Trusts Are Mostly Not About Taxes

Hello friends. Happy June (if you celebrate).

This week: why estate planning attorneys keep recommending trusts to clients who don't have a tax problem (it's not what you'd think), why an umbrella policy isn't a substitute for an LLC (also not what you'd think), and what to do about an irrevocable trust that isn't working (turns out, several things).

Two pages worth checking out while you’re here: Why “Memento Mori” if the name needs explaining, and For Referral Partners if you want to know how the referral relationship works.

As always, if after reading this you find yourself scratching your head or itching to ask a question, then (A) buy some ointment, and (B) shoot me an email.

— Doug Harvey

In This Issue:

Here is a question that comes up constantly. A client has an estate well below the federal exemption — no tax exposure, no tax planning to speak of — and yet their attorney has structured the plan to leave assets in trust for the surviving spouse and the children rather than just handing everything over outright. The advisor looks at it and reasonably wonders what the point is. There is no tax being saved. The structure looks like overkill.

It isn't overkill. The tax savings are one reason to use trusts. It is often not the most important reason. Trusts protect assets from creditors. They protect a surviving spouse's inheritance from a future spouse if he or she remarries. They protect a child's inheritance from divorce, lawsuits, and the child's own poor judgment. They keep the inheritance in the bloodline across multiple generations instead of disappearing into a stepfamily after one bad marriage. (The bad marriage is, statistically, the bigger threat.)

That said, the structure is a choice, not a default. The way we handle it is to lay out the pros and cons — the protection on one side, the simplicity of an outright distribution on the other — and let the client pick. Most clients, once they understand the protections, want the trusts. Some don't. The ones who don't, don't get them. The point is that the decision should be informed, not assumed in either direction.

Trusts are sometimes a tax thing. They are much more often the result of a parent or spouse doing what they can, while they can, to make things easier on the people they leave behind.

Real estate investors love this one. Insurance is (sometimes) cheaper than an LLC, easier to set up, and feels like a complete answer. Are they right? Well, kinda? But also kinda no.

To be clear: insurance is necessary. We recommend it, and any investor without proper coverage has a different problem we should also be talking about. But insurance and an LLC are not substitutes — they cover different failure modes.

An insurance policy is a contract. It pays what it says it'll pay, up to the amount it says it'll pay. Two things can go wrong: the incident isn't actually covered (exclusions exist, and they're not arbitrary — insurance companies aren’t in the business of paying every claim that walks in the door), or it's covered but the limits aren't enough. A serious injury or wrongful death claim can blow past a $2M policy in an afternoon. Whatever is above the limit (or not covered at all) is the owner's problem — and if the property is in the owner's name, the property is fair game.

Here's the thing about lawsuits: people don't really sue people. People talk to plaintiff's attorneys, and those attorneys decide whether to sue. They take cases on contingency, which means they're working for free until a recovery happens. So the first thing a good plaintiff's attorney does is figure out what's reachable. A defendant with a clean LLC structure, no personal exposure, and well-defined policy limits is a lot less appealing than one who owns three rental properties in his or her own name and has a brokerage account titled the same way. Sometimes the lawsuit doesn't happen at all. Sometimes it happens but settles fast.

An LLC handles what the policy doesn't. It keeps a problem at the property from reaching the owner's other assets, and a problem with the owner from reaching the property. It's also a bargaining chip — plaintiffs go after whatever they can reach, and "everything the owner owns personally" is a much softer target than "whatever sits inside the LLC." Belt and suspenders, plus a TGI Friday's flair button that says settle this for less.

Every estate planning client, at some point, says they want to keep things simple. They will say this with great conviction. They will also be unable to define it. When you come across this inevitability, use this line to get them to do the defining:

"When you say simple, do you mean fewer pieces of paper — or knowing your wishes get carried out, the way you intended, with as little friction as possible?"

“Our time is limited, so don’t waste it living someone else’s life.”

- Steve Jobs