Parts 1-3: A Primer on Trusts | Everything you need to know (and a whole lot more)
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This primer is meant for instructional purposes only. It has been created with the intent of providing only a surface-level overview of common trust types for a non-attorney audience. This primer is not a substitute for proper legal guidance. The trust arrangements described below should not be attempted without an experienced professional who can provide this counsel.
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Part One: What is a Trust?
Before learning about trusts, it is critical to know what a trust is. Trusts were created nearly a thousand years ago in medieval England using a very basic concept which is still very much alive today. Simply put, a trust is little more than a type of relationship. It involves three players:
a “trustor” who creates the trust (often called “grantor” or “settlor”);
a “trustee” who administers the trust; and
a “beneficiary” (or multiple beneficiaries) who benefit from the trust.
As you will see, it is possible for a single person or entity to serve in one, two, or all three of these roles at the same time, even if each role has distinctly different names and purposes. All trusts you will read about contain these three roles, no matter whether one, two, three, or even more individuals may fill them at any given time.
A trust must always have a beneficiary and it must have something to administer on behalf of that beneficiary. It will not fail to be a trust simply because the office of trustee is vacant. If a trustee passes away, a successor can fill their place, whether via the written instrument, a court process, or some other method. If, however, there are no longer any beneficiaries, or if there is no longer any property for the trust to manage, then the trust is dead—and usually cannot be revived. It has been exceedingly common over the last hundred years to see trust instruments which assign a single dollar (more often $10 or $100) into the trust to cover the gap in time (sometimes just seconds) between signing the trust instrument putting more substantial assets into it to govern.
Please note that a trust is not technically a legal entity like a corporation is. A trust cannot own property, be sued, file its own income taxes, or transact. Those are all acts the trustee does. A “trust” is only the name of the relationship between these parties. As such, the trustee is the literal owner of all the trust property, by and through their position as trustee (and as detailed in a written trust instrument1). For modern purposes it is common to hear and speak about trusts as if they take actions on their own, and this primer will be no exception. With that in mind, however, be advised that, in all cases that a trust appears to be taking an action, it is in fact the trustee who is undertaking this effort. This confusion is so common that it is often written into the law, and so is important to acknowledge this inconsistency.2 Now, let us look at a few specific types of trusts.
Part Two: The Revocable Living Trust (RLT)
When most people hear or think about a trust nowadays, they are likely to have in mind one very specific type of trust called a “revocable living trust” (RLT).3 This is a type of trust which works very differently from almost every other type of trust. We begin here with this type of specialized trust only because it is arguably the most common type of trust.
The reason why revocable trusts are so common is not because they are better or worse than other types of trusts, but rather because, in the modern era, they work very much like a substitute for a will when they are done correctly. A will is a legal instrument which governs what happens at a person’s death. In a well written will, one would expect to find instructions on who should serve as the executor (nowadays the “personal representative”), as well as on who should benefit from the estate’s property—and how. A will in most cases is submitted to probate, which is a court process. Many people think that having a will means that the person will avoid probate, but that is usually not true. While a will might help simplify the process and provide better for your beneficiaries, having a will does not typically avoid the court process of administering it.
For those people who want to avoid a probate at their death and are willing to shoulder the effort in life to do so, the law in every state now allows (and sometimes even encourages) its citizens to use an alternative method—the RLT. Although based strictly in the introductory trust law illustrated in Part One of this primer, the RLT is unique among all other trust instruments because the Trustor/Grantor usually serves in all three roles: (1) trustor, (2) trustee, and (3) beneficiary. Next, they reserve the right to change the trust; to modify, revoke, or amend it in any way they so choose and at any time, providing they retain the mental capacity to do so. That person places their assets into the trust upon creation (or otherwise coordinate their assets around the trust plan), where they are administered for the rest of the person’s lifetime. From that person’s perspective, little has changed, except for the legal title of their assets (such as a home) now appear in the name of their trust, in their care as “trustee” on behalf of their trust.
Most of the value of doing this work during life, however, comes at death. Probate is traditionally what happens when a dead person’s name is on an asset and that asset did not otherwise move by a beneficiary designation or similar titling feature.4 Probate is the method to remove the dead person’s name from the property and distribute it to their beneficiaries under the will; or if no will, then to the person’s heirs under the governing state’s “intestacy” law (dying without a will). An RLT, when properly funded, avoids probate by getting the asset out of the trustmaker’s name during life, while still allowing them to benefit from that asset while they are alive. When the person eventually passes away, their successor trustee (waiting on standby) takes over as the new trustee and administers the trust for the benefit of the trustmaker’s beneficiaries. No court process is usually required. A properly funded RLT mirrors a will from the perspective of a person planning their estate, with some important differences: A will must go through probate, while assets in an RLT typically do not. An RLT, on the other hand, needs much more work during life (requiring some consideration for every one of a person’s assets), while a will is simpler.
One other benefit of an RLT is incapacity protection, in conjunction with powers of attorney. An RLT is not a substitute for good powers of attorney (POAs), but can provide an additional layer of incapacity protection in conjunction with good POAs. Assets within the trust are controlled by the trustee. If the trustmaker becomes incapacitated, the next serving trustee takes over and assists the incapacitated trustmaker. This happens without ever needing to look at the powers of attorney or to begin a formal court-appointed guardianship. This only protects assets within the trust, however. For assets deliberately left out of the trust (to be designated elsewhere, or owned jointly), POAs are still essential even with a RLT as the core of an estate plan.
For many people, the value of an RLT comes down to state- and individual-specific factors. What is probate like in your state? Is it likely you might face multiple probates in multiple states? Is privacy important to you? Do you think a disgruntled relative or disinherited heir might contest your plan? Do you have a family history of (or extraordinary concerns about) incapacity? These are factors that could point to either a will or an RLT being superior to the other for any individual person. For these reasons, it is difficult to speak broadly about whether a will or an RLT is the better tool, even despite the array of publications claiming that RLTs are always superior.
Finally, no discussion of the RLT would be complete without a brief overview of two major types of taxes which impact trusts: incomes taxes and estate taxes.
Income Taxes: As a rule, a trust must file income taxes, which often results in more income tax liability than an individual would pay otherwise. RLTs are an exception to this rule. Because of their revocability, they are called “grantor trusts” and are ignored for income tax purposes. Even if a form 1099 is issued in the trust’s name, no separate income tax return needs to be filed. The individual(s) would continue to report the income on their own personal 1040(s), meaning there is generally no income tax “cost” to using an RLT. Again, this trust is an exception—many other types of trusts do bear this income tax cost. More on this subject in later Parts.
Estate Taxes: RLTs offer no estate tax advantages compared with a will. Although wealthier people often do gravitate toward RLTs, they get no estate tax advantages for this choice. The same revocability feature which caused the trust to be wholly ignored for income tax purposes also triggers estate tax inclusion according to the IRS. Even if an RLT avoids a probate—and even avoids the creation of a legal “estate”—it does not avoid being included in a person’s taxable estate for the purposes of calculating how much estate tax might be owing at death.
Put succinctly, there are no substantial tax advantages or disadvantages from avoiding probate by using a RLT as an estate planning vehicle. This is true of both income taxation and estate taxation. People who are motivated to use RLTs are generally motivated to do so for the other benefits described herein, and not for any reasons related to taxation.
As we move into the following sections describing other trusts, please keep in mind that RLTs are, in many cases, exceptions to general trust rules (like income taxation, for example). These exceptions are a large part of why RLTs are so attractive for basic estate planning, but most other trusts will function quite differently—and consequently often feel more restrictive.
Part Three: Testamentary Trusts
Regardless of whether a person uses a will or an RLT as their core estate planning vehicle, that person will ultimately die and their estate plan will need to be administered for the benefit of another person, charity, creditor, or government. Although planning for death can be stressful and existential, there are only two ways to leave assets: “outright” or “in trust.” Outright is simple—no strings attached, without any limitation whatsoever. If a person is thinking about setting up some restrictions, this often suggests leaving an asset to a person in a different way: “in trust.”
A trust can be created under a person’s will after their death, just like it can be created during someone’s life. The first type of trust is called a “testamentary trust,” while a trust created during someone’s life is called an “inter-vivos” trust. Although technically “testamentary” means “created under a will,” it will also be used here to describe a trust created under a RLT at the trustmaker’s death. An RLT is itself a type of inter-vivos trust, as it is created during a person’s life. Inter-vivos trusts will be discussed in more detail in the next section.
Both wills and RLTs can be used to create testamentary trusts following a person’s death. A person could use a will which creates a testamentary trust at death following a probate administration. Alternatively, a person might use an RLT which distributes all assets outright at death with no need for a testamentary trust. There is little that can be said that is universally true of testamentary trusts, except that they tend to be as varied and creative as the people who plan to use them are. Here are some common reasons why a testamentary trust might be desired:
Protection from a beneficiary’s creditors, predators, or divorcing spouses;
Problematic or underage beneficiaries who should not manage property;
Dynastic wealth planning, to pass assets beyond more than one generation;
Assisting special needs beneficiaries who are on means-tested government assistance;
Charitable planning that requires more sophistication;
Marital planning for spouses when there are threats of remarriage, or when there are children from prior relationships; and
Estate tax protection for married couples, using certain types of testamentary trusts called “bypass trusts” or “credit shelter trusts” at the death of one spouse.5
One last note on testamentary trusts: with some important exceptions, testamentary trusts are generally required to file income tax returns as a distinctly separate entity from the original trustmaker. This is very unlike how RLTs were described earlier, as a trust that is completely ignored for income tax purposes due to its revocability. A testamentary trust is usually irrevocable, no matter whether it was created by will or RLT. This income tax return typically needs to be filed on an annual basis, but it does not necessarily mean that income tax liability is increased. When thinking using testamentary trusts in an estate plan, it is a good idea to consider the income taxation impact over the years this trust is intended to run. A testamentary trust will never have the advantage of having its trustmaker alive to guide the administration of the trust, and so special care should be given for these ongoing income tax concerns inherent in most testamentary trusts.
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[1] A CST that is written in a will requires a probate of that will at the death of the first spouse in order to create the CST. A CST written into a properly funded RLT could be created without a probate. The type of instrument used, and whether a probate results from that choice, does not impact the availability of the CST for a married couple.
[2] The majority of states do not administer a state estate or inheritance tax regime. Of the few that administer a state estate tax regime, the majority have exemptions higher than Washington’s. Some of those states also allow for estate tax portability, unlike Washington. For all these state-specific reasons, CSTs are very powerful tools in this state.
[3] This refers to the unlimited step-up in basis, which often has the result of erasing unrealized capital gains at death. This positive result happens automatically in any all-to-spouse plan once the survivor passes. However, all-to-spouse plans might not be the right estate planning choice for a married couple, for various tax and non-tax reasons. Using a CST risks losing some of this income tax benefit at death because assets in a CST are not generally includable in the survivor’s estate. The QTIP election provides a possibility for the couple to have their estate planning goals in a CST without a corresponding income tax cost. These benefits are worthwhile to consider even for people who are nowhere near the estate tax limit, as income tax planning impacts people regardless of wealth.
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