What is a Trust?
A trust is a legal tool that creates a fiduciary relationship between a Settlor/Grantor (the creator) and a Trustee (the third party). The Trustee is authorized to hold title to property or assets on the behalf of a beneficiary. A fiduciary is a person or entity that owes a duty to prudently take care of assets or money. This could range anywhere from prohibiting self-dealing to ensuring a spendthrift beneficiary won’t squander a trust fund. To create a trust, one must:
- Use a trust-creating document (or provisions in a will)
- Name a trustee
- Name beneficiaries
- Fund the trust (title assets in the name of the trust)
Confused yet? Look at it this way, Person A (Settlor) use a trust document to create a trust. They name Person B (Person A’s sister) as the Trustee, Daughter C as the beneficiary, and title property in the name of the Trust (“Person A Family Trust”). Person B manages the trust on the behalf of Daughter C. Person B cannot run off to Las Vegas with the trust assets and gamble them away because that would not be very prudent (especially if Person B is bad at poker). There are several different types of trusts and ways they are created.
A Living Trust is created and funded during the life of the Settlor. A Testamentary Trust is created after death and follow the terms of one’s will. For simplicity purposes, let’s start with some general terms: Irrevocable Trusts and Revocable Trusts.
Irrevocable Trusts
As the name demonstrates, an irrevocable trust cannot be revoked. That’s it, that’s the article . . . just kidding. It’s true, this type of trust cannot be amended or otherwise altered. The Settlor transfers all ownership of assets into the trust. The most common use of irrevocable trusts is for the purpose of a tax-shelter, avoiding high estate taxes.
The current federal estate tax exemption is $11.58 million, so the average person will not have this concern. Generally, property transferred to an irrevocable living trust will not count toward the estate’s gross value. The choice of an irrevocable trust may also be made to ensure eligibility for social security, medicaid (nursing home care), or other governmental benefits. While the terms cannot be modified, there are rare exceptions that can be written into the trust instrument. Between the trustee and beneficiary, there is less control on the part of the Settlor to dictate the trust’s management.
Trusts are a unique estate planning tool, so understanding how complex this process can be is critical.
Revocable Trusts
Revocable trusts are more familiar and widely used because the Settlor maintains control. In this type of trust, a competent Settlor can revoke or amend it at any time. Death or incapacity make a revocable trust irrevocable. This makes sense because making changes to a Settlor’s trust without their input changes the nature and control of the trust.
Unlike an irrevocable trust, property in a revocable trust will be included toward the valuation of an estate for tax purposes and qualifying for government benefits. Keep in mind that the federal estate tax exemption is $11.58 million and double that for married couples. In Washington state, there is a much lower state exemption for estates valued at or below $2.19 million per individual. Understand where your estate will end up and speak with a tax professional about your specific situation. There is a vast difference between tax compliance and tax strategy.
Living Trust
A major benefit of a revocable living trust is that the Settlor can also name herself as the Trustee and, in some instances, as one of the beneficiaries. She may also earn income generated from the trust corpus (the principal). Creating a living trust allows the Settlor to continue to transfer assets in and out of the trust during her lifetime. She can add or remove beneficiaries over time. Another benefit is that a living trust stays private, as opposed to court-involved estates that often have public filings.
A major disadvantage of this kind of trust is an inability to protect the trust from creditors. Make sure you consider provisions in your trust that could protect the assets from your own creditors, a beneficiary’s creditors, or immediate family’s creditors. It is also crucial to properly title assets in the name of the trust and update beneficiary designations (to the trust). Common assets in a living trust are:
- Bank accounts
- Investment accounts (non-retirement)
- Real estate
- Business interests
- Debts owed to the Settlor
Testamentary Trust
A testamentary trust is created under a will. Unlike a living trust, a testamentary trust is not created until a person’s death (the decedent). The executor named in the decedent’s will instructs him to create a testamentary trust to go into effect at the settling of the estate. The trustee named in the testamentary trust would be in charge of managing the trust for the named beneficiaries.
Here, the decedent may have included specific instructions in order for a beneficiary to use assets. For example, a testamentary trust may require beneficiaries to use the trust funds for college or, in the alternative, the funds shall be donated to a needs-based academic nonprofit. This provides for long-term management of the trust.
By the time this type of trust is created, all creditors should be paid, bequests distributed, and the estate is settled. The residuary estate, or leftover assets, would then be transferred into the newly created trust and the trustee would continue fiduciary duties on the behalf of the trust beneficiaries. This may be a good structure for a decedent with multiple children, special needs dependents, or for a beneficiary that may squander assets.
Trust Overview
A trust creates a major advantage in avoiding probate, a process to determine how assets should be distributed with or without a will. It can be lengthy and may involve major court involvement. Although this advantage exists, there are many ways to make major mistakes. When considering when and how to create a trust consider the following:
- Update the trust as circumstances change
- Locate certificates of ownership and other titling documents
- Fund the trust (no assets, no trust)
- Make sure you trust your trustee (competency and honesty)
- Understand current or potential creditors (Settlor, beneficiary, spouse, children)
- Communicate about tax compliance and strategy
Estate planning is complex, but the idea is to create a plan. Don’t put it off until the last minute. If you don’t know where to start, engage an estate planning attorney that you trust and put all options on the table. It is not a bad idea to start while your estate is small and grow into something that fits your lifestyle. There is no fill-in-the-blank form that will be perfectly tailored to your needs, especially as they change from time-to-time.
