Myths and Limitations of a Revocable Living Trust

Those who want to sell you on buying their do-it-yourself book, software program or quick and easy legal service to create a revocable living trust have an incentive to overstate the problems of probate or the benefits of setting up a living trust. Here are some of the common myths about probate.  

"Avoiding Probate Will Save Money"  

Except for actual probate fees, most of the costs of probating an estate are incurred for fees to accountants, appraisers, attorneys and the estate administrator. The administrator or executor is required to be sure all the assets and debts are identified and that all of the heirs are found. If an estate is large enough to require filing an estate tax return, the assets in a living trust will be included in the estate. A major cost in the probate process is the process of valuing the assets in the estate and preparing the estate tax return. A living trust doesn't reduce those fees. In some cases, a living trust will result in more legal fees if the trust and the executor are not represented by the same lawyers, according to Martin Goldberg. A lot of the expenses of probate are incurred when there is no will (or when there is more than one will), when heirs can't be found or when the estate includes property that is hard to value. A living trust doesn't really prevent these expenses.  

"A Living Trust Will/Won't Save Estate Taxes" 

The advocates of a living trust may tell you that the trust will save estate taxes. The critics will tell you it won't help you to save estate taxes. Who is right? Both are right and neither are right. A living trust can be drafted so that a second trust is created, when you die, that makes maximum use of two lifetime estate tax exemptions if you are married. However, this estate planning arrangement isn't unique to a living trust. It's often done with a well-drawn will and with trusts that are created at the time of your death. And if you are single (or a surviving spouse), you are only eligible for one lifetime estate tax exemption  - which is available to you regardless of whether you have a will or a trust.  

"You Need A Trust so Funds Can Be Distributed To Heirs Without Delay" 

A well-designed will and a qualified executor can make distributions to the family even while the estate is being probated. In addition, life insurance and jointly held assets can provide immediate funds for the family. Sometimes, a living trust can backfire with respect to distributions to the heirs. If the trustee of the living trust is not the same person as the executor of the estate, the trustee might make distributions in excess of what is needed for estate taxes. If that happens, the IRS can collect the taxes from the heirs and the trustee is then liable to the heirs for any losses they might have sustained in the process. If the IRS can't get the money from the heirs, they will try to get it from the trustee.  

So if you are ever the trustee of a living trust, you should make an extreme effort to coordinate your management of the trust with the management of the rest of the estate. 

"You Don't Need A Will with A Living Trust" 

That's only true to the extent that the trust includes all the necessary instructions to carry out your wishes and only if the trust is the owner of all of the assets of the decedent. In most cases, there are other assets that are not included in the trust and these assets must still go through the probate process. For co-ordination, most lawyers advocate having a "pour over will" to transfer any probate assets to the trust so that they can be managed as a whole.  

"A Living Trust Provides Creditor/Asset Protection" 

No! No! No! Not so.

Not if you are talking about a revocable living trust created and funded by the grantor who is also the beneficiary and/or trustee. Asset protection implies protection during the lifetime of the grantor of the trust. Until the grantor dies, he or she has the power to recover any or all of the assets from a revocable living trust. Therefore, those assets are available for the satisfaction of any creditor's claims.  

The above statement may be true if the living trust is an irrevocable living trust and the grantor has not retained any powers over the trust assets or over the trustee. Even then, there are other legal issues to be considered such as whether the statute of limitations has expired with respect to possible claims of a fraudulent transfer or whether the grantor was solvent immediately after the  transfer of assets to the irrevocable trust.  

However, a living trust does make it easier to segregate assets so they can't be taken by the creditors of multiple joint owners. A joint owner of a parent's assets and a joint owner of assets with a spouse are at risk if any of the joint owners are sued and the plaintiff were to prevail. An alternative for those with a concern about lawsuits is to use a living trust for each property owner, combined  with a durable power of attorney.  

"A Living Trust Can't Own S Corporation Stock" 

It's commonly believed that trusts can't be shareholders of the stock of an S corporation. However, there are exceptions for a grantor trust with a single beneficiary, a testamentary trust, certain voting trusts and a "qualified sub-chapter S corporation trust" that distributes all of its income to one income beneficiary. 

Other Ways To Avoid Probate 

If your primary concern is to avoid the costs, delays and publicity of the probate process, there are other alternatives. One of the most popular with those who have small estates is the use of joint ownership with the right of survivorship. The major problem with this arrangement is that the jointly owned property is subject to the claims of any creditors of both property owners. And, for those with estates in excess of the lifetime estate tax exemptions (per spouse), joint ownership has some estate tax disadvantages.  

There are many other problems with joint ownership that are beyond the scope of this article, but even in smaller estates, there is an income tax disadvantage with jointly owned property. If a spouse is the joint owner of an asset, only half the value of the asset is included in your estate. If the asset is highly appreciated, the half in your estate gets a new cost basis equal to the value at the time of your death. The half that isn't included in your estate is still subject to income taxes on any appreciation (over the original cost) when the asset is sold. (The Tax Relief Act of 2001 has made significant changes in the future estate and gift tax rules but they are not yet effective and are beyond the scope and purpose of this article.) 

Any assets that require a beneficiary designation will go to your beneficiary without going through probate. Examples include pension or IRA assets, life insurance and annuities with residual benefits. If you have a living trust, these assets will be paid to the named beneficiary instead of to your trust. They may be part of your estate for estate tax purposes but they will not be part of your probate estate. 

You can also avoid probate on any assets that you transfer by gift while you are living. Thus, a family limited partnership could be an alternative to a living trust to the extent that you choose to give your limited partnership interest to your heirs while you are living. Meanwhile, you can be the managing partner and can receive some compensation for managing the partnership. This arrangement also provides substantial protection from lawsuits and other claims that are a threat to your life savings. However, the partnership does not offer the privacy of a living trust and it's likely to cost a lot more to establish and to maintain.

Vernon K. Jacobs

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