This is a common question and misbelief that many people have, and it is a question that I get asked often. A Revocable Living Trust (“RLT”) is an essential part of an estate plan that any property owner should have in place (before dying). The main purpose of this kind of trust is to manage your property if you are no longer able to and pass it to your chosen heirs (spouse, children, grandchildren, others …) without having to go to court (for a conservatorship while you are alive and unable to act, and probate after you die). Both of these court processes are long, costly, and painful.
An RLT, upon its execution, becomes an operational instrument AND a living document. More importantly, it does not terminate upon the Grantor’s passing (the person who created the trust). Thus, any asset titled under this kind of trust would be easily transferred to the mentioned beneficiary within the trust without needing to use our currently bogged-down court system to make such a transfer.
Estate and Gift Tax Exclusion
Before I go on further to explain why an RLT is not the ideal trust to avoid estate taxes, let me briefly mention our current estate and gift tax exclusion. The current estate and gift tax exclusion, as of the timing of this article, is $12.06 million per person (for a United States citizen) in 2022 – going to about $12.9 million in 2023. This exclusion, after inflation adjustments, will automatically be cut in half in 2026 unless Congress changes the rules.
Also, as you think about your current estate’s value and the potential that your estate will be subject to estate taxes (currently at a rate of 40%), you must keep in mind that your estate tax exposure is not based on your current net worth but rather the net value of your estate at the time of your (and maybe your spouse) passing.
In general, your net worth will double about every 14 years (with the expectation of a relatively modest rate of return of about 5%). For example, a man aged 58 in an affluent household with good medical care has a substantial likelihood of surviving more than 28 years. If his net worth at age 58 is about $10 million, by the time he reaches the age of 86 (28 years later), his net worth will be $40 million. And even if the current estate and gift tax exclusion remain at the current amount, his estate will be subject to over $11 million dollars in estate taxes.
When the IRS calculates the value of your estate at the time of your death, they will first look to see the value of the assets you had under your personal name. Asset in your RLT will also be included, as will most IRA and qualified plan assets. The value of your estate at the time of your death will be determined by valuing all of your property, real or personal, tangible or intangible, wherever it happens to be located. This is easy and straightforward (at least initially).
However, assets owned by a trust that you created before your death could only become part of your estate if the trust instrument provides certain powers and controls to you (the actual exercise of the power is not required). This is where using an RLT, for estate tax planning, will be less effective.
You may wonder what kind of powers I may be referring to. Well, let me give you a few examples: the power to receive income and or principal from the trust, the right to use and enjoy the trust assets, and the power to alter, amend, revoke, or terminate the trust (in part or entirely), to name a few.
If you are at all familiar with an RLT, all the powers mentioned above are powers that the Grantor of an RLT retains, which means that upon the Grantor’s passing, the assets held under the RLT will be included in his or her estate and would be subject to estate taxes (again and to reemphasize, there will be no estate taxes to pay if the Grantor’s estate is not above the-then exclusion amount).
In a joint RLT where each spouse is a Grantor, upon the passing of the first spouse, the deceased spouse’s share of the estate could be placed in an estate tax exclusion trust, commonly referred to as a Family Trust, Credit Shelter Trust, or B Trust. If the share for the surviving spouse from the deceased grantor is larger than the-then estate tax exemption, it can be funded to a trust for the surviving spouse, often referred to as a QTIP Trust. The other spouse’s share remains in an RLT for her, but the part that remains revocable, plus the Marital or QTIP Trust, will be included in the survivor’s share for estate tax purposes. However, since the implementation of this part of the RLT does not take place until the first spouse passes away, this will not be ideal for a family that has a net worth that is close to or above the estate tax exclusion.
If the person’s net worth is or is expected to grow before death to be close to or above the estate tax exclusion, then in most cases implementing advanced estate tax planning will produce a much more desirable result (which will be to completely eliminate or substantially reduce estate taxes at death). The trusts used in advanced estate tax planning are the types of trusts that exclude the aforementioned powers. I generally prefer to refer to them as “Estate Tax Protection Trusts.” Two of the most common structure of these types of trust are referred to as “Intentionally Defective Grantor Trust” (“IDGT”) and “Spousal Limited Lifetime Access Trust” (SLAT”).
Assets placed in a well-drafted IDGT or SLAT will be excluded from the Grantor’s estate and not subject to estate taxes when the Grantor or spouse passes away. An IDGT allows you to transfer assets into the trust by making a gift, a sale, or both without triggering any capital gain taxes for the assets that were sold to the trust. A SLAT is a trust created by one spouse for the benefit of the other. A trust could be drafted to qualify as both an IDGT and SLAT.
Keep in mind that these Estate Tax Protection Trusts are all irrevocable and have certain restrictions that must be followed. However, this does not mean that such trusts could not be drafted to allow you to keep your current lifestyle and certain in-direct control over the trust.
For example, you can have the power to borrow money from the trust, swap trust assets, sell assets to the trust for a promissory note, and change Trustees. Also, the Trust Protector of the trust could be given the power to add you as the trust’s beneficiary, remove a beneficiary, change the governing laws of the trust, and terminate the trust.
In conclusion, an RLT is not the optimal estate planning tool to be used for estate tax planning.
However, I do not want to leave you with the impression that these RLTs are not an essential part of an individual’s estate plan. Most of us need an RLT, whether or not we have a taxable estate. In larger estates, we use an RLT and one or more Estate Tax Protection Trusts. A well-drafted and fully funded RLT can avoid probate, provide incapacity planning, transfer assets to our beneficiaries in such a way that the assets will not be subject to estate taxes at their passing, and provide a great deal of asset protection for them, so future creditors and predators (ex-spouses) will not receive what you worked so hard to build.
The Time for Planning is Now
If you think your net worth could grow before you pass much above $7.5 million as an individual or $15 million as a couple, PLEASE spend some time with an experienced estate planner as soon as possible to evaluate what you can do to protect your wealth from substantial death tax exposure. And remember that good drafting can help you pass property in ways that protect from further taxes when one generation passes away while still giving that generation the ability to use, manage and spend from such property during the older generation’s life.
Don’t let procrastination allow changes in the law to steal decades of sacrifice and hard work from your family. It takes time to plan these strategies well in the context of your family situation. It takes even more time to implement them in the best way.
I know from experience that owners of income properties care about planning for the future.
Most of you have sacrificed for decades to build wealth, most of which you do not plan to spend but which you want used to benefit your heirs. You probably did not build this wealth just to see much of it taken in unnecessary taxes when you, your spouse, or your other heirs die.
I offer CONSULTATIONS FOR AOA MEMBERS in appropriate cases. If you do not do a conference with me, please find an estate planner familiar with a range of advanced strategies and well-versed in issues relevant to the owners of income properties.
Ali Talai, J.D., LL.M. (Taxation with a Certificate in Estate Planning), focuses on integrated estate planning for apartment owners to save income, property, gift, and estate taxes. He also provides trust and probate administration assistance after the death of a loved one. For more information, call (818) 285-2850, email [email protected] or visit www.TalaiLaw.com.
Note: This article is general in nature and not intended as advice for clients. This article may be considered attorney advertising. Please get advice from counsel you retain for your own planning. Drafted in December 2022.