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When considering their estates, some may worry that surviving spouses might remarry and cut off the children. Others may be concerned about a beneficiary’s spending habits or may be uneasy about the possibility that a disgruntled, disinherited relative will cause legal trouble. In order to help meet your current needs and pass as much as possible to your heirs, you need to remain flexible.

One technique that may help you reduce your taxable estate and protect assets for beneficiaries is a “discretionary sprinkling family trust.” What makes this type of trust unique is that the trustees have full discretion as to whether to make distributions to the beneficiaries. The idea is to allow money to go to the people who need it the most. Consequently, the trustee is given the discretion to “sprinkle” income and/or principal among several beneficiaries or to let it accumulate in the trust.

How it works

A sprinkling trust gives the trustee the right to provide income to a single beneficiary, distribute some or all of the income to or among a group of beneficiaries and to do the same with trust principal. In other words, the trustee need not treat all beneficiaries equally.

For grantors who want maximum flexibility for themselves and their beneficiaries, a sprinkling irrevocable trust allows the independent trustee to disburse income or principal based on the beneficiaries’ health, education, support, and/or maintenance needs. The sprinkling trust can be used within other trusts, such as a credit shelter, QTIP, or dynasty trusts. Grantors are able to remove assets, and any appreciation, from their estates yet can still keep them on a string. The funds are held and invested for a class of beneficiaries that could include a spouse, children, grandchildren, or even the grantor.

A good option for multiple children

A sprinkling trust often makes a great deal of sense for minor children. Separate shares can be created for each child, or the funds can be held for all children in a single “pot” until the youngest (or oldest) child reaches a specified age. The trustee can also make predetermined distributions outright once the children reach specified ages. For example, the trustee could distribute a specified sum to each child upon reaching a certain age. Or, if there are separate shares for each child, the grantor could specify that the child would receive one third at age 21, one third at age 25, and the final distribution at age 30. Or, the trust could be crafted to allow the trustee to distribute principal and income in other than equal shares. This could allow the trustee to determine the children’s needs some years after the grantor’s death.

With a sprinkling trust, the trustee also has the authority to invest the undistributed trust assets for total return. To accomplish this, an outside investment advisor may be hired to manage some or all of the trust’s assets, thereby resulting in a team approach to trust administration.

Tax advantages of a sprinkling trust

Because assets retained in a sprinkling trust will not be subject to future estate or gift taxes, sprinkling trusts are often funded with investments that have low value with the potential for high growth, such as limited partnerships and depressed stocks.

The distribution flexibility with a sprinkling trust may reduce income taxes. For example, if all of the trust income went to the surviving spouse, it would be taxed at his or her tax rate. However, if the trustee redirected some of that income to children or grandchildren who are in lower tax brackets, more after-tax dollars would stay with the family.

There have been situations where couples resisted setting up irrevocable trusts because they were concerned that they might need their funds in the future. In such cases, each spouse could establish his or her own sprinkling family trust and the trustees would be given the ability to distribute income and principal to the couple’s children and/or to the other spouse. The grantor does not retain any interest that is taxable for federal estate tax purposes, so the trust’s assets will not be included in his taxable estate. But if his or her spouse is the sprinkle beneficiary, the grantor will pay the income tax on the trust’s ordinary income and capital gains. These tax payments may serve to further reduce the grantor’s taxable estate because they can be made out of personal funds that might otherwise be exposed to estate tax at the grantor’s death.

In addition, the creation of a sprinkling trust may be more efficient tax-wise than a gifting program. Whereas gifts to children and grandchildren in excess of the gift tax exclusion allowed each year would be subject to gift tax, distributions from a sprinkling trust would have no gift tax consequences (although the recipients may be subject to income taxes on some portion of the annual income earned by the trust if that income is not taxable to the grantor).

If you choose to create a sprinkling family trust, the trustee will have a great deal of discretion over your beneficiaries’ financial lives; therefore, you should take time in selecting the right trustee. And since trusts have to be designed to last a long time, they must allow for the possibility that corporate trustees (trust companies or banks) may be needed to replace family members who decline or are unable to serve as successor trustees.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. Investing involves risk, and you may incur a profit or loss.

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