You probably need at least one trust in your Estate Planning setup. It seems almost all estate planning has one these days. Many problems can be solved and goals achieved with the right trust. Trusts no longer are restricted to the very wealthy.
Too many people are intimidated by talk of trusts. You don’t learn much about trusts in daily life, and estate planners often don’t do a good job explaining trusts and making people feel comfortable with them.
In this visit we give a quick course in trusts. You won’t know everything after this, but you’ll know the basics and then some. You should be comfortable with and have a working know-ledge of trusts that will enable you and your estate planner to develop an effective estate plan in which you have confidence.
Stripped to their basics, trusts are fairly simple. A trust is a contract between three parties.
One party is the grantor, or creator, who, of course, is the person who originated the trust, sets its terms, and usually puts all the assets in the trust. Putting assets in the trust is known as funding the trust.
Another party is the trustee, who agrees to manage and make distributions of the assets according to the terms of the trust agreement and the law. Technically the trustee is the legal owner of the trust property, but he is a fiduciary. He owns the property as trustee for the benefit of others and can’t treat it as his own property.
The third party is the beneficiary. A beneficiary has the right to receive income or principal or both from the trust but only 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 grantor usually names beneficiaries when the trust is created.
A beneficiary can be primary or contingent. A contingent beneficiary is one who doesn’t have any rights to income or property until after the primary beneficiary’s rights have expired.
The beneficiary can have a life, term, or remainder interest. A life interest is, as the name implies, for the life of the beneficiary. A term interest is for a fixed period of years. A remainder interest is of trust property that remains after all the life or term interests have expired. A remainder interest might be little or nothing if distributions to the income or term beneficiaries drain the trust.
The beneficiary might be entitled to income, principal, or both. An income interest means the beneficiary can receive distributions only from income earned by the trust. Income usually is defined as interest, dividends, rent, and royalties. Anything else is principal and can’t be distributed to an income-only beneficiary.
Either the beneficiaries or grantor normally can sue the trustee for violating the trust agreement or mismanaging the assets.
Each of the roles can be filled by more than one person at the same time. In addition, the same person can be in more than one of these roles at the same time. For example, the grantor of the trust also might serve as primary beneficiary.
A trust can be created but not funded. The trust has no effect and there is no business for it to do until money or property is transferred to it, until it is funded. It is not unusual for grantors to create trusts then fail to transfer title of assets to them. Also, a trust can be created during life but funded only by the grantor’s will.
There are few limits to the terms that can be put in the trust agreement. Lawyers and the tax law have shorthand names for trusts designed to achieve specific goals. All those trust names fall into a few categories.
In general, it is easiest to divide trusts in four functional categories with two Types of Trusts in each category. Many trusts have features from more than one category. Once you learn these categories, you’ll be able to talk trusts with an estate planner.
Living vs. testamentary. A Living Trust simply is a trust created during the grantor’s lifetime. A testamentary trust is created in the will. A living trust also is given the Latin name inter vivos trust, and a testamentary trust is called post mortem.
When most people hear the phrase “living trust” they usually are thinking of a revocable living trust, which is discussed in the next category.
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. A revocable trust might not be fully revocable. A grantor might reserve only the right to change certain terms, such as the beneficiary. An Irrevocable Trust is what the name says. The grantor can’t revoke it and retrieve any property that was transferred to it.
A frequently-used trust is the revocable living trust, which is used to avoid probate. It also is an aid in disability planning, because a substitute trustee takes over when the initial trustee is disabled.
The grantor and grantor’s spouse are both the initial trustees and beneficiaries and transfer title to almost all their property to the trust, including homes, cars, financial accounts, and household furnishings. They generally treat the property as they did before the trust, except everything is owned by the trust instead of them as individuals, and they manage it as trustees instead of individuals.
After the grantors pass away, successor trustees take over and the property is managed and distributed to the next generation under the terms of the trust agreement. A will has no effect on property owned by the trust, and property owned by a trust avoids probate. There is no public recording of the trust, and the trustees do not have to ask a court to transfer title to heirs.
Significant tax differences exist 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 though the assets were owned in his or her own name.
Irrevocable trusts can reduce income or estate taxes. When properly structured, trust property is not included in the grantor’s estate, and income and capital gains are taxed to either the trust or the beneficiary. To reduce taxes, irrevocable trusts really must be irrevocable; the grantor can’t have the right to retrieve the property or receive distributions.
Income vs. total return. This category refers to how distributions to the primary beneficiary are determined. Remember there can be income beneficiaries and remainder beneficiaries, though one person can be both. Traditionally, income beneficiaries receive only income earned by the trust’s assets. A standard arrangement is for all income to be paid to the grantor’s spouse for life with possible payments of principal as needed or for specific purposes. After the spouse’s demise, the children receive the trust remainder.
An income interest can be insufficient when interest rates are relatively low and the cost of living increases. The trustee could try to increase income by investing in riskier, higher-yielding income vehicles, but that puts the principal at risk. Also, 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 or what the definition of income is. Instead, the trustee invests for long-term growth with a diversified portfolio and makes annual distributions from income, capital gains, or principal. The total return trust is better today than a traditional trust that pays only income to the primary beneficiary.
Of course, the distributions to the income beneficiary can decline under the total return trust if the trust’s investments decline or the returns are less than the distributions.
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 primary beneficiary annually and distribute one third of the principal to the beneficiary upon turning age 21 and the remainder at age 35.
A discretionary trust allows the trustee to exercise judgment at least some of the time. The trustee might have discretion to distribute to the surviving spouse all income earned by the trust plus principal or capital gains as needed to maintain the spouse’s standard of living in the trustee’s judgment. Or the trustee might be able to withhold distributions 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. The grantor might have provided some guidelines for the trustee to consult. The trustee might have discretion to increase distributions when the beneficiary has an unexpected need, such as medical expenses.
These are the broad categories of trusts. Within these categories are many specific or specialized trusts. There are charitable trusts (several types of them), dynasty trusts, grantor retained annuity trusts, grantor retained income trusts, and many more. We’ve discussed these in the past and will discuss them in the future. Taxes and the tax law usually drive specialized trusts but so do particular goals or interests. But each of the specialized trusts can be fit within the broad 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 March 2015.