The other day I met with a husband and wife and their adult son to discuss the parents' estate plan. We discussed tax planning, avoiding probate and steps to provide for financial management if either or both spouses become incapacitated.
Then I told the son that he and his sister have a choice. When they inherit from their parents they can either have everything distributed outright to them or have it remain in trust for their benefit. We call these "family protection trusts." As I explained to the son, family protection trusts provide the following benefits:
- Bankruptcy protection. If either the son or the daughter were to run into financial difficulties they could declare bankruptcy and still have the family protection trust funds available to them. Their creditors would have no claim against the family protection trusts.
- Divorce protection. Family protection trust funds are more protected in the event of a divorce than funds in the son or daughter's own names. Whether that protection is absolute depends on state law and how the trust funds are used.
- Protection from lawsuit. If either the son or the daughter were to be sued, the funds in the family protection trust would be protected from any claims.
- Keeps assets in the family (upon death of child). When the son or daughter dies, the funds in their family protection trusts would stay in the family for the benefit of their children. This would be important if the surviving spouse were to remarry.
- Provides for management of assets (for children who might need assistance). Some children are better financial managers than others and a family protection trust can be used to make sure whatever is left to the children is well managed for their benefit.
- Public benefits. While a family protection trust is not the same as a special needs trust, it can be written so that the funds do not have to be spent down in the event the child becomes disabled and needs to apply for public benefits. This can even be the case even when the child becomes elderly herself and needs to apply for MassHealth to cover long-term care costs.
- Avoids double taxation. The funds in the family protection trust will not be included in the taxable estate of the child. While this is irrelevant for just about everyone in terms of federal estate taxes with the threshold currently set at $5.5 million, in Massachusetts the threshold is $1 million, making many more estates subject to taxation.
Of course, with every upside there's a downside. Family protection trusts do have their drawbacks, which include the following:
- Cost. Our fee for preparing a plan for the parents that includes family protection trusts is somewhat higher than a simpler plan without them. In addition, these trusts provide the strongest protection when a professional trustee is involved, which would require the payment of annual fees, but not until they are funded after both parents have passed away.
- Tax return. Once funded, the trusts must file their own tax returns each year. But they do not pay taxes. The income passes through to the trust beneficiaries. The trust tax returns are for reporting purposes only.
- Depends on child following the rules. While the trusts function best with a professional trustee, most clients choose to name their children as trustees of their own trusts. This saves the cost of a professional trustee, but runs the risk that the child does not follow the guidelines set out in the trust document. If the child begins to treat the trust funds as if it were his own bank account, they could lose the protections described above because the trust could be regarded as a sham.
- Loss of control. When the child is trustee of her own trust, the trust only permits her to take out the trust income on her own. If she needs access to principal, she must appoint an independent trustee. Then the independent trustee has discretion to determine whether it's appropriate to distribute principal to her as she requests.
After explaining these pros and cons to my clients' son, he said he would discuss them with his sister and get back to me.