Trusts — An Introduction

A trust can serve many purposes, but as a tool for estate planning, its main purpose is to avoid probate and its high costs, and to allow a greater control over the disposition of the income and property of the decedent. If the trust holds valuable property it may also be used to reduce taxes.

Necessary Components of a Trust: Settlor, Trustee, Ascertainable Beneficiaries, and Property

A trust is a legal entity that holds property for the benefit of others and managed by a trustee. The property rights are bifurcated: the trustee holds legal title to the property while the beneficiaries of the trust hold equitable title.

Trusts have 4 components: settlor, trustee, beneficiaries, and property. The settlor (aka grantor, trustor) creates the trust. The trustee manages the trust, and the beneficiaries receive the benefit of the trust. Unless it is a charitable trust, the beneficiaries must be ascertainable, because only they have standing to enforce the terms of the trust or to enforce the fiduciary duty required of the trustee.

Often, the settlor and the trustee is the same person, and sometimes that person is also the beneficiary! However, the settlor cannot be the sole beneficiary — otherwise the trust would serve no purpose. In such a case, the legal and equitable title to the property is said to merge — hence, there is no bifurcation of the property interest and, hence, no distinction between the settlor's property and the property of the trust.

There must be beneficiaries, because it is the beneficiaries who enforce the terms of the trust and for whom the trustee manages the property. Therefore, pets cannot be beneficiaries. Although they may benefit from an honorary trust, they are not legal beneficiaries since they cannot enforce the terms of the trust.

The property held by the trust is called the trust principal (aka trust corpus, trust res). The trust can only exist if it has property, since if it holds no property, it serves no purpose.

Beneficiaries may receive only the income from the trust or may also receive some of the principal. However, once all the property has been transferred to the beneficiaries, the trust naturally terminates.

Types of Trusts

Trusts are an effective instrument to hold and manage property when there are many owners or beneficiaries, because it is managed by the trustee for the benefit of the stakeholders. There are 2 exclusive types of general trusts: simple and complex. A simple trust must distribute all trust accounting income annually, and there can be no charitable contributions or distributions of the corpus. A complex trust is defined simply as one that is not a simple trust.

In years past, businesses formed business trusts because such trusts were less regulated than corporations. In the late 1800's or early 1900's, the trust was an effective means of managing diverse businesses and forming monopolies so that higher prices could be charged — which is why laws passed to prevent such monopolies or to break them apart were called antitrust laws.

Private trusts, which are created by individuals rather than organizations, can be further classified by their objectives. Charitable trusts have charities as beneficiaries. Honorary trusts are the only trusts that do not have true beneficiaries, but are created to carry on duties, such as caring for a pet or maintaining the settlor's gravesite.

Trusts are also classified as to whether the trustee has discretion in disposing of the income and property to the beneficiaries. The trustee has no discretion in a mandatory trust, but must pay the beneficiaries according to a schedule set by the trust document. However, if the settlor wants the trust to be responsive to the needs of the beneficiaries or to minimize taxes, then a discretionary trust is created that allows the trustee some discretion in paying income and principle to the beneficiaries. A spendthrift trust, for instance, can be created to prevent the beneficiaries from squandering the money or allowing them to assign their interest in the trust to creditors.

A trust can be revocable or irrevocable. A revocable trust can be terminated by the settlor; an irrevocable trust cannot be revoked. Irrevocable trusts, managed by the trustee who could be the grantor but often is not, are structured and operated according to the trust document used to create the trust. As separate taxable entities, trustees of irrevocable trusts must file Form 1041, U.S. Income Tax Return for Estates and Trusts annually. Irrevocable trusts are often used to extend dead hand control over the trust property, to protect assets from creditors of the beneficiaries, and to save on gratuitous transfer taxes.

A contingent trust (a.k.a. step-up trust, standby trust) is set up when a specific specified event occurs, usually as a result of the grantor's physical or mental incapacity, so it may also be coupled with a durable power of attorney.

A living trust (aka grantor trust, inter vivos trust) is created by the settlor while still alive whereas a testamentary trust is created by the settlor's will. A living trust is usually revocable, but a testamentary trust is always irrevocable. Income from a living trust is included in the income of the grantor and taxed at the grantor's rates.

A hierarchical diagram showing different types of trusts, including inter vivos, revocable, irrevocable, testamentary, bypass, marital, and residuary trusts.

There are many other types of trusts and other ways to classify them, but these are the main types encountered in estate planning.

How a Trust Avoids Probate

The major benefits of a trust in estate planning are that it allows more control of the distribution of the settlor's property than can be accomplished with a will and it may also reduce taxes. However, the main benefit of a trust is that it avoids probate. Probate is the process where the decedent's will is probated by the probate court, where property is distributed, and any challenges to the will can be heard. Probate usually takes 1 to 2 years. Significant costs incurred by lawyers and other professionals, such as appraisers, hired to probate the property may lower the value of the estate, leaving less for the beneficiaries.

Probate is necessary because, in the absence of a trust, titled property cannot be transferred without going to court to effect the title transfer. For instance, if the settlor were still alive, he could easily transfer property to someone else by simply signing a few forms. When the settlor dies, he can't grant permission to transfer his property; hence the need to go to court. A trust circumvents this problem by taking legal title to the property, and since the trustee has legal title to the property and the trust survives the settlor, the trustee can transfer property without going to court.

Indeed, a trustee can maintain control over the property for an extended time, so that income or principal can be paid to beneficiaries over time and even to beneficiaries not yet alive. The trustee may also invest trust principal and income to increase benefits for the beneficiaries.

Taxation of Trusts

There are special tax rules that apply to trusts, but a trust must conform to state law under which the trust is organized, because the federal government will only recognize trusts that are valid under state law. Any income generated by a revocable trust is included the grantor's income tax, so no separate tax return must be filed for the trust. However, when a trust becomes irrevocable, then it must file Form 1041, U.S. Income Tax for Estates and Trusts if its income exceeds $600.

Trusts generally pay a higher tax rate than individuals. The marginal tax brackets are mostly the same, but they begin at much lower income levels. For instance, in 2019, the top tax bracket of 37% begins when undistributed trust income exceeds $12,750. Likewise, the 20% capital gains rate and the 3.8% Medicare surcharge on investment income also applies, which explains why most trust income is distributed to beneficiaries annually. If the trust retains income by the end of the tax year, then it must pay taxes on that income at its own rates. If the income is distributed to the beneficiaries before the end of the tax year, then the income is taxed at the beneficiaries rate. See Taxation of Trusts and their Beneficiaries for more information.