Trusts Explained

Most people have heard that trusts are a good estate planning tool. Even Consumer Reports recommends using a trust for estate planning. But most people do not understand what a trust is or what a trust does. Part of the lack of understanding is due to the fact that there is an infinite variety of trusts and purposes for trusts. This column will be a short explanation of commonly used trusts. If assets are owned in trust, they do not go through probate as the trustee does not own the asset personally and the beneficiaries only have a beneficial interest. Probate is required to transfer assets owned by an individual that do not pass via payable on death arrangement or survivorship.

For centuries, a trust separated legal title and beneficial ownership. Think of wealthy people giving money to the bank as trustee to take care of a grandchild’s education. The bank owns the money for benefit of the grandchild. 

That was not a real attractive option to avoid probate for most people. Who wanted to give assets to someone else to hold in trust, even if they could retain a power to direct the trustee? Over time, states agreed that a person could be trustee of the person’s own trust. The trust would state the person could do whatever the person wanted with trust assets while alive and at death directed distribution. That is the genesis of a living trust.

The IRS recognized that was kind of a “fake” trust and adopted rules to ignore the trust for tax purposes. The person keeps filing tax returns with his or her social security number. At death, the assets are considered owned by the trust and since not owned by the individual they do not have to go through probate.

The IRS calls these trusts grantor trusts. Because the grantor retains the right to change or revoke them at any time, they are also known as revocable trusts, and are sometimes referred to as revocable living trusts or simply living trusts.

These living trusts are referred to as living because they are created and exist while someone is alive for benefit of the person creating them (ultimately to benefit those chosen to receive assets when the creator dies). 

Trusts can also be created in a Will and are known as testamentary trusts. A testamentary trust does not come into existence until death of the person creating the trust.

The traditional trust is still utilized under which legal ownership and beneficial interest are separated. A good example is a trust established by someone to take care of a spouse during the spouse’s lifetime with direction that whatever is left be distributed to the person’s children. This is often used to benefit spouse of a second marriage and children from a previous spouse. It allows someone to take care of their spouse after death but retain assets for distribution to children from the prior marriage.

Sometimes a parent does not want a child to inherit a lot of money at an early age. Other times, a parent believes that a child has problems that interfere with management of money. In these situations, a trust can be established under which assets are left for benefit of that child with a trustee along with directions for use of the assets. If the only problem is age, the trust can direct that the trustee uses the assets for benefit of the child until a certain age at which time the child gets everything left in the trust. If the problem is something like drug use, the funds may remain in trust for benefit of the child until they are exhausted, or the child dies.

Trusts are frequently used to provide for a disabled child or relative. A person with a disability is often eligible for substantial governmental assistance. If the disabled person is given anything of value, it may disqualify that person from governmental assistance. To avoid disqualification, a trust can be established limiting use of funds in a manner that will not disqualify the beneficiary from governmental assistance. These trusts are known as special needs trusts. There are similar trusts that can be used to transfer assets so that someone will qualify for Medicare payment of assisted living expenses other than completely exhausting personal assets before qualifying for government assistance.

Trusts are frequently used to minimize or avoid taxes. A qualified personal residence trust (QPRT) is a good example of a tax saving trust. In a QPRT, owner of a personal residence transfers the residence to a trust with the owner as trustee. The trust is for a term of years after which the residence passes to someone else (usually the owner’s children). If the owner outlives the term of the trust, the children get the residence.

How does that save taxes? A QPRT saves estate and gift taxes two ways. First, it is considered a present gift of a future interest resulting in discounted value for the gift. There is a valuation discount because a buyer would not pay full price for property the buyer will not get for a term of years. Second, appreciation in value of the residence is not included in the estate of the person establishing a trust.

After the QPRT terminates, the former owner can rent the property back from the children and thereby move more money out of his or her estate into the beneficiary or beneficiaries. Beneficiaries will pay income tax on that rent, but the income tax rate is still less than the estate tax rate. A QPRT is not a good option for someone with a small estate because the trust is irrevocable and is intended to transfer an asset before death of the owner. 

There are a lot of other trusts for tax saving and other purposes. Recommendation of what might be appropriate is best left to the legal experts.