TRUST CONCEPTS

When clients first hear the word “Trust” used in an estate planning conference, they frequently have a negative impression. Many think the word “Trust” is a synonym for a Will, or as a complicated planning technique. Others believe it is a tool for tying a beneficiary’s hands, or even as a device desired only for the very wealthy. All of the above images are misconceptions, and if allowed to continue, will often rob clients of effective estate planning. While Trusts are not panaceas, they do however, offer most clients whether married or single, “rich” or “of modest means” a vehicle for achieving a variety of estate and financial planning objectives. The purpose of this introductory article is to examine several fundamental trust concepts in estate planning.

WHAT IS A TRUST?

The Trust concept is very basic, and is nothing new to our body of law. The first Trusts appeared in England during the reign of King Henry VIII as a form of property ownership to avoid taxation. In a Trust, one person transfers property to another for the benefit of a third party. The person who transfers the property or establishes/creates the Trust is called the “Settlor” (synonyms are “Grantor”, “Trustor” or “Donor”). By comparison, the new owner of the property is called the “Trustee” or “manager”. The Trustee holds legal title to the property. What the Trustee can or cannot do is generally defined in the Trust Agreement between the Settlor and the Trustee. The third party in the Trust triangle is the “Beneficiary”, the person for whom the Trust is established. In many cases, the Settlor, Trustee and Beneficiary may all be the same person. In certain states where community property law concepts exist, a husband and wife may hold all three titles. However, not forever. If a Trust is well-drafted, it will designate a progression of Successor Trustees, as well as Alternate Beneficiaries. If a Beneficiary has an immediate right to receive benefits, such as the right to income, he or she is said to have a “present interest”. By comparison, a Beneficiary who only has the right to receive benefits after the occurrence of an event (i.e. the right to income after the Settlor’s death), has a “future interest”. Therefore, certain Trusts can transcend both life and death. You can establish a Trust during your lifetime for your own benefit and direct that it continue on after your death for the benefit of certain future beneficiaries (also known as remainders men).

Unfortunately, many clients establish Trusts and then fail to “retitle” or “fund” the Trust with assets (i.e. real estate, bank accounts, etc.). Property transferred into a Trust is called “principal”. If the principal is income producing, then the Trust will also have “income”. Depending upon the Trust’s terms, income may be paid to the beneficiaries or reinvested by the Trustee. Trusts that are required to distribute all income are called “Simple Trusts”. By comparison, Trusts that are allowed to accumulate income are labeled “Complex Trusts”.

Therefore, as a general rule, a Trust is a separate legal and tax entity, similar to a corporation. However, under current law, the only Trusts generally required to file separate “fiduciary income tax returns” are Irrevocable Trusts (i.e. Trusts which cannot be modified) and Revocable Trusts under which the Trustee/Settlor are not the same person. Once we understand what a Trust is, the next question becomes, “Why establish such a legal entity?”

WHY PEOPLE ESTABLISH TRUSTS

The reasons clients establish Trusts are as diverse as the clients themselves. However, in most cases, Trusts generally increase a client’s control of assets, as opposed to the common misconception of loss of control. Frequent reasons given for establishing Trusts are as follows:

1. Tax Savings – Many Trusts are established to avoid unnecessary income taxes, and transfer taxes, such as estate and gift taxation. In future articles, we will address more specific tax avoidance techniques. However, in 2019 forward and adjusted annually for inflation, a married couple utilizing traditional Trust planning including a Survivor’s Trust and a Credit Shelter/Exemption Trust can transfer an estate valued at $22,800,000, free of all estate taxation. Without such trust planning, federal estate taxation would be at a rate of forty-five percent (45%). By comparison, a single client may have an estate valued at $11,400,000, and pay no federal estate tax. In 2019, the Federal Estate Tax Exclusion Amount was adjusted by inflation, and currently is $11,400,000, per individual.
2. Asset Management – Property placed in trust may also relieve a Settlor, as well as future beneficiaries of certain investment responsibilities. This is a major concern where assets are ultimately being transferred to benefit minors, incapacitated or elderly clients. Likewise, certain states allow a Settlor to establish a Trust for the benefit of another (i.e. a child as beneficiary) and shelter the assets in the Trust from that beneficiary’s creditors. Likewise, Trusts established for the benefit of a minor are not generally required to end when the child attains majority (i.e. 18 years of age). Therefore, Trusts provide greater flexibility in asset range both during a Settlor’s lifetime, as well as following death.

LIVING TRUSTS AND TESTAMENTARY TRUSTS

As noted above, Trusts may transcend life and death. A Trust established during the lifetime of a Settlor is called a Living Trust. Such a Trust is a separate document from a Will. By comparison, a Trust established in a Will is called a “Testamentary Trust”, and only comes into effect upon the death of the Testator (the creator of the Will).

Both Living Trusts and Testamentary Trusts provide the following benefits:

1. The Trust generally becomes irrevocable at the Settlor’s death (i.e. cannot be changed), and assures that the Settlor’s desires are followed.
2. The Trust appoints a Successor Trustee to manage the assets for a beneficiary.
3. The Trust may continue on for a beneficiary’s lifetime thereby avoiding possible inclusion of such assets in that individual’s estate for various tax and probate purposes.

However, it is important to understand that a Testamentary Trust may have the following disadvantages when compared to a Living Trust:

1. Wills are generally offered for probate, and become part of the public record for anyone to read. Because a Testamentary Trust is part of a Will, it is open to public view following the Testator’s death. As a general rule, Living Trusts are private documents. However recently, certain states including California, require Trustees of certain Irrevocable Trusts to notify all beneficiaries (present and future) of their rights.
2.  Because a Testamentary Trust only comes into effect at death, it does nothing to manage assets in the event of incapacity. A properly funded Living Trust frequently avoids the need for a court appointed Conservatorship or Guardianship.
3.  Assets retitled in a Living Trust prior to a Settlor’s death avoid the costs and time delays associated with a probate estate administration. However, assets transfer into a Testamentary Trust at death go through an estate probate administration.

REVOCABLE TRUSTS AND IRREVOCABLE TRUSTS

The cornerstone of most married and single client estate plans will be comprised of at least one Trust. Quite often, that Trust is a Revocable Living Trust. Simply stated, such a Trust Agreement is completely amendable by the Settlor as long he or she is competent. The price of such flexibility is complete inclusion in the Settlor’s estate at date of death. However, as noted above, this type of Trust provides valuable personal family benefits as probate avoidance and privacy.

Likewise, in certain circumstances, an Irrevocable Trust may be desired. As a general rule, once an Irrevocable Trust is established, it cannot be changed (i.e. amended or revoked). The Settlor has given up all control over the Trust and property transferred into such a Trust. However, there are frequently major income tax and estate tax benefits derived from such arrangements.