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Financial Life Advisor
What is a Trust and Why Do People Want Them? - Demystifying Trusts part 1 of 3
Trusts are commonly misunderstood by the general public. A trust can fill many different needs but are most often used as part of an estate plan. In the first part of this series, I will attempt to explain the basic legal concept of a trust (I am not an attorney) as well as cover the basic types of trusts.
When I think of a trust, I think of it a lot like a corporation. It is the creation of a separate legal entity which can own physical property. Just like a company can own a piece of property, a trust can be titled as the owner of property. The person who sets up and funds the trust is known as the Grantor (or possibly Trustor, Donor or Settlor). The person who is in charge of operating the trust is the Trustee. The people who benefit from the trust are Beneficiaries. The Grantor, Trustee and Beneficiary can all be the same person or they can be different.
As an example, Grandpa could set up a trust and be the Grantor. His daughter could be the Trustee, and his grandchildren could be the Beneficiaries. In this example, Grandpa wanted to make sure his grandchildren went to college. His grandchildren are very young, and grandpa is not well. He is not sure he will be around to make sure the checks are written for tuition. In addition, he wants to make sure that he only pays for college while his grandchildren are full-time students earning a minimum 2.5 GPA. He could tell his grandchildren his wishes and give them the money outright to take care of it, but he has concerns that they might spend it on normal expenses or not enforce the full-time student status and GPA requirements. The trust in this case can help Grandpa meet his desired goals and provide some guidance and safeguards to ensure that his wishes are carried out, even if he is not around to make sure it happens.
Testamentary vs. Inter Vivos Trusts
A trust can be set up either inter-vivos (during life) or testamentary (at death in a will). The most common type of inter-vivos trust is a “Living Trust”. A Living Trust generally is set up and funded with major assets (real estate, brokerage accounts, etc) to be an alternative to the probate process.
During life, if someone wants to transfer a piece of property to someone else, they simply sell it. If they are no longer alive, they cannot sign their own name to transfer property. Probate is the legal process of transferring ownership from a deceased person to heirs. The will is the set of instructions and the court must oversee the transfer of assets. The court then gives authorization to transfer property to the heirs.
With a Living Trust, the trust owns the property, so when someone dies, there is no need to transfer title of that property. If the Trustee dies, the trust has provisions for a successor trustee. The Trustee changes per the trust document, and title of the property never changes. The Living Trust completely bypasses the probate process.
If a trust is set up only upon death, then it is a testamentary trust. In order to set up a testamentary trust, the estate must go through probate. A testamentary trust may not even be created unless a certain set of circumstance is met. For example, a trust could be created only if there are minor children who are heirs. So if one spouse dies, no trust is created, but if both spouses were to die, then a trust would be created for the children. Testamentary trusts are generally set up for estate tax purposes or, like in illustrated in the previous example, to provide for beneficiaries which either cannot or should not have full control of the inheritance.
Revocable vs. Irrevocable Trusts
A revocable trust is just as it sounds—a trust which can be cancelled or amended. If someone wants to change the provisions of the trust or simply wants to undue or eliminate it, a revocable trust allows for that. A revocable trust can become an irrevocable trust if a certain event takes place (such as the death of the Grantor). Since the trust is revocable, and the Grantor has retained full right to amend or change the trust, all of the assets of the trust are considered the property of the Grantor. That means that when a trust is revocable, the assets of the trust are taxable to the Grantor and included in the Grantor’s estate at death.
With an irrevocable trust, changes cannot be made. The trust in effect becomes a stand-alone entity. The advantage of an irrevocable trust is that for income tax purposes and estate tax purposes, the assets of the trust are usually not considered assets of the Grantor. This means that annual gifts (which qualify for the annual gift tax exclusion) can usually be made to an irrevocable trust. Outside of a Living Trust, most trusts are irrevocable.
In the blog posting, I will be discussing one of the most misunderstood and common types of trusts. Find out by reading part 2 of 3 in the Demystifying Trusts series, “The Advantages and Disadvantages of a Living Trust.”
Posted by Ben Gurwitz on 18th January, 2010 | Comments | Trackbacks
Tags: Financial Planning, Jan 10, Estate Planning
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