When setting up a revocable trust in California, one of the key decisions is whether to leave property to beneficiaries through outright distribution or in a continuing trust. Both options have distinct benefits and drawbacks, depending on your family’s specific circumstances. Below, we’ll explore the pros and cons of each approach to help you make an informed decision.
Outright Distribution: Pros and Cons
Outright distribution means that once the Grantor (the person who created the trust) passes away, the beneficiary receives the assets directly, without any continuing oversight by a Trustee. This option is straightforward and often attractive to clients who prefer simplicity.
Pros of Outright Distribution:
1. Immediate Access to Assets: Beneficiaries receive their inheritance quickly, without restrictions on how they can use the funds.
2. Simplicity: The trust is easier to administer since it ends when the assets are distributed, meaning there’s no need for long-term trustee involvement.
3. No Need for Future Trustee Management: The beneficiary doesn’t have to navigate trustee decisions or restrictions.
Cons of Outright Distribution:
1. Lack of Creditor Protection: Assets distributed outright are vulnerable to creditors, predators, lawsuits, and divorcing spouses. For instance, if your beneficiary is going through a divorce or faces a lawsuit, the assets could be at risk.
2. No Long-Term Control: If a beneficiary is a minor, a young adult, financially irresponsible or inexperienced, or they may not be ready to handle a large sum of money responsibly, this could spell disaster allowing for an outright distribution of their inheritance. Outright distribution provides no safeguards for poor financial management. Imagine an eighteen-year-old inheriting a large sum of money with no restrictions or supervision. They may be taken advantage of, blow through the money, not go to college, get involved in drugs.
3. Lack of Tax Planning Advantages: Outright distributions may miss out on long-term tax strategies available in continuing trusts, such as application of a generation-skipping transfer tax exemption allowing the assets to grow over time and when they cascade to the beneficiary’s children, would be subject to further estate taxes.
Continuing Trust: Pros and Cons
A Continuing Trust allows the assets to remain in trust title for the benefit of the beneficiary for the beneficiary's lifetime. The trust is managed by a Trustee (sometimes the beneficiary is allowed to act as his or her own trustee at a stated age), who distributes the funds according to the terms of the trust, potentially offering much more creditor protections.
Pros of Continuing Trust:
1. Creditor Protection: One of the most significant benefits of a continuing trust is the protection it offers against creditors, including divorcing spouses, lawsuits, or business creditors. If properly structured with no demand right (where the beneficiary cannot demand distributions), creditors will have a much harder time accessing the inherited assets in the trust.
2. Financial Oversight: The trust ensures that the beneficiary doesn’t receive too much money too quickly, which can be particularly useful for young or financially inexperienced beneficiaries.
3. Flexibility with Trustees: You can appoint a discretionary Trustee (also known as an independent Trustee), who has full control over when and how to distribute funds. This adds a layer of protection because the Trustee can withhold distributions in the event of a lawsuit or other creditor threat.
4. Generational Wealth Transfer: If any assets remain in the trust when the beneficiary passes away, the continuing trust can pass those assets to the next generation or any other named beneficiary with similar protective provisions. And if allocation of the generation-skipping transfer tax exemption has been made to a continuing trust that springs from the main trust, the assets could be passed to successive generations without implication of additional estate taxes.
Cons of Continuing Trust:
1. Complexity: A continuing trust requires ongoing management, which entails more effort. Beneficiaries will need to work with the Trustee to access their funds. However, if the beneficiary is allowed to serve as a trustee at a stated age of maturity, this drawback is mitigated.
2. Cost: There may be additional costs associated with maintaining the trust, particularly if you hire an independent Trustee or professional trust company.
3. Potential for Conflict: If the Trustee (who is not the beneficiary) is too restrictive with distributions, it could lead to conflicts with the beneficiary. This is especially true when the Trustee is a relative or close family member, potentially causing friction in family relationships.
Key Considerations for Continuing Trusts:
For clients seeking maximum protection for their beneficiaries, there are two critical components to consider in a continuing trust:
1. No Demand Right for the Beneficiary: Ensuring that the trust does not grant the beneficiary a “demand right” over trust assets is crucial for asset protection. A demand right allows the beneficiary to withdraw funds at certain ages or life milestones, but it also opens the door for creditors to claim those funds as if they were the beneficiary.
2. Choice of Trustee: Selecting the right Trustee is vital. An independent Trustee (someone unrelated to the Grantor or beneficiary) can be given discretion over trust distributions. This ensures that in the event of a creditor threat, the Trustee can choose not to make a distribution. On the other hand, an interested Trustee (such as a first-degree family member) may be bound by the "HEMS Standard" (distributions limited to health, education, maintenance, or support) and may not provide the same level of creditor protection as an independent trustee. But if listing a family member is preferred, provisions for a successive independent trustee can be drafted or for the ability of an independent “Trust Protector” to remove and replace an interested trustee in favor of an independent trustee.
The decision between outright distribution and a continuing trust in a California revocable trust comes down to your family’s unique needs and goals. By considering the specific circumstances of your beneficiaries and consulting with a qualified estate planning attorney, you can create a plan that provides the right balance of access and protection for your children or other loved ones.
If you, a friend, or family member need help establishing or updating an estate plan, please reach out to our Intake Department at 760-448-2220 or at https://www.geigerlawoffice.com/contact.cfm. We have offices in San Diego County (Carlsbad) and Orange County (Laguna Niguel), but we assist can families throughout California as well.
