The Total Return Trust:
Providing for Your Surviving Partner in Same Sex Permanent Relationships

Effective estate planning for gay or lesbian couples requires “thinking outside of the box.” Since estate tax laws for same sex partners are so unfavorable, the stakes are high. Estate tax rates range from to 37-55% for total taxable estates over $675,000, whereas for traditional married couples, the surviving partner receives an unlimited marital deduction.

The predominant high-level estate planning practices use a variety of techniques revolving around the unlimited marital deduction.  There is also a well-developed field of estate planning for business owners. What about a gay or lesbian couple where one or both partners have a lot of stock and retirement assets and neither partner owns a business?

Same sex partners face complications beyond not having access to the unlimited marital deduction. If there are children, chances are, at least at this point in time, the children will have only one of the partners as a legal parent.  Many gay or lesbian life partners may wish to choose different ultimate beneficiaries.

There is no one-size-fits-all answer. This article, however, presents a detailed look at one of my favorite methods for maximizing asset value for gay and lesbian couples and their families—the total return trust.  (At the end of the article, I list a variety of other techniques that I use in my estate planning practice.)

Let’s take it as a given that you want to provide for the financial security and protection and even over-protection of your life’s partner.  But, what do you want to have happen upon the death of your partner?  Creating a trust is one effective way to have your wishes respected. In general, there are good reasons for these trusts and they often present an obvious solution to many problems. However, they also pose a problem once they are funded.  The devil is in the details.

For the sake of this example, we will assume that you want what remains of your money to go to your sister’s children on the death of your partner. The trust stipulates that upon your death, your life’s partner will receive the income from the trust for the remainder of his or her life.  Upon the death of your partner, the principal remaining in the trust will be distributed to your nieces and nephews.  The individual you pick as trustee has the responsibility of managing the fund to satisfy the interests of both your partner and your sister’s children.

Put yourself in the role of the impartial trustee managing the trust:

The income beneficiary, that is the surviving partner, comes to you and suggests that you invest the money in a variety of junk bonds that are paying 7% interest.  This option would excellently serve the needs of the surviving partner.  However, the junk bonds offer little in terms of long-term appreciation for the principal beneficiaries.  Then, the children, the principal beneficiaries, come to you and recommend that you invest in stocks like Microsoft and Intel that pay no dividends, but do offer substantial growth opportunities—another excellent choice, but only for the principal beneficiaries. It is your duty to somehow satisfy both parties.

You opt to make prudent investments regardless of the income distribution problem.  You choose a portfolio that includes a diverse mix of assets, with a concentration in the stock market.  Unfortunately for the surviving partner, even a well-diversified portfolio will provide little in the way of “classic income” which is historically defined as interest and dividends.  Therefore, your income beneficiary is unhappy.  You decide to compromise. You choose a portfolio that includes a higher percentage of income producing assets even though it does not make sense from a pure investment standpoint. Your best solution results in moderate disappointment for both the surviving partner and the principal beneficiaries.  The truth of the matter is, that with the type of trusts lawyers have been drafting for hundreds of years, there is no perfect or even good solution.

The crux of the problem is how we define income, i.e. interest and dividends from stocks and bonds.  Currently an investment portfolio that makes good economic sense will include assets that have significant growth potential, but that do not pay significant interest or dividends.  Managing the assets of the most common trusts presents a dilemma. One choice limits income, the other limits growth, and attempting to balance the two interests leaves everyone feeling like they are missing out on strategic opportunities. What is the solution?

Let's consider drafting a different type of trust where we define income as a percentage of principal.  For example, let's assume there is $1 million in a trust and “income” is defined as five percent (5%) of the balance of the trust. This means the income beneficiary is assured of earning $50,000 annually even if the assets do not grow.  Of course, without being restricted to investments that produce sufficient interest and dividends for the income beneficiary, the trustee is likely to obtain a much better investment rate of return than five percent.  Let’s assume the trustee is successful and achieves a combination of income and growth equal to 10 % of the principal.  The trust balance the following year would be $1 million plus $100,000 or $1,100,000. Of that, $50,000 is paid as income to the income beneficiary (5% of the original $1M), leaving a balance of $1,050,000.  If income and growth remain at 10%, the trust will continue to increase. The balance of $1,050,000 in the first year, plus $105,000 from income and growth of principal for the next year results in a balance of $1,155,000 from which $52,500 (5% of $1,050,000) is distributed to the income beneficiary.  (More realistically, distributions would probably be monthly or quarterly, not annually.)  Since the income beneficiary is receiving a percentage of the principal, his or her income keeps growing as the investments grow.

Now everybody is on the same page. The income beneficiary benefits when the corpus of the trust increases, and the principal beneficiaries also benefit from the growing principal because, after the death of the surviving partner, they will get more money.  The trustee is happy because he or she can now find investments that will maximize the principal in the trust without having to worry about offending, or perhaps even having legal liability, to either the surviving partner or the principal beneficiaries.  This type of trust is much more likely to preserve peace and unity between the income and principal beneficiaries, and the trustee.  It is a win-win-win situation.

J. Wolff pioneered this concept.  He has written eloquently on the benefits of this type of trust—referred to as a Total Return Trust—particularly for second marriages in which both spouses have children from prior relationships. It came to me that this type of trust meshed seamlessly with estate plans for many of my gay and lesbian clients. And, to my satisfaction, the total return trust has enjoyed enthusiastic approval.

The concept of having the income beneficiary receive a percentage of principal is not new.  A typical endowment fund operates similarly.  The fund invests the money in both income and growth assets and distributes a percentage of the assets each year. This is also how a Charitable Remainder Unitrust (CRUT) works.  However, expanding the use of the total return concept to trusts for same sex couples outside the charitable world will yield huge dividends, or perhaps more accurately, more wealth for both the surviving partner and the principal beneficiaries.

Of course, the total return trust is only one strategy.  Most of the planning I do for gay and lesbian couples involves multiple strategies including: sophisticated and multiple beneficiary designations on retirement plans, Roth IRA conversions, irrevocable life insurance trusts, family limited partnerships, charitable remainder trusts, grantor retained interest trusts, gifting, qualified personal residence trusts, self canceling installment notes, life estates, first-to-die life insurance policies, Section 529 plans (qualified state tuition programs) and other popular techniques.  While these techniques were not created for gay and lesbian couples, they will often resolve planning problems and maximize assets for both partners and surviving family members.  Without the benefits of the unlimited marital deduction and other advantages that traditional married couples enjoy, same sex couples need to aggressively seek out alternate solutions to maximize their assets and reduce their taxes.

James Lange is a tax attorney and CPA who provides specialized retirement and estate planning services to same sex couples with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for IRAs and other retirement plans. You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@outestateplanning.com.