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Trust Basics

January 29, 2013

Trusts are not necessary in most estate plans, but when they are used properly, they provide significant benefits.


Many trusts provide a means of distributing income and principal in an orderly, managed way.  Some trusts provide a degree of asset protection, designate groups or classes of beneficiaries, and force the use of professional financial planners, managers and trustees.  Some trusts are set up to outlive the presently living beneficiaries and need to have appropriate protections and guarantees.  And, some trusts are set up to avoid or circumvent the probate process.

Definition of a trust

A trust is an entity established by a person, called a grantor, for the benefit of others, called beneficiaries, that is controlled or operated by a third person or entity called a trustee.  The beneficiaries can consist of one group that receives the current income or fixed dollar amount or percentage of assets and another group who will receive the trust principal or corpus at a later time.  The principal beneficiaries can also be the same people as the income beneficiaries.  The beneficiaries can also be people not living yet, such as children born after the trust is established.  There is wide flexibility and great leeway in establishing who the beneficiaries are and the distribution terms, but once established, they cannot easily be changed, if at all.

Trustees and their powers

Trustees can be individuals, or entities such as a bank or trust company.  There can be a single trustee or multiple trustees.  Trustees have very broad powers to not only control the distributions in amount and timing and sometimes to whom, but also how to invest the principal. Trustees can also have broad powers to invade principal to make a distribution to a particular beneficiary to exclusion of other beneficiaries. All powers given to trustees are explained and detailed in the trust document.  Any power not given in the trust agreement cannot be done with certain narrow exceptions.

How trusts are established

Trusts can either be established by someone that is living or through a will.  Trusts are formed under the laws of the jurisdiction where they are set up.  The different states have their own rules, as do foreign countries.  Some states and countries are particularly useful in creating trusts for specific purposes.  When establishing a trust it is necessary to use an attorney familiar with the different jurisdictions and purposes for that particular trust.  Trusts set up during the lifetime of the grantor are called inter vivos trusts.  Trusts that are established pursuant to a will are referred to as testamentary trusts.  Trusts can be set up as a separate document or within a will or other trust.  Trusts set up in a will have no meaning and have no effect until the testator dies, and the will is probated.

Irrevocable trusts

Trusts where absolute title to assets transferred to the trust that has an independent trustee are irrevocable.  Lifetime (inter vivos) transfers made to an irrevocable trust are subject to gift tax.  Trusts where the grantor can make changes whenever they want for whatever purposes are revocable.

Grantor trusts

This is a type of trust that is irrevocable but where the grantor has certain rights as defined in Internal Revenue Code (“IRC”) Sections 671 – 679.  Because of these rights the trust’s income is reported on the grantor’s individual income tax return and the grantor pays the income tax instead of the trust or beneficiaries that receive income or income distributions.  The grantor pays the tax regardless of whether he receives any income or distributions from the trust.  Inter vivos transfers to grantor trusts are subject to gift taxes.  A common grantor trust is an irrevocable life insurance trust.  Gifts to the trust are taxable gifts and the life insurance is not included in the estate of the grantor, but any income earned by the trust during the lifetime of the grantor is included in the grantor’s individual tax return.  The grantor in this instance has no rights whatsoever.  Separate taxpayer identification numbers (“TIN”) for Grantor Trusts are not required – the grantor’s Social Security number is used.  Some banks, brokers and insurance companies require the separate TINs, causing fiduciary tax returns to be filed, but the income is still taxed by the grantor.   Sometimes grantor trusts are called defective trusts because they violate “sound” trust drafting rules that cause them to fall under the IRC §671-679 traps set up to “catch you.”  They are “defective” based on tax laws.  Using grantor or defective trusts can be an effective estate planning tool if used in the proper circumstances.

Living trusts

A trust set up by a grantor where they are the trustee is called a living trust.  Living trusts are always revocable, and are not recognized for income or estate tax purposes.  Transfers to a living trust are not subject to gift taxes.  Living trusts become irrevocable upon death of the grantor/trustee.  At that point, the alternate trustee immediately becomes the trustee and assumes complete control of the trust.  Living trusts are occasionally considered and used as substitute wills, but should not negate preparing a will. Living trusts do not need to file tax returns, or use taxpayer identification numbers.  They use the grantor’s Social Security number and the transactions are reported on the grantor’s individual income tax return.  All transactions in the living trust are disregarded for any tax purposes – income and estate.  To serve the purpose for which they are created, assets must be legally transferred to the trust and the ownership change must be made.

Closing comments

A trust will possibly provide for a degree of asset protection and a shield from future creditors.  This is a very technical issue and should not be used for asset protection purposes without a serious consultation with an experienced attorney in that area of law.  Dynasty trusts can be set up to last past the lives of children and grandchildren, and those yet to be born.  Be aware that costs will be incurred in establishing the trust and in trust maintenance, operation, government reporting and tax return filing.

Reprinted from Getting Your Affairs in Order by Edward Mendlowitz, CPA ©2012 Edward Mendlowitz, CPA.  Available for sale at and in print and e-book editions.
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