When creating a trust, a central topic at the planning table is how the trust will be funded. During your discussions, your advisors may mention two key methods of funding trusts — pecuniary and fractional — and the explanations may be confusing when you first hear them. Both options have distinct advantages and considerations that can impact your trust’s administration, tax exposure, and asset values. Choosing the right funding method for you depends on your understanding of the methods of funding and how they apply to your unique family circumstances.
How pecuniary funding works
Pecuniary funding allocates a specific, fixed-dollar amount to a trust. This method is straightforward and easier to administer because it defines a clear sum to be distributed. For example, a trust might specify that $500,000 be allocated to a marital trust, with the remaining assets going to a credit shelter trust. The key benefits of pecuniary-funded trusts are:
- Simplicity. The fixed amount is easy to calculate and distribute.
- Predictability. Beneficiaries know the exact amount they’ll receive, regardless of changes in asset values.
- Ease of administration. Pecuniary formulas are easier to draft and administer than fractional share formulas, as they simply determine an amount to be distributed to one share, with the balance going to the other.
When considering pecuniary funding for your trust pay careful attention to the potential impact of asset value changes. If the value of the estate’s assets changes significantly between the date of death and the date of distribution, the fixed amount allocated in the estate plan may no longer be reflected in the current value of the estate. This could lead to abatement, which is the reduction of inheritances if an estate doesn’t have enough assets to fulfill all bequests. When this happens, a proportional reduction is typically applied, meaning each beneficiary might receive a smaller portion (rather than eliminating some inheritances entirely).
How fractional funding works
The alternative method of funding a trust — fractional funding — allocates a percentage or fraction of the estate’s total value to the trust. There are two key features of fractional funding.
- Equity between beneficiaries. Beneficiaries receive a proportionate share of the estate, which can be fairer if asset values fluctuate. Therefore, if the value of the estate drastically increases or decreases between the date of death and the trust funding date, each class of beneficiary equitably shares in the risk of asset appreciation or depreciation.
- Proportional distribution. The fractional share formula requires that shares in the trust — for example, marital and nonmarital shares — each have a proportional fractional interest in each asset, ensuring that both shares change with appreciation or depreciation between the date of death and the date of distribution.
The fractional funding method adjusts the distribution based on the estate’s value at the time of funding, making it more flexible but also more complex to administer — a potential disadvantage. Also consider that beneficiaries may not know the exact amount they’ll receive until the estate is fully valued and distributed.
Tax implications of pecuniary and fractional funding
Understanding the tax implications of pecuniary and fractional funding methods is also important for effective estate planning. Each method has distinct tax consequences that can impact the overall estate and the beneficiaries. Tax implications of each include:
- Capital gains tax
- Pecuniary: When funding a pecuniary bequest, any appreciation in the value of assets between the date of death and the date of distribution is subject to capital gains tax. This is because the distribution is treated as a sale of the appreciated assets.
- Fractional: Fractional funding can avoid the immediate recognition of capital gains tax on appreciated assets. And, since the distribution is based on a percentage of the estate’s total value, the assets are allocated proportionally, and any appreciation is spread across the entire estate.
- Estate tax
- Pecuniary: The fixed-dollar amount specified in a pecuniary bequest can lead to a higher estate tax liability if the estate’s assets appreciate significantly. If the appreciation is transferred to the marital share, this could potentially increase the surviving spouse’s estate and future tax burden.
- Fractional: Fractional funding can be more tax-efficient because it adjusts with the estate’s value, potentially reducing the taxable estate. This method ensures that both the marital and nonmarital shares benefit proportionally from any appreciation or depreciation in asset values
Key considerations relating to assets
Accurate valuation of your estate’s assets is critical for both methods, requiring a comprehensive inventory of your assets, including real estate, bank accounts, investments, and personal property. Effective planning involves considering the potential appreciation or depreciation of the assets and the impact on the estate’s overall tax liability. Your wealth manager and tax professionals will work with you to help optimize the funding method for your specific needs.
Choosing the right method
The journey of estate planning is a deeply personal and significant endeavor. By carefully selecting the appropriate funding method for your trust, you not only safeguard your assets, but also ensure that your legacy is preserved and passed on according to your wishes. Collaborating with knowledgeable wealth management and estate planning professionals is essential in navigating the complexities of trust funding, ensuring the planning you undertake today will lay the foundation for generations to come.
