May 22, 1998

LIVING TRUSTS: WHAT THE PITCHMEN DON'T TELL YOU

Edited by Dennis Berman

You've seen the advertisements in newspapers: "Come to the seminar on Living Trusts. Shield your estate from ruinous estate costs! Slash estate taxes!" and so on. What the pitches don't mention is that living trusts are not for everyone; in fact they benefit only a very small percentage of estates, and if you're not careful, creating one can savage your careful estate planning efforts.

First some basics. A so-called living trust is really a revocable, inter-vivos trust, which means that it was created during your lifetime, rather than after you die (those are called testamentary trusts). It is revocable because during your lifetime the grantor, you and perhaps your spouse, can revoke the trust and take back the assets put into the trust.

Why make the trust revocable? Irrevocable trusts are taxed separately, at absurdly high rates (39.6% for income above $8,350 in 1998). For income tax purposes, a revocable trust is transparent. The IRS views it as if you had never set up the trust -- the income and expenses are taxed directly to you. This is good because you don't have to file a separate trust tax return. You also benefit from the favorable individual income tax rates.

However, a living trust becomes irrevocable at your death. At this point a trustee disposes of your assets in accordance with your wishes.

Here's where the much-hyped rewards of a living trust kick in. First, living trusts are not subject to probate costs -- expenses involved in disposing of your estate, including attorney fees, executor fees, court costs, and appraisal fees. (Assets such as closely held businesses and real estate are costly to probate, while items such as cash and stocks are much less so.) Although some states such as Iowa have maximum attorney fee rates (2% of the gross estate), many states such as New York and Connecticut have no ceiling on attorney fees. In these states only rules of thumb guide the attorney, and oftentimes the local judge has total discretion in approving or disapproving attorneys fees. Get the wrong attorney or judge, and suddenly an uncomplicated $2 million estate might ring up $60,000 to $100,000 in attorney payouts.

The other benefit of living trusts: privacy. A probated will is public information -- which means anyone can visit the local courthouse and scrutinize your assets item by item. Trusts are not available to the public.

Sounds good so far, right? So why not sell everybody a living trust? Well, most estate holders don't need them. Assets held in joint tenancy escape probate anyway, and married couples usually own their house, autos, and at least some of their checking accounts, savings accounts, and brokerage accounts jointly. Your life insurance policies also escape probate, unless you list your estate as the beneficiary instead of relatives. Several other kinds of assets (found mostly in very wealthy estates) also escape probate. So for most estate holders, the probate cost savings will be insignificant compared with the costs of establishing a living trust. And the privacy issue also disappears as an advantage. Remember, assets that escape probate do not become public information.

Sellers of living trusts also imply that the trusts will help you avoid big federal estate taxes. This is nonsense. Assets going into the irrevocable trust at death do escape probate, but they do not escape federal estate taxes.

Even if you do have an estate for which a living trust may be a boost, watch out for these pitfalls:

Individual retirement accounts. IRAs cannot be put into a living trust. Federal income tax law forbids trusts from owning IRAs. A living trust can be the beneficiary of an IRA, but there can be severe tax disadvantages to the living trust being the beneficiary, as opposed to, say your spouse. Talk to your tax expert for details.

Real estate. To make the most of your living trust, you will want to transfer most if not all of your real estate into the trust (your real estate is a big part of your estate, and it is costly to probate). Transferring the title, of course, involves a considerable cost. Also, your title insurance may not transfer -- it may be unique to the person, not to the property. Getting a new title to an insurance policy could be expensive, so be sure to check what can travel with you.

Jointly held property. As previously mentioned, jointly held property escapes probate anyway. You would want to transfer this to the living trust only if there were some overriding estate tax reason to do so. Otherwise, you incur extra costs for nothing.

Contrary to some living-trust marketers, who provide you with no-hassle, "no lawyer" tear-out forms, correctly establishing and transferring assets into a living trust is not a cheap process--because you need a lawyer to do it right. That can cost you from $500 to several thousand dollars. Is it worth it to you? If you have a substantial estate, live in a state with high probate costs, and desire financial privacy, a living trust may be for you. But investigate carefully. You may be paying for a pig in a poke.

By Gary L. Maydew, Associate Professor at the College of Business, Iowa State University