REVOCABLE LIVING TRUST CONSIDERATIONS By: First Merit Bank, N.A. Trust Company 330-384-7300 AN IMPORTANT ESTATE PLANNING ALTERNATIVE Revocable living trusts are increasingly popular in estate planning. With them, titles to real estate, securities and other assets are placed in a trust while the owner is still alive. The plan's major focus is to outline instructions for managing the individual's assets during his or her lifetime and how to distribute them after death. When your assets are placed in the trust, they are under control of the trustee. However, don't let this frighten you. You may choose to be your own trustee with our bank named as successor trustee, or you may want to name our bank immediately -- whichever you prefer. THE ADVANTAGES OF REVOCABLE LIVING TRUSTS Revocable living trusts can help you avoid probate, obtain favorable estate tax and income tax results, provide for the management of assets and for the distribution or retention in trust of assets at death. AVOID COSTLY AND TIME CONSUMING PROBATE With a will, your estate must be settled in probate court where attorney and executor fees can add up; delays are likely and the proceedings are all a matter of public record. On the other hand, a living trust is settled out of court with a trustee distributing assets according to your pre-determined plan. This process is almost always faster, less expensive and with more respect to individual privacy. Your trust may also own out-of-state real estate, thus avoiding the expense of filing an ancillary administration (out of state probate). PROTECT YOUR ASSETS FROM UNNECESSARY TAXATION The majority of husband/wife living trusts are established to be divided into two sub-trusts at the death of a spouse. One is called the "A" or marital trust and the other are called the "B" or residuary trust. At the death of a spouse, the two trusts are funded according to a formula to allow the maximum amount to pass tax-free into the "B" trust. This amount currently can be as high as $650,000. The surviving spouse may be able to receive principal from both the "A" and "B" trusts, with specified restrictions, while also receiving income from the assets. At the death of the sole surviving spouse, the property in the "B" trust passes tax-free to named beneficiaries, while the assets in trust "A" will not be subject to tax if they don't exceed $650,000. So, with careful planning, as much as $1,300,000 can pass tax-free to children and other beneficiaries. Without the "A" and "B" trust plan, beneficiaries would owe $200,000+ in federal taxes on a $1,300,000 estate. As previously referenced, the amount of property exempt from Federal Estate Tax is $650,000. Based upon legislation passed in 1997 this amount will be raised during the next several years until the exemption reaches $1 million per individual in 2006, thus allowing $2,000,000 to be exempted from taxation with proper trust planning. INCOME TAX SAVINGS Frequently individuals wonder if there are "income tax savings" with a Revocable Living Trust. It's important to realize that while the Grantor (the person creating the trust) is living, taxable events, such as the sale of stock at a gain, will be "passed through" the trust and taxed personally to the Grantor. This effectively means that there are no positive or negative income effects while the Grantor is living. At the death of the Grantor, property within the trust, or property held in the individual's name, will receive a "stepped up" basis for income tax purposes. The "stepped up" basis is determined by the fair market value of the assets on the date of the death of the Grantor. Any gain in the value of an asset between its time of purchase and the application of the "stepped up basis" will avoid taxation. Income tax will be due only on any subsequent increase in value between the "date of the death" (stepped up value) and its sales price. An area where the trust may significantly help with income tax planning would occur after the death of the Grantor. The trust could be directed to "sprinkle" income to a class of beneficiaries. This could include a spouse, children and grandchildren. If the spouse is in a high tax bracket and doesn't need the income, the trustee could pay it to the children and/or grandchildren who are in a lower tax bracket, thus saving tax dollars for the family unit. 2 PROTECT YOUR ASSETS DURING ILLNESS OR INCOMPETENCY One of the main benefits of placing assets into a living trust is to avoid court supervised guardianships should the parties become unable to manage their own financial affairs. For example, if a home or stock is in joint tenancy outside of a trust, a spouse cannot sell it should the other spouse become incompetent. Instead, they would have to petition the court to name them as a guardian and then keep copious records, which have to be produced to the court annually. The living trust can avoid these problems. Since title to assets belongs to the trustee, guardianship proceedings are not necessary and assets can be managed without inconvenience. Because you may wish to act as your own trustee, you can provide for a successor in the event of your incapacity MANAGEMENT OF ASSETS One of the primary advantages of naming a corporate trustee is the assistance you will receive with your investments. Normally an administrator and portfolio manage will work with you, or your beneficiaries, to determine short, intermediate and long-term financial needs. Whether the concern is long-term growth, immediate income or a balance of these two, you or your family will receive recommendations based on your particular circumstances. The trustee will then create an investment portfolio tailored to your needs. This asset management is provided for a modest annual fee (usually 1% or less of the assets under management) rather than sales commissions or charges on securities and mutual funds. Therefore, the client is assured of objectivity and unbiased judgment. CONTINUOUS FLOW OF ASSETS Another benefit of the living trust is that when you die, the trust keeps on working without the inconvenience and delay you would find in probate. For example, should you die and your trust provides for income to your spouse, he/she can expect to be paid without delay. This is definitely not the case with probate. PRIVACY Without a living trust, when you die anyone can go to court and find out what assets are in probate. So details about beneficiaries or the estate enter the public record. As you might expect, this may not always be advantageous to the deceased party or his/her family. 3 LIVING TRUSTS ARE DIFFICULT TO CHALLENGE Trusts can be contested, but not as easily as a will. You don't even need a lawyer to contest a will. The usual grounds for contesting a will are undue influence or mental incompetence. This is more difficult to prove when you have a trust in existence for a long period of time, which has been operating under the influence of the Grantor. To contest a living trust, the person must hire a lawyer to initiate a civil suit. However, trust assets are normally not frozen, because of the legal action and will continue to be managed and distributed according to the plan, pending the outcome of any litigation. INCOME TAX DEDUCTIONS Currently, you can take the costs of creating a living trust as an income tax deduction if you itemize. The same is not true when creating a will. In addition, all trust administration expenses except those attributable to any tax- exempt income, are also deductible to the extent that they exceed the 2% miscellaneous business expense requirements. MORE CONTROL OVER THE DISTRIBUTION OF ASSETS Everything in your estate needn't be in your living trust in order for it to be properly managed when you die. A properly drafted will, along with properly designated life insurance, pension plan and profit sharing forms will, in effect, "pour over" all assets into your trust for centralized control and distribution. Without the trust, your assets could be distributed piece by piece, which could cause delays and inequities. For example, if the child you name as the beneficiary of your pension plan dies within a short time of your death, the funds could be distributed to their spouse, even though your intent was to care for your grandchildren. To prevent this, you might name the trust beneficiary of your pension plan, because of its stipulations that your child must survive you for a period of time before assets are distributed. Because of the complexity of income, estate, and gift tax law it's extremely important that issues such as these be carefully reviewed. MORE FLEXIBILITY TO CHOOSE YOUR TRUSTEE With a traditional will, state law may prohibit you from choosing certain people to administer your will in probate. However, with a living trust, you can designate almost any corporation or person as trustee, regardless of their state of incorporation or residency. 4 THE DISADVANTAGES OF REVOCABLE LIVING TRUSTS For most people, the advantages of living trusts far outweigh the disadvantages. Some things to consider, however, include the problem of transferring titles to homes and other property, bank accounts, securities, businesses and other investments into the name of the trust. The trust will have to file a separate income tax each year if someone other than the Grantor is serving as trustee. The trustee will also be entitled to compensation. Legal fees to create the trust, although normally modest, are another consideration. THE PROPER WAY TO FUND YOUR LIVING TRUST To avoid probate, it is essential that you understand the rules that apply to transferring assets. The trustee can only manage assets, which have been transferred to it. If you die and assets have not been placed in the trust, they will then go through the probate process. Below is an overview of the most common assets transferred to revocable living trusts. SECURITIES If a corporate trustee is used, they will assist you with the necessary documentation to transfer the assets into the trust. This will include obtaining the tax cost of your securities, as most corporate trustees will provide a tax cost tracking service to you. This becomes extremely important if your stocks have had splits and/or stock dividends, or if your mutual funds have had capital gains distributions. If the trustee is an individual (where no bank is involved), the most common way to transfer securities is to place them in the name of the trustee as trustee of the specific trust (i.e. John Doe, Trustee of the Doe Revocable Trust dated January 2, 1998). Registration and deregistration of securities by this method is rather simple, but you may encounter transfer delays while certain conditions of the broker are being met. Another alternative, if you are your own trustee, is a bank custody account. You, as trustee, transfer assets to a bank, which then holds them in a special custody account. The bank then processes your securities and passes the dividends or interest to you as trustee. Because the bank holds the securities, there are not undue delays with the sale or transfer, as discussed earlier. If you have unregistered securities (those in bearer form), you should encounter no transfer or registration problems. REAL ESTATE Transfer of these assets leads to many of the same problems encountered in entrusting securities. Reason being -- the trust agreement defines the trustee's power to deal with the real estate. In most cases your lawyer will prepare a deed, which transfers the property from you personally to your trust. Out-of-state realty can be complicated because oftentimes a corporate trustee (bank) or successor trustee from the grantor's state of residence has no power to act in the state where the real estate is located. This may require the use of a nominee partnership (or ancillary trustee), which can be created by the grantor or by the grantor's attorney. If you have any interests in real estate that don't constitute absolute ownership, such as a land contract, vendor's or vendee's interest or a lessee's interest, you may consider assigning these interests to the trust. BANK ACCOUNTS The best way to fund bank accounts through a living trust is to register the account in the name of the trustee (John Doe, Trustee of the John Doe Living Trust, dated January 2, 1998). This information should be on the registration card held by the banking institution. In addition, any checkbooks, pass cards, etc. should reflect the trustee status. In cases where there is more than one trustee, all names should appear so that all signatures are not required to transact business. LIFE INSURANCE In most cases, insurance on a grantor's life is made payable to the trustee. The grantor needs to make sure that the beneficiary of the life insurance is the trust. SERIES E BONDS To transfer Series E bonds to a living trust, you need to apply to the Bureau of Public Debt or Federal Reserve Bank on FORM PD 1851. As a result, all bonds will be re-issued in the name of the trustee and will reflect the original date of issue. Consequently, you will not incur any new income tax consequences. 6 RETIREMENT BENEFITS You may want to transfer the guaranteed portion of your retirement plan, as opposed to benefits that terminate at your death, to the trustee in the same manner as life insurance. This issue must be carefully reviewed because of potential income tax consequences. SETTING UP A LIVING TRUST FOR PROPER TAXATION When the grantor of the trust is not the trustee, an identifying number is required for income tax purposes. Known as an employer identification number (EN, it performs the same function for the trust as a Social Security number does for an individual. The number will also be used when filing fiduciary income tax returns for the trust. The bank being named trustee, or becoming a successor trustee under the terms of a self-trusted trust, will normally apply for the EIN and handle all paperwork associated with this process. ADMINISTERING THE TRUST The trustee is the legal owner of all trusts assets. A properly working trust agreement makes sure that all assets are managed and disposed according to the desire of the trust's grantor. By its very nature, a revocable living trust gives the owner the right to amend or revoke any or all of the terms, including the naming or replacing of trustees. Although these conditions provide for maximum flexibility over the control of assets, people who use living trusts must meet certain obligations. RECORD KEEPING There is a required level of maintenance with all living trusts. The trustee is responsible for keeping accurate records with regard to: income received, income paid out, additions to principal, deductions from principal, principal on hand and changes in trust investments. All transactions must be fully documented, preferably at the time when the trust is established. After the death of a grantor, oftentimes it is near to impossible to gather certain information needed for the proper administration of the trust. Where there are successor trustees, accurate and up-to-date records are even more important, should the assets pass from trustee-to-trustee whose capabilities include tax lot accounting in securities, asset summary statements, and transaction statements that detail all activities within an account. 7 TAX RETURNS If the trustee is other than the grantor, the trustee must file appropriate federal income tax return forms. Normally, a corporate trustee will prepare the appropriate trust tax returns for your personal trust advisor. ADD IT UP -- A REVOCABLE LIVING TRUST MAY BE RIGHT FOR YOU This document has attempted to explain the advantages and disadvantages of revocable living trusts. While the main purpose of a trust is to gain maximum control over assets without probate or unnecessary taxation, there may be other advantages or disadvantages encountered on an individual basis. For further information, please contact your attorney or the FirstMerit Trust Division nearest you.