Trusts have been around for centuries. Despite that long heritage, few people really understand trusts. There is not simply one type or form of trust. The same type of trust can even be referenced by different names. That makes it even harder for someone to truly understand trusts and how they might be used.
Trusts can be created and funded during one’s lifetime and can also be created by a will or other document which takes effect upon death. Trusts created and funded during life are often referred to as inter vivos trusts. Trusts created by will are referred to as testamentary trusts. It is not uncommon for both kinds of trusts to accomplish the same goal.
Perhaps the most commonly referenced trust is the revocable trust. A revocable trust is created during lifetime of the testator. A testator is a person creating a trust. A revocable trust is usually created to avoid probate. This trust is referred to as a revocable trust, living trust, a revocable living trust, living trust and possibly other names, all of which refer to the same type of trust.
Originally, a trust created a split in ownership of legal title from beneficial interest and in the good old days someone would hold legal title for the benefit of someone else. Think of wealthy people establishing a trust under which they gave money to the banker to hold for the benefit of their children or grandchildren. If the same person was trustee and beneficiary, the trust ended as there was no split of legal and beneficial ownership.
The revocable trust is used primarily to avoid probate. For that purpose, it was inconvenient to have to appoint someone else as trustee of the testator’s own property to hold the property for the testator’s benefit. To avoid probate, assets are placed in the trust and at death of the testator the assets are considered owned by the trust and therefore do not go through probate as assets owned by the decedent. Beginning in the 1960s, the revocable trust became an increasingly popular way to avoid probate and with increased use came recognition that requiring appointment of a separate person or entity to be trustee of one’s own trust was cumbersome and problematic.
States gradually all agreed. The same person can now be trustee of his or her own trust. Such revocable trusts are a legal fiction as the same person is trustee and beneficiary with complete and unfettered discretion as to use of assets in the trust and ability to amend and revoke the trust. The IRS recognizes these trusts and calls them grantor trusts, under which the trustee\beneficiary continues to file income tax returns using his or her social security number and does not have to get a separate federal tax identification number for the trust. Since the revocable trust is primarily a probate avoidance tool, it also includes provision for distribution of its assets when the testator dies. That is just like a will, but does not have to go through probate. A revocable trust offers no protection from creditors as there is really no difference between owning something personally and owning it is trustee of your own trust with complete discretion as to its use.
An irrevocable trust is not revocable. Once established, it generally cannot be changed (although there are exceptions). The irrevocable trust can be created during life or at death. In fact, a revocable trust generally becomes irrevocable at death. Irrevocable trusts created during life either seek tax advantageous treatment of assets or protection from creditors.
A qualified personal residence trust is a good example of a trust that can be created as part of a tax saving strategy. The testator transfers a home used by the testator to the trust. The terms of the trust allow the testator to continue to use the home for a set time, after which the home passes to beneficiaries. The beneficiaries often lease the home back to the testator if the testator survives the term, but they get ownership at the end of the term.
How does that save taxes? The home transfer is considered a delayed gift and is valued at a substantial discount. If the trust term is 10 years the discount is related to how much someone would pay for a home they would not get for 10 years. That gets the home out of the testator’s estate with a value that is substantially less than the value that would attach if the testator still owned it at time of death. Since Congress increased the federal estate tax exemption to over $11 million per person, this type of trust is now generally used only by the very wealthy. But, tax laws may change.
Charitable trusts are another way to leverage tax benefit. A testator can establish a trust under which the testator receives income for life for a set time and at death the assets in the trust go to the charity. That is known as a charitable remainder trust. A testator can also establish a trust under which the charity gets an income stream after which time the assets return to the testator or other beneficiaries. That is known as a charitable lead trust. The testator gets benefit of a charitable deduction based on the future estimated value of the charitable gift in a charitable remainder trust or the present value of the future payments in a charitable lead trust.
Asset protection trusts are a recent addition to trust options. In years gone by, these trusts generally had to be established outside of the United States with assets transferred to them and held by a foreign trustee under irrevocable terms. Some states have taken note of the business opportunity afforded by asset protection trusts. Alaska took the lead and 6 other states now allow asset protection trusts. These trusts are normally irrevocable although modification of beneficiary, trustee and sometimes terms can be made by the testator. They are expensive and have operating expenses, so they are generally only attractive to wealthy individuals with risk of creditor claims. And, even when used, not all creditor claims are avoided.
A more specialized asset protection trust is the Medicaid asset protection trust. These trusts allow the testator to use the assets but removes them from accountability for Medicaid qualification, with goal of having Medicaid pay the cost of assisted living or nursing home. The trust usually provides that the testator’s children or grandchildren will receive the assets after the testator dies. This type of trust provides 2 benefits. One is the qualification for Medicaid assistance in paying assisted living expense and to avoiding the gift tax consequences of giving assets to family members before death. That means instead of using the assets for assisted living, the government pays and the assets remain. These trusts have the approval of the government.
Gift tax law provides that a recipient of a gift gets the gift for tax purposes as if they bought it for the lesser of value on date of the gift or basis of the giver (what it cost). That may not be a big problem initially, but when the recipient goes to sell the asset he or she might face a painful capital gains tax. If the recipient gets an asset due to death of another, the recipient gets it as if the recipient bought it for what it was worth on the date of death.
Drawback of medical trusts is loss of control and access to the assets as even if one wants or needs the funds, the trust does not provide flexibility of access. The trust can provide for income payments and those payments are accountable for Medicaid qualifications, but the principal in the trust is not counted as a resource.
Trusts established for the benefit of others, such as children, usually include provisions directing how the assets are to be utilized. In some cases, the assets are to be held until the beneficiary reaches a certain age. In many cases income or principal can be distributed if needed. Most of these trusts are established to be funded at time of death and can be included as part of distribution from a revocable trust or one’s will.
Special needs trust is a trust established for a person who receives or may receive governmental benefits so that availability of the assets in the trust will not disqualify that person from governmental support. A special needs trust provides for payment for items which would not be paid by the government assistance. That could be luxuries, travel, essentials not paid by the government and even spending money. Qualifying expenses are fairly broad, but just to make sure, most of these trusts provide they will terminate if they disqualify the beneficiary from government assistance.
These are just some of the kinds of trusts that can be created. Other trusts include tax bypass, spendthrift and qualified domestic trust. Trusts can be created by operation of law. A constructive trust is created by a judge to carry out equity by restricting use or retention of an asset. If the trust is established so that the creditors of the beneficiary cannot reach the assets, it is known as a spendthrift trust.
Trusts allow tremendous flexibility, limited only by the creativity of client and attorney. The name or title is not as important as the content. Because trusts cover such a broad spectrum, they can be confusing and difficult to grasp. That makes it important to consult with an experienced attorney and not proceed down the trust road alone.
William G. Morris is the principal of William G. Morris, P.A. William G. Morris and his firm have represented clients in Collier County for over 30 years. His practice includes litigation and divorce, business law, estate planning, associations and real estate. The information in this column is general in nature and not intended as legal advice.