Trusts serve to transfer assets from one person to another with certain special benefits and privileges that might not otherwise be available. For example, outright gifting property to a loved one would incur a massive tax on their part and severely cut into your own gift tax exemptions. In addition, transferring a home to a loved one after death via a will would require that the property goes through probate and may open your estate to federal estate taxes depending on the value of the property and the combined value of the rest of your assets.
On the other hand, trusts are very flexible estate planning documents designed and written to bypass these issues effectively. For example, through a trust, a person can select a property to pass to a loved one without incurring estate taxes by transferring the property into an irrevocable trust before death and thereby wholly separating it from themselves and their name. Another way of reducing or eliminating the impact of estate taxes on the bequeathment process is through a trust that allows couples to combine their estate tax exemption limit.
The current estate tax exemption limit as of 2021 is $11.7 million – when combined through a marital trust, a married couple has access to a combined exemption limit of $23.4 million. This will continue to be adjusted for inflation every year until legislation changes the base estate tax exemption limit (it was only $1 million per individual in 2003, for example, with a much steeper tax rate).
This means that, through a marital trust, a person can fold their total lifetime exemption limit into their surviving spouse’s exemption limit while passing assets to their spouse tax-free. Thus, marital trust is part of a two-step process by which married couples can transfer wealth tax-free between themselves and their descendants. To understand how a marital trust works, we need to go over the basics of setting up a trust.
Basic Anatomy of a Trust
A trust has three key human elements:
- The grantor, or trustor.
- The trustee.
- The beneficiary.
Every trust is defined and outlined by a trust document but exists as its own legal entity. For example, when funding assets into a trust, the assets must be transferred to the trust’s name. In this sense, the trust itself becomes the owner of the received asset. Funding a trust is one of the fundamental steps of implementing it. It usually isn’t enough to draft up and notarize a trust document – you need to amend the documents of each asset and property associated with the trust to reflect their new status.
There are circumstances under which a trustee and an estate planning attorney can argue that a trust document is enough intent to transfer assets into a trust even after death (to avoid probate). Still, it’s always safer to avoid the hassle of having to prove this by taking the necessary steps needed to fund the trust properly. Trusts can be either revocable or irrevocable. The major difference between these two categories is the level of separation between the trust and the trustor:
- Revocable trusts can be more easily amended. However, as the name implies, they can also more easily be revoked. Assets within a revocable trust belong to the trust but are still functionally under the control and ownership of the grantor (until their death).
- Irrevocable trusts are a much more permanent separation of the trust and grantor. Assets placed within the trust are, for all intents and purposes, sealed away from the grantor. A grantor has limited control over these assets and properties. Most control passes to the trustee (until the terms of the trust are met and the assets transfer to the beneficiaries). This is part of the reason why irrevocable trusts are used to protect certain assets from creditors and separate assets from the grantor’s estate (to reduce the value of the estate for tax purposes).
Trusts Are Versatile
For example, a blind trust is set up to avoid conflicts of interest in political positions of power, or when transitioning into the non-profit sector, by transferring control over the trust to a trustee and ensuring that the grantor has no control or knowledge over how their assets are traded and invested. The trustee has a fiduciary duty to the grantor but cannot consult them on how their trust is doing.
On the other hand, a spendthrift trust allows the grantor to utilize the services of a trustee to manage and invest their child’s inheritance for them until certain conditions are met or until the trust is fully distributed over a period of time multiple years. Finally, marital trusts are set up to provide the surviving spouse with a much larger estate tax exemption and help them set up their estate plan to maximize the transfer of wealth to the next generation.
Why Set Up a Marital Trust?
A marital trust involves transferring selected assets and property to a surviving spouse without levying estate taxes on the decedent’s estate or the trust. As a result, the surviving spouse can benefit both from the principal of the trust (i.e., its contents) and its income (generated through capital gains, rent income on certain properties, investments made by the trustee, and so on). Thus, marital trusts are designed to provide assets and income to the surviving spouse.
Still, the trust’s goal is to pass on to the next generation while providing income to the surviving spouse and minimizing the tax impact of death and wealth transfer. In addition, the surviving spouse inherits powers of appointment to pick and choose another trustee and can benefit from a portion of the principal should a special need arise (although the first spouse can set a limit on how much of the principal can be withdrawn). Thus, a marital trust must be set up carefully to work.
Without careful consideration, many assets can pass immediately to a surviving spouse rather than into a trust, bypassing some of the benefits of setting up a marital trust in the first place. If you are interested in setting up an AB trust, marital trust, or QTIP trust to carefully manage how your assets will be transferred upon death – especially as our estate tax exemptions are slated to drastically decrease after 2025 – be sure to discuss these options with an estate planning professional before anything else.