While many trusts distribute assets outright to other beneficiaries such as children and grandchildren, others direct for a distribution into a continuing testamentary trust for the benefit of children, grandchildren, and other beneficiaries. Oftentimes, these distributions don’t occur until the surviving spouse is deceased and the marital trust distributes out to the children/grandchildren, but in some cases, the children/grandchildren trust shares are created immediately upon the Settlor’s death.
The segregation of various assets into the children/grandchildren’s shares must be carefully considered. If there is a home or other property that one child wants to have that the others do not, then the property must be appraised so that when all of the shares are ultimately distributed, every beneficiary is treated fairly and receives value in proportion to the relative percentages that the trust document provides.
As an example, assume that Sally and Stan are both named as equal beneficiaries of Mother’s trust. Mother’s trust owns a residence worth $200,000 and $600,000 of stocks, bonds, and mutual funds. Sally wants Mother’s residence as part of her share, and Stan is fine with that arrangement. In the end, the trustee will distribute the $200,000 residence to Sally, along with $200,000 of the stocks, bonds, and mutual funds. Stan receives $400,000 of the stocks, bonds, and mutual funds so that they are treated equally.
The above example is an oversimplified version of the decisions that the trustee, attorney, and CPA for the file must make. The trustee must, for example, consider factors other than fair market value to ensure that the beneficiaries are being treated fairly. One example of those considerations is the tax costs associated with the assets being distributed to the different shares.
So you may be wondering why don’t all of Mother’s assets in my example have no capital gains to consider. If the children/grandchildren are receiving assets from a trust held for the surviving spouse that does not qualify for the marital deduction (a Family Trust/Credit Shelter Trust is a good example of this), then there won’t be a step-up at Mother’s death.
If Mother’s residence and her stocks, bonds, and mutual funds all have a different tax cost basis, then that may alter which assets are to be distributed to each beneficiary. When I refer to “tax cost basis,” I am pointing to unrealized capital gains that will be taxed when the assets are ultimately distributed. The trustee must fairly allocate the unrealized gains between Sally and Stan’s shares so as not to give one of the beneficiaries a materially larger tax burden than the other, unless the beneficiaries agree to a different arrangement.
So before making distribution of the assets of the estate or trust to the children/grandchildren’s shares, it will be important for the trustee to prepare an accounting and schedule of proposed distribution that details all relevant income, expenses, capital gains, and other material items. The trustee would want all of the beneficiaries to consent to the accounting and schedule of proposed distribution, and waive any objection to it prior to making distribution.
A trustee who goes ahead with the distribution before obtaining all consents and releases runs the risk that a beneficiary may file a lawsuit against the trustee after the assets and money leave the trustee’s control. The beneficiary may claim that they didn’t receive everything that they were entitled to, or that the distribution schematic was unfair to that beneficiary.
If the trustee has not yet made distribution, then the trustee has the opportunity to consider the objection and change the schedule if that is appropriate. If the trustee doesn’t believe that the objection has any validity, then at least he still has the funds to pay legal, accounting, and other expenses associated with the investigation, defense, and resolution of any such challenge. If, on the other hand, the trustee has already made distribution, then the trustee could be in the undesirable position of either having to defend the lawsuit out of his or her own pocket, or actually having to seek a refund of amounts that were made to other beneficiaries wrongly, if that turns out to be the case.
Even more troubling, if the trustee is determined to have made a wrongful distribution, the trustee may have to satisfy any damages out of their own pocket. So for these reasons, it is imperative that before making final distribution, or making distribution into a trust created for the beneficiaries, that waivers and consents be obtained.
Once the amounts that are to be transferred from the decedent’s revocable trust to the children’s trust shares are determined, the actual transfer must be made. Like the marital trust, the trustee must apply for a taxpayer identification number(s) and typically uses those numbers to establish bank or brokerage accounts for the trust. If real property is being distributed, then deeds must be prepared.
The trustee must be careful to reserve amounts to pay final professional fees (accounting, legal, and other such fees that may apply), taxes, and expenses before transferring assets into the children/grandchildren’s trust shares.
In larger estates that may be taxable, it may be important to segregate the children/grandchildren’s trust shares into “exempt” and “non-exempt” shares. Hopefully, the trust document either directs the trustee to so segregate or allows the trustee to do this on his own.
The “exempt” and “non-exempt” portions refer to an exemption from the generation skipping transfer tax (GSTT). The GSTT is a penalty tax imposed on top of the estate tax when amounts above the GSTT exemption amount are distributed to individuals who are two or more generations below the Settlor of the Trust. The idea behind the tax is to only allow a certain amount of assets to be held in estate-tax free trusts that avoid taxation as each generation of a family dies off.
I am not going to go into all of the nuances of the GSTT here, except to say that if it applies to a situation, it is vital that qualified professionals are involved in the segregation of the assets and the transfer of those assets to the trusts shares in order to minimize or avoid the application of the GSTT to the given situation.
In many cases, the administrative trustee of the decedent’s trust will transfer the assets to another trustee who will be the trustee who administers the children’s/grandchildren’s trust. Oftentimes, it is the child/grandchild himself who is the trustee for his or her own share. Sometimes, however, it might be a bank, trust company, or other trusted relative. A common example of this is when a decedent’s child is named as the trustee for amounts that are to be held in a continuing trust for a grandchild.
The terms of each trust share will govern the distributions going forward. An income tax return should be filed annually, although when the trust distributes out all of its income, then no tax is paid. Instead, the beneficiary (the child/grandchild) who receives the income will pay the income tax at his or her own rates.
Annual accountings should be sent to the remaindermen beneficiaries unless the trust contains a “designated representative,” which under Florida law allows the trustee to circumvent the annual accounting requirement.