Trusts are an essential part of most estate plans, even the plans of people with moderate wealth.Not too many years ago, trusts were reserved largely for the very wealthy. Times have changed, how-ever, and most estate plans have at least one trust. Trust terms and concepts are unique, and many lawyers don’t do a good job of explaining them. That’s why trusts are confusing to many people. The money spent creating trusts often is wasted.
Because you need to know the basics of trusts, this month, I review the key terms and concepts and describe the most widely used types of trusts. Keep in mind that some of these trusts are given different names in some regions or by different estate planners, but you should be able to tell if the trust described is one of these.A trust is a legal agreement involving at least three parties. The terms of the trust usually are embodied in a legal document called a trust agreement. The person who creates the trust is known as a trustor, grantor, settlor, or creator.
The trustee is the second main party to the agreement. The trustee has legal title to the property in the trust and manages the property according to the terms of the trust agreement and state law. In most states, when title to the property has to be recorded, it is recorded in the trustee’s name but as trustee, not as an individual, such as “John Smith, Trustee of the Smith Family Trust.” A beneficiary is a person who benefits from the trust. There can be multiple beneficiaries at the same time.
There also can be different beneficiaries over time. There can be primary or current beneficiaries, and they can be followed by contingent, successor, or alternate beneficiaries.Sometimes an individual is an income beneficiary, meaning he or she receives only income earned by the trust, such as interest and dividends. Other beneficiaries might be remainder beneficiaries, receiving what remains in the trust after previous beneficiaries pass away or their rights expire.
The trustee is a fiduciary who is obligated to manage the trust property solely in the interests of the beneficiaries and consistent with the trust agreement and the law. The same person or persons can be in more than one of these roles at the same time, as I explain below. A trust is funded by transferring property to it.
A living trust, also known as an inter vivos trust, is one created during the trustor’s lifetime. A testamentary trust is created in the trustor’s last will and testament. A trust can be revocable, meaning the trustor can revoke it or change its terms at any time. An irrevocable trust can’t be changed or revoked, though limited changes are allowed in some irrevocable trusts. Perhaps the most frequently used trust is the revocable living trust, which many people refer to simply as a living trust.In a typical revocable living trust, a married couple creates the trust and serves as the first co-trustees and co-beneficiaries.
Ownership of most of their assets is transferred to the trust, including real estate, vehicles, financial accounts and more. The trustees manage the assets for their own benefit just as they did before the trust was created. After they pass away, a successor trustee named in the trust agreement (often one of the settlors’ adult children) takes over and acts for the benefit of the successor beneficiaries (usually the children and perhaps grandchildren of the settlors).
Typically, the assets are distributed to the successor beneficiaries as directed in the trust agreement. Assets owned by the revocable living trust avoid the cost, delay and publicity of probate under local law. The trust agreement operates as a substitute will, directing how the assets are to be distributed after the settlors pass away. A revocable living trust also serves as a substitute for a power of attorney.
If the initial trustee becomes disabled, the successor trustee can step up and manage the trust assets as long as the initial trustee is unable to do so.There are no tax benefits to a revocable living trust. During their lifetimes, the settlors-trustees are taxed as though they still were owners of the assets.
In addition, the assets in the trust are included in their estates under the federal estate tax. An irrevocable trust usually is created to save income or estate taxes or both. It also can protect assets from creditors. When assets are transferred to an irrevocable trust, the income and gains no longer are taxed to the trust grantor. Income and gains are taxed to the trust when they are retained by the trust and taxed to the beneficiaries when distributed to them. Under the federal estate tax and most state estate taxes, assets that were transferred to an irrevocable trust aren’t included in the grantor’s estate.
Transfers to the trust are gifts to the beneficiaries. The grantor’s gift tax annual exclusion or lifetime exemption can be used to avoid gift taxes, but gifts that exceed the exclusion and exemption are subject to gift tax. A grantor trust is an income tax term describing a trust in which the grantor is taxed on the income. The revocable living trust is an example of a grantor trust.
An interesting wrinkle is that the income tax and estate tax have different details in their rules.That leads estate planners to recommend to some clients an intentionally defective grantor trust (IDGT).
In an IDGT, the grantor is taxed on the trust income, though it is distributed to the beneficiaries or accumulated in the trust for them. Yet, the assets in the trust aren’t included in the grantor’s taxable estate. In effect, the grantor is making additional tax-free gifts to the beneficiaries by paying income taxes on the trust income. It can be a good strategy for very wealthy people.
A trust can be discretionary or non-discretionary.A trustee of a discretionary trust has authority to make or withhold distributions to beneficiaries as the trustee deems appropriate or in their best interests.
The discretion allows the trustee to withhold or reduce distributions if the beneficiary is wasting the money or has a problem such as sub-stance abuse or gambling. The trustee also can protect the money from creditors and divorcing spouses. Discretion allows the trustee to increase distributions when the beneficiary has a need or good use for more money. The discretion also allows the trustee to take income taxes into consideration and distribute or accumulate income to minimize overall income taxes.
In a nondiscretionary trust, the trustee makes distributions according to a formula or directions in the trust agreement. A spendthrift trust is an irrevocable trust that can be either living or testamentary. The key provision limits the beneficiary’s access to the trust principal. The beneficiary and the beneficiary’s creditors can’t force distributions.
Once money is distributed to the beneficiary, it could be wasted or seized by creditors. The spendthrift provision is used when the settlor is concerned a beneficiary might waste the money or have trouble with creditors.
Most states allow spendthrift trusts, but some states limit the amount of principal that can be protected or don’t recognize spendthrift provisions. A special needs trust is created to provide for an individual who needs help and assistance for life, often a child or sibling of the trust settlor. It can be either living or testamentary.The key to a special needs trust is it has provisions that ensure the beneficiary can receive financial support from the trust without being disqualified from federal and state support programs for those with special needs.
Those are the key trust concepts and the most frequently used types of trusts. Next month, I’ll describe some additional important trusts to consider for your estate plan.