A trust is a legal arrangement through which a person enters into an agreement (the trust) with another person or institution (such as a bank), as the trustee to take possession, control and own property that is transferred to the trust. The rules or instructions under which the trustee operates are set out in the trust instrument. Trusts have one set of beneficiaries during their lives, often donors, and another set — often their children — who begin to benefit only after the first group has died. The first are often called “life beneficiaries” and the second “remaindermen.”
Uses of Trusts
There can be several advantages to establishing a trust, depending on your situation. Best-known is the advantage of avoiding probate. In a trust that terminates with the death of the donor, any property in the trust prior to the donor’s death passes to the beneficiaries by the terms of the trust without requiring probate. This can save time and money for the beneficiaries. Certain trusts can also result in tax advantages both for the donor and the beneficiary. These are often referred to as “credit shelter” or “life insurance” trusts. Other trusts may be used to protect property from creditors or to help the donor qualify for Medicaid. Unlike wills, trusts are private documents and only those individuals with a direct interest in the trust need know of trust assets, trust terms and how the trust will be distributed. Provided they are well-drafted, another advantage of trusts is their continuing effectiveness even if the donor dies or becomes incapacitated.
Kinds of Trusts
Trusts fall into two basic categories: testamentary and inter vivos.
A testamentary trust is one created by your will, and it does not come into existence until you die. In contrast, an inter vivos trust starts during your lifetime. You create it now and it exists during your life.
There are two kinds of inter vivos trusts: revocable and irrevocable.
Revocable trusts are often referred to as “living” trusts. With a revocable trust, the donor maintains complete control over the trust and may amend, revoke or terminate the trust at any time. This means that you, the donor, can take back the funds or property you put in the trust or change the trust’s terms. Thus, the donor is able to reap the benefits of the trust arrangement while maintaining the ability to change the trust at any time prior to death.
Revocable trusts are generally used for the following purposes:
Asset management. They permit the named trustee to administer and invest the trust property for the benefit of one or more beneficiaries.
Probate avoidance. At the death of the person who created the trust, the “grantor” or “donor,” the trust property passes to whoever is named in the trust. It does not come under the jurisdiction of the probate court and its distribution need not be held up by the probate process. However, the property of a revocable trust will be included in the grantor’s estate for tax purposes.
Privacy. Since there is no probate, no inventory is ever made public. Nor is how the trust assets are divided ever made public.
Tax planning. While the assets of a revocable trust will be included in the grantor’s taxable estate, the trust can be drafted so that the assets will not be included in the estates of the beneficiaries, thus avoiding taxes when the beneficiaries die.
An irrevocable trust cannot be changed or amended by the donor. Any property placed into the trust may only be distributed by the trustee as provided for in the trust document itself. For instance, the donor may set up a trust under which he or she will receive income earned on the trust property, but that bars access to the trust principal. This type of irrevocable trust is a popular tool for Medicaid planning. It also avoids probate, has privacy features, and provides for asset management and tax benefits.
As noted above, a testamentary trust is a trust created by a will. Such a trust has no power or effect until the will of the donor is probated. Although a testamentary trust will not avoid the need for probate and will become a public document as it is a part of the will, it can be useful in accomplishing other estate planning goals. For instance, the testamentary trust can be used to reduce estate taxes on the death of a spouse or provide for the care of a disabled child.
Supplemental Needs Trusts
The purpose of a supplemental needs trust is to enable the donor to provide for the continuing care of a disabled spouse, child, relative or friend. The beneficiary of a well-drafted supplemental needs trust will have access to the trust assets for purposes other than those provided by public benefits programs. In this way, the beneficiary will not lose eligibility for benefits such as Supplemental Security Income, Medicaid and low-income housing. A supplemental needs trust can be created by the donor during life or be part of a will.
According to who sets up the trust (who the donor is), the trust may require a pay back of benefits to beneficiaries who received Medicaid. If the donor is someone other than someone who owes a duty to the beneficiary, it is possible to set up such Supplemental Needs Trusts without any pay back (provision).
Credit Shelter Trusts
Credit shelter trusts are a way to take full advantage of the estate tax exemption. The first $5 million (in 2011) of an estate are exempt from taxes, so theoretically a husband and wife would have no estate tax if their estate is less than $10 million. However, if one spouse dies and leaves everything to the surviving spouse, the surviving spouse may have an estate that is greater than $5 million. With the uncertainty of the estate tax law, that may be a problem in 2012.
To avoid this problem, the spouses can create a credit shelter trust as part of their estate plan. When one spouse passes away, the first $4 million of that spouse’s estate is put in to a trust. The surviving spouse can receive income from the trust, but as long as he or she does not control the principal, the money will not be included in the surviving spouse’s estate when he or she passes away.
Trusts are wonderful tools. However, they must be properly drafted in light of the various requirements and the goals that are attempting to be accomplished. Inappropriate provisions can create very adverse tax consequences and very adverse problems for the intended beneficiaries, as well as problems for the donor.
Similarly, if a trust is administered improperly, trusts can be put into jeopardy.
And, finally, if a trust is not “funded” properly, many of the intended benefits of a trust may be frustrated.
Be sure and seek quality legal advice before embarking on establishment of a trust.