized options exist to ensure the inherited property is used wisely.
Funding the Trust
One of the primary reasons that a client may choose to use a Living Trust is to ensure their estate avoid the requirement of Probate at death. The trust is used in the place of a Last Will and Testament and can thereby eliminate the need for your family to have to administer your estate through the probate court. For your reference, Probate is discussed in more detail in the next section.
However, a trust does not automatically avoid Probate. In order for a trust to avoid Probate, all of the clients’ assets must be coordinated with, or “funded” into, the trust. For many assets, such as real estate, bank accounts, and investment accounts, this is done by retitling the assets from your individual names into the name of the trust. For other assets, such as life insurance and retirement accounts, this is done by naming the trust as a beneficiary on the account. In either case, if any asset is not funded into the trust appropriately, it will not be governed by the trust at your death and therefore could subject your estate to Probate. In a comprehensive trust based estate plan, there would be a Pour-Over Will that would direct the assets back into the trust – but it would require a Probate to accomplish this, which emphasizes the importance of properly coordinating your assets with the Living Trust.
For any client that has an existing Living Trust (or is considering creating a Living Trust), we recommend a periodic review to ensure that all assets are appropriately titled in the name of the trust or beneficiary designated to the trust. If there are assets that are not appropriately coordinated, this should be corrected immediately.
The role of the Trustee is to administer your estate after your death and follow the instructions contained within your trust. Further, the Trustee would manage any Children’s Trusts for any child under a specified age, and approve or deny distributions to your children until that age. Any time that a trust is reviewed, it is recommended to review the Trustee nominations to ensure that they continue to match your intentions and goals. If a change is desired, clients can consider many different options for their successor Trustee, including siblings, children, other family members, friends, corporate trust departments (i.e. bank or financial institution), or professional trustees (i.e. CPA, financial advisor, of attorney).
Trustee selection is an incredibly important aspect of the overall estate plan, as the Trustee has significant power and responsibility. They are a fiduciary to the trust or estate, and to each of the beneficiaries, and must act in the best interest of all interested parties, which can be a challenge in and of itself. In addition to handling distributions to beneficiaries, the Trustee will be responsible for prudently investing the trust property and making decisions about what assets to keep, sell, or consolidate. Often, they are charged with balancing the risk versus rewards of decisions relating to disposition of specific assets, investment decisions, fairly dividing tangible personal property, responding to desires (sometimes competing desires) of various beneficiaries, and interpreting the language of the trust document. If you do not feel that you have a family member or friend in your life who would be capable of filling this role (or if you don’t want to burden anyone with this role), you may want to consider a professional trustee (CPA, attorney, etc.) or a corporate trustee. If you do select a friend or family member, it is important that your intent and the language of the trust is clear, so as to avoid ambiguity that could create liability for the Trustee.
Additional Ancillary Documents
Below is a brief summary of the additional ancillary documents that typically make up a comprehensive estate plan: General Durable Powers of Attorney for finances and property, Powers of Attorney for Health Care, and Livings Wills. If you have these documents, they should be reviewed to ensure they are up to date based upon current law, as well as to ensure they nominate the appropriate individuals. If you do not have any of these documents, they should be added to your estate plan.
*Durable Powers of Attorney to provide for the ability of a named agent to manage your financial and other day-to-day affairs on your behalf during an incapacity.
*Health Care Powers of Attorney to provide for the ability of a named agent to make health care decisions on your behalf. The document also provides guidance to your named agent regarding your health care wishes and instructions.
*Living Wills to clearly state your wishes regarding end of life decision making to your physicians and other care providers.
*HIPAA Authorization to specifically authorize certain family members and loved ones to communicate with your doctors during your incapacity. These documents are based upon our HIPAA privacy laws, which were passed in 2003. It is important to ensure access to information, and open communication, so I would recommend drafting this document.