Understanding Trusts: What You Need To Know

What Is a Trust?

A trust is a legal arrangement that allows assets to be transferred from the trust creator (known as the grantor or settlor) to a trustee, who then manages and administers those assets for the benefit of the trust beneficiaries.¹

Trusts are legal entities established to control how assets are distributed and administered during life and after death. The document that creates the trust is called the trust agreement or declaration of trust. It details how the trust assets will be managed and distributed to the beneficiaries.

Trusts can be used for various purposes as part of an estate plan. While a will passes through probate court upon death, assets in a trust avoid this process, saving time, expenses, and public disclosure associated with probate.

Trusts allow grantors to retain control over their assets while alive but distribute them privately and efficiently upon death. Trusts can be customized to meet a grantor's wishes for asset protection, tax minimization, and distribution management.

Why Use a Trust?

The primary purpose of a trust is to manage and protect assets for the benefit of one or more beneficiaries. While the specific purposes can vary based on the type of trust and the intentions of the grantor (the person or entity creating the trust), some of the most common purposes include:

• Estate Planning: Trusts can ensure assets are distributed to beneficiaries as specified by the trustor upon their death, often bypassing the often time-consuming and costly probate process.
• Asset Protection: Trusts can protect assets from creditors, lawsuits, or other financial threats, especially if irrevocable.
• Tax Efficiency: Certain trusts can help minimize estate and gift taxes, allowing more of the grantor's assets to be passed on to beneficiaries.
• Control Over Asset Distribution: Trusts allow the grantor to specify conditions for asset distribution, such as disbursing funds when a beneficiary reaches a certain age or achieves a specific milestone.
• Providing for Minors or Special Needs Individuals: Trusts can be set up to provide financial support for minors until they reach adulthood or for individuals with special needs without jeopardizing their eligibility for certain government benefits.
• Charitable Giving: Charitable trusts are designed to support philanthropic organizations while providing tax benefits for the grantor.

While these are some of the primary purposes of trusts, the flexibility of trust structures means they can serve a wide range of objectives and complex situations.

Different types of trusts can be used depending on your needs and financial situation. It is important to take the time to research setting up a trust within your estate plan thoroughly. Consider all available options, including your financial objectives, family, and personal preferences.

Trusts can be complex, but they can be valuable for managing and protecting your assets.

How Do Trusts Work?

A trust is an estate planning tool based on a fairly straightforward principle, but its specific mechanisms vary widely depending on its type and purpose. Here's a basic overview of how trusts work:

Establishment: A trust is created when a person, referred to as the grantor or settlor, transfers ownership of specific assets to the trust through a trust agreement outlining the trust's terms. A Living Trust is created while you are still alive, and a Testamentary Trust is created as part of your last will and testament at time of death.

Management: Once the trust is established, a trustee (or multiple trustees) is designated to manage it. This person or entity is responsible for ensuring that the assets within the trust are handled and distributed according to the trust's terms.

Beneficiaries: The grantor specifies beneficiaries as the individuals or entities designated to ultimately receive the assets or income from the trust, according to the conditions outlined in the trust documents.

Terms & Conditions: Trust documents outline specific terms dictating how the beneficiaries will receive assets or income.

Types of Trusts: Trusts can be either revocable or irrevocable. A revocable trust allows the trustor to alter or terminate the trust during their lifetime. In contrast, an irrevocable trust cannot be easily changed or terminated without the beneficiary's permission. Some of the common types of trusts include:

• A-B Trust: Designed for married couples to maximize estate tax exemptions.
• Asset Protection Trust: Protects assets on behalf of a beneficiary from claims by future creditors or lawsuits.
• Charitable Remainder Trust: Offers you and your beneficiaries regular payments from an annuity over a set period, with the remaining assets donated to charity.
• Discretionary Trust: Empowers trustees to determine when to distribute assets and income to the beneficiaries.
• Grantor Retained Annuity Trust: Set up for a certain period to minimize taxes on large financial gifts to family members or other beneficiaries.
• Life Insurance Trust: Designed to hold and manage a life insurance policy, keeping the policy proceeds outside of the insured's taxable estate.
• Qualified Personal Residence Trust: Bypasses probate for your primary home by placing it into a trust for a designated period before it is handed over to the heirs.
• Special Needs Trust: Intended to help people with disabilities without risking their eligibility for government benefits.

Taxation: The taxation of a trust and its generated income depends on the type of trust and jurisdiction, with taxes applied to the grantor, the trust itself, or the beneficiaries, based on the case.

Duration: Trusts can be established to exist for a specific period or indefinitely, and some may terminate upon events like the grantor's death or when a beneficiary reaches a certain age.

Consulting with an estate attorney and financial advisor to fully understand the considerations, costs, and benefits is essential before deciding whether a Trust is the right choice for you.

How to Choose a Trustee?

Choosing a trustee is crucial when setting up a trust, so selecting someone reliable, competent, and trustworthy is vital. Here are some key considerations to help you in this decision:

• Understand the Role: Before selecting a trustee, it's crucial to understand their responsibilities, including managing investments, distributing assets, preparing tax returns, and more. The role can be time-consuming and complex, requiring a blend of financial acumen, discretion, and integrity.
• Consider Professional Qualifications: For a complex trust, it's advisable to choose a trustee skilled in finance, law, or investing, such as a lawyer, accountant, or financial advisor.
• Assess Reliability & Integrity: The trustee must be someone you can trust implicitly. They should have a history of being responsible, ethical, and unbiased.
• Think About Longevity: Since some trusts may last for decades, consider the age and health of a potential trustee, especially if you're thinking about an individual rather than an institution.
• Corporate Trustee Option: Banks and trust companies provide professional independent trustee services for a fee. These services are beneficial for managing complex trusts or when there's a risk of family conflicts, as they offer expertise, impartiality, and consistency.
• Evaluate Potential Conflicts of Interest: If the trustee stands to benefit from the trust or has relationships with beneficiaries, it might create conflicts of interest.
• Consider Co-Trustees: Having two or more trustees can provide a system of checks and balances. It can also divide the workload. However, ensure co-trustees can work well together to avoid disputes.
• Review Fees: If you're considering a professional or corporate trustee, understand their fee structure. Ensure it's reasonable, given the size and complexity of the trust.
• Discuss With Potential Trustees: Before deciding, have an open conversation with potential trustees. Discuss your expectations and ensure they feel comfortable with the responsibilities.
• Plan for Succession: If your chosen trustee can no longer serve, have a backup plan. Designate successor trustees in the trust document.
• Re-Evaluate Periodically: Circumstances can change over time. It's a good idea to periodically review your choice of trustee and make changes if necessary.

Remember, the right trustee for your situation will depend on your trust's specifics, relationships, and financial circumstances. This decision warrants careful consideration and consultation with a qualified attorney or financial professional.

Pros: What Are the Benefits of a Trust?

Trusts offer a variety of benefits, serving different needs and objectives. Here are some of the advantages of establishing a trust:

• Avoid Probate: Probate can be time-consuming, public, and costly. Assets held in a trust bypass the probate process, allowing for a quicker and often more private distribution to heirs.
• Control Over Assets: With a trust, the grantor (the person creating the trust) can dictate specific terms for asset distribution, ensuring that assets are used or distributed according to their wishes.
• Protection from Creditors: Properly set up trusts can shield assets from creditors, lawsuits, and divorcing spouses.
• Tax Benefits: Trusts can provide tax advantages, including minimizing estate taxes and facilitating charitable giving strategies.
• Privacy: Unlike wills, which become public records during probate, trusts can maintain the confidentiality of the grantor's wishes and the details of the assets.
• Protection in Incapacity: A trust can manage and distribute assets without court involvement if the person who created it becomes incapacitated.
• Multigenerational Planning: Trusts can be structured to benefit several generations, ensuring that assets remain within and benefit the family for an extended period.
• Charitable Giving: Charitable trusts allow individuals to support charitable causes while enjoying tax benefits.
• Special Needs Planning: Special needs trusts are designed to provide supplemental resources to individuals with disabilities without jeopardizing their eligibility for government assistance programs.

Cons: What Are the Drawbacks of a Trust?

While trusts offer numerous benefits, they also have potential drawbacks when contemplating their use. Here are some of the disadvantages of trusts:

• Setup and Administrative Costs: Creating a trust involves legal fees for expert guidance, especially for intricate ones, and can also include yearly costs like trustee fees, tax filing, and accounting expenses.
• Complexity: Managing a trust, particularly a complex one, can be daunting. There's a need to understand trust laws, the responsibilities and duties of a trustee, tax implications, and more.
• Irrevocability of Certain Trusts: Some trusts, once established, cannot be altered or revoked. While this can serve specific estate planning goals, it can also be restrictive if circumstances change or if there are unintended consequences.
• Potential Tax Consequences: Depending on the type and structure of the trust, there can be tax implications. For instance, trust income may be taxed higher than individual income.
• Loss of Personal Control: For irrevocable trusts, the grantor relinquishes control of the assets transferred into the trust, meaning they can't easily access or use those assets, even if they later wish to.
• Rigidity: While trusts can be tailored to specific situations, they can also be rigid, mainly if not correctly structured.
• Loss of Beneficial Tax Breaks: Assets in certain trusts may not qualify for specific tax breaks, such as the step-up in basis upon death, potentially resulting in higher capital gains taxes for beneficiaries.

When considering the establishment of a trust, it's crucial to weigh these potential drawbacks against the benefits tailored to individual circumstances and goals. Consulting with an experienced estate planning attorney can help you understand these intricacies and make informed decisions.

How Much Does a Trust Cost?

Establishing a Trust involves several costs, which can vary widely depending on the type of trust, the complexity of the estate, the attorney's fees, and the jurisdiction. Although it's challenging to offer an exact price without detailed information, let's examine the overall financial considerations:

• Attorney's Fees: Legal fees for a Trust may range from a few thousand to several thousand dollars, and they can be higher for complex trusts.
• Trustee Fees: When managing a trust, bank or professional trustee fees are typically a percentage of the trust's assets and can vary with the trust's complexity and services provided. Individuals serving as trustees often incur lower costs, including compensation and management expenses.
• Administrative Costs: Filing trust documents, preparing tax returns, and managing trust finances, especially for large or complex estates, require continuous management and may incur costs and accounting fees.
• Asset Management Fees: Investment advisory fees will apply if the trust's assets are actively managed. Property management fees may be incurred if real estate is held within the trust.
• Ongoing Operational Costs: Additional expenses may be incurred in managing and executing income distributions, particularly if professional services are required for detailed record-keeping.

Given the range of costs involved in setting up and maintaining a Trust, it is crucial to obtain detailed estimates from attorneys, trustees, and other professionals before proceeding.

How Are Trusts Taxed?

Trusts are taxed differently depending on their structure:

1. Revocable Trusts: These are treated as "grantor" trusts for tax purposes, meaning all income, deductions, and credits are reported on the grantor's personal tax return, and the trust doesn't pay income taxes. Essentially, the IRS views the assets in a revocable trust as belonging to the grantor.
2. Irrevocable Trusts: These are separate tax entities. The trust itself is responsible for paying taxes on any income it generates, according to trust tax rates, which can be higher than individual rates. If the trust distributes income to beneficiaries, that income is typically taxed to the beneficiaries at their individual tax rates, and they must report it on their personal tax returns.

Trusts must submit an annual tax return if their taxable income or total assets exceed a specific limit. The tax obligations can vary based on the trust's revenue, the nature of its earnings, and the distribution guidelines outlined in the trust document.

Remember that tax laws are subject to change and can vary significantly, and the rules that apply at the trust creation could differ from those in future years. Some states have their own estate or inheritance taxes, while others might tax trust income differently than the federal government.

Due to the complexities and potential for significant tax liability, it's crucial for individuals considering a Trust to work closely with estate planning attorneys, tax professionals, and financial advisors. These professionals can help design the trust to maximize tax efficiency and minimize estate taxes while meeting the grantor's family and philanthropic legacy objectives.

Is a Trust Right for You?

Whether or not a trust is worth it depends on your circumstances and financial goals. Trusts can offer many benefits, including asset protection, tax benefits, control over how your assets are distributed, privacy, and flexibility. However, they can also be complex and expensive to create and maintain.

Here are some things to consider when deciding whether or not a trust is worth it for you:

• The size and complexity of your estate: A trust may not be necessary if your estate is relatively small and straightforward. However, if your estate is large or complex, a trust can help you manage and protect your assets more effectively.
• Your family situation: If you have minor children or disabled family members, a trust can help ensure their needs are met after you are gone. A trust can protect your assets from creditors or lawsuits if you have financially irresponsible family members.
• Your tax situation: Trusts can be used to reduce estate and gift taxes. However, consulting with a tax advisor for tax planning is essential to determine how a trust would affect your tax liability.
• Your financial goals: Trusts serve multiple financial objectives, including supporting your grandchildren's education, creating a charitable legacy, or guaranteeing that your assets are allocated to your heirs as you desire.

Trusts offer a powerful addition to your estate planning toolkit. Exploring trusts could be a wise decision if you want more control over your assets, privacy for your affairs, and greater efficiency for your beneficiaries.

Sources

1. Trust - Cornell Law School. https://www.law.cornell.edu/wex/trust.
2. Definition of a Trust - Internal Revenue Service (IRS). https://www.irs.gov/charities-non-profits/definition-of-a-trust.