Basic Concept of a Trust
In general, a trust is an arrangement whereby one person agrees to hold property for the benefit of another. All trusts must have the same basic components:
A Grantor. The person who creates the trust. The grantor may also be called the “donor,” or the “settlor,” or the “trustor.” All these terms are used interchangeably.
A Trustee. A person or entity must agree to hold money and/or property for the benefit of someone else. There may be more than one trustee and the trustee does not need to be a person. It may be a corporation with trust powers, such as a bank.
A Principal. Something, money and/or property, must be held by the trustee for the benefit of someone else. Also, it may be called the “corpus” of the trust or “res”.
A Beneficiary. The person who benefits from the trust. There may be more than one beneficiary.
Classification of Trust
All trusts do not contain the same property, nor do they have the same purpose, nor are they all created in the same manner. These differences distinguish one type of trust from another.
Living vs. Testamentary Trusts. Ask whether the trust becomes effective during the Grantor’s lifetime or only after the Grantor’s death.
A living trust is a trust that becomes effective during the Grantor’s lifetime. Also called and “inter-vivos trust,” Latin for during life, most living trusts are generally created by a written instrument.
If the trust is created through a Last Will and Testament, it is called a testamentary trust. This trust only becomes effective after the Grantor’s death because the Last Will and Testament does not become effective until the Grantor’s death.
Revocable vs. Irrevocable Trusts. If the grantor reserves the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is a revocable trust. If the grantor gives up the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is an irrevocable trust. Please note that testamentary trust are always revocable. Only living trusts can be either revocable or irrevocable.
The Grantor of a revocable trust can still has control over the property put into the trust. Also, the Grantor can change the terms and conditions. The Grantor retains all incidents of ownership, thus the Grantor is treated as the owner for property tax purposes.
The Grantor of an irrevocable trust is giving up all rights to the property put into the trust. The Grantor has no right to amend, revoke, terminate or change the conditions of the trust. The Beneficiary, not the Grantor, is treated as the owner of the property for tax purposes. A person may use an irrevocable trust to protect their assets from creditors, to become eligible for Medicaid, and to avoid estate taxes.
Types of Trusts
Credit Shelter Trusts
A Credit Shelter Trust is a type of trust that is used by married couples with large estates in order to avoid federal estate taxes upon the death of the first spouse. This type of trust is structured so that, upon the death of the first spouse, the maximum amount of property sheltered from the estate tax is transferred to this trust. The trust is designed so that the assets in this trust will not be subject to estate tax in the surviving spouse’s estate upon his or her subsequent death. As a result, the assets placed in this trust upon the death of the first spouse will not be subject to estate taxes in either spouse’s estate and will be transferred to other beneficiaries (normally the children) free of any estate taxes.
Even though the assets in a Credit Shelter Trust will not be taxed in the estate of the surviving spouse, the trust is designed in such a way that the surviving spouse can enjoy the benefits of the assets placed in this trust.
- Not subject to Estate taxes.
- The Grantor has the ability to change the cost basis of certain assets.
- High legal fees.
- Transferring property into the trust is cumbersome.
- A Grantor may need to designate a co-trustee.
A Charitable Trust is a type of trust that has one or more charitable beneficiaries. If properly established under tax laws, a charitable trust will entitle a grantor to deduct a portion of the amount contributed to the charitable trust as a current charitable income tax deduction. There are other tax benefits as well, depending upon the type of charitable trust established.
For example, the amount passing to charity under a charitable remainder trust qualifies for a charitable estate tax deduction upon the death of the grantor. There are four types of charitable trusts; i.e., the charitable lead annuity trust (CLAT), the charitable lead unitrust (CLUT), the charitable remainder annuity trust (CRAT), and the charitable remainder unitrust (CRUT). In charitable lead trusts, one or more charities are paid a certain amount each year for a fixed number of years, with the remainder passing to non-charitable beneficiaries. In charitable remainder trusts, one or more non-charitable beneficiaries are paid a certain amount each year for a fixed number of years or for life, with the remainder passing to one or more charities.
- A Grantor may reduce their taxable income.
- There may be double capital gain benefits.
- Once the property is within the trust, the Grantor cannot benefit from the principal.
A Crummey Trust is a life insurance trust with certain provisions that allow gifts to the trust to qualify for the annual gift tax exclusion.
Initially, the IRS ruled that gifts of money to a Life Insurance Trust, which were used to pay premiums on life insurance policies held in the trust, did not qualify for the annual gift tax exclusion because the beneficiaries did not have a present interest in those gifts. The only interest they had was a future interest; i.e., when the insured died and the death proceeds were paid into the trust. Under the gift tax rules, the annual gift tax exclusion only applies to gifts of a present interest.
In order to get around this problem, a Mr. D. Clifford Crummey created a life insurance trust that prohibited the trustee from using any money gifted to the trust for at least 30 to 60 days after the gift was made. During that 30 to 60 day period, the beneficiaries were given the right to withdraw the money if they wished. If they didn’t withdraw the money during the 30 to 60 day period, their withdrawal rights terminated and the money could then be used to pay the premiums that were due. Of course, the grantor never intended to have any of the money withdrawn from the trust during that 30 to 60 day period. That right was given to them solely to qualify the gift for the annual gift tax exclusion.
The IRS challenged these provisions in court, claiming that the right to withdraw the money was a sham because everyone knew that the money was needed for payment of the insurance premiums. Nonetheless, the IRS lost. The court stated that whether the beneficiaries actually withdrew the money or not, they had the right to do so – and that right is all that’s needed to give the beneficiaries a present interest in the gift.
- The trust offers grantors a higher amount of control than any other irrevocable trust.
- The trust is an investment option that falls outside those permitted in Section 529.
- The principal is available for withdrawal for a short period of time and there is a potential risk that the beneficiary will withdraw the principal.
- The trust is treated as a minor’s asset for financial aid purposes.
A dynasty trust is a trust designed to avoid or minimize estate taxes being applied to great family wealth with each transfer to subsequent generation. By holding assets in the trust and making well-defined distributions to each generation, the entire wealth of the trust is not subject to estate taxes with the passage of each generation.
The assets that are put into the trust are subject to federal gift/estate tax just once, when the Grantor transfers the assets to the trust. They are not taxed again, though multiple generations benefit from them.
A Grantor may use a dynasty trust when the Grantor’s assets are greater than the Federal Estate exemption amounts. Currently an individual’s exemption is $5.25 million and a married couple is $10.5 million. Additionally, as income tax needs to be paid on trust assets, non-income producing assets are better suited for the trust. These trust are generally used for families with great wealth.
When using a dynasty trust, Federal Estate/Gift Taxes only occurs once. Without this, trust assets left to your children would be taxed. Then when these assets were left to their children it would be taxed again.
Additionally, the Grantor has great control over the Dynasty Trust. The Grantor decides who his or her beneficiaries are and what rights they get. The Grantor will appoint a Trustee (Bank or Trust Company) to manage the money and spend it on beneficiaries’ needs according to the terms the Grantor set forth in the Trust. The Grantor can give power to the beneficiaries to give away some trust assets or leave them to others at their own deaths.
This is an irrevocable trust and descendants cannot alter the terms of the trust when circumstances change.
- The Trust assets are only subject to Federal Estate/Gift Taxes once.
- Ensure that succeeding generation of the Grantor’s family pay as little tax as possible.
- Grantor has control of money long after death.
- Income taxes are still due on income generated by trust assets.
- Beneficiaries have no control over trust (unless otherwise given enumerated powers).
- The Grantor must guess what will be in the best interest of his or her distant relatives decades into the future.
- The Trust terms cannot be altered to fit future circumstances.
- The Grantor must choose a Trustee that will manage the trust well into the future.
- Gift and Estate Tax Rules change significantly over time.
- Subject to the Rule Against Perpetuities, depending on State the Trust may only last a finite amount of years. In New Jersey, the Rule Against Perpetuities has been repealed thus making New Jersey one of the only States that truly allows for a Dynast Trust. See the Trust Modernization Act of 1999, N.J.S.A. 46:2f-9 et seq.
Generation Skipping Trusts
A “Generation-Skipping Trust“ is a type of trust that is specifically designed to hold the amount of property that is exempt from the generation-skipping tax under the federal estate tax laws. There are limitations on the size of a generation-skipping trust. The current tax-free limit is $2 million per person, which means if the grantor plans to leave less than that in the trust, the grantor’s grandchildren can withdraw the total amount tax free.
- The Grantor’s estate pays less Estate taxes.
- The value of the trust cannot exceed the generation-skipping tax exclusion amount.
- Assets within in the trust can increase in value, thus exceeding the exclusion amount.
Grantor Trust or Intentionally Defective Grantor Trust (IDGT).
An IDGT is a trust that is purposely drafted to invoke the Grantor Trust Rules. A trust that runs afoul of the rules contained in IRC §671 through §679. The Grantor, for income tax purposes, is the owner of the trust assets and is therefore personally responsible for all items of income attributable to the assets held in trust.
Though the Grantor is treated as owner of the Grantor Trust for income tax purposes, he or she is not necessarily treated as owner for Estate tax purposes. (Estate tax inclusion rules are applied separately to make the latter determination).
In some cases, a beneficiary can be treated as Grantor of the Grantor trust, thus allowing the beneficiary to utilize any tax benefits or detriments that would be otherwise attributable to the Grantor Trust.
This trust can be used to accomplish the following:
- Increase the value of the trust assets. Because the Trustor/Grantor pays the income taxes incurred by the IDGT, the assets held in the IDGT can grow unreduced by such income taxes. Thus, increasing the value of the assets available to the trust beneficiaries. Essentially the payment of taxes by the Grantor is a gift to the trust beneficiaries that is not subject to transfer tax.
- Reduce assets held in the Grantor’s Estate. Payment by the Grantor of the income taxes will also reduce the assets held in the Grantor’s Estate, thus reducing Estate Taxes.
- Medicaid Planning. A person can structure ownership of assets to enable eligibility for Medicaid coverage. The Grantor must be mindful of the look-back period.
- Asset Protection. As an IDGT is an irrevocable trust, trust assets generally cannot be attached to satisfy judgments against the grantor if the assets were not illegally transferred to the trust.
An IDGT can be created in one or more the following ways:
- The Trustor or his or her spouse retains power to recover the trust assets. E.g., the Trustor retains the right to reacquire property out of the trust in exchange for property of equal value;
- The Trustor or his or her spouse can or does benefit from the trust income. E.g., the Trustor and/or a nonadverse Trustee can disburse income for the benefit of the Trustor’s spouse;
- The Trustor or his or her spouse possesses a reversionary interest worth more than 5% of the value of the trust upon its creation;
- The Trustor or his or her spouse controls to whom and when trust income and principal is to be distributed, or possesses certain administrative powers that may benefit the Trustor or his or her spouse. E.g., a nonadverse Trustee may add beneficiaries of the trust income and/or principal;
- The Beneficiary has a power to withdraw the trust income or principal to himself or herself. E.g., a Crummery power; and/or
- The Trustor and/or a nonadverse Trustee has the power to apply trust income to the payment of premiums for insurance on the life of the Trustor or the Trustor’s spouse.
- Trust Assets left free to Increase.
- Grantor ‘s Estate decreases for Estate Tax Purposes.
- Grantor must pay income taxes on trust assets.
Life Insurance Trusts
A “Life Insurance Trust” is a type of irrevocable trust that is designed to hold life insurance on the life of the grantor or another person. The objective of a Life Insurance Trust is to exclude the life insurance proceeds payable on the death of the grantor from federal estate taxation. If a life insurance policy is owned by a grantor, the death benefits are included in the grantor’s estate for federal estate tax purposes because the grantor has the power (among other things) to designate the beneficiary or beneficiaries to receive the death benefits under the policy upon his or her death. Life Insurance Trusts are attractive to individuals and couples with estates large enough to be concerned with federal estate taxes.
- The proceeds of your life insurance policy are removed from your estate and become free of estate taxes.
- The trust does not pass through the public probate process.
- Beneficiaries can use trust proceeds to pay estate taxes.
- Proceeds held in the trust may be protected from the creditors of the trust beneficiaries.
- If you are married, you can arrange for your spouse to receive income from the trust during his or her lifetime.
- Once the trust is set up, you can’t change its terms.
- Once you transfer a life insurance policy to the trust, you 1) give up control over that policy, 2) can’t make loans or withdrawals of the cash value of that policy, and 3) can’t change its beneficiaries.
- Trustees and legal advisors must carefully handle gifts made to the trust to prevent triggering gift taxes.
- Professional trustees usually charge annual administration fees and may not agree to manage smaller trusts.
Qualified Personal Residence Trusts (“QPRTs”)
A “Qualified Personal Residence Trust” or “QPRT” is a type of irrevocable living trust that is designed to reduce the value of a personal residence for federal estate tax purposes upon the death of the grantor. A QPRT allows a grantor to transfer his or her home to an irrevocable living trust and still continue living in the home, while reducing the value for federal estate tax purposes. A QPRT is a form of a Grantor Retained Income Trust (“GRIT”).
- It removes the value of your primary or secondary residence, and all appreciation, from your taxable estate at cents on the dollar.
- Allows continued use of the residence and tax benefits.
- Hedges against possible decreases in lifetime gift tax exemption and estate tax exemption.
- Creates a legacy for your family.
- Selling a home owned by a QPRT can be difficult.
- Heirs will inherit the residence with the Grantor’s income tax basis at the time of the gift was put into the trust.
Qualified Terminable Interest Property Trusts (“QTIP Trusts”)
A Qualified Terminable Interest Property Trust or “QTIP Trust” is a type of Marital Trust that is designed for use by a grantor when a second marriage is involved. It allows the grantor to transfer property in trust for his or her surviving spouse estate-tax free by virtue of the unlimited marital deduction, even though the surviving spouse is not given the right to determine the beneficiaries of the property upon his or her subsequent death. A QTIP Trust is an ideal vehicle to provide for a surviving spouse while insuring that the property is ultimately distributed to your children upon the surviving spouse’s death.
- The first spouse to die can control disposition.
- The assets within the trust are not included in Probate.
- Conflicts may arise between the surviving spouse and the remainder beneficiaries.
- The surviving spouse has limited power to withdraw from the principal.
Special Needs Trust.
A Special Needs Trust is a trust that is established for a person who is receiving government benefits. The intent of a Special Needs Trust is to provide a source of funds for persons without disqualifying such persons from receiving government benefits. Ordinarily when a person is receiving government benefits, an inheritance or a gift or even the receipt of a sum of money for damages in a personal injury law suit could reduce or eliminate the person’s eligibility for such benefits. With a Special Needs Trust, a beneficiary can obtain certain luxuries and other benefits without defeating his or her eligibility for government benefits. Often a Special Needs Trust will include a provision that terminates the Trust if it makes the beneficiary ineligible for government benefits.
- It can keep person eligible for government programs like SSI and Medicaid and help pay for services and care over and above what the government provides.
- Funds used to create a SNT are tax-deductible.
- It insures that funds are used for the care of the person with a disability – This is especially
- comforting when there is a concern that the person with a disability could be influenced or taken advantage of in matters concerning money.
- Funds are not available to creditors or for paying judgments – The money is used only for the care of the person with a disability.
- Annual fees and a high cost to set up a SNT can make it financially difficult to create a SNT –The yearly costs to manage the trust can be high. Also, there are often minimum amounts required to set up a SNT. It is important to check with a Financial Planner with experience in special needs planning to see what the actual costs will be.
- The beneficiary has to request funds from the trustee and the trustee has complete discretion as to whether the request is appropriate based on the terms laid out in the trust. Thus, the person with a disability has very little control over the use of their money. This can lead to feelings of frustration and decrease independence.
- Certain funds in a SNT must be used to pay back Medicaid in an amount equal to the amount Medicaid paid on the person’s behalf. This often results in the trust being completely wiped out once the Trust ends (either at the person’s death or through legal termination of the Trust).
A Spendthrift Trust is any kind of trust that includes certain language giving the trustee wide latitude to avoid making distributions to beneficiaries when the distribution would go to a creditor, or when the trustee fears that the distribution would be wasted by the beneficiary.
An example of a spendthrift provision is as follows:
“Spendthrift Provision. Except as otherwise provided by law, no power of appointment created hereunder shall be subject to involuntary exercise, and no interest of any beneficiary in the income or principal of any trust created hereunder shall be subject to assignment, alienation, pledge, attachment, or claims of creditors, including claims for alimony or support, until the same is distributed to such beneficiary or beneficiaries.”
- A spendthrift trust is a good way to provide lifetime income or financial support to a beneficiary that lacks the ability to manage money or property.
- A spendthrift trust can be a way to protect the assets of a beneficiary that has claims against their property and income due to lawsuits, alimony, medical bills, and other unpaid debts.
- The beneficiary of a spendthrift trust is prohibited from selling, assigning, transferring or pledging the trust assets so it provides the grantor or settlor some assurance that the beneficiary’s financial needs may be met for a longer period of time.
- The Grantor has no control over the principal.
- The Beneficiary has no control over disbursements.
A Totten Trust is a form of trust in which the Grantor places money in a bank account or security with instructions that upon the Grantor’s death, whatever is in that account will pass to a named beneficiary. Also called a “Payable on Death” account.
Although this method of creating a trust did not meet the formal requirements of trust creation, or the testamentary formalities required to make a valid will, the Court which created this trust noted that such an arrangement typically involved a small amount of money left by a person of modest means, who could not otherwise afford to establish a legal mechanism for passing the specified property. For this reason, the device is sometimes called a “poor man’s will”. The funds in question are not subject to probate and, if held in a bank account, are insured in the same manner as any deposit. The beneficiary has no access to the account until the depositor’s death and need not be notified that the account exists.
- They are easy to create.
- There is no limit to how much money a Grantor can leave.
- Designating a beneficiary to a bank account costs nothing.
- It is easy for the beneficiary to claim the money after the Grantor dies.
- You cannot name an alternate beneficiary.