What Is a Trust?
A trust is a legal agreement allowing a trustee to manage one’s assets.
In simplest terms, it’s a legal agreement between three parties:
- The grantor (sometimes called the the “donor”, “trustor” or “settlor”): This is the individual who creates the trust agreement.
- The trustee: This person or entity is responsible for managing the property transferred and titled into the the trust.
- The beneficiary or beneficiaries: These people or entities receive the benefits of the property in the trust.
A trustee can be a professional with financial knowledge, a relative or friend, or a professional trust company. The trustee holds the title to the property and manages the property for the benefit of the beneficiaries who may be a specific person, a group of people, or an organization.
What Are the Basic Types of Trusts?
There are two basic types of trusts: A “testamentary” or “after-death trust” and a “living” or “inter vivos” trust.
Testamentary or After-Death Trusts
An after-death trust is created by a will after a person’s death. The assets to fund these trusts must usually go through the probate process and may be supervised by the court even after the estate is closed. An example of an after-death trust would be one created by a parent leaving land to a trust to benefit a minor child in his or her will. The will establishes the trust to which the land is transferred, to be administered by a trustee until the child reaches a stated age, at which point title to the land is transferred to the child outright.
A living trust is a trust made while the person establishing the trust is still alive. In this case, a parent could establish a trust for a child during his or her lifetime, designating himself or herself as trustee and the child as beneficiary. As the beneficiary, the child does not own the property, but instead receives income derived from it. Living trusts can be revocable or irrevocable.
The most popular type of trust is the revocable living trust. This allows the settlor to make changes to the trust during his or her lifetime. A revocable trust usually directs the trustee to pay all income to the settlor for life and to pay the trust assets to named persons after the settlor’s death. Revocable living trusts avoid the often lengthy probate process but, by themselves, don’t provide shelter for assets from federal or state taxes. These trusts are often considered tax-neutral as the tax consequences for the grantor are usually the same whether or not the property is placed in a trust.
An irrevocable living trust is usually set up to reduce estate or income taxes. For tax purposes, the trust becomes a separate entity; the assets cannot be removed nor can changes be made by the settlor. In most cases, the settlor cannot be sole trustee of an irrevocable trust without losing the intended tax benefits.
Trusts can be tailored to fit certain goals.
- A charitable trust is used to make donations and realize tax savings for an estate. Property such as art or real estate can be transferred to a trust. The trust holds the assets until an appointed time (usually the grantor’s death) when it is transferred to a charity. The donor may continue to enjoy the use of the property and also realize estate tax savings by donating it to a charity.
- A bypass trust allows a married couple, in certain cases, to shelter more of their estate from estate taxes. The first spouse to die can leave assets in a trust which provide income to the surviving spouse. Upon the death of the second spouse, the assets in the trust belong to the children or other beneficiaries, without being taxed at the second spouse’s death.
- A spendthrift trust can be a good idea if the beneficiary is too young or does not have the mental capacity to handle money. The trust can be established so that the beneficiary receives small amounts of money at specified intervals. It is designed to prevent the young person from squandering money or losing the principal in a bad investment. Further, creditors will not be able to take a beneficiary’s income from this trust.
- A life insurance trust is often used to give an estate liquidity. In this case, the trustee is named as the beneficiary of the life insurance policy. The trust then receives the life insurance proceeds upon the death of the insured.
What Are the Pros and Cons of a Revocable Living Trust?
Revocable trusts offer some advantages:
- First, a revocable living trust enables one to have a trustee with financial expertise manage one’s assets during one’s lifetime. The trustee with financial experience might charge a fee of around one percent of the total amount of the property in the trust. This arrangement is particularly useful if someone is having difficulty managing their financial affairs. A trustee could invest assets, arrange for payment of bills and debts, and file tax returns. With a revocable living trust, one can establish one’s self as a co-trustee.
- Second, a revocable living trust can protect one’s privacy regarding the distribution of one’s assets. With a will, the probate laws require that an inventory of the estate’s assets be filed with the court. The will and the inventory are public information. With a revocable living trust, generally only the beneficiaries of the trust will be informed of the nature and the value of the assets. The important thing is to make sure that all of one’s property is in the trust.
- Third, by placing one’s assets in a revocable living trust instead of a will, time delays that are typical of probating a will can be avoided. Trust assets, in most situations, can be distributed to beneficiaries almost immediately after the death of the grantor.
- Fourth, if there is land owned in another state, a revocable living trust might help avoid a probate proceeding in the other state for that property. For example, by having a cabin in Wisconsin placed in a revocable living trust, a Wisconsin probate proceeding may be avoided.
There are some potential drawbacks to a revocable living trust:
- First, transferring property into a revocable living trust may make the grantor ineligible for Medical Assistance.
- Second, when the grantor is also the trustee, the grantor has a fiduciary obligation to the beneficiaries for both present and future income. A fiduciary duty is a high standard that requires the trustee to follow the terms of the trust and the law in good faith and with loyalty, confidence, and candor to the beneficiaries.
How Is A Trust Established?
Establishing a trust requires a document that:
- specifies the grantor’s wishes,
- lists beneficiaries,
- names a trustee or trustees to manage the assets,
- and describes what the trustee or trustees may do.
For a living trust, the grantor can name his or her self as trustee. In this case, it is important to also name a successor trustee to take over if the grantor should become disabled or pass away. Once the document is completed, assets may be transferred to the trust. In the case of certain assets, such as real estate, fees and transfer taxes may be incurred.
If the living trust contains all of the grantor’s property, a will may be unnecessary and probate can be avoided. If the trust contains only part of the grantor’s property, a will is necessary for the rest of it. If there is property to go into the trust after the grantor’s death, a “pour-over” provision can put the remaining property into the trust upon the grantor’s death.
Any assets not put into a trust and disposed of by a will will have to be probated. This negates the advantage of the living trust.
What Is the Role of the Trustee?
The trustee is considered a fiduciary and therefore must adhere to a high standard of care with respect to the trust. Included in this standard is the duty to protect trust property, to manage trust investments prudently, to refrain from engaging in self-dealing or receiving improper benefits from the trust, and to not mingle trust assets with the trustee’s own assets. The trustee has a duty to manage the trust’s assets in the best interests of the beneficiary or beneficiaries. This might include managing rental properties, investing funds, or paying income to the beneficiary.
Trusts differ in how a trustee can distribute trust income. A simple or mandatory trust requires the trustee to distribute income to the beneficiary. A complex or discretionary trust may afford the trustee discretion over the principal and income to be distributed. The requirements imposed on the trustee should be specified in the trust.