Defining Trusts, Avoiding Hype

Trusts can be difficult to understand when you hear some estate-planning professionals talk about them. But those people may be more interested in selling you expensive investment vehicles than they are in making sure you understand enough about trusts to make wise and informed decisions yourself.

Don’t worry. This chapter helps you get a handle on trusts — with three definitions:

An incredibly oversimplified definition
A slightly more complicated definition but still using plain language
An “official” definition that uses just enough legalese but still won’t cause your head to start spinning

Shazam! An oversimplified definition of trusts

In many comic books and related movies and TV shows, an ordinary person goes into a “special place” and comes out a superhero with a new identity and, very often, with superpowers. Bruce Wayne goes into the Batcave and comes out as Batman. Clark Kent goes into a phone booth and comes out as Superman. Billy Batson says “Shazam!” and turns into Captain Marvel.

Think of a trust as a special place in which ordinary property from your estate goes in and, as the result of some type of transformation that occurs, takes on a sort of new identity and often is bestowed with superpowers: immunity from estate taxes, resistance to probate, and so on.

So in many ways, a trust is your own personal Batcave — a place to go when you want to change the identity of some of your estate’s property. And even though Batman doesn’t have any superpowers, he does pick up that nifty utility belt with all kinds of weapons while he’s in the Batcave. Similarly, when property is in your trust, it can “pick up its own utility belt” and do things that aren’t possible outside of the trust.

Adding a bit of complexity with an ingredient list

Suppose you want to set up a trust. Just like with a cooking recipe or building something in your garage workshop, you need to make sure you have everything you need before you start. To cook up a trust, you need these seven basic ingredients:

The person setting up the trust (that’s you)
The reason you want to set up the trust and certain objectives you want to achieve
The trust document itself
The property that you decide you’re going to place into the trust
The trust’s beneficiary (or beneficiaries, if more than one), whether that beneficiary is a person (your oldest daughter, for example) or an institution, such as a charity
Someone to watch over and manage the trust and the property that is now in the trust
A set of rules that tells the person watching over and managing the trust what he or she can and can’t do

All the items in the preceding list come together, and when everything is done properly — Shazam! — you now have a trust.

Adding some lawyer talk to the definition

If you’re comfortable with a little bit of legalese, here’s a somewhat more “official” description than comic book analogies and simple recipe-style lists. Here, we add a tiny bit of attorney talk to the seven basic elements:

Person setting up the trust: The person is commonly known as the trustor, though you may sometimes see the terms settlor or grantor.
Objective of the trust: You use different types of trusts to achieve a variety of specific estate-planning objectives. You can use some trusts for a single estate-planning objective, while others help you achieve more than one goal. Some of the most common estate-planning objectives for trusts (discussed later in this chapter in more detail) are to reduce the amount of estate tax liability, to protect property in your estate, and to avoid probate for certain property. Before you decide whether you need one type of trust or another, you must think about what you’re trying to accomplish in the first place.
Specific kind of trust: As discussed later in this chapter, trusts come in many different varieties. And just like ice cream, yogurt, or pudding, you find different colors and flavors, some of which you may like and others which just don’t do it for you. Regardless, when you’re setting up a trust, you need to decide what type of trust you want and make sure that you follow all the rules for that particular type of trust to make sure that it’s proper and legal, and carries out your intentions.
Property: After you place property into a trust, that property is formally known as trust property — that is, just like with the Batcave analogy, the property now has a different identity and, in one way or another, isn’t quite the same as it was before you placed it into trust.
Beneficiary: As with other aspects of your estate plan (your will, for example), a trust’s beneficiary (or, if more than one, beneficiaries) benefits from the trust in some way, usually because the person or institution will eventually receive some or all of the property that was placed into trust.
Trustee: The person in charge of the trust is known as the trustee. The trustee needs to clearly understand the rules for the type of trust he or she is managing to make sure everything in the trust stays in working order.
Rules: Finally, some of the rules that must be followed are inherently part of the type of trust used, whereas other rules depend on what is specified in the trust agreement. You’ll find still more rules in state and federal law.

Putting all the preceding information together, the trust agreement is a document that spells out the rules that you — the trustor — want followed for the property that you’ve placed into the trust to benefit the beneficiary (or beneficiaries) of the trust, as managed by the trustee. (Got all of that? If not, keep rereading until it makes sense, checking back with the list to help clear up the parts that seem difficult.)

Consider the following simple example. You decide to put $300,000 in a trust for your two twin 10-year-old daughters, and you want your sister to oversee the trust. You specify that neither daughter is allowed to receive anything other than interest on the property in that trust before reaching the age of 25, and then they can receive a maximum of only $10,000 each year on their birthday until the age of 35, at which time the remaining money in the trust (which hopefully has been growing along the way because of your sister’s wise investment choices) will be split 50-50 between the two of them.

In this example, you are the trustor, your twin daughters are the beneficiaries, and your sister is the trustee. The conditions about when your daughters can start receiving money, how much, and until when are part of the terms of the trust agreement.

But what kind of trust can you set up? Aha! That is often the $64,000 question (or $300,000 question, or $1 million question, or perhaps the $5,000 question … all depending on the value of the property you place in the trust). You can use different trusts to achieve different objectives, and we discuss the major categories briefly later in this chapter.

Attaching all the bells and whistles to a trust

Beyond the basic definition (or, in this case, multiple definitions) of what a trust is, you need to be aware of several little tidbits about trusts. When Batman enters the Batcave, he needs to know where his utility belt is, whether the Batmobile has enough fuel, and where he’s headed as soon as he gets outside. Otherwise, he may be in big trouble.

The same is true for trusts, which is why you need to work with your estate-planning team — particularly your attorney — to make sure that before that trust goes into effect, you have everything in order and haven’t set yourself up for the estate-planning equivalent of an ambush by the Joker.

The following list may seem a bit nitpicky, but you can use the items in this list when you work with your attorney to avoid any problems. For example:

Make sure the trust agreement is in writing. Although an oral trust may be considered valid, just like an oral (nuncupative) will can be, certain trusts, such as those dealing with real estate, must be in writing. Therefore, just like with your will, you should put the trust agreement in writing instead of relying on word of mouth so misunderstandings or other problems don’t arise.
A trust must provide duties and obligations for the trustee (again, the person in charge of the trust). Typical duties and obligations include how and when to make payments from the trust, or how to manage or oversee the property in the trust (such as paying property taxes on real estate in the trust, renewing certificates of deposit in the trust, and so on). In legalese, a trust that adequately features such duties and responsibilities is known as an active trust.
If the trust doesn’t adequately include trustee duties and obligations, a court may consider it to be a passive trust. Watch out! The court may deem it as “no trust at all.” Furthermore, the law automatically transfers the trust’s property to the beneficiary or beneficiaries, and everyone loses out on whatever the objective of the trust was, such as tax savings. So make sure that when you (or, more accurately, your attorney) set up a trust that the trustee’s role is well defined so you won’t have any problems down the road.
The wording of the trust agreement must clearly specify that you’re actually setting up a trust and indicate what property you’re placing in the trust (or intend to place in the trust at some future date).
The trust agreement must clearly identify the beneficiary or beneficiaries — the person or people by name and other identifying characteristics (“my daughter Ellie Mae Clampett,” for example) or an institution (“The Meow Cat Shelter of Tucson, Arizona”).
Don’t take the process of deciding on and appointing a trustee lightly. Make sure that whoever you select as a trustee has the right background — education or profession, for example — for the job at hand. If you want someone to manage a trust containing lots of money, make sure that the trustee understands and has adequate experience in portfolio management, diversification strategies, and other investment management techniques. But just as important (maybe even more important) than education and professional background is that your trustee has the honesty, character, and integrity to fulfill the responsibilities. Sometimes being in charge of lots of money intended for someone else (the trust’s beneficiary or beneficiaries) can be, shall we say, a bit too tempting.

A trustee may have a legal interest in the property in a trust but doesn’t have a beneficial interest. The trustee is responsible for managing the trust’s property, but he or she can’t benefit from the trust other than receiving the agreed-to trustee compensation (fees and costs) for taking on this job.

Designate a successor trustee — a pinch hitter to step in if the primary trustee can’t serve or continue to serve for some reason — when you set up a trust. Otherwise, the court that has jurisdiction may appoint a successor trustee, and that may not be someone whom you want.

Trust Power — Making Your Beneficiaries Smile

You’re probably thinking: “Why should I care about trusts?”

In a very general sense, the primary reason you set up a trust is to benefit a person or institution more than if you didn’t set up the trust. After all, trusts are often complex, can be time-consuming to set up and oversee, and cost you some amount of money (a modest amount for a straightforward trust, or perhaps a lot of money for a very complex setup involving multiple trusts, different jurisdictions’ laws, and so on). So you should have a good reason to go to all this trouble.

Here are some examples of benefiting a person or institution better:

You have some part of your estate or your overall personal financial situation, such as a life insurance policy, that under applicable law is likely to cost your estate some amount of money in estate taxes. But by setting up a trust, your estate can avoid paying some or all taxes, meaning that more money is left over for your trust’s beneficiaries.
As described in Book 5, Chapter 3, the probate process can cause problems for your estate, anywhere from minor annoyances and delays to major costs and inconvenience. However, you can use trusts for certain property that you absolutely, positively don’t want to be subjected to the problems and delays of probate. Your beneficiary may gain ownership and use of that property more quickly if you had set up a trust than if you used the regular method of having that property as part of your probate estate.

The following sections look at the most significant objectives you likely want to achieve by using trusts.

Avoiding taxes

Some trusts have the “special power” (or maybe that’s “superpower”) to avoid estate-related taxes that otherwise may apply. One of the most common tax-saving trusts is an irrevocable life insurance trust. The proceeds from your life insurance policy (the death benefit amount) are added back into your estate, often turning an estate that isn’t subject to federal estate taxes into an estate that needs to write a substantial check to the IRS.

However, an irrevocable life insurance trust is one of several ways you can shelter life insurance death benefit proceeds from estate taxes. After setting up the trust, you still have life insurance, and your beneficiary or beneficiaries still receive the proceeds from your policy upon your death. But now, estate taxes may not be a problem.

Avoiding probate

Book 5, Chapter 3 discusses living trusts as a form of will substitute to help you avoid probate. By keeping certain property out of your probate estate — the part of your estate that is subject to probate — you may be able to avoid many of the hassles, costs, and concerns about privacy that are related to probate.

You have a number of other means at your disposal to avoid probate for other property — joint tenancy with right of survivorship, payable on death (POD) accounts, and others discussed in Book 5, Chapter 3 — so work with your estate-planning team to figure out what the best probate-avoidance tactic may be for each type of property in your estate. For some, the costs of a trust may make sense, particularly if you’re not only trying to avoid probate but also trying to accomplish one of the other goals talked about in this section (avoiding estate taxes, protecting your estate, and so on). For other property, a simpler, less costly way to avoid probate, such as joint tenancy, may be a better choice for you.

Protecting your estate

One of the primary uses of trusts is to protect your estate — not only while the estate is yours but also when your estate becomes someone else’s estate (and so on).

For example, suppose you want to leave $500,000 to your only son, but you’re concerned that if you were to die while your son is still relatively young (say, under 30), he won’t be responsible or mature enough to adequately manage a large amount of money. Before you can say, “sail around the world,” you’re afraid he will have spent the entire half million.

You can use a trust in the manner described in the previous paragraph to parcel out the money to your son as you see fit. The trust can give him a little bit each year for some duration and then a final lump sum at some age when you think he’ll be mature enough to protect the money as if he had actually earned it himself. Or you can add conditions to how the money in the trust is dispersed, such as your son receives a little bit of money until a certain age, and then he gets the rest only if he graduates college or meets some other criteria you determine when you set up the trust.

Trusts are an important part of your estate plan when you want to leave money to your minor children and make sure that

The money is available to them when they reach certain ages.
The money is set aside (think “officially reserved” meaning that nobody else can touch it) for your children and managed by a trustee, instead of just leaving it to your brother-in-law and saying, “Please don’t spend this money on a Rolls Royce; make sure you keep it safe for my kids.”

Providing funds for educational purposes

Another common use for trusts is to make money available to your children, grandchildren, other relatives, or even nonrelatives (your employees’ children, for example) for educational purposes, such as college tuition and living expenses.

You can set up and fund trusts that parcel out money for educational purposes, but that also come with the restriction of “no school, then no money!”

Benefiting charities and institutions

You can help out charities in many ways: through gift giving or by leaving money or other property to one or more institutions as part of your will.

Alternatively, you can set up some type of charitable trust that may, for example, annually give money to the charity while you’re still alive, give a larger amount upon your death, and then from what is left in the trust after you die, continue to make regular payments to the charity. You can even set up a charitable trust to make regular payments to the charity for some amount of time but eventually “give back” whatever is left to you or, if you’ve died, to someone else in your family. Alternatively, you can set up a charitable trust to work the other way — pay you while you’re still alive, and upon your death, the remaining amount in the trust goes to the charity.

Sorting Out Trusts — from Here to Eternity

In general, there are two different ways of categorizing trusts:

Those trusts that are in effect while you’re still alive versus those that take effect upon your death
Trusts you can change your mind on versus those that are absolutely, positively, unchangeable

Trusts for when you’re alive versus when you’re gone

An intervivos trust is a trust that you set up and that is in effect while you’re still alive. In contrast, if you set up a trust under your will and that trust doesn’t take effect until your death, you’re using a testamentary trust.

Here’s a quick example to emphasize the distinction between these two categories. Suppose you want to help out your favorite charity and, after consulting with your estate-planning team, you decide that a trust is the best way to go. If you set up a particular type of charitable trust that makes annual payments to the charity while you’re still alive, then that trust is an intervivos trust. If, however, you set up a trust under the terms of your will to become effective (and start making payments) after your death, you’ve set up a testamentary trust.

The following sections look at both of these categories of trust in more detail.

Selecting intervivos trusts for your estate plan

If your primary objective of creating a trust is to provide an economic benefit (cash payments, transfer of real property that is currently in your estate, and so on) to specific people or institutions (again, your children, your favorite nephew, your favorite charity, and so forth) or for yourself, then you should strongly consider setting up some type of intervivos trust.

With an intervivos trust, payments and other types of property transfers may begin while you’re still alive instead of waiting until your death (in this case, “sooner” is better than “later” when it comes to money). Furthermore, you usually have a better handle on the amount and value of your property with which you fund an intervivos trust than with a testamentary trust, as we discuss in the next section.

With an intervivos trust, you know what your estate is worth and how much is available to fund such a trust. Essentially, you have a higher degree of control with an intervivos trust than with a testamentary trust. When you set up an intervivos trust, you can initially fund the trust with certain property from your estate, add more property throughout your lifetime, and even make arrangements for additional property to be added to the trust upon your death. For example, if you initially fund an intervivos trust with stock, you can always add more later to cover any shortfalls if the shares you used for the trust have decreased in value. Or if your portfolio has skyrocketed — including the stock you used to fund the trust — and you’re feeling particularly generous, you can increase the trust’s value.

Choosing testamentary trusts for your estate plan

If you aren’t particularly concerned about providing economic benefit to a trust beneficiary while you’re still alive, you can still set up an intervivos trust, or you can hold off on creating the trust until after your death and instead, create a testamentary trust under your will.

So how exactly do you set up a testamentary trust if you’re already dead? Actually, you lay the groundwork for a testamentary trust in your will while you’re still alive, which means the following:

Along with all the other contents of your will discussed in Book 2, Chapter 4, you include appropriate language to set up a testamentary trust that, just like everything else in your will, doesn’t actually “come alive” until your death. (Ironic, huh?)
Your will goes through probate and must be in compliance with various will statutes. Your testamentary trust also needs to be in compliance because it’s technically part of your will. If you make any goofs in the language you use relating to the trust (or trusts) you want to establish, all kinds of complications set in, just as with any other part of your will.
Unlike a testamentary trust, an intervivos trust generally doesn’t have to go through probate, but the probate court still has jurisdiction over an intervivos trust if any controversy or problems arise, just as it does for a testamentary trust.
The funding of a testamentary trust can often be up in the air because the actual funding doesn’t take place until your death. As with other parts of your will, if your circumstances have changed and property you had anticipated using for the trust no longer is in your estate or is worth far less than it once was, you and the trust’s beneficiaries may be out of luck because, quite simply, the necessary funds aren’t available.

To help prevent unpleasant surprises, such as an underfunded or even unfunded testamentary trust, review all aspects of your trust when you do your annual review of your will. (After all, the provisions for a testamentary trust are contained in your will, so doing so is only logical.) If the property you had planned to use to fund the trust is no longer worth enough to accomplish your goals, then you can look for additional property in your estate and adjust your will accordingly, change the details of the trust to reflect a reduced value, or in the worst case, cancel your plans for the testamentary trust.

Deciding whether an intervivos or testamentary trust is better

Which is better for your estate plan: an intervivos trust or a testamentary trust? The favorite answer of estate-planning professionals comes into play here: It all depends. As with most other aspects of estate planning, you and your estate-planning team need to carefully look at many different factors to put strategies and instruments in place that are specific to your needs.

Intervivos trusts, together with plain old gift giving, are a good way to reduce your estate’s value and reduce or negate the effect of federal estate taxes. And, as mentioned earlier in this section, you can give early and give often with an intervivos trust, benefiting people or institutions sooner than if they had to wait for your death.

On the other hand, suppose that you want a trust to come alive only if you die before a certain age and you want to make provisions for your minor children’s care, education, and so on. You can use a testamentary trust as part of your will. If you live long enough so that your children are no longer minors and are out on their own and don’t need to have money parceled out, you can revise your will and eliminate the testamentary trust provisions.

If you do a good job at outlining your objectives for setting up a trust in the first place, the most appropriate category of trust — intervivos or testamentary — should become fairly obvious.

Changing your mind: Revocable and irrevocable trusts

An intervivos trust — again, a trust you set up that goes into effect while you’re still alive — can be either

Revocable, meaning that you can change your mind
Irrevocable, meaning, sorry, what’s done is done

Irrevocable trusts are the easier of the two to understand. After you place property into an irrevocable trust, you can’t retrieve the property. For all intents and purposes, that property now belongs to the trust, not to you.

With a revocable trust, however, you can place property into the trust and at some point in the future, undo the transfer by removing the property and terminating the trust.

Very often, if you die or become incompetent, the provisions of a revocable trust call for the trust to become an irrevocable trust. Consider a revocable burial trust as an example, which you can terminate at any time, usually before death or incompetency. However, if the burial trust is still in existence when you die (or become incompetent), the trust becomes irrevocable and the money is used for your funeral expenses.

The most significant distinctions between revocable and irrevocable trusts are the estate tax considerations. Property that you place in an irrevocable trust is no longer considered part of your estate, meaning that the property typically isn’t included in your estate’s value when it comes to determining if you owe death taxes and, if so, how much. However, you still own property that you place into a revocable trust, and therefore that property is still subject to death taxes. (Which is very logical, if you think about it. If you can change your mind about the trust and retrieve the property from the trust at any time while you’re still alive, the property is really yours and should be considered part of your estate).

You most likely have gift tax consequences when you establish an intervivos irrevocable trust, so make sure your accountant is “in the loop,” along with your attorney. Also, certain transfers within certain time periods prior to your death can be included in your estate as “gifts in contemplation of death” under both state and federal statutes. So watch out for possible death tax implications.

If you get a break on estate taxes only with an irrevocable trust, why would anyone want to use a revocable trust without the estate tax break? Estate tax savings is only one of the reasons you may consider including a trust in your estate planning. If your estate’s value is nowhere near the federal estate tax exemption amount magic number, then you really don’t need to be concerned about federal estate-tax-saving tactics — for now, anyway. Your motivation for setting up a trust may have more to do with estate protection or helping out a charity, but you also may want a safety valve that allows you to pull money out of a trust if circumstances change in some way.

Make sure to work with your accountant to understand any and all tax implications — gift, federal estate, and state inheritance or estate — for property transfers to both irrevocable and revocable trusts. He or she can help you set up the right provisions and avoid unpleasant tax-related surprises from the government because of some provision of the tax code you didn’t know about.

LOOKING CLOSELY AT REVOCABLE TRUSTS

Estate-planning advisers often point to revocable trusts — particularly living trusts, discussed in Book 5, Chapter 3 — as “the perfect way to totally avoid probate.” Put all your property into revocable trusts and you can have control over that property, the pitch goes, and because none of your property is now in your probate estate (that is, it’s all held in trust), your estate doesn’t have to go through the probate process because your probate estate is “empty!” And, by avoiding probate, you avoid the costs of probate, the lack of privacy, and the other disadvantages to the probate process discussed in Book 5, Chapter 3.

Not so fast. True, you can avoid probate costs, but do you really think setting up and maintaining trusts is free? No way! Your costs to set up a revocable trust vary depending on attorney fees and other costs, but be prepared to pay to have your trust managed.

You also need to make sure that everything you own is held in trust form. If you fail to include any part of your estate in your trust(s), then you have a probate estate that is subject to the probate process. So every time you buy a new home, open a new brokerage account, or make any changes to your estate’s inventory, you need to make sure that you transfer that property into your trust(s). And that can be a pain.

Remember also that probate isn’t always bad, either. The probate court, which has the responsibility of making sure that property in your probate estate is disposed of properly with no behind-the-scenes funny games, supervises your probate estate. Without the probate court’s supervision, part or all of your estate that is held in trust or other nonprobate form (joint tenancy with right of survivorship, for example) can be in for problems if someone close to you in a position of authority has, shall we say, a lack of ethics. Eventually, all the beneficiary problems may get straightened out but quite possibly because of prolonged, costly legal battles.

Also keep in mind that you may be required to file state or federal estate or inheritance tax returns, even though you have no “probate estate” (or “probate assets”). At the state level, at least, those returns are usually considered to be public records. Therefore, if privacy concerns are important to you, your desire for privacy may be defeated.

Understanding Trusts