Five Essential Trusts and the Tax Traps You Didn’t See Coming

Why Timing and Structure Matter — Especially in Pennsylvania

You can use trusts to cement your legacy, organize your estate and limit your exposure to estate and gift taxes.

When most people think of estate planning, they focus on avoiding probate or ensuring their children “get everything.” But a more strategic approach asks: How can I protect my family, minimize taxes, and preserve control long after I’m gone? Trusts are often the answer — but which one, and when?

Let’s explore five essential trusts, when to use them, and the lesser-known tax and drafting issues — especially relevant for Pennsylvania residents, where inheritance tax rules differ from federal law.

Trust #1: Qualified Terminable Interest Property (QTIP) Trust

Best for: Blended Families and Second Marriages with Legacy Protection Concerns

A QTIP Trust is often the instrument of choice when you wish to provide income for a surviving spouse without relinquishing control over the ultimate distribution of your estate. It allows the grantor to allocate income to the surviving spouse for life, while preserving the principal for children or other designated beneficiaries.

This structure qualifies for the unlimited marital deduction, deferring federal estate tax until the death of the surviving spouse. Upon the spouse’s passing, the trust's remaining assets are included in their estate and become subject to federal estate tax (if applicable), even though the spouse had no control over the trust principal.

Hidden Issue – Pennsylvania Tax Exposure:

Unlike federal law, Pennsylvania imposes inheritance tax on QTIP assets at the surviving spouse’s death, even though they never owned the principal. If your children are remainder beneficiaries, they will owe 4.5% on their inheritance, potentially leading to unanticipated liquidity demands.

Sample Language:

“The Trustee shall pay all income from the trust, in quarterly or more frequent intervals, to my spouse, [Name], for her lifetime. Upon her death, the remaining trust assets shall be distributed to my children in equal shares, per stirpes.
This trust is intended to qualify under IRC §2056(b)(7), and my Executor shall make the necessary QTIP election on the federal estate tax return. The Trustee shall maintain separate records of principal and income consistent with QTIP requirements.”

Trust #2: Special Needs Trust (SNT)

Best for: Children or Beneficiaries with Disabilities Who Rely on Government Assistance

A Special Needs Trust (SNT), also known as a Supplemental Needs Trust, allows families to provide for a disabled loved one without compromising eligibility for means-tested benefits such as SSI, Medicaid, or waiver programs.

A third-party SNT — funded with assets that do not belong to the disabled individual — enables trustees to pay for life-enhancing services and supports that public assistance does not cover, such as therapies, education, specialized equipment, and certain travel or home improvements.

Hidden Issue – Disqualifying Distributions and PA Tax Impact:

If the SNT is improperly drafted — or if the trustee distributes funds directly to the beneficiary — it may jeopardize eligibility for essential government benefits. Additionally, in Pennsylvania, while SNT assets avoid probate, they are not exempt from inheritance tax unless the beneficiary is a minor child or certain other exceptions apply.

Proper trust administration and accurate characterization of disbursements (e.g., payments to providers, not to the individual) are essential.

Sample Language:

“The Trustee shall make no distributions directly to [Name], but shall pay for services and goods that directly benefit the beneficiary, including educational programs, adaptive technology, therapy, housing modifications, and recreation.
This trust is intended to be a third-party special needs trust that preserves the beneficiary’s eligibility for public benefits. The Trustee shall consult with counsel or a public benefits advisor as necessary.”

Trust #3: Spendthrift Trust

Best for: Heirs with Creditor Exposure, Addictions, or Financial Immaturity

A Spendthrift Trust is an excellent tool when a beneficiary may lack the maturity or capacity to manage a significant inheritance. Whether the concern is substance abuse, compulsive spending, gambling, or exposure to lawsuits or creditors, this trust allows you to restrict direct access to assets while still providing for the beneficiary’s needs.

The trustee maintains sole discretion over distributions, which can be made pursuant to a “health, education, maintenance, and support” (HEMS) standard or broader discretionary guidelines.

Hidden Issue – Risk of Losing Spendthrift Protections:

To be effective under Pennsylvania law, the trust must expressly prohibit voluntary or involuntary alienation of interests. If the trust permits the beneficiary to compel distributions or gives them excessive control over income, it may fail to shield assets from creditors.

Moreover, while the trust can protect principal, PA inheritance tax still applies to distributions at the time of the grantor’s death (typically 4.5% for children, 15% for unrelated parties).

Sample Language:

“This trust is intended to constitute a spendthrift trust under Pennsylvania law. No interest of any beneficiary shall be assignable or subject to the claims of creditors, and no beneficiary shall have any right to compel distributions. All distributions shall be made solely in the discretion of the Trustee and may be made directly to providers for the benefit of the beneficiary.
The Trustee is authorized to provide for [Name]'s health, education, support, and maintenance, considering their lifestyle and reasonable needs.”

Trust #4: Irrevocable Life Insurance Trust (ILIT)

Best for: Reducing Estate Tax Liability and Protecting Liquidity for Heirs

An ILIT is designed to own life insurance policies outside your taxable estate. By transferring ownership of a policy — or by having the trust purchase the policy directly — the death benefit will not be included in your estate for federal estate tax purposes, assuming all requirements are satisfied.

This structure is especially effective for high-net-worth individuals whose estates may exceed the federal exemption threshold, as well as for clients seeking to create immediate liquidity for estate settlement costs or generational wealth transfers.

Hidden Issue – Three-Year Rule and Pennsylvania Exposure:

If an existing policy is transferred into an ILIT and the grantor dies within three years, it will be pulled back into the estate under IRC §2035. A better approach is to fund the trust and have it purchase the policy directly.

In Pennsylvania, even though life insurance proceeds are not subject to income tax, they may become subject to inheritance tax if payable to the decedent’s estate or to a revocable trust. An ILIT structured correctly — with named beneficiaries — can help avoid this.

Sample Language:

“The Trustee shall use annual contributions from the Grantor to pay premiums on one or more life insurance policies on the Grantor’s life. Upon the Grantor’s death, the Trustee shall collect the death benefit and administer the trust in accordance with the beneficiaries’ best interests.
No portion of the trust assets shall revert to the Grantor or the Grantor’s estate. This trust is irrevocable and is intended to remove all incidents of ownership over the life insurance policies.”

Trust #5: Charitable Lead Trust (CLT) and Charitable Remainder Trust (CRT)

Best for: High-Net-Worth Donors Seeking to Combine Legacy and Philanthropy

Charitable trusts enable you to make a meaningful philanthropic impact while securing income, tax benefits, and family wealth transfer. There are two primary variants:

• A Charitable Lead Trust (CLT) pays an annual amount to one or more charities for a term of years or for life. At the end of the term, the remainder passes to non-charitable beneficiaries, often heirs.
• A Charitable Remainder Trust (CRT) provides income to a non-charitable beneficiary (e.g., you or a spouse) during life, with the remainder passing to charity at death.

Both structures offer significant income tax deductions, potential capital gains deferral, and, in the case of CLTs, effective wealth transfer strategies that leverage the compressed present value of remainder interests.

Hidden Issue – IRS Scrutiny and PA Inheritance Tax:

The IRS imposes strict rules on valuation, annual payments, and irrevocability. Noncompliance may disqualify the trust from favorable tax treatment. In Pennsylvania, the remainder interest distributed to heirs under a CLT is subject to inheritance tax, just like any other transfer at death.

To maximize tax efficiency and avoid scrutiny, charitable trusts must be carefully structured, appraised accurately, and administered with discipline.

Sample Language (CRUT Example):

“The Trustee shall pay to [Donor or Designated Beneficiary] during his/her lifetime, in quarterly installments, an amount equal to five percent (5%) of the net fair market value of the trust’s assets, valued annually. Upon the death of the income beneficiary, the remaining principal shall be distributed to [Named Charity].
This trust is intended to qualify as a charitable remainder unitrust under IRC §664 and shall be administered in accordance with all applicable federal regulations.”

Bonus Insight: The Pennsylvania Inheritance Tax Trap

Unlike the federal government, Pennsylvania imposes an inheritance taxon nearly all asset transfers at death, including certain trust distributions, based on the recipient:

• 0%: Spouse or charity
• 4.5%: Lineal heirs (children, grandchildren)
• 12%: Siblings
• 15%: Others (including friends or unrelated individuals)

Assets titled in revocable trusts are subject to PA inheritance tax, just like those in your personal name. Irrevocable trusts may avoid tax if funded properly and more than one year before death.

Final Thoughts: Why Trusts Are Worth the Investment

Yes, trusts require planning, legal fees, and careful administration. But they offer enormous value:

• Avoid probate
• Protect heirs from creditors and themselves
• Control distribution timing
• Reduce (or defer) estate and gift taxes
• Preserve eligibility for public benefits
• Enable charitable giving on your terms

The key is not just what trust you choose, but how and when it’s created. If you live in Pennsylvania or own property here, the state inheritance tax must be factored into every trust strategy.

Need help deciding which trust structure best suits your family, your goals, and your tax reality? Contact RJ Fichera Law Firm has helped hundreds of clients throughout Pennsylvania and beyond design estate plans that work. Let’s build yours with intention, clarity, and confidence.

This article was first published by Kiplinger Magazine, and brought to you by the RJ Fichera Law Firm, with personal comments by RJ Fichera throughout the article. Our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!

Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.

Protect your rights with trusted legal expertise – visit the RJ Fichera Law Firm today to consult with a dedicated attorney committed to your best outcome.