Beneficiaries of terminating trusts have a lot more to think about than just the dollars and cents of their distribution. It is important to understand what is going to happen, the options, and the impact of those choices on the beneficiary’s overall wealth management plan.
From Termination to Distribution
There may be quite a bit of time between the event which triggers the termination and when a distribution of trust assets is made. Some trusts, for example those that have existed for a long time or have more than a few beneficiaries, may take more time to complete the termination process. There may be a formal accounting process, requiring court approval, that needs to occur. This could take as long as a year or more. Alternatively, there may be a less formal closing process that will require the preparation and signing of legal documents and could take months.
Planning Point—Do not make financial commitments on the expectation of receiving your distribution in the short term.
When a beneficiary does receive a distribution of trust assets, it may come in the form of cash, marketable securities, or other illiquid assets such as shares in a closely held company or mineral interests. The type of assets received may have as much impact on the options available as when they are received.
In Kind or Cash?
Trusts often distribute equal shares to all beneficiaries in the same generation. At first blush, it may seem simple – great-grandmother’s trust is ending and your brother, sister, and you will each get a check in the same amount.
There may be more to it than that. The trust likely holds a variety of investments, not just cash. The trustee will likely ask all beneficiaries if they want to receive their distribution in kind or in cash. With an in-kind distribution, each beneficiary will likely receive a proportionate share of each asset remaining in the trust. A cash distribution requires the trustee to first sell trust assets and then make the distribution in cash in the form of a check or wire transfer.
This decision may not be as straightforward as it sounds. There are situations whereby all beneficiaries may have to make the same election, to receive either cash or in-kind distributions. For some siblings, a collective decision about how to receive their distributions may be challenging; for others it may be easy.
For large terminating trusts, in our experience, most families choose to take in-kind distributions. In-kind distributions delay possible negative tax ramifications. No sale of the assets means no capital gains recognition at the time of distribution. An in-kind distribution may be necessary when one or more of the trust assets is illiquid. It also avoids having a period when assets are not invested.
A Taxing Situation
Receiving an outright distribution from a trust does not usually create an immediate tax obligation for the recipient, but it likely carries with it some tax consequences. The distribution you receive may increase your estate and your exposure to federal or state estate taxes for the first time. In addition, if you are receiving securities or other noncash assets, you may receive the asset with a carry-over cost basis which may result in a capital gains obligation upon sale of those assets. If that is not understood before those securities are sold, you may find your net proceeds to be less than you initially expected.
Creating New Trusts
For those planning to gift a portion of their inheritance to heirs or a charity, it may make sense to create trusts to manage the distribution proceeds. This is particularly the case if the gifts are sizeable. If you are planning a gift to a family member, do not rule out creating a new trust based on experience with an older one. Unlike trusts of the past, there is now tremendous flexibility in the manner in which modern-day trusts can be set up for the benefit of your spouse, descendants, or both. Gifting to family members in trust can deliver a means to protect assets and provide for heirs over time. It could allow a young person time to learn what this resource really means for them and their future. Be aware some of your preferences might be counterbalanced by tax considerations.
You may view your pending trust distribution as a vehicle to advance your charitable intentions. Here too there are many choices. Sometimes people are inclined to sell assets received from a distribution and then send a check to the organization(s) they wish to support. However, if the assets received in the distribution have a cost basis lower than the sale price, the sale will incur capital gains tax. If the assets received from the trust can be easily transferred, such as marketable securities, making the gift in-kind to the nonprofit organization will allow the organization to sell the assets without the donor incurring capital gain. If the distribution you receive is large you could also consider a charitable trust of one variety or another. Charitable trusts can be a good fit for many situations. If you want to make a large gift to an organization but feel you cannot afford it right away, a charitable remainder trust might be worth considering. A charitable lead trust could be a good fit for those who wish to benefit a charity today and a younger generation of family members in the future. In either case, creating a trust can be a good way to be certain your chosen organizations will receive your support.
Weighing Your Options
There are at least five actions that recipients of trust distributions can take when they receive their distributions. Each may have impacts from a wealth management standpoint. Beneficiaries may choose one or some combination of the following actions:
- spend their distribution;
- retain it in their own name (save it);
- title it jointly with another person;
- give it away to a person or charity; or
- put it in a trust.
Spending Your Distribution
You might spend the distribution you receive on something ephemeral, in which case no further discussion is necessary. Some who receive substantial distributions relative to their other resources purchase lasting assets, such as a vacation home, a boat, or even a plane. Any such significant acquisition may spawn the need to review insurance, tax-planning, and estate-planning issues.
Retaining Your Distribution
Retaining a substantial distribution in your own name may seem simple, but doing so may create choices that need to be considered. If your distribution is in the form of a substantial amount of marketable securities, you may be adding to an existing investment portfolio or beginning to maintain one for the first time. In either event, you should consider an account at a financial services firm in order to easily receive your distribution. In addition, you will need to review your asset allocation and overall investment strategy.
Keeping these assets may also mean you have more risk exposure than prior to the distribution because of how these assets impact your overall asset allocation, making it prudent to review all of your insurance policies and estate plan.
You may also want to consider creating or updating durable powers of attorney or a revocable trust. A significant increase in net worth may mean you need someone who might be able to help manage your affairs for a period of time if you cannot do so. Durable powers of attorney are useful for this purpose. So too is a revocable trust, which can be helpful in setting out a longer-term estate plan.
Keeping it in the Family
Do you and at least some of your siblings or cousins also receiving distributions intend to make long-term investments with these resources? There may be an opportunity to act in concert with other family members if their objectives are in alignment with yours. If so, forming an entity to comingle investable assets from multiple family members may provide economies of scale savings with regard to investment advisory fees. It may also open up investment opportunities that would not be available with less assets. In our experience, it is not uncommon for families who want to choose and engage investment managers together to establish a limited liability company as a tool to facilitate that goal.
Similarly, if charitable intent is in alignment between you and other relatives, a commingled charitable vehicle such as a private foundation or charitable trust may prove useful. Connecting family members with similar charitable intent around a common conduit with a shared decisionmaking platform can have multifaceted benefits.
Placing Assets Received in Joint Ownership with Another Person
Placing assets in joint ownership with another person creates a host of potential issues that are often ignored or misunderstood. Placing property into joint ownership could mean you are giving rights to the other joint owner, taking away rights from yourself, and/or expanding your exposure to creditors of the other joint owner. Most estate and tax advisors today generally recommend against placing significant assets in joint ownership as the desired results can often be achieved another way without the potential negative effects. If you are considering placing inherited property in joint name, you should seek legal advice.
Giving Away Your Distribution
If you are considering a gift to one or more people, typically children or grandchildren, it may be a fairly simple decision if the distribution you are going to pass on to each is relatively modest. If the distribution you are receiving is large, a range of issues may need to be considered, including the following:
- Will there be any tax ramifications associated with your gift?
- Are you comfortable knowing that an unrestricted gift can be used for any purpose at any time by the recipient?
- How will the gift be perceived by the recipient(s)? Might it cause them to change behaviors in unproductive ways?
For these reasons, and perhaps others, you might want to consider placing your distribution in a trust (see Creating New Trusts section above).
As the beneficiary of a trust you may find its termination to be an empowering event. There are, however, likely to be a number of considerations that need to weighed. In preparation for a distribution, we believe it is important to learn what to expect and review key decisions that need to be made so you are prepared to enjoy your inheritance.
For more information, please contact your PNC advisor.