A trust is a legally formed entity built to benefit a specific party. Trusts can be created to manage family assets, fund charitable efforts, and avoid certain taxes, among other things. Accounts set up for trusts are considered fiduciary accounts.
Numerous parties with varying responsibilities are involved with trusts.
The grantor is the person responsible for creating and funding the trust. Grantors utilize legal services to create a trust agreement, which is the foundation of a trust. Some hire lawyers, while others utilize modern digital resources like LegalZoom. Either way, the trust agreement specifies the trust’s objectives, management, and beneficiary. Trusts can have various purposes, including 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 according to the instructions provided by the grantor. When a trust account is opened at a brokerage firm, trustees have the power to trade and transact on the account.
The trust is managed for the sole benefit of its beneficiaries, which could be a person or an organization (e.g., a charity). Beneficiaries don’t have any legitimate power over the trust, as the trustees are in control. However, the trustees serve the trust and its beneficiaries.
It’s possible one person acts in all three trust roles. One individual could act simultaneously as the grantor, trustee, and beneficiary.
Trust accounts are fiduciary accounts, but are not subject to the same suitability standards as typical fiduciary accounts. Most fiduciary accounts are managed safely and cautiously (e.g., a court-appointed guardian looking after the assets of an incapacitated person). If the grantor specifies in the trust agreement, trustees could pursue more risky investment strategies. Additionally, trust accounts can be opened as margin accounts (those that allow borrowing) as long as the trust agreement specifically allows it. When a trust account application is received, the brokerage firm requests the trust agreement to see if the account is eligible for margin.
The grantor must determine whether the trust will be revocable or irrevocable when they create a trust. There are pros and cons related to both.
Revocable trusts, also known as living trusts or inter vivos trusts, may be amended during the grantor’s lifetime* if necessary. In particular, the specifics laid out in the trust agreement can be changed, which include the trust objectives, trustees, beneficiaries, or even the existence of the trust (it can be terminated). The biggest benefit of a revocable trust is its ability to be revised.
*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 the avoidance of probate. As we discussed in the previous chapter, assets left to a person’s estate are subject to the probate process. In many circumstances, this is a cost and time-intensive process. Almost all trusts (except for testamentary trusts, which are discussed below) have explicit instructions for how trust assets should be distributed upon the grantor’s death.
One drawback of revocable trusts is their inability to 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 upon the grantor’s death. Estate taxes can be substantial if they apply, which is a major factor for clients with revocable trusts.
Irrevocable trusts force the grantor to give up control of trust assets, and they cannot act as trustees (grantors act as trustees on revocable trusts). Additionally, the provisions of the trust agreement may not be changed. The lack of flexibility is definitely a drawback.
The benefit of an irrevocable trust relates to its taxation. First, the trust is viewed as a taxable entity, which shelters 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 those beneficiaries. In most scenarios, the grantor is only taxed if they receive income from the trust.
Second, trust assets are not subject to estate taxes upon the grantor’s death. The grantor gave up ownership of the assets when funding the trust; therefore, trust assets are not the grantor’s property upon their death. Therefore, 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 be classified based on how it distributes income to beneficiaries.
Simple trusts must distribute investment income* to beneficiaries annually. Additionally, it may not distribute principal (basis). In fact, the distribution of the principal terminates the trust. Some tax benefits are attributed to simple trusts, but you likely will not be tested on the specifics.
*Income distributed by a trust to its beneficiaries is referred to as distributed net income (DNI).
Complex trusts do not meet the requirements of simple trusts. Specifically, this type of trust may accumulate investment income annually (no need to distribute income to beneficiaries).
A testamentary trust is written into a person’s will. As we learned in the previous chapter, many people create a last will and testament to determine who receives their assets upon death. With the help of a legal resource (e.g., an estate attorney), a testamentary trust is embedded into the will and becomes active upon the person’s death. Additionally, certain assets held by the person (designated in the will) become the trust’s property.
Wills are always part of estate settlement, making the testamentary trust virtually the only trust subject to the probate process. Assets held in testamentary trusts are also subject to estate taxes.
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