Estate Planning Basics: Trusts

Trust planning ensures long term security for you, your family, and your estate.

We’ve reached the last article in our “What is an estate plan?” series. Last week we went over wills and the week before, we went over powers of attorney. Today, we’ll tackle one of the most popular estate documents – the trust.

As usual, let’s start with some definitions. The grantor or settlor is the person who creates a trust. The Trustee is the person who administers the trust. A fiduciary obligation is a legal requirement to act in the best interest of something or someone. All trustees carry a fiduciary obligation to the beneficiaries. A revocable trust, or living trust, or inter-vivos trust, is a trust set up by a settlor that they can freely modify or revoke. An irrevocable trust is a trust where the settlor gives up control of assets in trust. Probate is the process to execute a will. A pour-over trust, or testamentary trust, is a trust that arises from a will.

Trusts, for all intents and purposes, are separate legal entities that provide for the distribution of property. Trusts differ from wills by staying out of probate and reducing the size of the settlor’s estate. As an estate planning tool, trusts are highly recommended. Trusts minimize the grounds for challenge, separate the settlor, the trust, and the beneficiaries, and provide customization and mitigation for a variety of issues.

For a baseline understanding, trusts are formed by a settlor creating a trust document, providing the title to property to the trustee, and the trustee then manages those assets in accordance with the trust document. Where real property or benefit payouts (Such as life insurance) are meant to go to the trust, the settlor should ensure all applicable deeds and beneficiary information is in the name of the trust. For tax purposes, the type of trust will determine whether a separate tax identification number is required, and beneficiaries of the trust may have to report trust distributions on their income. We will only touch generally on taxes today.

Inter-Vivos Trusts. Inter-vivos trusts are created when a settlor names themselves trustee in a trust document. The settlor may amend or revoke the trust freely, so they are revocable trusts. During the settlor’s life, the trust almost doesn’t “exist” as the settlor is simply managing their assets as they would have otherwise. The settlor should take steps to make sure any assets they want in trust are titled appropriately. The most common problem with this type of trust is that the settlor neglects to name the trust as the beneficiary of payouts like 401k plans, deeds for homes, or life insurance payouts. While many of those assets designate a beneficiary or will fall to someone by law, if you pay to set up a trust and put estate planning resources into the effort, it’s a shame to have these assets fall outside the trust. The Internal Revenue Service (“IRS”), generally, views revocable trusts as a discarded entity. This designation simply means the IRS will look to the settlor-trustee to pay taxes on any income produced by the trust. Since the trust is fully under the control of the settlor, the IRS doesn’t consider the trust a separate legal entity for tax purposes.

Irrevocable Trusts. If revocable trusts allow for free modification and revocation, the irrevocable trust is a more iron-clad vehicle. In an irrevocable trust, the settlor cannot modify or revoke the trust, assets are given over to a trustee, and the settlor loses all right to control or dispose of those assets. Once an irrevocable trust is established only certain events can terminate it. Irrevocable trusts are most often limited in their trust document in purpose or duration. The beneficiaries of an irrevocable trust may also vote to terminate the trust. Unanimous consent is required to terminate an irrevocable trust. An irrevocable trust may be modified through a process known as trust decanting, but it can be a very difficult process to navigate. For purposes of this article, consider the irrevocable trust untouchable.

The irrevocable trust is the base form for a few different trusts in Virginia. Virginia recognizes special-needs, pet, charitable and non-charitable trusts. Special needs trusts allow for the care of a disabled child or family member. Pet trusts allow for the care of a pet, they do not facilitate your beloved Pomeranian inheriting your primary residence. Charitable trusts ensure funding for charitable causes. Non-charitable trusts are odd in that they need not specify a definite beneficiary but for a specific non-charitable use. Noncharitable trusts have 21 years to start to find their purpose before they revert to the settlor or their estate.

From an estate planning perspective, the irrevocable trust also forms the vehicle for things like the qualified terminable interest in property trust. Interestingly, a revocable trust where the settlor passes away becomes an irrevocable trust, as well. Once the grantor of a revocable trust passes, a secondary trustee takes over and the settlor, passed away by now, cannot modify or revoke their trust.

Irrevocable trusts allow the settlor to shrink the size of their estate, which provides tax benefits for the settlor, reduces the amount of the spousal share against an estate, moves tax burden to the trust, produces a step-up in basis for assets through transfers, and, most importantly, avoids probate. That’s right, trusts do not have to go through the court system for distribution and oversight.

Contents. The content of a trust is generally the same whether it’s revocable or irrevocable. Trusts generally must identify the settlor, the beneficiaries, and include the intent to establish a will. After that’s established, the settlor should lay out their intended distribution, purpose, directions, and assets to populate the trust. Any non-settlor trustee will have to rely on the trust document to ensure that they properly account and administer the trust based on assets within the trust. Settlors may choose to compensate the trustee and, if the trust is silent, a trustee is entitled compensation for their efforts. Trustees may decline to be appointed and may also be sued by the beneficiaries for removal.

A special note. I mentioned pour-over trusts earlier. One of the few times that a trust will interact with wills is when a will contains what is called a pour-over provision. The pour-over provision allows for any property that isn’t distributed through the will to go into a trust. This places estate assets into trust for the beneficiaries. The trustee should be considered a necessary party to any will reading to ensure that pour-over assets can be claimed by the trustee and administered appropriately.

If anything, trusts shine as a way of avoiding probate. Probate can be a costly process that ties up estate assets in court administration, requires notification and inventory with the court and public record, and begets administrative costs. Trusts, on the other hand, are a legal vehicle that moves property out of a settlor’s estate and can provide for beneficiaries’ needs long term as opposed to a one-off bequest. Trusts also afford tax benefits by increasing the tax value of assets prior to distribution and by even allowing the trust to ensure taxes are included in distributions.

Any estate plan can benefit from a trust plan. If you are considering the long term stability and health of your estate and your beneficiaries, trusts are difficult to argue against. In tandem with a will, trusts can provide for a great way to manage potential costs associated with any transfers. When you’re considering your estate plan or even your tax posture, contact me today to make sure you’re comprehensive and thorough. I’m more than happy to help walk you through the process and ensure your estate and assets are where they need to be to achieve what you’re trying to accomplish.