Ep. 21: Trusts 101: Understanding the Basics of the Four Essential Trusts We Create for Our Clients

Hello everyone, my name is Attorney Ted Gudorf. Welcome to the Repair The Roof Podcast. This name comes from President Kennedy’s famous quote, “The time to repair the roof is when the sun is shining.”

In this show, we help individuals and families learn more about all things estate planning and elder law. This is Episode 21 – The 4 types of trusts. In this episode, we’re going to give a brief overview of the 4 types of trusts that we create on a weekly basis here at Gudorf Law Group. It is important to understand the key distinctions between these trusts and make a determination as to how many of these trusts you’re going to need. More often than not, most of our clients will have at least 2 of these types of trusts. What are the 4 types that we’re going to talk about today?

Well, the first type I want to cover is revocable trust. The second broad category is called irrevocable trust and of the irrevocable trusts, today I want to talk about 3 in particular, I want to talk about those trusts that are used to protect assets from Medicaid. I want to talk about those types of irrevocable trusts that are used for asset protection from creditors. And then number 3, I want to talk briefly about those types of irrevocable trusts that are used to protect assets from the federal and state estate tax.

Well, most of you are probably familiar with a revocable trust. It differs from a will in very significant aspects. Why do we use a revocable trust? Well, the primary reason is twofold. First of all, a basic premise of law is that assets held in a revocable trust, that are owned by that revocable trust during the trust maker’s lifetime, will avoid the probate process. In the event, the trust maker becomes incapacitated or dies. Now remember, if all we have is a will or worse yet have no will at all, and we become mentally incapacitated, more likely than not, we’re going to have to seek living probate or a guardianship.

Under Ohio law, there are 2 types of guardianship. One is guardian of the person, that is we’re going to designate somebody to make medical decisions or number 2, we can have a guardian of the estate. And the guardian of the estate is charged with managing all financial assets, whether liquid or real property. Generally speaking, we want to avoid probate because of 3 things. First, it’s very public. All of your business is out there on the internet as published by the local probate court. Most of us would prefer to keep our business private. Number 2, every time we want to do something, the lawyer who is designated by the guardian has to go to court to get approval and that can be expensive; it can be very costly. Some of our clients who do no planning end up having to go through living probate during their period of incapacity, and then upon death go through death probate, so they get hit while they’re alive, and their estate gets hit upon their death, and that becomes very costly.

Needless to say, the probate process after death takes a while. The average probate in Montgomery County, Ohio, is roughly about 2 years. Sometimes it can be done a little quicker, but sometimes it even takes longer than 2 years. Trust administration is done outside the purview of court. So whether you have a revocable or an irrevocable trust, both will avoid probate during your lifetime, that is a guardianship and both will also avoid probate upon death. Now, in addition to avoiding probate, a revocable trust, ______ established subtrust for the benefit of your beneficiaries, whether that be for your spouse or whether that be for your children or grandchildren. One of the things we like to do is to focus in on providing some multigenerational planning to provide certain protections for our spouse or for our children or for our grandchildren.

Please understand that if you have a revocable trust and upon your passing, it creates what we call a subtrust for your spouse or a subtrust for the benefit of your children or grandchildren. Those subtrusts can be set up so that the assets that pour into those subtrusts upon your death are fully protected during the beneficiary’s lifetime from such things as lawsuits, creditors, bankruptcy, nursing homes, divorces, and upon the death of the beneficiary, can be designated to pass down your bloodline. More often than not most of our clients prefer that their assets pass from their children to their grandchildren, rather than to their son-in-law or daughter-in-law, and you can accomplish that through the use of a revocable trust. It’s not often that we see people who have a will who accomplish the same result. It’s not often that we see the do it yourself. revocable trusts that are downloaded online accomplish that, but when you work with a sophisticated estate planning law firm, who knows how to do effective multigenerational planning, virtually in every case, we’re going to create these subtrusts for the benefit of the beneficiary, and more often than not, those subtrusts are going to be beneficiary controlled. It’s not necessary to have an independent party involved, they can be beneficiary controlled.

So, revocable trusts are a key ingredient of all of our estate plans. But if you want to achieve some other goals, you’re probably also going to have to add an irrevocable trust. Sometimes when folks come to us for basic planning and establish the revocable trust, the next step in the process maybe 2 years later, 3 years later, might be to establish an irrevocable trust. On the other hand, some of our clients recognize the benefit of that revocable trust and establish it right off the bat.

When we talk about the creation of the revocable trust, most of our clients, they will during my lifetime, I want to be in control of my own checkbook. That is, I want to make sure I can still have access to my social security, to my pension. All of those are going to go into your revocable trust. We’re not going to put those into your irrevocable trust. In other words, the revocable trust is designed to be what you live out up. On the other hand, there are assets that we all own, that are more of our rainy-day-type assets, and we want to protect them. Now, depending upon your individual situation, your goal may be to protect those rainy-day assets. Maybe it’s your brokerage account, maybe it’s your rental real estate, maybe it’s your life insurance policy, maybe it’s your deferred annuity, whatever it might be, maybe you want to protect that, and you don’t really plan on spending it during your lifetime but you may want to protect it for the benefit of your beneficiaries.

So, what are the things that you want to protect assets from? Well, some of our clients come to us right off the bat and say, look, if I have a long-term care event, I want to make sure that I don’t have to spend down all of my assets and give those assets to a nursing home. Is there a way for me to protect what I got in the event I become incapacitated, so that the government through the Medicaid program or the Veterans Benefit Program for wartime veterans will pay for part or all of my care? And the answer is yes. One type of irrevocable trust, we call a Medicaid asset protection trust, otherwise known as a MAPT, Medicaid asset protection trust.

Now the key to establishing a trust that protects assets from Medicaid, counting those assets, so that you remain eligible for Medicaid is as follows: First of all, the number 1 rule Is that we have to understand that there is a 5-year look back rule. So if we properly create the trust, transfer assets into it, they’re not going to be fully protected for 5 years. Let me give you a recent example. I had a client of mine come to me almost 5 years ago, to create a Medicaid asset protection trust, because his wife had become disabled and needed to go to a nursing home. He calculated that she had about 5 years worth of assets that could get her through a nursing home stay at the rate of about $9,500 per month plus the cost of prescriptions. So, he established a Medicaid asset protection trust and transferred approximately $1 million into it. Now, 5 years has gone by, he has come back to see me and he wanted to know whether we could file a Medicaid application.

Well, after investigating his situation, we realized that we could not yet apply for Medicaid because when he worked with his financial advisor rather than transferring all of the IRA money from his name into the irrevocable trust in the year of 2018. They did part of it in 2018, part of it in 2019, part of it in 2020, and part of it in 2021. Now, the problem with not moving it all within the first year, is that each of those subsequent payments has its own 5 year look back, and I had to advise him that, under that scenario, he would not be eligible to apply for Medicaid for his wife for at least another 2 years. Now, what we calculated was that as we had previously determined his wife’s resources were going to run out. Consequently, because he did not transfer his IRA funds into the trust, because he didn’t want to pay the taxes. He is going to have to privately pay for her care for a period of time that I calculated to be approximately 10 months. That’s how long it’s going to take for his wife’s resources to end and how long it’s going to take for him to become eligible, because of the 5-year look back rule. So the number 1 rule, understand when we’re talking about an irrevocable trust, we have a 5-year rule.

Number 2: When we create that a revocable trust, either the husband or the wife, if it’s a married couple, or the individual trust maker, if they’re single, is allowed to serve as a trustee of the trust during their lifetime. Typically, we’re going to find somebody else, like a child. Sometimes, as in this case, we picked his oldest son. In other cases, we’ll pick 2 or 3 of the kids to serve as trustees. It cannot be the spouse and it clearly cannot be the trust maker. Oftentimes, it’s going to be a child or a grandchild. But if you do not have a child or grandchild, then you have to find somebody else.

Recently, I had somebody asked me if I would be their trustee and I agreed. For a flat fee every year I will serve as a trustee. Sometimes it’s a CPA, sometimes it’s a brother or a sister. So rule number 2 on the Medicaid trust is that somebody else has to serve as trustee.

Rule number 3: Generally speaking, the trust maker or their spouse should not be a beneficiary of the trust. There are rules that say you can become an income beneficiary of the trust, you can never become a principal beneficiary of the trust. Principal is what you basically what you put into the trust, not any of its earnings. The earnings have a tendency to be income. Generally though, income is limited to interest, dividends, and net income. Now, just remember, if you’re going to continue to have access to the income of the trust assets, then the nursing home will have access to that as well. If you don’t have access to income in principal, which is what we generally recommend, then the nursing home won’t have access to it either.

Now, who is the beneficiary of this trust during your lifetime? who can get assets out of the trust and that your, typically speaking, what we call your lifetime beneficiaries, which is normally going to be your children or grandchildren. So, just remember, even though we’re creating a trust, generally speaking, you’re not going to be a lifetime beneficiary, but your children or grandchildren can be lifetime beneficiaries. In addition, your children or grandchildren can be trustees. And if we need to take assets and sell them in the name of the trust, the trustee can do that. We subsequently want to take assets out of the trust, they can be transferred out to one of the lifetime beneficiaries, who then can gift it back to the trust maker of the trust. So that is an incredibly important rule to understand that you cannot be a beneficiary of the trust or at least not a beneficiary of the principal of the trust. Good news is, when we’re doing this for Medicaid asset protection purposes, you can retain what we call a limited power of appointment to be able to change the beneficiaries of the trust upon your death during your lifetime.

So let’s say recent example. I had a client come in, she had created a trust all the way back in the year 2006. She had named her son and daughter as trustees and she named her 5 children as beneficiaries, but did not make them equal beneficiaries, because one of her children was disabled. So she gave that one child a 5% interest as a remainder beneficiary of the trust, and the remaining 95% of the trust went to her other 4 children. She came back in to see me this year after her disabled son passed away. Turns out, the disabled son had 3 children. She felt as though now that her son had passed, that the disabled children should have an equal share in the estate, not the 5% share she had given to their father. Well, because she had retained a power of appointment, she was able to modify the trust document so that each of the 4 children; i.e. the 4 children plus the deceased child’s 3 children, would each receive a 20% Share. Consequently, 4 of the kids would get a 1/5^th share if they survived, and the 3 grandchildren would get a 1/15^th share. That was perfect for what she wanted to accomplish because we created the trust in 2006, and we gave her that limited power. She had the ability to do that. As she also inquired if she wanted to change who the trustees were. Was there a mechanism to accomplish that? And the answer is yes.

So the first type of Irrevocable trust that we create for our clients on a regular basis is a Medicaid asset protection trust. This second type of asset protection trust has nothing to do with Medicaid. Why? Well, it doesn’t work for Medicaid because this type of irrevocable trust while being protected from lawsuits and creditors, the trust maker, the creator of the trust remains a lifetime beneficiary of both income and principal of the trust and remember what I said earlier, if the beneficiary if the trust maker is a beneficiary of the trust for either income or principal, it will not qualify for Medicaid protection. Therefore, this type of trust is generally used by people who already have long term care insurance. Yes, they’ve made the decision rather than relying upon Medicaid, they are going to instead rely upon long-term care insurance or they’re going to privately fund their care, but what they’re more concerned about is a car accident and getting sued because of that or some other reason. They realized that in today’s world, we’re in the litigious society. We got a lawsuit being filed every 4 seconds. There’s TV ads, by law firms every single day encouraging people to file lawsuits for newfound theories of recovery, newfound theories of liability. Therefore, those who have been successful and who have some assets want to protect those assets.

Now we got to remember under the law, there are some assets that are already protected. A retirement account, IRA, 401K, 403B already protected. Your Life Insurance cash value already protected. A small equity in your house already protected. What is not protected? All your checking, your savings, your CDs, your money market, your brokerage accounts, your stocks, bonds, mutual funds, your annuities, your rental real estate, your vacation home, none of those assets are protected. You today can create what is sometimes called an Ohio Legacy Trust, otherwise known as a domestic asset protection trust. You can remain the beneficiary of the trust, and unlike the Medicaid rules, your spouse can be the trustee of the trust. Also, you can have other people serve as trustee. Again, it might be a child, it might be a parent, it might be a brother or a sister, a lawyer or CPA, but they can all be trustees of the trust while you remain a beneficiary of that trust.

If it’s set up correctly and you are able to sign an affidavit of solvency at the time you create the trust or transfer assets subsequently into the trust, that says you’re not doing it to defraud creditors, that you have no lawsuits pending against you that you have no creditor looking after you. You’re not intending to file for bankruptcy. You can create an asset protection trust that you are a beneficiary. Why is this a big deal? Well, this has not been allowed under Ohio law since the inception of our state in 1803. It’s that big of a deal. This is the first time we are now able to create what I call a revocable irrevocable trust.

Why do I call it revocable irrevocable? Well, today we can create the trust, put assets into it today, sign the affidavit of solvency and our spouse can take the assets out of the trust at any time. It truly is a revocable irrevocable trust, and oh, by the way, the Medicaid trust, as well as the Ohio Legacy Trust, do not have to have a tax return filed while the trust maker is alive. No, they are considered to be what we call grantor trust, and therefore, all income is reported on the individual’s tax return with no trust tax return required.

So the second type of trust we like to create is for asset protection purposes. Oftentimes, it’s going to be an Ohio Legacy Trust, if we have a client who’s in the state of Ohio, we can also create them under the jurisdiction of other states, including where I’m licensed, Wyoming. We can do them in the state of Indiana as well, in Tennessee.

Let’s talk about the third type of irrevocable trust, and that is an estate tax trust. What is an estate tax trust? Well, first of all, let’s talk about the estate tax. Here in Ohio, we had it in Ohio estate tax, it was going to tax roughly 7% of everything over $338,333 for an individual, double that for a married couple. Now, on January 1, 2013 that was abolished and probably will not come back unless the legislature has a change of heart which I don’t see that happening in the near future, that’s for sure. Let’s talk about the federal estate tax. I think almost all of us are aware. For instance, when I started my career back in 1986, the federal estate tax exemption amount was somewhere around $600,000. That is that each of us could transfer during our life or at death, roughly $600,000 and pay no tax. Here we are in 2023. We now each of us has the ability to transfer either during lifetime or at death $12.92 million. And if we’re a married couple, take that x2, nearly $26 million can be transferred today during our lifetime free of the federal estate tax. And if that $26 million grows, after we’ve transferred it to one of these estate tax trusts, all future appreciation is out of our taxable estate. What a wonderful thing we can do. So for the less than 1% of my clients who have in their possession, more than $13 million of assets or more if you’re a married couple more than 26 million, you can transfer a significant amount out of your taxable estate by putting it into an irrevocable trust.

Now, little caveat, the federal estate tax exemption amount that I just discussed is scheduled to be rolled back to approximately $7 million per person on January 1, 2026. That is a married couple will have a total of $14 million, more or less. We don’t know the exact number because it is dependent upon the inflation rate this year and over the next couple of years, but we’re projecting it to be around $7 million exemption amount. So if we can transfer 13 million today, 7 million on January 1, 2026. The question is, if we transfer 13 million today, if we’re a single person or 26 million if we’re a married couple, and the exemption amount falls back, is that gift we made today still good of the excess amount? And the answer is yes, we believe it is. So many of our wealthy clients today are recognizing we are in a limited period of time. Here it is, today, it is July 3, 2023. We have until December 31, 2025 to make transfers into an estate tax irrevocable trust, so that these amounts will not be includable in our taxable estate and subject to the current 40% federal estate tax. Think about that. How significant is that? And remember, it includes all future appreciation.

Now when we think about creating an irrevocable trust, for estate tax purposes, there are some fundamental rules. Unlike the Ohio Legacy Trust that we use for asset protection purposes, more akin to the Medicaid trust, neither you nor your spouse can be trustees. Unlike the Medicaid trust, we do not recommend that your children serve as trustees, but when we’re doing an estate tax trust, we highly recommend that we have a professional service trustee. That is, we want to make sure that it’s probably a CPA or a lawyer that is serving as trustee because the fundamental rule of the estate tax is that you’re not allowed to have any bad strings attached to any of these assets, and we don’t want that bad string to be created if we have a spouse or a child involved as trustee. It’s easy to create a bad string when we have a related party serving as trustee. So most estate planners are always going to recommend we find an independent party, somebody who’s not related or subordinate to you to serve as trustee number 1.

Number 2, you clearly can not be a beneficiary of either income or principal of these trusts. You as the trust maker cannot. Now depending upon the type of trust we create, your spouse can be a beneficiary, your children can be beneficiaries, your grandchildren can become beneficiaries. Oftentimes, if we’re going to name a spouse as a beneficiary, we’re going to create what is called a spousal limited access trust, also known in the business as a SLAT. That trust is designed to be out of, say for instance, if we pick on the husband, out of the husband’s taxable estate, yet available to the spouse during their lifetime, if they need access to it for their health, for their education, or their maintenance, or for their support.

So imagine this, today, we can put into this trust up to 12.92 million, we don’t have to put the full amount. We can do half that amount. We can do whatever we want. If we want to get 3 million out of our taxable estate, we can create a spousal limited access trust transferred 3 million, lived for another 20 years that 3 million grows to 10 million. All 10 million will be out of our taxable estate all the while our spouse has limited access to that trust for their health, education, maintenance, and support. And by the way, if we do it correctly, a husband can do it for their wife, wife can do it for the children, will make those trusts are different, but yet similar, and both can be out of your taxable estate. That’s called a spousal limited access trust.

Another type of estate tax trust is known as an irrevocable life insurance trust, otherwise called an ILIT. Again, we recommend an independent trustee. Again, we recommend, more often than not, that we’re going to have children and grandchildren as the lifetime beneficiaries. Typically, we’re going to have children as the residuary beneficiaries. The idea behind this trust is that we’re going to buy a cash value life insurance policy, titled in the name of the trust, the trust will be the beneficiary. The trust maker will make premium payments by making annual exclusion gifts into the trust that the trustee will use to make available to the beneficiaries for a finite period of time, typically 30 days, and will then pay the premium on this large policy. When the trust maker dies, 100% of that death benefit that we purchased that at life insurance policy is not going to be subject to the federal estate tax.

Individuals have transferred literally 10s of 1000s of dollars from their brokerage account by placing those funds inside of a life insurance policy through annual exclusion gifts, knowing full well that upon death, 100% of that death benefit is going to be free of the federal estate tax. We have been doing ILITs in this country for many, many, many years, it dates back to well, as far as I know, the original tax case, that allowed this was in the 60s. So it’s well over 50 years that we’ve been doing it and it is again a very effective way, a simple way, a straightforward way to handle and resolve the federal estate tax issue if we have that in our state.

A third type of trust is called a grantor retained annuity trust, otherwise known as a GRAT. A GRAT is simply a way to make a gift into an irrevocable trust to retain an income stream through an annuity payment during our lifetime, knowing full well that the principal amount in any appreciation is going to be out of our taxable estate.

Almost all of these trusts, unless we desire otherwise, will not require a 1041 tax return to be filed on behalf of the trusts during the trust maker’s lifetime, but instead, will be created as what we call grantor trust, again, so that all of the income and principal to the extent that there is any will be reported on the individual’s tax return.

Well, hopefully you have found today’s session to be interesting. Hopefully, you learned a few things, perhaps it provided some clarity and some better understanding that will allow you to move forward. Again, just remember, you’re not limited to one of these types of trusts that can create a few different ones, most of our clients will have irrevocable trust, along with at least 1 irrevocable trust. Thanks for being with me today. I hope to see you in the near future. And if we can offer you any assistance, feel free to reach out and touch base with us. Thank you so much.

Until our next session, just remember the time to repair the roof is when the sun is shining. To get started with your estate plan, you can go to gudorflaw.com/getting started. For a free copy of our recently published book called The Ohio Estate Planning Guide, go to gudorflaw.com/book.