Subscribe to "Family Wealth Matters"
Trusts Made Simple
Ronald P. Adams
The legal and financial issues associated with trusts
can at times feel overwhelming. To help distill some of those arcane concepts to
an easily understood level, this article will provide a simple illustration for
some of the concepts that we apply regularly during the estate planning process.
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.
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
“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
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
An irrevocable life insurance trust (ILIT) owns the trustmaker's life insurance
policy; if properly funded, it protects the policy's proceeds from estate
An intentionally defective grantor trust (IDGT) allows the trustmaker to make a
gift of an asset, its appreciation and its accumulated income; for estate tax
purposes, the asset is removed from the trustmaker's estate.
A lifetime protective trust. When a client leaves an inheritance to a child
outright, it can be subject to the child's creditors, former spouses, addiction
problems, inability to manage money, and federal estate tax on the child's
Leaving an inheritance in a protective trust will shield these assets from such
predators. A lifetime protective trust can be designed to become a dynasty
trust, which can provide protection for generations.
A testamentary trust, which may be contained in a will, comes into existence
upon the trust maker's death and is subject to probate proceedings.
A special needs trust is established to benefit a child with disabilities who is
entitled to government assistance such as Social Security disability payments.
An inheritance held within a special needs trust will not disqualify the child
from receiving the assistance. Distributions are made at the discretion of the
trustee for the child's special needs. The trust can be stand-alone or a
sub-trust of a revocable living trust.
An asset protection trust. When a trust maker puts assets into a revocable
trust, the assets are not protected from claims by the trust maker's creditors
or lawsuits. Several states now permit domestic asset protection trusts (DAPT),
which allow a trust maker to transfer property into an irrevocable trust of
which he or she is the beneficiary. If the statutory requirements are met, then
the trust assets are protected from predators, usually after a certain time
period has passed.
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.