What is a trust?

In a nutshell

A trust is a legal arrangement that can minimize your estate taxes and so help pass your assets to your heirs in a tax-efficient way.

• Trusts generally avoid probate, which could allow your heirs quicker access to your assets than if passed by a will.
• A trust allows a trustee to hold assets on behalf of one or more beneficiaries.
• A trust can be arranged in various ways to control how and when assets pass to the beneficiaries.

What is a trust?

A trust is a legal arrangement designed to ensure that a donor’s assets go to their designated beneficiaries in the manner of the donor’s choosing. The trust’s creator funds the trust with the assets they wish to pass on to their designated beneficiaries. They then authorize a custodian to manage and administer those assets on behalf of the creator for the benefit of the beneficiaries.

There are three main parties to a trust:

• The grantor is the person who creates the trust and who funds the trust with assets.
• The beneficiary or beneficiaries are the person or persons who will ultimately receive the assets from the trust.
• The trustee is a person or an organization that administers the trust.

There are a number of different types of trusts that can be used to meet different estate planning needs. The two broad categories of trusts are revocable and irrevocable trusts.

How trusts work

A trust is a legal entity designed to manage and then distribute assets. The grantor ideally works with a qualified legal professional to establish the trust. They then fund the trust with assets like stocks, bonds, mutual funds, ETFs, real estate, art, collectibles, life insurance, or other assets that they want managed and ultimately distributed by the trust.

As part of the process of establishing the trust, the grantor names the beneficiaries of the trust. These are the ultimate recipients of the assets held in the trust. This might be your children or other family members, or it could be a charity. The trust terms will dictate when and how these assets can be distributed.

You will also need to name a trustee or trustees for the trust. In some cases this can be yourself, but more likely it will be a trustee who works for a bank or other institution. They are responsible for overseeing the trust, including management of the assets and overseeing the distribution of the assets at the appropriate time. They are also responsible for ensuring that any tax or administrative issues are properly handled.

Types of assets that can be held in trust

A wide range of assets can be held in a trust, though there are variations based on the type of trust. The assets that can be held inside of a trust include:

• Non-retirement brokerage and mutual fund accounts.
• Individual bonds and stocks.
• Stock owned in a closely held corporation.
• Nonqualified annuities, which are annuities not held inside of an IRA or other type of qualified plan account.
• Certificates of deposit (CDs).
• Safe deposit boxes.
• Notes receivable or other debt instruments.
• Life insurance (note that life insurance trusts can be complicated so it is best to use a qualified professional to draft the trust document.)
• Art and collectibles.
• Your interest in a business (in some cases).

Real estate, which can include your home or an investment property that you own, is a common asset to be held in trust. Titling real estate in the name of the trust can help facilitate the transfer of this asset upon your death. One word of warning: if the property has a mortgage against it some lenders may not allow the mortgage to be transferred to the name of the trust.

There are also assets that are not appropriate for a trust. Some of these include:

• Retirement accounts such as an IRA, 401(k) or 403(b), as well as most qualified annuities, should not be transferred to a trust. This is due to the tax issues that would occur due to the need for the money to be withdrawn from the account. However, retirement accounts can name a trust as a primary or secondary beneficiary.
• Health savings accounts and medical savings accounts cannot be transferred to a trust for many of the same reasons as retirement accounts. A trust can be named as the beneficiary of one of these accounts, however.
• Checking and other accounts used to pay bills and for regular financial activity. Unless the account owner is the trustee, the transfer of these assets to a trust is not advised.

Types of trusts

Marital or “A” trust

This is a trust designed to provide benefits and preserve assets for a surviving spouse. These trusts are generally included as part of the taxable estate of the surviving spouse.

Bypass or “B” trust

This trust is also known as a bypass trust. It is established to bypass the surviving spouse’s estate to make full use of any estate tax exemption for both spouses.

Testamentary trust

This is a trust that is created through your will after your death. The assets in the trust are generally subject to probate and transfer taxes. The assets often continue to be subject to the supervision of the probate court after the trust grantor’s death.

Irrevocable life insurance trust (ILIT)

This is a trust that is designed to exclude the life insurance death benefits from the deceased’s taxable estate and to provide liquidity for the trust’s beneficiaries and the deceased’s estate.

Charitable lead trust

This trust provides benefits to a charity for a specified period of time, with the remaining assets then being transferred to a non charitable beneficiary at the end of that time period. A charitable lead trust offers tax advantages, but can also be used to combine charitable giving with estate planning.

Charitable remainder trust

A charitable remainder trust allows the donor to receive an income stream from the trust for a period of time, after which the remainder of the assets in the trust revert to charitable beneficiaries. A CRT offers tax and estate planning advantages to the donor and their estate.

Generation skipping trust

This type of trust takes advantage of the generation skipping exemption allowing assets to be distributed to the deceased’s grandchildren or a later generation without incurring either the generation skipping tax or an estate tax upon the death of the deceased’s children.

Qualified terminable interest property (QTIP) trust

This trust is used to provide an income stream for a surviving spouse. Upon the death of the surviving spouse, the remaining assets in the trust go to additional beneficiaries that were named by the deceased. A QTIP trust is often used in a second marriage situation, or to provide estate tax planning flexibility.

Grantor retained annuity trust (GRAT)

This is an irrevocable trust funded by gifts from the trust’s grantor. It is designed to shift future appreciation on assets in the trust to the next generation during the grantor’s lifetime.

Revocable vs. irrevocable

Among the many types of trusts there is a major distinction as to whether the trust is revocable or irrevocable. There are a number of differences between the two types, including differences in the tax treatment and in creditor protections for the trust assets.

Revocable trusts

A revocable trust, often referred to as a revocable living trust, is a trust that can help pass assets to the trust beneficiaries outside of the probate process. A revocable trust can allow you (as the grantor of the trust) to retain control over the assets in the trust during your lifetime. A revocable trust typically becomes irrevocable once the grantor dies.

You can name yourself as trustee or co-trustee and retain control over your lifetime, and still make provisions for a successor trustee to step in if you become incapacitated or in the event of your death.

While a revocable trust does help to avoid probate, the assets in the trust are generally still subject to estate taxes, based on the size of the estate. During the grantor’s lifetime the trust will be treated just like any other asset.

Irrevocable trusts

As the name implies, an irrevocable trust cannot be altered once the trust has been executed. An irrevocable trust removes the assets from the grantor’s estate and also avoids probate.

Once the assets are turned over to the trust, they are beyond the control of the grantor. This removes the assets from the grantor’s estate and also from their control. If the grantor changes their mind about the trust at some point they will not be able to reverse it.

Legal considerations and regulations

There are a number of legal requirements for creating a trust, including:

• There must be a clear intent to create a trust by the grantor.
• The grantor must own the property or the assets to be transferred to the trust at the time of its creation.
• The trust must be created for legal purposes. For example, a trust created to shield assets from creditors or in connection with illegal activities would not be valid.
• The beneficiaries of the trust must be clearly named.
• The trust documents must outline the duties of the trustee or the person managing the trust.
• The assets to be held in the trust must be legally transferred to the trust.
• The trust must be valid in accordance with the laws of the state in which it was created.

Role of state laws in governing trusts

Laws on trusts vary by state. Some states require formal registration of the trust. Others may have fewer formal laws surrounding the registration of a trust. Be sure to work with an estate planning professional or an online preparer like Trust & Will who is familiar with the trust rules for your state.

Tax implications of trusts

The tax implications of a trust will vary based on the type of trust, and can be complicated. In general, however:

• With a grantor trust, the grantor of the trust is generally responsible for any taxes incurred by the trust during the grantor’s lifetime.
• With an irrevocable trust, the trust not the grantor is taxed. It is important to note that the trust tax rates may be higher than those for an individual.

Advantages of establishing a trust

There are a number of advantages to establishing a trust including:

Greater control

A trust allows you greater control over your wealth through the terms of the trust. A revocable trust allows you to maintain control over the trust assets during your lifetime. An irrevocable trust allows the trust assets to avoid being subject to estate taxes. There are a number of trust variations that can be used to control income taxes and estate taxes, as well as when and how the assets are distributed to trust beneficiaries.

Protecting your legacy

A trust can be used to shield assets in the trust from your heir’s creditors and from beneficiaries who are not capable of managing the assets themselves.

Privacy

Probate is a public process. If you want your assets to pass to your heirs with greater privacy, then a trust can be the way to go.

Potential drawbacks and limitations of trusts

There are also some downsides to a trust, including:

Fees and expenses

A trust can be expensive to establish depending upon the complexity of the trust and the fees charged by your attorney. There can also be ongoing fees and expenses for trustee fees, tax preparation fees and legal expenses.

Ongoing record keeping requirements

Trusts require detailed record keeping and accurate records of all trust activity must be kept. Trusts must be run under a strict legal framework.

Trust assets may not be protected

The type of trust will determine the level of protection the assets in the trust receive from creditors and others.

Taxes

Trusts can carry a higher tax burden since trust tax rates are generally higher than individual tax rates. This can be a factor depending upon the type of trust.

When to create a trust?

There are a number of situations where creating a trust can make sense, including:

• You want to ensure that your assets are managed for the benefit of your heirs and in accordance with your wishes. This might include minor children.
• You want to minimize the taxes and probate costs associated with transferring assets via a will and the probate process.
• You want to establish a charitable gift.
• You need to ensure that your assets are managed for the benefit of the trust beneficiaries in the event you become incapacitated.
• A special needs trust can help ensure that a special needs child or other relative’s needs are taken care of after you are gone.
• A trust can be used to ensure that your interests in a business are passed on as you desire.

The AP Buyline roundup

A trust can be an excellent vehicle to help ensure that certain assets are properly managed during your lifetime, and that those assets are properly passed on to your heirs.

There are a variety of trust types that can be tailored to your unique needs. In deciding on the type of trust, and even if a trust is right for your situation, determine what your objectives are for the assets you are considering placing in a trust and how you want these assets passed to the potential trust beneficiaries.

When deciding on a trust it is important to understand how the trust works, any tax implications (both during your lifetime and upon your death), as well as any expenses associated with the ongoing management of the trust.

While a trust can be an excellent tool as part of your overall estate planning efforts, a trust is not always the right vehicle. Be sure to work with qualified financial planning and estate planning professionals to help you decide whether a trust is right for you, the right type of trust, and that the trust is drafted in accordance with your needs. It is important to be sure the trust adheres to any state laws as well as federal rules as well.

Frequently asked questions (FAQs)

How do I choose a trustee?

Choosing a trustee for your trust is important and there are a number of factors to consider. The trustee is legally bound to manage the trust in accordance with the trust documents and to manage the trust in the best interests of the grantor and the trust’s beneficiaries.

There are a number of requirements a trustee will assume. These include filing any trust tax returns, ensuring the assets in the trust are properly invested, reporting to the trust beneficiaries, and managing the distribution of trust assets at the appropriate time.

Depending upon the type of trust, the grantor can be the trustee, a friend or family member can be designated as trustee, or a corporate trustee can be named. In the latter case the corporate trustee might be associated with a financial institution or other similar entity. Above all, be sure that any trustee you choose is qualified to carry out their duties.

Can a trust be changed or revoked?

This will depend on the type of trust. A revocable trust can be modified or revoked during the lifetime of the grantor. An irrevocable trust cannot be changed or revoked once the trust is formed.

What happens to a trust after the trustor passes away?

This will be governed by the terms of the trust. Generally, a trust will include provisions for the distribution of assets after the death of the grantor of the trust. In some cases, the assets may be distributed right away. In others, the assets may continue to be held under management for beneficiaries and distributed over time. This is common in the case of a minor beneficiary or a beneficiary who may not be deemed able to manage their own financial affairs.

What assets should not be in a trust?

Retirement accounts such as an IRA, 403(b) or 401(k) should generally not be held in a trust, because the death of the grantor could trigger unwanted tax consequences. Likewise with a health savings account (HSA).

Additionally, a checking or savings account that is actively used to pay bills and to make regular financial transactions might not be a good candidate to be held in a trust.

Can the IRS take assets in a trust?

Assets in a revocable trust can be seized by the IRS through a levy since these assets are still deemed to be under the control of the grantor of the trust.

Assets in an irrevocable trust generally cannot be seized by the IRS, since these assets are not technically owned by the grantor anymore. Don’t take this as a blanket statement, however: it is always best to use a qualified estate planning professional to draft any trust you are considering. They will be equipped to tell you whether the trust structure prohibits seizure by the IRS or anyone else.