The pandemic introduced a tectonic shift of perspective about wealth planning, changing from “it’s never too late to plan” to “it’s never too early to plan.” As people become more cognizant of their own mortality, they have also become more pragmatic because, as Dr. Susan David, award-winning Harvard Medical School psychologist and named one of the world’s most influential management thinkers, aptly said, “Life’s beauty is inseparable from its fragility.” Given this change in mindset, one favored tool for wealth planning is a Trust — a malleable tool even with the backdrop of the particularly challenging and sometimes complex compulsory heirship rules in the Philippines.
A Trust is primarily a fiduciary relationship between a person called a Trustor or Settlor and a Trustee. The Trustor sets up a Trust, i.e., putting assets in a Trust or under the name of a Trustee. The Trustee is a person or entity appointed by the Trustor to take care of the assets placed in the Trust on behalf of or for the benefit of the Beneficiaries named in the Trust. As the Trustor is trusting the Trustee to take care of assets in favor of designated beneficiaries, the Trustee has a fiduciary obligation to the Trustor. Fiduciary obligation here means that the Trustee’s responsibility is not just within the level of a “good father of the family;” the Trustee should handle the Trustor’s and beneficiaries’ interests with the highest meticulous care. They hold a duty to preserve good faith and the trust reposed upon them.
A TRUST AS A WEALTH OR ESTATE PLANNING TOOL
Employing a Trust is similar to writing a Last Will and Testament but without the burden of a costly, cumbersome and possibly protracted probate proceeding. Under Philippine rules, a Last Will and Testament has to be probated or have its legal validity recognized before a court. Because a probate proceeding is a judicial process in our jurisdiction, it will require lawyer’s fees and may result in considerable delays in the distribution of the benefit to the heirs.
It is in the Trust Deed or Trust Agreement that the Trustor should put all their instructions as regards who should be benefited, when they should be benefited, what they will get (if hard assets), how much (if cash), and what conditions the beneficiaries must fulfill to be entitled to the income and/or principal of the Trust. In all of these, the Trustor must bear in mind the concept of “legitime” or the minimum entitlement under the law of compulsory heirs, which cannot be burdened with any condition.
Once the Trustor passes away, the Trustee simply implements the distribution to the heirs/beneficiaries in accordance with the instructions of the Trustor. In most Trust arrangements, the Trustor is free to appoint a Protector or Overseer (usually a close and trusted family friend) who is tasked to see to it that the Trustee will perform all of its fiduciary obligations to the letter.
REVOCABLE OR IRREVOCABLE?
When deciding whether the Trust should be revocable or irrevocable, the following points should be considered:
Generally, the substantial terms and conditions of an Irrevocable Trust (e.g., addition or subtraction of named beneficiaries) can no longer be changed. In a Revocable Trust, the Trustor can change the terms and conditions of the Trust for whatever reason. There is more flexibility for the Trustor in a Revocable Trust in terms of control over the assets in the Trust and in adding or removing beneficiaries.
Transfers of assets to an Irrevocable Trust is essentially a donation, attracting a donor’s tax of 6%. This means that assets transferred to an Irrevocable Trust are no longer part of the estate of the Trustor and will no longer be subject to the 6% estate tax upon the passing of the Trustor. Therefore, the decision to set up an Irrevocable Trust is also a choice between paying a 6% donor’s tax at today’s value or paying the 6% estate tax based on the prevailing value later. This is particularly crucial for real property assets to be passed on to the next generation since the appreciation in value of real estate, especially those in prime locations, is unbelievably exponential.
On the other hand, assets transferred to a Revocable Trust are still considered assets of the Trustor, such that upon the Trustor’s demise, the assets in a Revocable Trust will still be subject to 6% estate tax as donor’s tax was not paid during the transfer of assets to the Revocable Trust.
Assets transferred to an Irrevocable Trust are also protected from creditors of both Trustor and beneficiaries, subject to certain rare exceptions. This also means that assets in an Irrevocable Trust are protected from future in-laws. This is the complete opposite in the case of assets transferred to a Revocable Trust, as future in-laws can potentially acquire assets from the Trustor’s family line due to Philippine compulsory heirship rules or other contingencies like annulment. This is also the reason why an Irrevocable Trust is very useful in wealth planning if the Trustor intends for specific assets not to cross family lines. For example, an Irrevocable Trust can shield shares of stock in a family-owned corporation if it is the family’s policy not to allow in-laws from owning shares in the family corporation to prevent potential complexity to the family dynamics.
In an Irrevocable Trust, as long as the title to the assets is in the name of the appointed Trustee, estate tax will not apply even if any of the beneficiaries passes away since none of the latter own any assets in the Trust. This means that several generations of estate tax can be saved for as long as the corpus of the assets remain in the Irrevocable Trust. This benefit is not present in a Revocable Trust arrangement as assets from a Revocable Trust are distributed to beneficiaries upon the death of the Trustor.
An Irrevocable Trust can also be used for wealth replenishment or “reforestation” if used in combination with life insurance. The fund of an Irrevocable Trust can be used to insure the life of the beneficiaries, and name the Trustee of the Irrevocable Trust as custodian of the proceeds of the life insurance policy for the benefit of or on behalf of the next generation. As long as the designation of the intended beneficiaries is irrevocable, the beneficiaries of the policy will get the proceeds tax-free. This cycle can be repeated in every generation to replenish the fund in the Trust.
This arrangement is also useful when the intended beneficiaries of the life insurance policy are minors, suffering from any physical or mental disabilities and require life-long care, or when the parents believe that the beneficiaries would not be able to handle their own finances. Appointing a Trustee to manage, grow and control the periodic distribution of the funds would be ideal. However, when the named beneficiary of a life insurance policy is the Revocable Trust, the proceeds of the life insurance policy will be subject to estate tax, since a Revocable Trust has no personality distinct and separate from the Trustor.
In a blog article, “Are trusts on your radar for succession planning?” Michael Parets, EY EMEIA Private Tax Desk Leader, offered other insights about Trust as wealth planning tool, such as choice of jurisdiction and the presence of laws recognizing Trusts; the domicile and citizenship of intended beneficiaries; the competence and reputation of the Trustee; and of course, the expertise of the tax advisor.
FUTURE-PROOFING WITH TRUST
A Trust is not just a planning tool for the wealthy, but a viable wealth management tool for everyone who wishes to future-proof their assets for their heirs. In addition, we should remember that while there is certainly a cost in planning, there is a potentially higher cost in doing nothing – not just in tax, but more importantly, in maintaining peace and harmony within the family.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.
Jules E. Riego is the Business Tax Services (BTS) Leader of SGV & Co. and the EY Asean BTS Leader.
