Gift Your Heirs Tax Protection

Individuals commonly establish estate plans with trusts to mitigate their own tax exposure. But what about their heirs? With bequests, family members often inherit assets that immediately become part of their taxable estates. Setting up an "inheritor's" trust now can help ease the burden when a loved one may be least capable of shouldering it.

Better than Bequests

An inheritor's trust allows heirs to receive the inheritance in trust, rather than as an outright gift or bequest. This keeps the inherited assets out of their own taxable estates. Having assets pass directly to a trust benefiting heirs not only protects the assets from being included in the heirs' taxable estates, it also shields them from other creditor claims, such as those arising from a lawsuit or a divorce.

father and daughter walking on their farm

Because the trust, rather than your family member, legally owns the inheritance, and because the trust isn't funded by the heir, the inheritance is protected. For example, if your son is having marital problems and is concerned that his inheritance could one day become community property, establishing an inheritor's trust can provide asset protection. Everything you gift or bequeath to the trust (including growth and income from its assets) is owned by the trust, and therefore can't be treated as community property. Although an inheritor's trust can't replace a prenuptial or postnuptial agreement, it can provide a significant level of asset protection in the event of divorce.

With an inheritor's trust, your heirs can also realize wealth building opportunities. If you fund an inheritor's trust before you die, your daughter, for example, can use a portion of the money to start a new business. A prefunded inheritor's trust can also own the general partnership interest in a limited partnership or the voting interest in a limited liability company or corporation. If you decide to fund the trust now, your initial gift to the trust can be as little or as much as you like.

Your Heir's Role

To ensure full asset protection from creditors, an inheritor's trust must be set up before the heirs receive an inheritance. The trust is drafted so that your heirs are the investment trustees, giving them power over the trust's investments. Your heirs then each select an unrelated person — someone they know well and trust — as their distribution trustee. The distribution trustee will have complete discretion over the distribution of principal and income, which ensures that the trust provides creditor protection.

Heirs should design the trust with flexibility to remove and change distribution trustees at any time and make other modifications when necessary — such as when tax laws change. Bear in mind that unfettered power to remove and replace trustees may jeopardize the creditor protection aspect of the trust. That could result in the inclusion of the trust property in the heir's taxable estate.

Because it's your heirs, and not you, who set up the trusts, they will incur the bulk of the fees, which vary depending on the trust. In addition, they may have to pay annual trustee fees. Your cost, however, should be minimal — only the legal fees to amend your will or living trust to redirect your bequest to an inheritor's trust.

Working with Professionals

Before deciding to go this route, speak with family members. Make sure they consult estate planning professionals to draft their trusts according to federal and state law. This will help avoid potential IRS audits and court challenges. And talk with your own advisor about the best way to incorporate inheritor's trusts into your estate plan.

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