The often-overlooked benefits of a trust protector

How having a trust protector can enhance financial planning flexibility

Nov 10, 2013 @ 12:01 am

By Ed Mccarthy

The use of trust protectors is likely to increase as financial advisers recognize their potential benefits. A standard feature in offshore asset protection trusts, they're found less frequently in the domestic variety but could be a smart move for clients who want more oversight and flexibility.

A trust protector does not replace any of the traditional roles in trust management, such as an administrative trustee and an investment adviser. Instead, the trust protector acts as an overseer to ensure the trust operates according to the grantor's intentions.

You can think of the trust protector as a “safety net” in case of problems with existing trustees, said Martin Shenkman, an estate-planning attorney with Martin M. Shenkman PC. “A trust protector is a powerful but limited role intended to preserve the intent of the original trust through certain limited powers they may be given,” he said.

The protector can be an individual or an institution. Randy Gardner, a professor at the University of Missouri-Kansas City and an attorney with Estate Plan Inc., said that 99% of the protectors in his clients' trusts are certified public accountants. In that role, CPAs monitor tax laws and collect beneficiaries' feedback on how well the trust arrangement is serving them. If necessary, the CPA can hire an attorney to make changes to the trust. “The trust protector is acting on behalf of the grantors, and really the beneficiaries, too, to make this trust what it was intended to be by the grantors when they set it up,” Mr. Gardner said.

Protectors can be helpful in circumstances such as assessing discretionary distributions, said Kristi Mathisen, managing director of tax and financial planning with Laird Norton Wealth Management. She cites the scenario of a grantor who wants his trust to have the ability to make discretionary distributions to beneficiaries who are starting businesses. Stating that provision in the trust document, however, might encourage beneficiaries to start businesses primarily to receive additional trust distributions. Omitting that language while allowing the trust protector to make those distributions based on his or her evaluation of the situation accomplishes the goal and reduces the risk, Ms. Mathisen said.


The scope of the protector's powers can be broad or limited, depending on the trust document's specific details. For example, the protector could be given authority to move the trust to another state if the state where it's currently located makes unfavorable changes to its laws or taxes. A trust also could allow the protector to change trustees and create general powers of appointment.

Having a trust protector enhances planning flexibility by allowing the trustee to “toggle” trust provisions on and off, said Mr. Gardner. He cites a client who wanted to create an irrevocable life insurance trust to keep the policy's proceeds out of that client's estate. An additional goal, though: The client wanted an accelerated-death-benefit rider on the policy should she need funds for long-term care or become terminally ill.

That's a dilemma, because reserving the power to access the policy's value would pull the proceeds back into the estate. One possible solution: Give a trust protector, who is not a beneficiary, the ability to change the trust so that the trustee can make loans to the grantor. If the client dies with the original trust unchanged, the life insurance is out of her estate. If she needs the trust funds later in life, the trust protector has the ability to “flip” the trust and allow advances to the grantor. At that point, “we know it will be included in her estate, but that's not our big concern anymore,” Mr. Gardner said. “Getting to those buildups in the life insurance policy is the goal.”

Changes in tax rates illustrate another case where a protector can add flexibility and improve outcomes for trust beneficiaries. Under the American Taxpayer Relief Act of 2012, the top income tax rates and Medicare investment income surtax take effect at much lower income levels for trusts than individual taxpayers. Trusts and estates now pay the 3.8% Medicare investment income surtax, the top 39.6% ordinary income tax rate and the 20% capital gain rate on amounts over $11,950. By contrast, the top ordinary income and dividend rates don't affect individuals with taxable income below $400,000, and the Medicare investment surtax starts at a modified adjusted gross income of $200,000.

The difference between the tax scales creates planning opportunities for clients with irrevocable trusts. Interest and dividends are taxed either to the irrevocable trust when retained in the trust or to the beneficiaries if distributed, but not both. (With grantor trusts, tax liability flows through to the grantor, so trust-level tax isn't an issue.) Consequently, trustees can allocate income between the trust and beneficiaries to minimize overall tax liability.

For instance, trusts pay a 15% rate on their first $2,450 of ordinary income. If a beneficiary's marginal tax rate is higher than 15%, retaining that $2,450 in the trust reduces the overall tax expense. And distributing income to beneficiaries in tax brackets lower than the trust's produces the same result of a lower overall liability.


Capital gains raise a different issue. Because trusts incur the 20% capital gain rate and the 3.8% Medicare surtax on amounts over $11,950, the tax bite on gains adds up quickly. If the beneficiary is in the 0% capital gains bracket, that's a 23.8% tax rate differential in favor of distributing the gain.

But there's a potential catch: Most states' laws allocate a trust's capital gains to principal. When a trust lacks language allowing the trustee to allocate capital gains to income instead of principal, the trustee must pay the trust's tax rate on the gains. A trust protector can overcome that problem, Mr. Gardner said, by having an attorney add language to the trust giving the trustee the ability to allocate between principal and income. That flexibility lets the trustee manage distributions more effectively and reduce the combined tax liability.

Ed McCarthy is a certified financial planner and freelance financial writer in Pascoag, R.I.


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