Trusts

What is a Trust?

A trust is an estate planning tool if you're concerned with providing for one or more beneficiaries for an extended time, such as minor children, someone with special needs, or even someone who is just not very responsible with money so you don't want them to receive a windfall all at once.

What is a beneficiary?

A beneficiary is a person or entity that benefits or derives an advantage from something, such as a trust, a will, or a life insurance policy. A beneficiary can be your wife, your kids, your sister, your friend next door, or even your favor charity. There is almost no end to who can be your beneficiary.

So, what is a Trust again?

There are actually many different types of trusts and there is no one-size fits all.

What is a Living Trust.?

The Living Trust, sometimes called inter vivos (living), is a category of trusts that are created during the life of the settlor. A settlor is also known as a trustor, grantor, or donor. The settlor gives a trustee, which can be an individual or legal entity, the power to hold and administer property and assets for the benefit of a beneficiary.

A trustee is an individual or legal entity, entrusted with the power to hold and administer property and assets for the benefit of a beneficiary.

A living trust is designed to allow for the easy transfer of the settlor's assets while bypassing the often complex and expensive legal process of probate.

What is Probate?

Probate is the court-supervised process of “authenticating” your will after you have passed away. It involves the court and attorneys and it can be expensive. Everyone should avoid probate if possible.

Types of trusts

Although there are many different types of trusts, each fits into one or more of the following categories:

Living or Testamentary

A living trust – also called an inter-vivos trust – is a written document in which an individual's assets are provided as a trust for the individual's use and benefit during his lifetime. These assets are transferred to his beneficiaries at the time of the individual's death. The individual has a successor trustee who is in charge of transferring the assets.

A Testamentary Trust is a trust contained within your Last Will and Testament. Testamentary Trusts provide for assets and money devoted to your beneficiaries but these assets initially go into your probate estate. The named executor then moves your estate to the Testamentary Trust with rules set by you in your Last Will and Testament and is overseen by the courts. An executor is just an individual or legal entity given legal responsibility to take care of the estate.

Revocable or Irrevocable

A revocable trust can be changed or terminated by the trustor during his lifetime. An irrevocable trust, as the name implies, is one the trustor cannot change once it's established, or one that becomes irrevocable upon his death. Living trusts can be revocable or irrevocable. Testamentary trusts can only be irrevocable.

Funded or Unfunded

A funded trust has assets put into it by the trustor during his lifetime. An unfunded trust consists only of the trust agreement with no funding. Unfunded trusts can become funded upon the trustor’s death or remain unfunded. Since an unfunded trust exposes assets to many of the perils a trust is designed to avoid, ensuring proper funding is important.

The trust fund is an ancient instrument – dating back to feudal times, in fact – that is sometimes greeted with scorn, due to its association with the idle rich (as in the pejorative trust fund baby). But trusts are highly versatile vehicles that can protect assets and direct them into the right hands in the present and in the future, long after the original asset owner's death.

A trust is a legal entity employed to hold property, so the assets are generally safer than they would be with a family member. Even a relative with the best of intentions could face a lawsuit, divorce or other misfortune, putting those assets at risk. Though they seem geared primarily toward high net worth individuals and families, since they can be expensive to establish and maintain, those of more middle-class means may also find them useful – in ensuring care for a physically or mentally deficient dependent, for example.

What if I am a private person?

Some individuals use trusts simply for privacy. The terms of a will may be public in some jurisdictions. The same conditions of a will may apply through a trust, and individuals who don't want their wills publicly posted opt for trusts instead.

Tax benefits

Trusts can also be used for tax planning. In some cases, the tax consequences provided by using trusts are lower compared to other alternatives. As such, the usage of trusts has become a staple in tax planning for individuals and corporations. Assets in a trust benefit from a step-up in basis, which can mean a substantial tax savings for the heirs who eventually inherit from the trust. By contrast, assets that are simply given away during the owner’s lifetime typically carry his or her original cost basis.

Here's an example of how the calculation works:

Shares of stock that cost $5,000 when originally purchased, and that are worth $10,000 when the beneficiary of a trust inherits them, would have a (tax) basis of $10,000. Had the same beneficiary received them as a gift when the original owner was still alive, their basis would be $5,000. Later, if the shares were sold for $12,000, the person who inherited them from a trust would owe tax on a $2,000 gain, while someone who was given the shares would owe tax on a gain of $7,000. Note that the step-up in basis (discussed below *) applies to inherited assets in general, not just those that involve a trust.

* Step-Up in Basis - If you were to inherit assets that appreciated while they were in possession of the decedent, you would get a step-up in basis. This means that the appreciation that took place before you acquired the assets would not be your responsibility. For capital gains purposes, the value of the assets would be equal to their value when you inherited them. The capital gains tax can come into play if you are in possession of assets that appreciated after you originally acquired them. You are not required to pay the tax on an ongoing basis as the assets appreciate. The capital gains tax is only applicable when you realize a gain. A gain is realized when you sell an appreciated asset and take possession of the liquidity. There are two types of capital gains in the eyes of the IRS: long-term capital gains and short-term capital gains. The rate of taxation for each respective type of gain is different. A short-term capital gain is a capital gain that is realized less than a year after the original acquisition of the asset. These gains are taxed at your regular income tax rate.

Trusts Explained Further

General Revocable Trust

General Revocable Trust. All trusts are probate avoidance. If you don't have a lot of assets, this trust is probably the type of trust you'll want. Unless you have specific reasons, you'll want a revocable trust instead of an irrevocable trust. A revocable trust is a trust whereby provisions can be altered or canceled dependent on the grantor. During the life of the trust, income earned is distributed to the grantor, and only after death does property transfer to the beneficiaries. This type of agreement provides flexibility and income to the living grantor; she is able to adjust the provisions of the trust and earn income, all the while knowing that the estate will be transferred upon death. This kind of trust lets your survivors avoid costly probate court proceedings after your death.

Note: Reason NOT to have Revocable Trust. You will probably not want this type of trust if there is property which is being maintained as separate property or if either you or your spouse is concerned about the other spouse having unlimited control over the entire trust if the survivor remarries.

Understanding Revocable Trust. A revocable trust is a part of estate planning that manages and protects assets as the grantor, or owner, ages. The trust is amended or revoked as the grantor desires and is included in estate taxes. Depending on the trust’s directions, the trustee, or holder of the assets, distributes the assets to the beneficiaries or holds and manages the property. The trust remains private and becomes irrevocable upon the grantor’s death. All trusts are either revocable–living trusts, that can be changed by the grantor if need be, or irrevocable—fixed trusts that cannot be changed once established.

In a revocable trust, the money or property held by the trustee for the benefit of someone else is the principal of the trust. The principal changes often due to the trustee’s expenses or the investment’s appreciation or depreciation. The collective assets comprise the trust fund. The person or people benefiting from the trust are the beneficiaries. Because a revocable trust lists one or more beneficiaries, the trust avoids probate. If the grantor experiences health concerns through the aging process, a revocable trust allows the grantor’s chosen manager to take control of the principal. If the grantor owns real estate outside his state of domicile and the real estate is included in the trust, ancillary probate of the real estate is avoided. If a beneficiary is not of legal age and cannot hold property in his name, the minor’s assets are held in the trust rather than having the court appoint a guardian. If the grantor believes a beneficiary will not use the assets wisely, the trust allows a set amount of money to be distributed on a regular basis.

Disadvantages of a Revocable Trust. Implementing a revocable trust involves much time and effort. Assets must be re-titled in the name of the trust to avoid probate. The grantor’s entire estate plan must be monitored annually to ensure the trust’s objectives are being met. Costs of maintaining a revocable trust are greater than other estate planning tools such as a will.

Disclaimer Trust

This type of trust should be used where you want maximum control to go to the surviving spouse and it is very unlikely that the estate will exceed the federal estate tax exemption.**

A disclaimer trust is one that has embedded provisions (usually contained in a will) that allow a surviving spouse to put specific assets under the trust by disclaiming ownership of a portion of the estate. Disclaimed property interests are then transferred to the trust, without being taxed. Provisions can be written into the trust that provide for regular payouts from the trust to support survivors. For example a trust can provide for surviving minor children as long as the surviving spouse elects to disclaim inherited assets, passing them on to the trust.

There are a number of rules that apply to disclaimer, but the two you should know is that (1) a disclaimer must be made in writing within nine months of the decedent’s death, and (2) you cannot control where the property goes after you disclaim it. Legally speaking, you are not obligated to accept a gift. And if you disclaim that gift, you are saying you do not want it and will not take any control over it. By doing so, the gift will pass according to the Trust terms as if you died before the Trust settlor. That means you wash your hands of the gift and you have nothing more to do with it.

How Disclaimer Trusts Work. For example, if an individual passes away and leaves her husband an estate, he may disclaim some interests in the estate, which then pass directly to the trust as though it were the original beneficiary. Minor children could then benefit from regular payouts. Disclaimer trusts require that the survivor act according to the wishes of the deceased, and disclaim ownership of some of the assets that the deceased has bequeathed. In the above example, if the surviving spouse does not disclaim ownership of any portion of the estate, then the deceased's wish to transfer assets to the surviving minor children goes unfulfilled. In other words, a Disclaimer Trust is merely a safety valve that allows the survivor to disclaim whatever portion of the estate would be over the $5.45 million mark after the surviving spouse’s death. Once that determination is made, the assets can be disclaimed, and the Disclaimer Trust is created.

Disclaimer Trust and See Through (or Pass Through) Trust. As another example of a trust in which assets move through to additional beneficiaries is a see-through trust. This is a fund that is treated as the beneficiary of an individual retirement account (IRA). See-through trusts use the life expectancies of the beneficiaries to determine the required minimum distributions (RMD) that will occur after the death of the retirement account holder. Individual retirement account (IRA) owners are able to choose their beneficiary, and federal laws prohibit accounts from continuing on indefinitely.

Disclaimer Trust and Inheritance. Disclaimer trusts, along with other trusts, can bring up challenges with regard to inheritance. These are usually set out clearly in a grantor’s will; however, if a will is not finalized at the time of death, determining rightful heirs proves much more complicated. In most countries, inheritances are taxable. An inheritance tax is generally distinct from an estate tax in that an inheritance tax would aim to tax the heir who has received the inheritance, while an estate tax would apply to the assets of the deceased's estate.

** The Estate Tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death. The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your Gross Estate. The property included may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. Once you have accounted for the Gross Estate, certain deductions (and in special circumstances, reductions to value) are allowed in arriving at your Taxable Estate. These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses and qualified charities. The value of some operating business interests or farms may be reduced for estates that qualify. After the net amount is computed, the value of lifetime taxable gifts (beginning with gifts made in 1977) is added to this number and the tax is computed. The tax is then reduced by the available unified credit. Most relatively simple estates (cash, publicly traded securities, small amounts of other easily valued assets, and no special deductions or elections, or jointly held property) do not require the filing of an estate tax return. A filing is required for estates with combined gross assets and prior taxable gifts exceeding $11,580,000 in 2020. Beginning January 1, 2011, estates of decedents survived by a spouse may elect to pass any of the decedent’s unused exemption to the surviving spouse. This election is made on a timely filed estate tax return for the decedent with a surviving spouse. Note that simplified valuation provisions apply for those estates without a filing requirement absent the portability election.

Intentionally Defective Marital Deduction (Irrevocable) Trust

This trust creates an irrevocable trust for all of the decedent’s assets. It solves issues of “control” and “taxable gains”. It is “intentionally” designed to be included in the survivors taxable estate. This gives the entire estate a step-up in basis (no capital gains) at the second death. It has a “disclaimer” option to fund an “exemption trust” if needed (for example, if you hit the lottery or see a significant increase in assets).

Benefits of an Intentionally Defective Marital Deduction Trust. Something you never know when planning an estate is when you and your spouse will die, what laws may change after your estate plan is created, or how your circumstances or the size of your estate might change before or after your or your spouses death. You also don’t know, if your spouse survives you, whether your spouse will later decide to change beneficiaries, get remarried, or make other changes to assets left to him or her. An Intentionally Defective Marital Deduction Trust can be a good tool for planning your estate in anticipation of changes in the size of your estate, worries about control of assets, and/or concerns regarding changes in estate tax laws.

Creditor Protection and Medicaid Planning. By creating an irrevocable trust, the intentionally defective marital deduction trust can be useful for establishing creditor protection and/or Medicaid planning after the first death. Any assets placed into the irrevocable trust can be protected from creditors of the surviving spouse and from being included in assets to determine Medicaid for the surviving spouse. It can also protect assets from a divorce if the survivor remarries.

Protect From Changes in Beneficiaries. Sometimes a spouse may be worried that at his or her death, the surviving spouse could change the deceased spouses intended beneficiaries of his or her estate. An intentionally defective marital deduction trust protects the deceased spouse’s beneficiaries, by not permitting the surviving spouse or others to change the beneficiaries. If desired, it can still permit for the use of a limited power of attorney for flexibility for the survivor to change the beneficiary provisions.

Modified A/B Trust

A-B Trust. This is a joint trust created by a married couple for the purpose of minimizing estate taxes. An A-B trust is a trust that divides into two upon the death of the first spouse. It is formed with each spouse placing assets in the trust and naming as the final beneficiary any suitable person except the other spouse. The trust gets its name from the fact that it splits into two upon the first spouse's death – trust A or the survivor's trust, and trust B or the decedent's trust.

How an A-B Trust Works. After the death of an individual, his estate is taxed heavily before his beneficiaries receive it. For example, a married couple has an estate worth $3 million by the time one of the spouses die. The surviving spouse is left with $3 million which is not taxed due to the unlimited marital deduction for assets flowing from a deceased spouse to a surviving spouse. However, if the other spouse dies and his or her estate tax exemption is $1 million, the taxable portion of the estate will be $2 million. This means that $2 million will be taxed at 40% and the remaining amount will be transferred to the beneficiaries. To circumvent the estate from being subject to such steep taxes, many married couples set up a trust under their last will and testaments called an A-B trust. Following the example above, if the couple instead had an A-B trust, the death of the first spouse will not trigger any estate taxes as a result of the lifetime exclusion. After death, the sum of money equal to the estate tax exemption in the year that s/he dies is put in an irrevocable trust called the Bypass trust, or B trust. This trust is also known as the decedent’s trust. The remaining amount, $2 million, will be transferred to a Survivor’s trust, or A trust, which the surviving spouse will have complete control over. The estate tax on the A trust is deferred until after the death of the surviving spouse.

An A-B trust minimizes estate taxes by splitting the estate into a survivor portion and a bypass portion. The surviving spouse has limited control over the decedent's trust but the terms of the decedent's trust can be set to allow the surviving spouse to access property and even draw income. A-B trusts are not widely used as the estate tax exemption is sufficient for most estates.

Advantages to an A-B Trust. The A trust contains the surviving spouse’s property interests, but s/he has limited control over the assets in the deceased spouse's trust. However, this limited control over the B trust will still enable the surviving spouse to live in the couple's house and draw income from the trust, provided these terms are stipulated in the trust. While the surviving spouse can access the bypass trust, if necessary, the assets in this trust will bypass his or her taxable estate after s/he dies. After the surviving spouse dies, only the assets in the A trust are subject to estate taxes. If the estate tax exemption for this spouse is also $1 million and the value of assets in the survivor’s trust is valued at $2 million, only $1 million will be subject to estate tax. The federal tax exemption is transferable between married couples through a designation referred to as the portability of the estate tax exemption. If one spouse dies, the unused portion of his or her estate tax exemption can be transferred and added to the estate tax exemption of the surviving spouse. Upon the death of the surviving spouse, the property in the decedent's trust passes tax-free to the beneficiaries named in this trust. This is because the B trust uses up the estate tax exemption of the spouse that died first, hence, any funds left in the decedent’s trust will be passed tax-free. As the decedent’s trust is not considered part of the surviving spouse's estate for purposes of estate tax, double-taxation is avoided.

Net Worth and A-B Trusts. If the deceased spouse’s estate falls under the amount of his or her tax exemption, then it may not be necessary to establish a survivor’s trust. The unused portion of the late spouse’s federal tax exemption can be transferred to the surviving spouse’s tax exemption by filling out IRS Form 706. While AB trusts are a great way to minimize estate taxes, they are not used much today. This is because each individual has a combined lifetime federal gift tax and estate tax exemption of $5.43 million. So only people with estates valued over $5.43 million will opt for an A-B trust. With the portability provision, a surviving spouse can include the tax exemption of his or her late spouse, allowing up to $10.86 million in assets that can be transferred tax-free to beneficiaries.

Qualified Terminable Interest Property (QTIP) Trust

A QTIP Trust enables the grantor to provide for a surviving spouse and maintain control of how the trust's assets are distributed once the surviving spouse dies. Income, and sometimes principal, generated from the trust is given to the surviving spouse to ensure that the spouse is taken care of for the rest of their life.

How a QTIP Trust Works. This type of irrevocable trust is commonly used by individuals who have children from another marriage. QTIPs enable the grantor to look after his current spouse and make sure that the assets from the trust are then passed on to beneficiaries of his choice, such as the children from the grantor's first marriage. Aside from providing the living spouse with a source of funds, a QTIP can also help limit applicable death and gift taxes. Additionally, it can assert control over how the funds are handled should the surviving spouse die, as the spouse never assumes the power of appointment over the principal. This can prevent these assets from transferring to the living spouse’s new spouse, should she remarry. The property within the QTIP providing funds to a surviving spouse qualifies for marital deductions, meaning the value of the trust is not taxable after the first spouse’s death. Instead, the property becomes taxable after the second spouse's death, with liability transferring to the named beneficiaries of the assets within the trust.

Spousal Payments and QTIPs. The surviving spouse named within a QTIP receives payments from the trust based on the income the trust generates, similar to the issuance of stock dividends. As the surviving spouse is never the true owner of the property, a lien cannot be put against the property within the trust or the trust itself. Payments will be made to the spouse for the rest of their life. Upon death, the payments cease, as they are not transferable to another person. The assets in the trust then become the property of the listed beneficiaries.

Trust Disinheritance or Exclusions

Disinheritance is often the driving force behind movie and television plots, but disinheriting a child or grandchild in real life should be approached very carefully. It's both an emotional and a financial decision and it can have significant ramifications, such as prompting a will contest and having your wishes overruled by a court. There are ways to do it and ways not to do it if you're contemplating cutting your offspring out of your last will and testament or other estate plan. It's virtually impossible for a parent to disinherit their minor child in any state. Courts will invariably provide for the child from your estate funds until the child reaches the age of majority, often 18 years old.

Controlling an Heir's Behavior. Don't use the threat of disinheritance as a way to manipulate an heir's current behavior. You might want your child or to do or not do something, and you think that threatening them with disinheritance will make them act or not act in that way. The end result is that you're using money as a control mechanism, and that rarely works out well. Consider exploring other solutions to the problem instead.

Controlling an Heir's Inheritance. You can create a living trust to control an heir's inheritance if your concern is that your child will blow their inheritance irresponsibility, maybe on fast cars, drugs, alcohol, or extravagant trips. The trustee can transfer funds in small increments rather than giving the entire inheritance at once, or pay bills directly on your child's behalf. This can be accomplished by setting up a lifetime trust for the heir's benefit and giving the trustee specific instructions as to how and when distributions can be made. You can include incentives such as going to college, working a full-time job, or staying drug and alcohol-free. You can't include incentives that would be against public policy, however, such as marrying or divorcing a certain individual, or practicing or not practicing a specific religion.

Give Someone Else Power of Appointment. You can also give the trustee of a lifetime trust the ability to re-inherit your child. This can be accomplished by giving the trustee a power of appointment that can be exercised in favor of re-inheriting the person you've disinherited.

Make Your Intentions Clear. Make your intentions of disinheritance clear if you decide to disinherit your child in your last will and testament. Don't simply fail to mention them. Specifically state your intent to disinherit. Seeing it in black and white will certainly drive the point home and it might even discourage a will contest that's based on grounds that the disinheritance was accidental or an oversight. Most state courts will assume the omission of your child from your will or trust terms was an oversight if you don't make your position perfectly clear. They could award a portion of your estate if you don't make your intentions known. You might also want to document your decision, then keep copies of that documentation with your will. This can be as simple as making journal entries indicating that you're considering disinheritance and why, or citing individuals with whom you've spoken about your decision. Documentation can also help prove that your decision wasn't impulsive and that no one else coerced you into it, both of which are potential grounds for a will contest. You might want to consider including language such as, I am intentionally disinheriting Susie for reasons I deem to be good and sufficient and therefore, for all purposes of this will, Susie will be deemed to have predeceased me. Include this at the very beginning of your will.

By the same token, you don't want to meticulously list your every grievance in your will or trust formation documents. This, too, can open the door for your disinherited child to challenge the will if it can be proved that the circumstances you've cited have changed. For example, maybe you don't want to trust your son's wife with access to the assets or cash you've amassed over your lifetime, but he's divorced her by the time of your death. Or maybe he's a terrible spendthrift, but he's seen the error of his ways and now owns a profitable corporation. Your disinheritance provision can potentially be overturned if you say, I don't trust John's spouse, Mary, or John has no sense of fiscal responsibility, if neither is the case any longer—even if it's only one of several reasons why you're reluctant to name him as a beneficiary.

You can also get your point across by leaving your heir a token gift, something small so it's clear that you haven't unintentionally overlooked or forgotten about them. You might have heard tales of someone who was left $1 in a will. Now you know why.

Include a No-Contest Clause. Some states allow you to state in your will that should any of your beneficiaries challenge it, they'll lose what you did give them if they're unsuccessful at having your will overturned. Of course, your child would have no reason not to file a will contest if you didn't make any bequest to begin with, but it can provide some food for thought if you're at least a little bit generous.

Update Your Beneficiary Designations. Check your beneficiary designations and update them, too, if necessary. These are sometimes overlooked in the haste to make sure that a potential heir is disinherited in a will or trust. You might have cut them out of those documents, but they're still named in your life insurance policy to inherit a windfall at the time of your death. Double check retirement accounts, too, such as IRAs and 401(k)s, and any accounts with payable-on-death or transfer-on-death designations.

Pretermitted Heir

A pretermitted heir is a person who would likely stand to inherit under a will, except that the testator (the person who wrote the will) did not include the person in the testator's will. Omission may occur because the testator did not know of the omitted person at the time the will was written. A will may contain a clause that explicitly disinherits any heirs unknown at the time that the will is executed, or any heirs not named in the will. While such a clause will not necessarily prevent a claim against an estate by a pretermitted heir, it may make it more difficult to succeed in such an action.

Afterborn Child

An after-born child is a child born after execution of a will by either parent or born after the time in which a class gift closes. Generally, an after-born child is entitled to receive a share of the parent's estate that s/he would have been entitled to if the parent had died without leaving a will. The beneficiaries of the will must contribute a proportionate share of what they inherited from the will to make up the after-born child's share. In most states, an after-born child is eligible to receive a share that he would have received if the parent had died without leaving a will. However, the after-born child does not receive the share if: (1) the omission was purposefully made; (2) the will left most of the estate to the surviving parent; or (3) the decedent has made some other provisions for the child.

For further information, contact our firm for a free consultation.