A trust is a legal entity created to benefit a specific party. People use trusts for many purposes, such as managing family assets, supporting charitable goals, and (in some cases) reducing taxes. Brokerage accounts opened for trusts are considered fiduciary accounts.
Numerous parties with varying responsibilities are involved with trusts.
The grantor creates and funds the trust. The grantor uses legal services to create a trust agreement, which is the foundation of the trust. Some grantors hire attorneys, while others use digital services like LegalZoom. Either way, the trust agreement spells out the trust’s objectives, how it will be managed, and who the beneficiaries are. Trusts can serve many goals, such as funding a child’s college education or caring for an elderly parent.
The grantor names trustees in the trust agreement. Trustees manage the trust as fiduciaries and must follow the grantor’s instructions. When a trust account is opened at a brokerage firm, trustees have the authority to trade and transact in the account.
The trust is managed for the sole benefit of its beneficiaries, which may be a person or an organization (for example, a charity). Beneficiaries don’t control the trust because trustees have the decision-making authority. Even so, trustees must serve the trust and its beneficiaries.
It’s possible for one person to serve in all three roles. One individual could be the grantor, trustee, and beneficiary at the same time.
Trust accounts are fiduciary accounts, but they aren’t subject to the same suitability standards as typical fiduciary accounts. Many fiduciary accounts are managed conservatively (for example, a court-appointed guardian managing the assets of an incapacitated person). With a trust, the grantor can authorize different approaches in the trust agreement, including riskier investment strategies.
Trust accounts can also be opened as margin accounts (accounts that allow borrowing) as long as the trust agreement specifically permits it. When a brokerage firm receives a trust account application, it requests the trust agreement to confirm whether margin is allowed.
When creating a trust, the grantor must decide whether it will be revocable or irrevocable. Each option has trade-offs.
Revocable trusts, also called living trusts or inter vivos trusts, can be amended during the grantor’s lifetime* if needed. That means the grantor can change the provisions in the trust agreement, including the trust’s objectives, trustees, beneficiaries, or even whether the trust continues to exist (it can be terminated). The main advantage of a revocable trust is flexibility.
*Revocable trusts become irrevocable upon the death of the grantor. The trust agreement provisions may not be changed once the grantor passes away.
Another benefit of a living trust is avoiding probate. As discussed in the previous chapter, assets left to a person’s estate go through probate, which can be time-consuming and expensive. Almost all trusts (except testamentary trusts, discussed below) include instructions for distributing trust assets when the grantor dies.
A drawback of revocable trusts is that they don’t avoid certain taxes:
First, investment income received by the trust is taxable to the grantor during their lifetime.
Second, the assets in the trust are subject to estate taxes when the grantor dies. Estate taxes can be substantial when they apply, which is an important consideration for clients using revocable trusts.
Irrevocable trusts require the grantor to give up control of trust assets, and the grantor can’t act as trustee (grantors can act as trustees on revocable trusts). The trust agreement provisions also can’t be changed, so the lack of flexibility is a key drawback.
The main benefit of an irrevocable trust is tax-related:
First, the trust is treated as a taxable entity, which can shelter the grantor from taxation. If investment income is retained in the trust, it’s taxable to the trust. If it’s distributed to beneficiaries, it’s taxable to the beneficiaries. In most cases, the grantor is taxed only if they receive income from the trust.
Second, trust assets aren’t subject to estate taxes when the grantor dies. Because the grantor gave up ownership when funding the trust, the assets aren’t considered the grantor’s property at death. As a result, irrevocable trusts can avoid significant estate taxes* when the grantor dies.
*Although estate taxes are not a concern for irrevocable trusts, contributions made to these trusts upon creation are subject to gift taxes.
A trust can also be classified by how it handles income distributions to beneficiaries.
Simple trusts must distribute investment income* to beneficiaries each year. They also may not distribute principal (basis). In fact, distributing principal terminates the trust. Simple trusts have certain tax benefits, but you likely won’t be tested on the details.
*Income distributed by a trust to its beneficiaries is referred to as distributed net income (DNI).
Complex trusts are trusts that don’t meet the requirements of a simple trust. In particular, a complex trust may accumulate investment income each year (meaning it doesn’t have to distribute income to beneficiaries annually).
A testamentary trust is created through a person’s will. As covered in the previous chapter, many people use a last will and testament to direct how their assets should be distributed at death. With help from a legal resource (such as an estate attorney), a testamentary trust is written into the will and becomes active when the person dies. Assets designated in the will then become property of the trust.
Because wills are part of estate settlement, a testamentary trust is essentially the only trust that goes through probate. Assets held in testamentary trusts are also subject to estate taxes.
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