Understanding and Using Estate Planning Trusts

Trusts are an essential part of Estate Planning, not only for the rich and famous. They’re also simpler than many lawyers and estate planning professionals make them seem. Almost every-one needs a working knowledge of trusts to ensure estate planning is effective. It’s easy to obtain that knowledge.

A trust is simply a contract between three parties.

One party is the grantor or creator who, of course, is the person who created the trust, set its terms, and usually puts all the assets in the trust. Another party is the trustee, who agrees to manage the assets and make distributions according to the terms of the trust agreement and the law.

The third party is the beneficiary. Beneficiaries have rights to receive income or principal or both according to the terms of the trust agreement. Trust assets are managed for the benefit of the beneficiaries. Sometimes beneficiaries have other rights, such as the ability to change trustees or name who receives their interests after they pass away. The trustee usually names beneficiaries when the trust is created, but there can be other ways a person becomes a beneficiary.

Either the beneficiaries or grantor normally can sue the trustee for violating the trust agreement or mismanaging the assets.

One person can be in more than one of these roles, even all three. Of course, a party can be one person or more than one person.

Estate Planning Factor #1

Trusts are very flexible. There are few limits to the terms that can be put in the trust agreement. Lawyers have shorthand names for trusts designed to achieve specific goals, and the tax law also gives names to trusts with certain provisions. All those names can make trusts seem confusing.

In general, it is easiest to divide trusts in four functional categories with two Types of Trusts in each category. Most trusts have features from more than one category. Once you learn these categories, you’ll be able to talk trusts with an estate planner.

Estate Planning Factor #2

Living vs. post mortem. A Living Trust simply is a trust created during the grantor’s lifetime. A post mortem trust is created in the will. A living trust often is given the Latin name inter vivos trust.

Keep in mind a trust can be created but not funded. For example, a grantor and trustee can sign the trust agreement. That creates the trust. But the trust has no effect and there is no business for it to do until money or property is transferred to it. It is not unusual for grantors to create trusts then fail to transfer title to any assets to them. Also, a trust can be created during life but funded only under the grantor’s will.

When most people hear the phrase “living trust” they actually are thinking of a revocable living trust, which is discussed in the next category.

Estate Planning Factor #3

Revocable vs. irrevocable. A living trust can be revocable or irrevocable. In a revocable trust, the grantor reserves the right to revoke the trust or change some or all of its terms. An Irrevocable Trust is what the name says. The grantor can’t change the terms after the trust agreement is signed.

A very common trust is the revocable living trust. It is used to avoid probate in states with high probate costs or long probate procedures, especially California and Florida. It also is an aid in disability planning, because a substitute trustee takes over management of the assets when the initial trustee is disabled.

Under the revocable living trust the grantor transfers title to almost all his or her property to the trust, including homes, cars, checking accounts, investment accounts, and household furnishings. The grantor and grantor’s spouse usually are the initial trustees and beneficiaries. They generally treat the property as they did before the trust, except everything must be in the trust’s name, and they manage it as trustees instead of individuals. The trust agreement spells out who succeeds them as trustees and beneficiaries.

After they pass away, property owned by the trust is transferred to the next generation under the terms of the trust agreement. A will has no effect, and property owned by a trust avoids the probate process. There is no public recording of the trust, and the trustees do not have to ask a court to transfer title to heirs. That is why a revocable living trust is called a will substitute.

There are serious tax differences between revocable and irrevocable trusts. When a grantor creates a revocable trust, the grantor usually is treated as the owner of the property for income and estate tax purposes. The trust assets are included in the grantor’s estate. Income and gains of the trust generally are taxed to the grantor as earned.

Irrevocable trusts can reduce income or estate taxes. When properly structured, trust property is not included in the grantor’s estate, and trust income and gains are taxed to either the trust or the beneficiary. To reduce taxes, irrevocable trusts really must be irrevocable, and the grantor cannot have the right to retrieve the property or be paid the income.

Estate Planning Factor #4

Income vs. total return. This category refers to how annual payouts to the beneficiary are determined, if annual payouts are made. There are income beneficiaries and remainder beneficiaries, though one person can be both. Traditionally, income beneficiaries receive only income earned by the trust’s assets. Income generally is defined as interest, dividends, and rents. Capital gains are not income. They are added to trust principal and become part of the remainder. A standard trust pays all income to the grantor’s spouse for life with possible payments of principal as needed. After the spouse’s demise, the children receive the trust principal, known as the remainder.

The income trust became less feasible as interest rates declined and the cost of living increased. Income stayed the same or declined as the income beneficiary’s cost of living rose. The trustee could try to increase income by investing in riskier, higher-yielding income vehicles, but that puts the principal at risk. Another tension is the remainder beneficiaries want some of the trust invested for growth. Otherwise, the purchasing power of their remainder interest declines because of inflation. But the needs of the income beneficiary discourage growth investing.

A total return trust solves these problems. The ?income beneficiary? is paid a percentage of the trust assets, a fixed amount, or an amount determined by a formula. The trustee does not worry about restricting payouts only to income. Instead, the trustee invests for long-term growth with a diversified portfolio. The income beneficiaries can be paid from income, capital gains, or principal. The total return trust is the better way to structure trust payouts today.

Estate Planning Factor #5

Discretionary vs. nondiscretionary. This category refers to the trustee’s ability to vary distributions or payouts. In a nondiscretionary trust, the trustee is told in the trust agreement how much to distribute to beneficiaries or how to calculate the distributions and when to make distributions. For example, the trustee might be told to distribute all income to the beneficiary annually and distribute one third of the principal to a beneficiary upon turning age 21 and the remainder at age 35.

A discretionary trust allows the trustee to exercise judgment at least part of the time. The trustee might distribute to the surviving spouse all income earned by the trust plus whatever principal or capital gains are needed to maintain the spouse’s standard of living in the trustee’s judgment. Or the trustee might be able to withhold any distribution when the trustee believes it is in a beneficiary’s best interest, such as when the beneficiary has a substance abuse or gambling problem. Some trusts are completely discretionary, allowing the trustee to distribute income and principal whenever and in whatever amounts are deemed in the best interests of the beneficiary. Others are nondiscretionary in general but give the trustee discretion under certain circumstances, such as when the beneficiary might have a substance abuse problem.

These are the broad categories of trusts. There are many specialized trusts. There are charitable trusts (several types of them), dynasty trusts, grantor retained annuity trusts, grantor retained income trusts, and many more. Taxes and the tax law usually drive specialized trusts. But each of the specialized trusts also can be defined by these categories.

Now, you know the basics of trusts. You can intelligently review and discuss estate plan options, know the key questions to ask about a trust and the consequences of the answers. You are ready to put together a more effective estate plan and to avoid having a trust you don’t need or that does not meet your goals.

RW August 2012.