What a Beneficiary Controlled Trust Can Do to Protect Your Legacy After You Are Gone

Posted on September 10th, 2023

Life is messy sometimes. Divorce, bankruptcies, and lawsuits happen, and they can potentially wipe out the inheritance you've carefully set aside for your loved ones. But there are many trust options to help keep life from ruining your legacy.

Many estate planners believe that their job is done when the beneficiaries avoid probate and receive their inheritance. However, when beneficiaries receive their inheritance in their name outright, that needlessly exposes the legacy you leave to the claims of creditors, lawsuits, divorce, the loss of governmental benefits they might otherwise receive, and even a second estate tax when they die. "Outright" distributions from the trust to the beneficiary in his or her name should rarely occur for large or even relatively modest estates.

A better approach is for each beneficiary's inheritance to go into his or her own beneficiary-controlled trust. If properly drafted and funded, the beneficiary can control, use, and enjoy the inheritance with fewer risks than outright ownership. A beneficiary-controlled trust will help protect your loved ones from the bad things in life that may occur without their fault. For example, divorce, lawsuits, creditor claims, bankruptcy, or even estate tax upon their death Sadly, bad things happen to good people. On the other hand, a spendthrift trust is traditionally intended to be used for beneficiaries who are not trusted to make good financial decisions. A spendthrift trust is similar to a spigot on a hose. The trustee, in his or her discretion, can open the spigot to permit spending or close the spigot to restrict or prevent spending by the beneficiary.

Asset Protection With Plenty of Control

A beneficiary-controlled trust refers to a trust where the beneficiary may also be the controlling trustee. The beneficiary can have virtually the same control as he or she would have with outright ownership. For example, the beneficiary, as the controlling trustee, could make all investment decisions. Investments such as a home or brokerage account would be held in the name of the trust and would be better protected from lawsuits, divorce, creditors, or predators.

An HEMS Trust: Estate Tax Protection Comes With Vulnerability

If the primary beneficiary wants to act as the sole trustee with control over investments and administration, distributions can be limited to the beneficiary's health, education, maintenance, and support (“HEMS”) to avoid estate tax (the “HEMS Trust”). This structure is designated by the Grantor (or trust creator) in the trust instrument or document created. However, some states permit certain creditors, such as a divorcing spouse or health care providers, to pierce through the trust and access assets up to the HEMS standard.

If they obtain a judgment against the beneficiary, the price to be paid for the beneficiary's additional control is potentially weaker creditor protection. A better approach, from a creditor protection standpoint, may be to empower the trustee to make discretionary distributions not tied to any specific standard.

Going With an Independent Trustee Instead

If the primary beneficiary of a beneficiary-controlled trust seeks even greater asset protection, they can appoint an independent trustee who acts as the distribution trustee. The independent trustee is authorized to make distributions to the beneficiary in such amounts and at such times as may be determined in the sole discretion of that Independent Distribution Trustee (the "Discretionary Trust"). The Discretionary Trust generally provides greater asset protection, irrespective of the beneficiary's state of residence.

Considering what happened to Brittney Spears, the beneficiary may be concerned about giving such discretion to the Independent Distribution Trustee. This issue can be minimized by providing the primary beneficiary with the right to remove and replace the Independent Distribution Trustee. While the beneficiary does not have direct control over distributions, the beneficiary can select who does, so long as the person selected is not a related party or subordinate person.

2 Ways to Deal With the Tax Consequences of Trusts

Careful consideration must also be given to the trust income tax rules. The highest marginal federal income tax rate for ordinary investment income is now 37%. In 2021, the highest federal income tax rates will be triggered with income for a single individual of $523,601 or more. For married taxpayers, the highest federal income tax rates are triggered with income of $628,301 or more. The highest marginal tax rate for a trust is also 37% in 2021, but it is triggered with income of only $13,050. The difference in tax liability can be substantial.

To help deal with that tax issue, the beneficiary-controlled trust can be drafted in some cases to be a "Grantor Trust." A Grantor Trust is a trust that is "disregarded" for income tax purposes. Income is taxed to the beneficiary without regard to whether the income is distributed to the beneficiary. A Grantor Trust will avoid applying the higher tax rates to a trust.

Alternatively, the beneficiary-controlled trust can be drafted as a "Complex Trust" for income tax purposes. The Complex Trust files a separate tax return. Income actually distributed to the beneficiary is taxed at the beneficiary's lower individual tax rates. Only income not distributed by the Trust will be taxed at the higher trust income tax rates.

There is no single best approach, and careful analysis of the client's goals, concerns, and situation should always be conducted. In some circumstances, the trust may have the ability to toggle, or switch, between a Grantor Trust and a Complex Trust.

As a general rule, a client with a substantial estate should always consider the protective features of a beneficiary-controlled trust. If you have any questions about this topic, contact our firm.

This article was provided by John M. Goralka, originally published in Kiplinger's Personal Finance Magazine, and brought to you by the RJ Fichera Law Firm, where 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!

This is not tax advice and should not be construed as such. Please seek professional tax services for more information and advice that will apply to your specific tax situation.

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