What is the Nature of a Trust?

Trusts are useful for many purposes, including avoiding probate, reducing or eliminating federal estate taxes, and managing property for a beneficiary when direct ownership by the beneficiary is not desired. Trusts also can be very useful for asset protection if the creditors of the beneficiary are prevented from reaching trust assets.

A trust can be an effective way to place assets outside the reach of creditors. However, not all forms of a trust will function as a means of asset protection. Further, even a properly structured asset protection trust can be challenged by creditors.

Before those issues can be addressed, you must understand some basics about the nature of a trust. Common forms of trusts and their objectives should also be considered, with a special emphasis on the asset protection trust.

What is the Nature of a Trust?

While there are many types of trusts, that serve many different purposes (including asset protection), they all have common elements.

A trust is a legal agreement between three parties:

  • The trustor (or settlor or grantor)
  • The trustee
  • The beneficiary

A trustor, or settlor, transfers legal title of some property to a trust, and then a trustee manages the property for a beneficiary. A trust can have more than one beneficiary, trustee, or settlor. Moreover, one individual may assume two or even three of the roles. Usually, in this case, the trust will provide for at least one contingent beneficiary, who will become an active beneficiary upon the death of the settlor.

Further, a single trust instrument can establish multiple trusts. For example, a trust could provide that, upon the death of a husband and wife, individual trusts could be established for each of their children. And again, in this situation, one person could assume all the three roles in this trust.

Common trust factors to consider include the use of a revocable or irrevocable trust, as well as whether the legal agreement is a living or a testamentary trust.

Avoiding Probate Versus Avoiding Estate Tax

When using trusts, it is important to realize that avoidance of probate court and elimination of federal estate taxes are two different issues. Separate rules apply to each situation, and in many cases it’s difficult to avoid them both.

Generally it’s easier to avoid probate court than to avoid estate tax. For example, a funded revocable trust (supplied with assets before death) will always avoid probate court, because ownership is transferred outside of the grantor’s will.

Neither type of trust will avoid federal estate taxes, because the settlor’s control over the trust (due to the fact that he or she can amend or revoke it) means that the assets must be included in the settlor’s taxable estate.

Similarly, co-ownership of property in joint tenancy, Payable on Death (POD) designations for securities and bank accounts, and beneficiary designations for life insurance and retirement benefits mean that these assets will avoid the probate court process, because title passes to the designated heirs outside of the will. However, absent any specific additional strategy to eliminate the federal estate tax (such as by creation of an irrevocable life insurance trust), these assets are still included in the owner’s taxable estate.

Spendthrift Clause Essential for Asset Protection

To be effective, any asset protection trust must have a spendthrift clause. This prevents the beneficiary of a trust from voluntarily or involuntarily transferring any current or future rights in the trust. In other words, it prevents the creditors of the beneficiary from reaching trust assets.

The term “self-settled spendthrift trust” refers to a trust with a spendthrift clause, where the trustor is also a beneficiary. There are offshore jurisdictions that allow this type of trust. Very few states allow for such trusts.

On the other hand, use of a spendthrift clause in a trust established for a different beneficiary (for example, a child) has always been recognized as valid. Thus, a spendthrift clause should always be used in a children’s trust, a bypass trust, a QTIP trust, a life insurance trust, etc.

When the trust is established for a separate beneficiary, the fact that the trust is revocable does not invalidate the spendthrift clause, as it imparts no rights to the beneficiary. However, the beneficiary should not be a trustee, and the trust should not provide for mandatory distributions of income or principal. Where mandatory distributions of income or principal exist, a creditor would be able to reach the distributions when they occur.

Understanding Trust Characteristics and Grantor Trusts

A revocable trust is a trust that can be amended or revoked by the settlor after it is created. In contrast, an irrevocable trust cannot be amended or revoked by the settlor after it has been created.

A revocable trust will become irrevocable upon the death of the settlor, however, as the settlor is no longer able to change or revoke the trust.

Trusts designed to avoid federal estate taxes are often drafted to be irrevocable (but not always, such as with a bypass trust), while trusts designed to only avoid probate court frequently are revocable. As noted earlier, avoidance of both probate court and estate tax at the same time is more difficult.

Living versus testamentary trusts. Once you have a basic understanding of the nature of a trust, you have many choices to make in drafting your comprehensive asset protection plan. Besides revocability, you’ll need to consider the timing of the transfer—during your lifetime or upon your death—in light of the consequences of the timing of the transfer.

A living trust (sometimes called an inter vivos trust) is one created by the settlor during his or her lifetime, while a testamentary trust is a trust created by the settlor’s will.

Only a funded living trust avoids probate. In a testamentary trust, property must pass into the trust by way of the will and, thus, must go through the probate court process. Similarly, an unfunded living trust technically does not exist until it receives some assets. If you attempt to create a living trust but do not transfer any assets to it except through your will, the property must go through probate just like a testamentary trust.

Avoiding probate, and the costs and delays associated with it, is a distinct advantage of the living trust. One the other hand, funding of the living trust means that the settlor must transfer assets into trust during his or her lifetime, and provide for management of those assets by a trustee. This creates its own burdens.

These burdens can be lessened when the settlor also acts as the trustee. However, in some cases, this can cause the trust assets to be included in the taxable estate. An estate planning attorney can structure the trust to prevent this outcome.

Common Types of Trusts

Given the nature of a trust, they can be created for almost any purpose and can include any conditions and requirements that you desire. Over time, a number of types of trusts especially useful for common purposes have been developed:

  • Grantor trust
  • Totten trust
  • Bypass/Credit Shelter trust
  • QTIP/marital deduction trust
  • Irrevocable Living Children’s trust
  • Irrevocable Life Insurance Trust
  • Grantor Trusts Provide Simplicity and Flexibility

Of the many types of trusts, the grantor trust is popular for its simplicity and flexibility. However, understanding legal and tax ramifications of a grantor trust is essential, or else you could cause more harm than good.

Grantor trusts are not separate entities. Generally, if a living trust is irrevocable, the trust is treated as a separate legal entity and taxpayer. This adds additional complexities and costs. Such a trust is taxed based on a rate schedule designed for estates and trusts that is extremely compressed—that is, it imposes high tax rates on very low levels of income. Furthermore, the trust and estate tax scheme does not allow for personal exemptions. Thus, in addition to the administrative burden, higher taxes are a very likely result.

However, language can be used in the trust to make it a grantor trust under the IRS definition. (“Grantor” here means the same thing as “settlor.”) In the grantor trust, the trust is not recognized as a separate taxpayer. Instead, the grantor reports the trust income on his or her personal income tax return, as if he or she owned all the assets personally and the trust did not exist.

This simplifies the administration of the trust. At the same time, other precautions can be taken so that the trust still removes the assets from the taxable estate of the settlor. In short, the grantor trust takes advantage of exceptions to the separate income tax and estate tax rules that apply to trusts.

Totten, Bypass, Marital Deduction Trusts Meet Different Needs

A very simple form of a revocable grantor trust used to avoid probate court is called a Totten trust. This trust is often referred to as a “payable upon death account.” Most banks have a simple form that a depositor can use to create this trust form for a bank account. In a Totten trust, the depositor is the settlor, the trustee, and the only beneficiary during his or her life. A contingent beneficiary is named in the trust instrument who takes over ownership of the account upon the death of the settlor.

The trust is revocable. The settlor can amend or revoke the trust during his or her life. The easiest way to do so is to simply spend the money in the account.

Because the contingency beneficiary has no rights in the account during the settlor’s life, the Totten trust is safer than, for example, a common alternative way of avoiding probate court with a bank account, namely, opening or converting the account to joint tenancy. When the joint tenancy alternative is used, the joint owner takes an immediate interest in the account, including the right to withdraw some or all of the funds.

In the Totten trust, the beneficiary has no immediate rights in the account, so the creditors of the beneficiary cannot reach the account. On the other hand, the creditors of a co-owner of an account held in joint tenancy can attach the co-owner’s interest in the account.

The Totten trust is just one example of the unique nature of trusts, where one person may assume multiple roles in the trust at once.

Married Couples Can Consider Using a Bypass/Credit Shelter Trust

The bypass trust, also known as a credit shelter trust, can be used to eliminate or reduce federal estate taxes. It is typically used by a married couple whose estate exceeds the amount exempt from federal estate tax.

Although a married person may leave an unlimited amount of assets to his or her spouse, free of estate taxes and without using up any of the estate tax credit, a problem occurs if the surviving spouse then dies with an estate worth more than the exempted amount. In this case, his or her estate would be subject to estate tax. Meanwhile, the first spouse’s estate tax credit was unused and, in effect, wasted.

The bypass trust was created to solve this problem. This type of trust may be revocable or irrevocable, and living or testamentary. Typically, the trust instrument initially creates a single living trust that is revocable.

Upon the death of the first spouse, the instrument establishes a separate, irrevocable “bypass” trust with the deceased spouse’s share of the trust assets. The surviving spouse is the beneficiary of this trust, with the children as beneficiaries of the remaining interest.

The irrevocable trust is funded to the extent of the first spouse’s exemption. So the amount in the irrevocable trust is not subject to estate taxes on the death of the first spouse, and the trust takes full advantage of the first spouse’s estate tax credit.

At the same time, special language is used in the irrevocable trust so that the assets in the irrevocable trust will not be included in the taxable estate of the beneficiary (i.e., the other spouse). Generally this involves giving the second spouse only limited powers to control the trust assets. Thus, the bypass trust is appropriately named, as the assets in the irrevocable trust bypass the estate tax that would be assessed when the second spouse dies.

Marital Deduction (QTIP) Trusts Controls Estate Assets

A marital deduction, also referred to as a qualified terminable interest property (QTIP) trust, is designed not to avoid federal estate taxes upon the death of a surviving spouse, but rather to provide management and control of assets for a surviving spouse after the first spouse dies.

The trust is structured so that all assets in the trust qualify for the unlimited marital deduction, as would outright gifts to a spouse. Thus, the trust avoids estate taxes upon the death of the first spouse. The real advantage of the trust is the ability to have an independent trustee control and manage the assets for the surviving spouse, and the ability to determine the contingent beneficiaries, who usually are the children.

The trust frequently is used when the settlor has children from the prior marriage, and the settlor wants to ensure that a certain portion of his or her estate will pass to children from the prior marriage. This cannot always be assumed when the property is left outright to the surviving spouse. The trust is used when professional management of the assets is desirable for the surviving spouse.

Irrevocable Trusts Avoid Probate

Importantly, the trust avoids probate court and the costs, delays and challenges associated with that process. In addition, this trust serves as an asset protection trust. Because a spendthrift clause is used in this type of trust, assets in it are shielded from the children’s creditors in the event of a major court judgment, bankruptcy, divorce, etc.

While management and control also can be achieved by establishing a custodial account for the child under the Uniform Transfers to Minors Act (UTMA), the disadvantage of the UTMA is that the assets must be distributed outright to the child at an early age, usually age 21.

In contrast, in a children’s trust, the assets can continue to be managed in the trust well past age 21; for example, the trust could continue until the child finishes college, gets married, produces grandchildren, or attains a certain age such as 25, 30, etc. Provisions can be written into the trust that require mandatory periodic distributions, or that give the trustee complete discretion over distributions. The settlor also can choose the exact circumstances in which distributions can be made (e.g., for education, new home, etc.). Importantly, the entire time the assets remain in the trust, the assets are shielded from the beneficiary’s creditors. When the assets remain in the trust for the beneficiary’s lifetime and for, perhaps, successive descendants’ lives, in order to take advantage of the protection, the trust is sometimes called a “Dynasty Trust.”

Parents can act as trustees, which eliminated administration costs and issues that arise from having someone else managing the trust assets.

The trust can be set up as a grantor trust to simplify administration. On the other hand, you may want to avoid the grantor trust rules so that the trust is a tax-paying entity. In the latter case, the trust may be able to offer income tax-splitting advantages.

The irrevocable children’s trust also can be used to eliminate estate taxes on the future appreciation in the underlying assets. Where elimination of estate taxes is not an issue, the trust can be revocable. The trust also can be established by way or a will (i.e., be testamentary in origin).

Finally, although such trusts are usually irrevocable—because of the significant benefits in avoiding estate taxes—the trust can be revocable. This gives parents the flexibility to amend or revoke the trust. This option also avoids probate court, but not federal estate taxes, and thus is not recommended where the trust will be funded with substantial assets.

Irrevocable Life Insurance Trust Avoids Estate Tax on Insurance

Of the various types of trusts, the irrevocable life insurance trust (ILIT) is concerned with wealth generated after death. Ordinarily, the face value of life insurance is included in the taxable estate of the owner of the policy. This can represent a significant source of estate taxes.

However, you can create a special type of trust that eliminates estate taxes on the life insurance benefits because the trust, and not you, will be deemed to be the owner of the policy.

It is usually desirable to establish the life insurance trust first, and then have the trust purchase the policy in its own name. The settlor funds the trust, which purchases the policy in its own name, and pays the policy premium against its own account. An independent trustee is absolutely required in this case.

It is possible to transfer an existing life insurance policy to such a trust; for example, when the settlor is older or has health problems that make a new life insurance policy cost-prohibitive. However, caution must be exercised so that the settlor irrevocably relinquishes to the trust absolutely all control over the policy. An estate planning attorney can ensure this is done properly.

The idea is that the trust takes ownership of the policy; the settlor then makes contributions to the trust, which uses the contributions to pay the policy’s premium against its own account.

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