What Is a Trust?
A trust is a legal entity with separate and distinct rights, similar to a person or corporation. In a trust, a party known as a trustor gives another party, the trustee, the right to hold title to and manage property or assets for the benefit of a third party, the beneficiary.
Trusts can be established to provide legal protection for the trustor’s assets to ensure they are distributed according to their wishes. Additionally, trusts can save time, reduce paperwork, and sometimes reduce inheritance or estate taxes.
Trusts can also be used as a closed-end fund built as a public limited company. Read on for more about trusts and how they are used to protect assets for beneficiaries.
Key Takeaways
- A trust is a fiduciary relationship in which a trustor gives another party, known as the trustee, the right to hold title to property or assets for the benefit of a third party.
- While they are generally associated with the idle rich, trusts are highly versatile instruments that can be used for various purposes to achieve specific goals.
- Each trust falls into six broad categories—living or testamentary, funded or unfunded, revocable or irrevocable.
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Understanding Trusts
Trusts are created by settlors(an individual along with a lawyer) who decide how to transfer parts or all of the individual's assets to trustees. These trustees hold on to the assets for the beneficiaries of the trust.
The rules of a trust depend on the terms on which it was built. In some areas, it is possible for beneficiaries to become trustees. For example, in some jurisdictions, the grantor can be a lifetime beneficiary and a trustee at the same time.
A trust can be used to determine how a person’s money should be managed and distributed while that person is alive or after death. A trust helps an estate avoid taxes and probate. It can protect assets from creditors and dictate the terms of inheritance for beneficiaries.
The disadvantages of trusts are that they require time and money to create, and they cannot be easily revoked.
A trust is one way to provide for an underage beneficiary or someone who cannot manage their finances due to medical or other conditions. Once the beneficiary is deemed capable of managing their assets, they will receive possession of the assets held in trust.
Categories of Trusts
Although there are many different types of trusts, each fits into one or more of the following categories:
- Living or testamentary
- Revocable or irrevocable
- Funded or unfunded
Living or Testamentary
A living trust, also called an inter-vivos trust, is a written document in which an individual's assets are provided as a trust for the individual's use and benefit during their lifetime. A trustee is named when the trust is established; this person is in charge of handling the affairs of the trust and transferring the assets to the beneficiaries at the time of the grantor's death.
A testamentary trust, also called a will trust, specifies how an individual's assets are designated after the grantor's death.It is not established until after the grantor passes away.
Revocable or Irrevocable
A revocable trust can be changed or terminated by the trustor during that person's lifetime. An irrevocable trust, as the name implies, cannot be changed once it's established.
Living trusts can be revocable or irrevocable. Testamentary trusts are generally irrevocable once established but can be revocable via a will if the grantor is still alive. The fact that it is unalterable, containing assets that have been permanently moved out of the trustor's possession, is what allows estate taxes to be minimized or avoided altogether.
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Funded or Unfunded
A funded trust has assets put into it by the trustor during their lifetime. An unfunded trust consists only of the trust agreement with no funding. Unfunded trusts can become funded upon the trustor’s death or remain unfunded. Since an unfunded trust exposes assets to many of the perils a trust is designed to avoid, ensuring proper funding is important.
Common Purposes for Trusts
The trust fund is an ancient instrument (dating back to feudal times, in fact) that is sometimes greeted with scorn due to its association with the idle rich (as in the pejorative "trust fund baby"). But trusts are highly versatile vehicles that can protect assets and direct them into the right hands long after the original asset owner's death.
A trust is generally employed to hold assets so that they are safe from creditors or others that might have a claim on them after the grantor's death. In addition, trusts are often used to keep assets safe from family members who might otherwise sell or spend them. Assets may be placed in trust for trustworthy family members—even a relative with the best intentions could face a lawsuit, divorce, or other misfortune, putting those assets at risk.
Trusts can also be used to secure assets for specific purposes, such as a beneficiary's education or to help them start a business.
Beneficiary Care
Trusts may seem geared primarily toward high-net-worth individuals and families, since they can be expensive to establish and maintain. However, those of more average means may find them useful. For example, trusts can be established to ensure a dependent with a physical disability or mental health condition receives care.
You might also find instances of someone who has created a trust to qualify for Medicaid and still preserve at least a portion of their wealth.
Privacy
Some individuals use trusts simply for privacy. The terms of a will may be public in some jurisdictions. A will's conditions can be applied through a trust, so many individuals who don't want their intentions publicly posted choose to use them.
Estate Planning
Trusts can also be used for estate planning. Typically, a deceased individual's assets are passed to the spouse and then equally divided among the surviving children. However, children who are under the legal age of 18 need to have trustees. The trustees only have control over the assets until the children reach adulthood.
Trusts can also be used for tax planning. In some cases, the tax consequences of using trusts are lower than other alternatives. Because of this, trusts have become a staple in tax planning for individuals and corporations.
Tax Saving Basis
Assets in a revocable trust benefit from a step-up in basis, which can mean substantial tax savings for the heirs who eventually inherit from the trust. However, if the assets are placed in an irrevocable trust, they are subject to carryover basis, or their original cost basis.
Here's an example of how the stepped-up basis calculation works, using stocks: The original cost of shares was $5,000. The shares were placed into a revocable trust and passed on to a beneficiary. At the time the stocks were passed on, they were worth $10,000, so they have a step-up in basis of $10,000. Had the same beneficiary received them as a gift when the original owner was still alive, their basis would be $5,000. The difference is key when calculating taxes.
So, if the trust beneficiary sold the shares for $12,000, they would owe tax on a $2,000 gain. A beneficiary given the shares, or one who had a carryover basis, would owe taxes on a gain of $7,000 ($5,000 plus $2,000). Note that the step-up basis applies to inherited assets in general, not just those that involve a trust.
Types of Trust Funds
Below is a list of some of the more common types of trust funds:
- Credit shelter trust: Sometimes called a bypass trust or family trust, this trust allows a person to bequeath an amount up to (but not over) the estate-tax exemption. The rest of the estate passes to a spouse tax-free. Funds placed in a credit shelter trust are forever free of estate taxes, even if they grow.
- Generation-skipping trust: This trust allows a person to transfer assets tax-free to beneficiaries at least two generations their junior, typically their grandchildren.
- Qualified personal residence trust: This trust removes a person's home (or vacation home) from their estate. This could be helpful if the properties are likely to appreciate significantly.
- Insurance trust: This irrevocable trust shelters a life insurance policy within a trust, thus removing it from a taxable estate. While a person may no longer borrow against the policy or change beneficiaries, proceeds can be used to pay estate costs after a person dies.
- Qualified terminable interest property trust: This trust allows a person to direct assets to specific beneficiaries (their survivors) at different times. In the typical scenario, a spouse will receive lifelong income from the trust, and children will get what’s left after the spouse dies.
- Separate share trust: This trust lets a parent establish a trust with different features for each beneficiary (i.e., child).
- A spendthrift trust: This trust protects the assets a person places in the trust from being claimed by creditors. It also allows for the management of the assets by an independent trustee and forbids the beneficiary from selling their interest in the trust.
- Charitable trust: This trust benefits a particular charity or nonprofit organization. Normally, a charitable trust is established as part of an estate plan and helps lower or avoid estate and gift taxes. A charitable remainder trust, funded during a person's lifetime, disperses income to the designated beneficiaries (like children or a spouse) for a specified period and then donates the remaining assets to a charity.
- Special needs trust: This trust is meant for a dependent who receives government benefits, such as Social Security disability benefits. Setting up the trust enables the person with a disability to receive income without affecting or forfeiting the government payments.
- Blind trust: This trust allows the trustees to handle the assets in the trust without the beneficiaries' knowledge. This could be useful if a beneficiary needs to avoid conflicts of interest.
- Totten trust: Also known as a payable-on-death account, this trust is created during the lifetime of the trustor, who also acts as the trustee. It's generally used for bank accounts (physical property cannot be put into it). The big advantage is that assets in the trust avoid probate upon the trustor’s death. Often called a “poor man’s trust," this variety does not require a written document and often costs nothing to set up. It can be established simply by having the title on the account include identifying language such as "In Trust For," "Payable on Death To," or "As Trustee For."
What Is the Benefit of an Irrevocable Trust?
By placing assets into an irrevocable trust, you give up control and ownership of them. This means they will not be considered part of your estate, which helps to minimize estate tax after you die and avoid the probate process.
How Much Does a Trust Cost to Set Up?
A trust is a complex legal and financial entity that should be established with the help of a qualified attorney. Costs increase depending on the complexity of the trust. The price to establish a revocable trust can range from less than $1,000 to $3,000; irrevocable trusts are more expensive—how much you'll pay depends on how complex it is and how much attorneys charge in your area.
Who Controls a Trust?
The one establishing a trust is called the trustor or grantor. The one who oversees and manages the trust is called the trustee. In a revocable trust, the trustor may control the trust as well, but in an irrevocable trust, the trustee must be somebody else. The trust's beneficiaries are those who benefit from the trust, and the trustee ensures that the beneficiaries are paid.
The Bottom Line
Trusts are complex vehicles, except perhaps for the Totten trust. Creating a trust typically requires expert advice from a trust attorney or a trust company, which sets up trust funds as part of a wide range of estate- and asset-management services.
Correction—Dec. 17, 2022: A previous version of this article did not correctly distinguish between the costs of revocable and irrevocable trusts.
