Post-Mortem Administration Series, Part IV: What You Need to Know About Your Inheritance Trust

Part III of our series on post-mortem trust administrations of trusts discussed the difference between receiving an inheritance “outright,” and receiving an inheritance “in trust.” Part IV of the series addresses what beneficiaries of inheritance trusts need to know in order to understand, manage, and protect their inheritance. While many implications stem from receipt of an inheritance in trust, this article will touch on some of the most salient considerations.

Who is in Charge?

Depending on the terms of the original living trust or the sub-trust (i.e. Family Trust, Credit Shelter Trust, QTIP Trust, Survivor’s Trust, etc.), the beneficiary of such a sub-trust may also be their own trustee. Serving as the trustee of one’s own sub-trust simply means that the beneficiary also may decide how the funds in the trust are consumed, subject to an ascertainable standard, identified in the Internal Revenue Code, as the beneficiary’s “health, education, maintenance, or support” (often referred to by the acronym, “HEMS”). Therefore, if you are the trustee of your own inheritance trust, you are in charge of deciding whether a distribution is appropriate under this ascertainable standard. If you are not the trustee of your own inheritance trust, you must seek distributions from the trustee, and the trustee may or may not make such distributions, depending on the guidelines set out in the trust document.

How Do I Get the Money Out?

If you are the trustee of your own inheritance trust, you can write a check, make a purchase, or make a transfer so long as the distribution satisfies the ascertainable standard. As outlined above, if you are not the trustee, someone else is in charge of determining whether a distribution would qualify under this HEMS standard. Regardless, most trustees have a discretionary standard, which allows the distribution of funds for the health, education, maintenance, or support of the beneficiary. Institutional trustees may have much broader standards for distributions. In addition, some trusts instead have a “unitrust” provision, which requires that a certain amount or percentage be distributed on a monthly or annual basis. This is detailed in the original living trust, and the trustee is required to follow the terms of the trust in making those distributions. It is important to note that this is the case even if you are both trustee and beneficiary.

For example, if you are a surviving spouse who is the trustee and beneficiary of a Family Trust (a/k/a credit shelter trust—see Part II of this series for a discussion on this type of trust), the trust might have been created primarily for your benefit, or it might have been created for your benefit and the benefit of your descendants. You may, therefore, have responsibilities, as trustee, to the other beneficiaries of the trust. Again, you must look to the terms of the original trust to determine who the current beneficiaries—those individuals entitled to receive distributions right now—are.

Even if you, as the surviving spouse, are the only current beneficiary of the Family Trust, the terms of the trust may require that you protect the interest of future beneficiaries by spending trust funds only if you otherwise lack the resources available to cover that expense. There can also be provisions prohibiting the spending of trust funds for the benefit of others, such as unrelated individuals, a future spouse, or charities. There may even be a provision requiring that you execute a valid prenuptial agreement prior to remarriage in order to maintain access to the Family Trust. Inheritance trusts for non-spouse beneficiaries tend not to be so restrictive, but again, these answers lie in the original living trust document. It can be challenging to discern your rights and/or responsibilities as trustee or as beneficiary, so we recommend working closely with your attorney to ensure you understand your obligations.

How is My Inheritance Trust Protected?

Leaving an inheritance to a beneficiary in trust, rather than outright, offers protection from estate tax as well as divorce or other creditors. This circles back, in part, to our earlier discussion of the HEMS standard. The funds in a beneficiary’s irrevocable trust are not includible in the beneficiary’s estate, so long as the beneficiary possesses a limited power of appointment, and the trust is governed by the HEMS standard. Additionally, Alaska Statute 34.40.110 provides strong protections for beneficial trust interests by preventing a trustee from transferring trust assets to anyone other than the beneficiary, if it is so directed in the trust. A directive like this is known as a “spendthrift” provision and is meant to prevent use of trust assets to satisfy the personal debts or obligations that the beneficiary may owe. As an aside, this protection is not bulletproof. When a beneficiary serves as their own trustee, the beneficiary’s creditors could argue that this control by the beneficiary as trustee is de facto ownership, making the asset attachable as property owned by the beneficiary. Therefore, when creditor protection is a goal, the question of trustee selection is paramount.

However, this protection stays intact only so long as the inheritance trust assets stay separate and segregated from the beneficiary’s assets. If funds are distributed out of the trust and to the beneficiary, directly, they are considered the beneficiary’s own property, and are therefore attachable. For example, if the funds are distributed to an account that is owned jointly by the beneficiary and the beneficiary’s spouse, these funds are likely considered a joint marital asset for the purposes of divorce. Further, while assets inside the inheritance trust can be invested and can grow without jeopardizing the trust’s creditor protection, the beneficiary may not contribute their own assets to the trust.

Finally, because it is a separate legal entity from the beneficiary, an irrevocable trust must have its own tax identification number (also referred to as an “EIN” or “Employer Identification Number”), which functions as the trust’s version of a Social Security Number. This number is separate and distinct from the beneficiary’s Social Security Number. Therefore, the beneficiary is not considered the “owner” of the property inside the inheritance trust, and the beneficiary’s personal creditors could not have had a reasonable expectation of being able to access or attach that property.

What About Taxes?

Trust income will be determined by the trust terms, and possibly the Alaska Principal and Income Act. The trustee of any sub-trust or irrevocable trust is responsible for filing any required income tax returns. These returns can be complicated and may require filing of K-1 returns to attribute income to the individual trust beneficiary in order to pay taxes at the beneficiary’s personal income tax rate, rather than the trust income tax rate. It is always advisable to work with an accountant who is familiar with irrevocable trusts in the preparation and filing of these returns.

There are a number of things that any inheritance trust beneficiary should keep in mind. If you have questions about your rights or responsibilities as trustee or beneficiary of an inheritance trust, feel free to contact our Generations paralegal, Alex Quast, who can schedule you for a phone/video conference or trust review appointment with one of the attorneys.