Choosing the Right Type of Trust for Your Needs

Trusts are hot topics in the world of estate planning.  They are versatile tools that allow attorneys to accomplish a wide variety of goals for their clients.  By using trusts, it’s possible to simplify or completely avoid probate, reduce or eliminate the impact of the estate tax, preserve a person’s eligibility for government benefits such as Medicaid, and designate a trustee to manage a beneficiary’s inheritance rather than leave the inheritance directly to the beneficiary him- or herself.  And that’s just for starters.

While I do not try to steer every client towards an estate plan that includes a trust, I do find that most people have estate planning goals that are well served by a trust.  But which kind of trust?  Trusts come in many varieties, but in this article, I will fit them into three broad categories and say a bit about what each category has to offer.  The discussion won’t be exhaustive, but hopefully it will illustrate just how powerful these estate planning tools can be.  If you have questions about how some sort of trust might fit into your estate plan, please give me a call or email to schedule a free consultation.

First, Some Background

While trusts come in many forms, some things will be constant across the different categories.  There are three key players involved in any trust: the person who creates the trust (the “Grantor”), the person who benefits from the trust (the “Beneficiary”), and the person who is in charge of managing the trust (the “Trustee”).  These terms will be used throughout this article.  The rights and responsibilities of these three key people will be spelled out in a written instrument which establishes the trust.  Depending on whether the trust is revocable, irrevocable, or testamentary, that written instrument can be a standalone document, or it can be a person’s will.

Revocable Trusts

Revocable trusts are a popular estate planning tool used to achieve an array of goals.  Some people might want to avoid probate; others might want to engage in some tax planning; others might want to make arrangements for a Trustee to manage a Beneficiary’s inheritance rather than giving property to the Beneficiary outright; and others might want to do some combination of these things or even all of the above.  In each of these cases, revocable trusts will be helpful.  Revocable trusts are established by a document known as a “trust instrument” or “trust agreement.”  Once the Grantor establishes a revocable trust by signing a trust instrument, the revocable trust exists and the Grantor can begin transferring property into the trust.  Bank accounts, business interests, real estate, and just about any other type of asset can be transferred into the trust to be managed by the Trustee of the trust.

What’s great about the revocable trust is that when a person establishes a revocable trust, that person is typically the Grantor, Trustee, and Beneficiary all at the same time!  That means that even though the Grantor has transferred assets out of his or her own name and into the name of the revocable trust, the Grantor still has total control over and enjoyment of those transferred assets by virtue of also being Beneficiary and Trustee.  But because these assets are now owned by the revocable trust and not by the Grantor in his or her own name, the assets owned by the trust will not have to go through probate when the Grantor eventually dies.  At that point, a successor Trustee named in the trust instrument by the Grantor will assume control of the trust property and will continue to manage it as directed by the terms of the trust instrument.  The trust instrument will say who can benefit from the trust property which remains in the trust after the Grantor’s death.  These successor Beneficiaries will often be members of the Grantor’s family, friends of the Grantor, and/or charities.  The Grantor can put limitations in place on how much money can be distributed to these successor Beneficiaries and the reasons for which distributions should be made (for example, to pursue an education, to start a business, for general support, or other reasons).  The Grantor can also say that some of these Beneficiaries should have trust property distributed to them immediately without any continuing restrictions put in place by the trust instrument.

While the Grantor is alive and competent, the Grantor has the power to amend the terms of the revocable trust at any time, or even to revoke it altogether (hence the name “revocable trust”).  In addition, the Grantor can put assets into the trust and then choose to take them back out again.  For this reason, the law does not treat a revocable trust as legally distinct from the Grantor.  The Grantor and the revocable trust both share the Grantor’s social security number, and the trust is ignored for tax purposes.  Once the Grantor dies and the trust can no longer be amended or revoked, the trust will have to apply for its own tax ID number and will continue its existence as a taxpayer distinct from the Grantor who initially established the trust.

Irrevocable Trusts

Irrevocable trusts are not used quite as often as revocable trusts.  They are generally used as part of an estate plan that aims to reduce estate and other transfer taxes (though they help with probate avoidance, too).  As I explained in my last article, the estate tax exemption is historically high right now, meaning few people have to worry about paying the estate tax.  But for those who expect to have taxable estates and want to reduce their eventual estate tax bill, irrevocable trusts offer a number of creative and tax-efficient wealth transfer solutions.

Irrevocable trusts come in many varieties.  There are irrevocable life insurance trusts (“ILITs”), charitable remainder trusts (“CRTs”), grantor retained annuity trusts (“GRATs”), intentionally defective grantor trusts (“IDGTs”), and many, many more.  All of these irrevocable trusts have the same overall goal:  to get assets from the Grantor to the Beneficiaries without estate or other transfer taxes.  While this is an amazing benefit of planning with irrevocable trusts, it comes with strings attached.

While revocable trusts are known for being flexible estate planning tools, irrevocable trusts are more rigid.  Once an irrevocable trust has been created, the terms of the trust cannot be changed (there are exceptions to this general rule, but they’re beyond the scope of this article). In addition, any property that has been added to the trust cannot be taken back out by the Grantor (again, exceptions to this rule such as the “swap power” are beyond the scope of this article).  As if that weren’t enough, in order for the irrevocable trust to provide the benefit of estate tax avoidance, the Grantor may only have limited rights as a Beneficiary or Trustee of the trust, meaning the Grantor must give up significant enjoyment of and control over any assets transferred to the trust.

The irrevocable nature of these trusts means that unlike revocable trusts, the law sees irrevocable trusts as separate taxpayers, distinct from the Grantor who created the trust.  The trust must apply for its own tax ID number, and depending on how the trust is worded, may have to file its own annual income tax returns.  If the trust has taxable income, that income will be taxed at a very high rate – usually much higher than an individual’s tax rate.  Because the trust and the Grantor are two different taxpayers, any transactions between the Grantor and his or her irrevocable trust will have tax consequences that must be carefully considered.

Testamentary Trusts

While typical revocable and irrevocable trusts are governed by trust instruments which exist as standalone documents, a testamentary trust exists within the terms of a person’s will.  The person’s will might say, for example, “I leave all of my property to the Trustee named below, and the Trustee shall administer the trust property in accordance with the provisions of Article II of this will.”  Article II of the will would then go on to spell out the terms of the trust. 

Testamentary trusts are interesting entities, lying dormant until a person’s death, and then springing into existence at that time.  This is because even though a person might sign their will today, the will doesn’t do anything until that person dies.  Therefore, even if a person’s will includes testamentary trust provisions, that trust doesn’t exist until the person dies and their will takes effect.   This means that unlike with revocable and irrevocable trusts, it’s not possible to transfer assets into a testamentary trust during life (because it doesn’t exist during life), and so testamentary trusts are not able to keep assets from going through probate.  However, as with a revocable trust, it is possible for a person to revise the terms of a testamentary trust while they are living and competent, because a person who is living and competent is free to update their will during their lifetime, meaning they can make changes to the provisions in their will which will establish the testamentary trust.

I typically recommend testamentary trusts to clients who are ok with the idea of going through probate and whose estate plans might only need a trust if certain circumstances exist at the time of their death.  For example, maybe a client is a parent who wants a trust to exist for his or her child if the child is below a certain age when the parent dies.  However, if the child is above that certain age at the time of the parent’s death, the parent feels that the child should be allowed to receive his or her inheritance outright.  In a scenario such as this, the testamentary trust keeps the client’s estate plan relatively simple – the client only uses a will instead of adding a separate trust instrument to the mix, and the client doesn’t need to take additional steps to transfer assets into a revocable trust during life in order to avoid probate.  This simpler arrangement still provides the client with an opportunity to enjoy some of the other benefits a trust can offer, such as allowing assets to be managed by a Trustee on a Beneficiary’s behalf.

Conclusion

Trusts can be useful tools in a person’s estate plan.  Some clients may benefit from an irrevocable trust, while others may have their needs met by a revocable or testamentary trust, and other clients may be happy to forego any type of trust planning at all.  The decision is for each individual client to make with help from their estate planning attorney.  If you have questions about trusts or other strategies that might be implemented as part of your unique estate plan, I hope you’ll get in touch to schedule a free consultation.  It would be my pleasure to help you understand your options and achieve your estate planning goals.

The information contained in this blog post is intended only as general legal information and should not be construed as formal legal advice on any matter, nor should its presentation be construed as intent on the part of The Law Office of Ryan A. Layton, PLLC to form an attorney-client relationship with any user of this website.  For more information, please see this disclaimer.