Many readers of this blog are familiar with trusts, having either established, administered, or benefited from them (and in some cases, all of the above!). However, trust planning is not an area of expertise for most people. Since trusts are both commonplace and complicated, the purpose of this article is to provide an overview of the primary characteristics and features of these instruments.
Let’s begin with a basic definition. A trust is a legal entity with three parties:
- The grantor, who establishes the trust;
- The trustee, who controls and administers the trust; and
- The beneficiary, who benefits from the trust by receiving property and/or income.
The terms of any trust are dictated by a trust document, or agreement. The trust document identifies the three parties and specifies a wide variety of rules pertaining to the management of the trust, when and how beneficiaries can receive funds from the trust, how long the trust remains intact, etc. The trustee is legally obligated to adhere to the terms of the trust agreement.
At the highest level, trusts allow a person to assert control over how his or her assets are to be managed and distributed to the stated beneficiaries, rather than giving control to the beneficiaries outright.
Trusts take two basic forms: revocable and irrevocable. As the names suggest, revocable (or living) trusts can be revoked, or modified, by the grantor. Irrevocable trusts, on the other hand, typically cannot be revoked or modified once they have been established.
- One of the primary benefits of a revocable trust is probate avoidance. Assets held in a revocable trust are not subject to probate court, which creates a more efficient estate settlement process for the grantor’s beneficiaries (avoiding court proceedings) and provides privacy for the estate (assets held in trust do not become public record). Revocable trusts can also be used for contingency planning. If the grantor (who typically serves as the trustee) becomes incapacitated, a successor trustee can step in and continue to manage the grantor’s financial affairs. Finally, revocable trusts are considered disregarded entities for income tax purposes, meaning that all trust income is taxed to the grantor.
- Irrevocable trusts, on the other hand, offer two primary benefits: asset protection and estate tax avoidance. Assuming the trust is properly structured and administered, assets in an irrevocable trust are protected from creditors of the grantor and the beneficiary, and are not included in the taxable estates of either party. Whereas revocable trusts are intended to benefit the grantor during his or her lifetime, irrevocable trusts are intended to benefit someone else (e.g. children or grandchildren, or even a charity). Placing assets in an irrevocable trust involves a relinquishment of control and access to those assets. Income in an irrevocable trust can be taxed at the trust level (using their compressed brackets and higher rates), although income that is distributed to a beneficiary is usually taxable to that person. Trusts can also be structured as “grantor trusts,” in which case all trust income is taxed to the grantor (even though the grantor does not benefit from the use of trust assets).
While trusts are often associated with ultra-wealthy families, the reality is that trusts can play a vital role in even the most basic estate plan. Here are a few examples:
- George and Susie own a primary residence in Texas and a second home in Colorado. To avoid probate in two jurisdictions, they place both homes in a revocable trust.
- Thomas and Clare have an adult daughter who has struggled with substance abuse issues. They establish a revocable trust to avoid probate, and within the same agreement, establish terms for a portion of their assets to pass to their daughter in an irrevocable trust so that a third-party trustee can manage and administer the assets on her behalf, following carefully considered guidelines.
- Charles is elderly, unmarried, and has no one to help him manage his financial affairs. He establishes a revocable trust and appoints a trust company as successor trustee so that, if he is no longer willing or able to manage his affairs, the corporate trustee can take over the management of his personal finances.
- Andrew and Susan are concerned about the impact that an inheritance will have on their children – that the money might diminish their motivation to work hard and create their own legacy. They establish irrevocable trusts so that when they pass away, the children will not have access to the funds until they reach a certain age, and then, only under certain conditions (e.g. they must be employed).
Of course, trusts play an important role for people with large estates, too. Here are a few examples:
- James and Melinda have a taxable estate of over $40 million. They establish irrevocable trusts for each of their three children and fund each trust with $5 million, shielding those assets from creditors and positioning the growth of those assets outside of their taxable estate.
- Parker has a taxable estate of $25 million. He establishes an irrevocable life insurance trust (ILIT), where the trust purchases a life insurance policy on his life. The death benefit will be paid to the trust, outside of his estate, and can be used to cover his expected estate tax liability.
- Mary has a significant investment in a high-growth company, and transfers her shares (worth $5 million) to a grantor-retained annuity trust (GRAT). This irrevocable trust will make payments back to her over the next five years equal to the initial value of the transferred shares. At the end of five years, the investment has doubled in value, and the $5 million of appreciation remains in trust for her beneficiaries, shielded from Mary's creditors and outside of her taxable estate.
- John has established a successful, growing family business, currently worth $50 million. He establishes an intentionally defective grantor trust (IDGT) and sells the business to the trust via an installment sale, so that the growth of the business is positioned outside of his taxable estate.
Like all aspects of your estate plan, trust documents should be regularly reviewed to ensure that the terms are still aligned with your goals and desires. If Ferris Bueller had been an estate planning attorney, he would have left us with this quote: “Life moves pretty fast. If you don’t stop and look at your trust documents once in a while, you could miss some valuable planning opportunities.”
The information offered is provided to you for informational purposes only. Robert W. Baird & Co. Incorporated is not a legal or tax services provider and you are strongly encouraged to seek the advice of the appropriate professional advisors before taking any action.
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