Many people think of wills and trusts as separate estate-planning tools. However, there are some cases where they overlap. Unlike most trusts used in estate planning, testamentary trusts are established as a part of a last will and testament. Once the will goes through probate, a trust is created to help manage asset distribution.
Testamentary trusts offer a low-cost, relatively straightforward way to control assets and manage their distribution. However, like any other estate-planning tool, they have their downsides. In this article, we’ll take a look at some common legal issues in testamentary trusts.
The Legal Risks of Extended Probate and Court Supervision
It’s important to seriously consider probate issues with testamentary trusts before deciding to include one in your estate plan.
One of the main advantages of both revocable living trusts and irrevocable trusts is that they bypass the probate process. Probate is the court-supervised procedure of settling a deceased person’s estate. It usually involves the following steps:
- Validating the will
- Inventorying and valuing all assets
- Paying all outstanding debts and taxes
- Distributing the deceased’s assets to heirs
Probate doesn’t always go smoothly. A testamentary trust technically can’t be established until the process is complete. If there’s a delay in probate court, heirs may have to wait several months (or potentially even years) to receive their assets.
But testamentary trust legal issues surrounding the probate process aren’t merely inconvenient.
Unlike revocable living trusts and most other types of trusts, testamentary trusts require ongoing court involvement. The probate court must supervise the trust for as long as it lasts, which means your family might have to contend with extensive court costs and legal fees.
Even if your loved ones don’t end up paying the cost of court involvement out of pocket, probate-related expenses can significantly diminish the value of the trust.
Resolving Ambiguities and Drafting Pitfalls in Trust Language
Confusion over language and resulting litigation are common problems with testamentary trusts. These trusts are part of the public record, which makes them more vulnerable to challenges. Even if no one challenges the trust based on unclear language, a lack of clarity could make your trustee’s job needlessly difficult.
The following are some common drafting pitfalls that can lead to legal issues in testamentary trusts.
Unclear Beneficiary Designations
While this issue isn’t unique to testamentary trusts, it’s nonetheless important to mention. Using nicknames or overly broad phrasings like “to my children” can create confusion, delay distribution, and lead to costly contests.
Poor Definition of Trustee Powers
Testamentary trusts become irrevocable after the testator’s death, so it’s extremely important for these trusts to come with clear administrative instructions. Anyone creating a testamentary trust should outline the trustee’s investment and financial-management powers in detail.
It’s also vital to name at least one successor trustee in case the person appointed is no longer able to do the job.
Vague Language Around Distribution
Testamentary trusts should include specific instructions for the distribution of assets to beneficiaries. Instructions like “fund living expenses” or “provide reasonable financial support” may be interpreted differently by different people, which can lead to major disputes.
Problems With Asset Descriptions
Over a person’s lifetime, their personal property constantly changes. Just as you should regularly update your last will to include all property, you should routinely update your testamentary trust as well.
In a similar vein, you should also avoid using excessively vague or broad descriptions of property. Each time you mention an asset, make sure to include enough detail to ensure that the trustee can clearly identify it.
Fiduciary Liability: The Legal Burden on Your Selected Trustee
When considering issues with testamentary trusts, many people overlook the sheer weight of responsibility placed on the chosen trustee. Like most trustees, the individual tasked with overseeing a testamentary trust has a fiduciary duty. This means that they’re obligated to act in the best interests of the trust and its creator.
If the trustee fails to fulfill that fiduciary duty, they may be held personally liable. This is true even if they don’t intentionally mismanage trust funds. Trustees who fail (or allegedly fail) to meet their obligations might have to deal with serious legal consequences, such as:
- Having to use personal assets to pay damages to the trust or to beneficiaries
- Being removed as the trustee due to mismanagement
- Being ordered to pay restitution for misused or wasted funds (this is called a “surcharge action“)
In some cases, trustees may be allowed to use trust funds to pay for their legal defense. However, if the court finds that the trustee breached their fiduciary duty, they may ultimately be responsible for paying their own legal fees.
Exposing Asset-Protection Vulnerabilities After Death
Many people who create trusts as part of their estate-planning journey do so at least in part to shield assets from creditors. One of the legal risks of testamentary trusts is that they generally don’t protect assets from the deceased’s creditors.
That’s because, unlike living trusts and other kinds of trusts, the deceased person’s assets must go through probate before they’re transferred to the trust. During the process, creditors may make claims against the estate.
If the deceased died with outstanding debts, the money they had intended to go to beneficiaries may go to creditors instead.
That doesn’t necessarily mean testamentary trusts are to be avoided at all costs. However, if you anticipate creditors making claims against your estate after your death, you may want to discuss other options with your estate-planning attorney as well.
Mitigating the Threat of Will Contests and Beneficiary Litigation
Dealing with legal challenges in testamentary trusts is more than just a headache. It could also mean that beneficiaries won’t receive the full inheritance the testator intended. Although there’s no way to guarantee that a will or testamentary trust won’t face challenges, proper planning can mitigate that risk.
Here are a few strategies that may reduce the chances that your last will and testament will be challenged after you pass.
Clearly Establish Your Mental Capacity
Claims of incapacity are some of the most common and fraught will challenges.
To reduce the chances of a future incapacity-based challenge, consider asking a physician to document your mental capacity during the process of creating your will and testamentary trust. You might also make a video of yourself signing the final document, just in case.
Include a No-Contest Clause
No-contest clauses (also known as “in terrorem” clauses) can be a powerful deterrent for anyone who’s thinking about challenging a last will. Under these clauses, anyone who challenges a will in court and is unsuccessful will have no right to an inheritance.
Discuss the Plan With Beneficiaries Ahead of Time
Discussing your estate-planning goals and the trust itself with your beneficiaries before your death can help promote transparency. When your beneficiaries understand how this tool works and have time to consider the way you want your assets to be distributed, they may be less likely to challenge the testamentary trust later on.
Choose a Neutral Trustee
If the person who has financial oversight over the trust is close to some beneficiaries but not others, it may make it easier for disgruntled family members to raise claims of impartiality. Choosing someone who’s truly neutral may make future claims of this nature less likely.
Navigating Complex Tax-Reporting and Estate-Liquidity Issues
When it comes to testamentary trusts, legal complications are more common than many people realize. Often, people creating estate plans become so focused on the issues mentioned previously that they overlook the complex tax reporting and filing requirements, which include the following:
- If the trust makes more than $600 in income, your trustee must file IRS Form 1041 (U.S. Income Tax Return for Estates and Trusts)
- If the trust owes $1,000 or more, the trustee must also make quarterly estimated tax payments
- Trustees must calculate the distributable net income (DNI) to ensure that the trust doesn’t have to pay tax on income passed to beneficiaries
- In some cases, trustees must calculate and pay the Net Investment Income Tax (NIIT)
For many, the liquidity issues that often come with testamentary trusts can create problems as well.
If you anticipate having to pay estate taxes, the executor of your estate typically has nine months from the date of your death to do so. If your estate doesn’t have sufficient liquid assets to pay, it may be necessary to sell off real estate and other illiquid assets.
One way to avoid liquidity issues is by creating an irrevocable life insurance trust. If your life insurance proceeds are paid directly into a trust that bypasses probate, your executor may be able to access enough cash to pay taxes without having to sell off assets.
Get Reliable Help Managing Legal Issues in Testamentary Trusts
Whether you need testamentary trust disputes explained in plain language or you’re trying to decide whether this option is right for you, the skilled testamentary trust lawyers at The Law Office of David S. Schleiffarth, LLC, can assist you. We’re committed to helping each client build a custom estate plan that truly serves their needs.
We understand that the estate-planning process can be emotionally and logistically difficult, which is why we aim to make it as streamlined and stress-free as possible. If you need to update your existing estate plan or create one for the first time, contact us today to schedule an appointment.
