Basics of Establishing a Trust

Trusts are not necessary in most estate plans, but when used properly, they provide significant benefits. Trusts can provide a means of distributing income and principal in an orderly, managed way, offer a degree of asset protection, designate groups or classes of beneficiaries and can force the use of various professionals.

Definition of a Trust

A trust is an entity established by a person called a grantor, for the benefit of others, called beneficiaries, that is controlled by a third person called a trustee. The beneficiaries can consist of one group that receives the current income, a fixed dollar amount or percentage of assets and another group who will receive the remaining trust principal at a later time. The income and principal beneficiaries can also be the same people. The beneficiaries can also be people not living yet, such as children born after the trust is established. There is wide flexibility and great leeway in determining who the beneficiaries are and the distribution terms, but once established, they cannot easily be changed, if at all.

Trustees and Their Powers

Trustees can be individuals, or a bank or trust company. There can be one or multiple trustees. Trustees have very broad powers to not only control the distributions in amount and timing and sometimes to whom, but also how to invest the assets. All powers given to trustees are explained and detailed in the trust document and if not, there cannot be done with certain narrow exceptions.

How Trusts Are Established

Trusts can either be established by someone that is living in a separate document (called inter vivos trusts) or through a will (called testamentary trusts). Trusts are formed under the laws of the jurisdiction where they are set up. Some states and countries are particularly useful in creating trusts for specific purposes. When establishing a trust it is necessary to use an attorney familiar with the different jurisdictions and purposes for that particular trust. Trusts set up in a will have no meaning or effect until the testator dies, and the will is probated.

Irrevocable Trusts

Trusts that cannot be altered with an independent trustee where absolute title to the assets is transferred is irrevocable. Inter vivos transfers are subject to gift tax.

Revocable or Living Trusts

Trusts where the grantor can make changes whenever they want for any reason are revocable and are sometimes referred to as living trusts. Transfers to a living trust are not subject to gift taxes and are disregarded for income and estate tax purposes. Living trusts become irrevocable upon death of the grantor and are occasionally used as substitute wills, but that should not negate preparing a will, and can bypass the probate process. To serve the purpose for which they are created, assets must be legally transferred to the trust.

Grantor Trusts

This is a type of trust that is irrevocable but where the grantor has certain rights as defined in Internal Revenue Code (“IRC”) Sections 671 – 679. Because of these rights the trust’s income is reported on the grantor’s individual income tax return and the grantor pays the income tax instead of the trust or beneficiaries regardless of whether he receives any income or distributions. Sometimes grantor trusts are referred to as defective trusts because they violate the IRC §671-679 tax laws, and not for any other reason.

Trust Taxation

Irrevocable trusts that are not grantor trusts are taxed on undistributed income at a trust tax rate schedule using Form 1041. Trusts get a deduction for distributions to beneficiaries who will report the income on their individual income tax returns. Filing requirements are based on the trust’s gross and taxable income. Living trusts and grantor trusts are not required to file tax returns so do not need to obtain taxpayer identification numbers– the grantor’s Social Security number is used and the transactions are reported on the grantor’s individual income tax return.

Costs

Be aware that costs will be incurred in establishing, operating and maintaining a trust, and for government compliance and tax return filing.

Conclusion

The above is a brief summary of what trusts are and how they work. If you believe a trust might help you or should be part of your estate plan, you should consult with a CPA or attorney that is expert in such matters.