Living Trust Disadvantages and Misconceptions

Living Trust Disadvantages and Misconceptions

Discussion of living trusts would be incomplete without a discussion of their potential disadvantages. While some of the disadvantages listed, such as no income or estate tax savings, may not be disadvantages in the true sense of the word, they are misconceptions about living trusts that need to be addressed.

No Income Tax Savings

The living trust does not avoid or save income taxes while you are alive. You retain control of the assets in your living trust, you receive the benefits of the trust, and you are both the grantor and trustee of the trust. The income earned by the assets in the living trust will be taxed to you. Although Forms 1099, K-1, and other such forms will be titled in the name of the living trust, you will be required to report this income on your individual income tax return, Form 1040.

During your lifetime, there is no requirement that a taxpayer identification number be obtained for the living trust, and no separate income tax return has to be filed for the trust.

After your death, the living trust must obtain a taxpayer identification number by filing Form SS-4, Application for Employer Identification Number with the Internal Revenue Service (IRS). The taxpayer identification number is similar to a person's Social Security number. All income earned by the living trust will be reported under the living trust's taxpayer identification number.

The living trust will be required to file a separate income tax return, Form 1041, to report all income received by the trust. Form 1041 will show how much of the income received by the trust was paid to the trust beneficiaries. The living trust does not pay income tax on income that is distributed to the trust beneficiaries during the tax year. The beneficiaries pay income tax on the income they receive from the trust. If the living trust does not distribute all of its income, it must pay income tax on the undistributed income.

No Estate Tax Savings

The living trust does not eliminate federal or state estate taxes. Both living trusts and last wills can be structured to minimize estate taxes. As discussed earlier, if your estate does not exceed the applicable credit amount, no federal estate tax will be due. Many states impose their own estate or inheritance tax. While there may be no federal estate tax liability, there may be a state estate tax liability.

No Deadlines for Claims of Creditors

When a will is probated (or an estate without a will is probated), a deadline is imposed on creditors of the decedent. Creditors are required to present their claim to the executor of the estate within a time period specified by statute. Each state has its own statute establishing this time period (which can range from a few months to one year) and the procedures that a creditor must follow to present its claim.

If a creditor does not follow the procedures within the statutory time period, the creditor loses its right to the assets of the estate and is forever prohibited from suing the estate to collect the assets it is due. In most states, however, a living trust is not subject to the same statutory procedures. Therefore, a creditor can sue the trust or its beneficiaries for amounts due long after you have died. Even after the trust has terminated and all of the trust assets are distributed to the beneficiaries, creditors can sue the beneficiaries for claims it has against the decedent.

Does Not Avoid Creditor Claims During Your Life

A living trust does not prevent your creditors from suing you or suing your trust to collect debts during your lifetime. Because you have maintained complete control over the trust assets, the courts treat you as the owner of the assets in the living trust and can force you to pay trust assets to your creditors.

Does Not Eliminate the Need for a Will

Even though you have a living trust that is funded with all of your assets during your lifetime, it is important to have a will. The will can name a guardian for your minor children, appoint a personal representative of your probate estate, and provide that no bond be required of your personal representative. There may be assets that you forgot to transfer to your living trust, such as an unexpected inheritance, or a lawsuit that must be filed on behalf of your estate after your death. A will covers these assets, even if the will only provides that such assets pour over to your living trust. Without a will, you have died intestate and your family must follow the probate procedures for intestacy. Intestacy procedures can be complex, time-consuming and costly, depending on where you live, the size of your probate estate, and other factors.