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 ownership of property 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 in the eyes of taxing authorities. For this discussion, we do not address in detail potential tax consequences the gift may create.
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 without restriction. A revocable trust will contain what is basically 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.
When a grantor transfers assets to a revocable trust for his own benefit, it is technically a gift of assets. However, because the trust is for the grantor’s own benefit and he may revoke it at any time, there are no gift tax implications. Also, for the same reasons, there are no income tax consequences when using a revocable trust.
When the grantor dies, one of two things will happen. The terms of the trust may specify the trust ends at the death of the grantor, in which case it will also contain specific directions as to what the trustee is to do with any assets or accumulated income remaining in its possession. Alternatively, the trust may contain provisions stipulating the trust is 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 it was not uncommon to see trusts that were so absolute. But there have been changes over the past few decades in how trusts are drafted and in the laws that govern how they are administered. Today irrevocable trust provisions can be drafted to be quite flexible.
Generally, a trust is irrevocable solely because the grantor declares it to be at the outset or the grantor has died, so she can no longer exercise any provisions that may have allowed her to make changes when living. That doesn’t necessarily mean the terms of the trust cannot be changed. Many states have enacted statutes that provide a variety of tools for modifying irrevocable trusts under certain circumstances. In some cases, a grantor may specify that a person or group of people may have the power to change the terms of a trust. Similarly, a grantor may include a provision that allows one or more people to withdraw assets from the trust.
Virtually every trust will have terms that dictate when and to whom income or assets are to be distributed out of a trust. Most irrevocable trusts are intended to exist for long periods of time, usually years if not decades.
To address this, grantors often want to account for different possible and perhaps unpredictable situations. Therefore, irrevocable trusts often have robust, sometimes complicated, provisions detailing how, when, and under what circumstances the trust’s resources are to be enjoyed by the beneficiaries. Grantors have virtually unlimited freedom to determine how they want their trust to provide benefits, although some choices may be in conflict with certain preferred tax outcomes.
*Common Types of Irrevocable Trusts: There are many types of irrevocable trusts. Some of the most commonly used include asset protection trusts, charitable lead trusts (CLTs), charitable remainder trusts (CRTs), dynasty trusts, grantor retained annuity trusts (GRATs), irrevocable life insurance trusts (ILITs), marital trusts, residuary or credit shelter trusts, and special needs trusts.
Irrevocable Trust Example
Lindsay has sold her business and decides she wants to set aside $1 million as a safety net for each of her three young-adult children. She could choose to write each of them a check, which would allow them to spend or retain the money as they wish. Instead, Lindsay wants to be certain that her gift will be available in the event any of her children face a potential future financial emergency. She creates three irrevocable trusts, one for each of her children, all containing the following provisions:
- during the child’s lifetime, pay each child the income generated from the assets held in the trust;
- permission for the trustee to distribute trust assets to a child for food, shelter, clothing, illness, or educational expenses;
- permission for the trustee to distribute trust assets to be used for the purchase of a home or wedding expenses;
- allow her child the unfettered right to withdraw up to half the trust assets at age 30; and
- allow her child to choose who will get the remaining assets in the trust when he or she dies.
Common Purposes of Irrevocable Trusts
Irrevocable trusts are most often created for one of two reasons: 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 forms differently in some respects.
There are many forms of irrevocable trusts. We have described only those attributes that are generally common across most types of irrevocable trusts along with a few other nuances.
Trusts can prove to be extremely useful in protecting loved ones, preserving resources, and helping to maintain family financial objectives. Having basic knowledge of how they work is key to understanding how they fit in a wealth plan and can help achieve long-term goals.
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 that tell the trustee who gets what and when
Fiduciary—a person or entity who is entrusted to hold and manage assets for another with explicit duties of loyalty and impartiality, also 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 assets or trust corpus
Probate—the process of settling a person’s estate
Remainder Beneficiary—a person who is entitled to receive trust benefits when the trust ends
Testamentary Trust—created under the terms of a will
Trust Assets—holdings and/or investments of a trust; also called trust principal or trust corpus
Trustee—a person or entity who is entrusted to hold and manage assets for another with explicit duties of loyalty and impartiality
Trust Income—the cash flows derived from the trust assets, typically dividends and interest payments, but might also include such things as rents or royalty payments