March 2006
A trust works like a bucket. First, someone puts property into the bucket. That someone is often called the trustor, grantor or trustmaker. Second, someone manages what's in the bucket. In most documents, that person is referred to as the trustee. Third, someone receives some benefit from the property in the trust. That person is known as the beneficiary.
One of the tricky things about trusts is that one person can play more than one role at the same time. Similarly, more than one person can play the same role. For example, a married couple can be the trustors and also serve as the trustees. In most living trusts, the same person or persons serve all three roles. They put the property into the trust for their benefit and appoint themselves as managers.
Different Buckets
There is more than one kind of trust. It may be revocable or irrevocable. It may be living or testamentary. Your job is to choose, probably with the help of an experienced trust attorney, which bucket best satisfies your needs.
“Revocable” and “irrevocable” refer to the ability of the trustor to undo the trust. A revocable trust can be undone; an irrevocable trust cannot. Because an irrevocable trust is very difficult to undo or change, it is generally used only in complex planning situations in which the trustor is trying to achieve asset protection and/or a reduction in certain types of taxes.
As for a “living” versus “testamentary” trust, the former (also known as an inter vivos trust) is established during the trustor’s lifetime, while the latter is established after the trustor’s death.
Another estate planning tool is a lifetime protective trust. Parents can place assets into this kind of trust to prevent the assets from being seized or taxed, and the protection applies for successive generations.
Then there is a qualified terminable interest property, or QTIP. This is a common planning tool that is often used in second marriages to prevent accidental disinheritance of children from a first marriage. A QTIP allows a surviving spouse to benefit from assets of the trust until his or her death, at which time the trust assets are distributed according to the trustmaker's wishes and taxed at that time.
Taxing the Bucket
Accountants will often ask whether a trust is “simple” or “complex.” This question isn't seeking to determine how easy the trust is to understand or administer; rather, it refers to the distribution of the trust income. Simple trusts mandate payment of the trust's income to the beneficiaries, while complex trusts do not.
Since we're talking about taxation of trusts, we need to consider the term grantor trust. With this type of trust, the income the trust earns is taxed to the trustor. Almost all revocable living trusts are grantor trusts, but some irrevocable trusts can be grantor trusts, as well, if the trust contains certain provisions.
If a trust is not a grantor trust, then the trust itself is considered a separate taxpayer, and it is responsible for paying the taxes on its income. In other words, if it isn't a grantor trust, the bucket must pay the taxes from the assets in the bucket.
Other types of trusts that are applicable in some situations and may offer tax protection include:
The Common Bucket
The needs of most of our clients are met through the use of a revocable living trust that is taxed as a grantor trust. Income from this type of trust is taxed directly to the trustor, just as if the trustor owned the trust’s assets outright. The trust is established during the trustor’s lifetime, and it can be undone if the trustor so chooses.
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