Trusts are used in wealth management plans to help provide financial support for family members, protect family assets from a myriad of risks, and help mitigate taxes. Here we introduce the fundamentals of how trusts work.
Originating in English common law, trusts have been used for centuries to manage holdings of the wealthy. Even though trusts are quite common, many people may find them hard to understand.
A good analogy for learning about trusts is to think about your house. When you own your house, you have the right to live in it, which can be considered a benefit. You also have the legal rights to rent, lease, or sell your house. A trust is a form of property ownership that separates the beneficial ownership from the legal ownership. It names a trustee to be the legal owner of assets while naming one or more beneficiaries who will enjoy the benefits of the property placed in the trust. The person who created the trust and transferred ownership of assets to the trust is known as the grantor or settlor.
Trustees keep track of trust assets separately from the income those assets generate. In part, this is because the grantor directs those resources differently. The core trust assets are often referred to as the trust principal or corpus. The dividends, interest payments, rents, etc., are called trust income.
Disputes over trust provisions and the general operation of trusts are primarily governed by state law and state courts. This means there can be wide variation in how trust provisions are interpreted and enforced if there is a question or problem.
A transfer of an asset by a person to a trust may be deemed a taxable gift by taxing authorities. For this discussion, we do not address in detail potential tax consequences of a gift to a trust. You may wish to discuss those consequences with your tax or legal advisors.
The Revocable Trust
Trusts can be revocable or irrevocable. A revocable trust may be created by a grantor for her own benefit during her lifetime. It can be drafted so it can be dissolved completely, the terms can be changed, and assets may be removed from it by the grantor without restriction. A revocable trust will contain what is essentially a list of instructions to the trustee as to what it may, or must, do with any property delivered to it in trust by the grantor. Among other things, most revocable trusts will specify:
- that the grantor may amend it or revoke it completely;
- that the grantor may place additional property into the trust or request distributions from it;
- that the trustee has a list of administrative powers that enable the trustee to deal with the trust assets; for example, the trustee is usually empowered to buy or sell securities; and
- what the trustee must do with the property when the grantor dies.
Generally, when a grantor transfers assets to a revocable trust for his own benefit, there are no gift tax consequences because the trust is for the grantor’s own benefit and he may revoke it at any time. Also, for the same reasons, there are generally no income tax consequences when using a revocable trust. For income tax purposes, the grantor is treated as owning the assets of the trust.
How Trusts Work —The Basics (Chart 1)
When the grantor dies, one of two things will happen. The trustee may be directed to distribute assets remaining in the trust, thereby terminating the trust, in which case the trust will contain specific directions regarding what the trustee is to do with any assets or accumulated income. Alternatively, the trust may contain provisions directing the trust to continue, how long it is to continue, and who the beneficiaries will be. If the trust continues, it becomes irrevocable because the grantor can no longer exercise the right to revoke it.
Common Reasons to Use Revocable Trusts
There are a number of reasons why revocable trusts are commonly used, including:
- When an incapacity clause is included in the terms of the trust, the grantor may have enhanced protection and support during any period of incapacity compared with that offered by a durable power of attorney. For example, the trustee can be empowered under an incapacity clause to make investment decisions, pay bills, or use assets already in the trustee’s possession to support a dependent.
- There may be reduced probate costs because the trust assets are not part of the grantor’s probate estate at death.
- The trust may afford the grantor increased privacy with regard to his financial affairs because many jurisdictions do not require a public record filing of a revocable trust.
- The grantor may specify that the trust will continue after death for the benefit of others. A revocable trust may operate as the primary means for controlling how a grantor’s assets are distributed to heirs. This can be a powerful source of peace of mind for many grantors and their families.
The Irrevocable Trust
The term irrevocable is often misinterpreted and perceived literally to mean that nothing can ever be changed with regard to how the trust works and that the assets are beyond the reach of beneficiaries. That may be the case in a specific trust, and some trusts were drafted with such absolute terms. However, over the years drafting techniques, preceding and jursiprudence regarding the administration of trusts have evolved to make irrevocable trusts quite flexible.
Generally, a trust is irrevocable because the grantor declares it to be at the outset or the grantor has died, so she can no longer exercise any powers to make changes. That doesn’t necessarily mean the terms of the trust cannot be changed. Many states have enacted statutes that provide ways to modify irrevocable trusts under certain circumstances. Additionaly, in some cases, a grantor can draft the trust so that a person or group of people may have the power to change the terms of the trust. Similarly, a grantor may include a provision that allows one or more people to withdraw assets from the trust.
Irrevocable Trust Example
Lindsay decides she wants to set aside $1 million as a safety net for each of her three young-adult children. Were she to write each of them a check, her children could spend or retain the money as they wish. Instead, Lindsay wants to be certain that her gift will be available should a child face a future financial emergency. She creates three irrevocable trusts, one for each child, all containing the following provisions:
- during the child’s lifetime, pay the child the income generated from the assets held in the trust;
- permission for the trustee to distribute trust assets to the child for food, shelter, clothing, illness, or educational expenses;
- permission for the trustee to distribute trust assets to provide for the purchase of a home or the child’s wedding expenses;
- allow the child the right to withdraw up to half the trust assets at age 30; and
- allow the child to choose who will receive the assets remaining in the trust when the child dies.
Most trusts will have terms that dictate when and to whom income or principal is to be distributed from a trust. Irrevocable trusts generally exist for long periods of time, usually years if not decades. To address this, grantors often want to account for many possible and perhaps unpredictable situations. Therefore, irrevocable trusts often have extensive and possibly complicated provisions detailing how, when, and under what circumstances the trust’s resources may be utilized by the beneficiaries. Grantors have an abundance of freedom to determine how to dispose of their property, which includes defining the terms of trusts and to whom trusts will provide benefits. Note, however, that some choices have undesirable tax outcomes, which you should discuss with your tax and legal advisors.
Common Purposes of Irrevocable Trusts
Irrevocable trusts are often created to control the distribution of cash flows or assets over time, or to achieve certain tax outcomes. Sometimes irrevocable trusts are crafted to do both. An irrevocable trust may be created by a grantor while living, in which case it is an inter vivos trust. It may also be created under the terms of a will, in which case it is a testamentary trust. Some states treat the two types of trusts differently for administration and oversight purposes.
There are many forms of irrevocable trusts. This article has described only those attributes that are common across most types of irrevocable trusts.
Trusts can prove to be very effective in protecting loved ones, preserving resources, and helping to maintain family financial objectives. You may wish to discuss these topics with your tax or legal advisors. Knowing how they work is useful to understand how trusts fit into a wealth plan and can help achieve your family’s long-term goals.
Table 1: Common Trust Terms
|Current Beneficiary||a person who is entitled to receive benefits from a trust currently.|
|Dispositive Provisions||one or more provisions of a trust directing the trustee how, when, and to whom to distribute trust income and principal.|
|Fiduciary||a person or entity who is entrusted to hold and manage assets for another with explicit duties of loyalty and impartiality, in the case of a trust, generally, known as the trustee.|
|Grantor||the person who created a trust, also known as the settlor or trustor.|
|Inter Vivos||during the grantor’s lifetime.|
|Principal||holdings and/or investments of a trust; also called trust corpus.|
|Probate||the process by which a document purporting to be a will is validated by the appropriate governmental authority as such person’s will.|
|Remainder Beneficiary||a person who is entitled to receive trust principal when the trust ends. It could be another trust.|
|Testamentary Trust||created under the terms of a will.|
|Trustee||a person or entity who is entrusted to hold and manage assets held in trust for another with explicit duties of loyalty and impartiality.|
|Trust Income||the cash flows derived from the trust assets, typically dividends, interest, and rents, but might also include such things as royalties.|
For more information, please consult your PNC Advisor or contact PNC Private Bank.
Chart 1: How Trusts Work —The Basics (view image of chart 1)
- Transfer of legal title of assets from the owner to the trustee
- The trustee holds, protects, and manages the assets, and distributes income or principal as directed by the terms of the trust.
- Current beneficiaries receive payments or distributions from the trust in accordance with the terms of the trust
- At some point many trusts end, or terminate, then...
- The trust may provide that any assets remaining in the trust at the termination date are distributed to the remainder beneficiaries.