Karyn Scott
Trusts have been around since the days of the crusaders. Once available and used only by the very wealthy, they have become a standard tool in estate planning. Trusts come in every shape, size and flavor, from providing for special needs to protecting assets for future generations. The flexibility of the trust allows it to accommodate complex family situations and span multiple generations.
Essentially, a trust is a legal relationship where someone gives property to another person they “trust” to hold and manage for the benefit of a third party. For example, Grandmother gives $1 million in trust for the benefit of her grandchildren to be used for their education. She names her son the “trusted” person to manage these funds. The son is the trustee and it is his responsibility to see that the funds are maintained and used according to the expressed wishes of Grandmother. These wishes are expressed in the trust agreement or trust instrument, as it is sometimes referred.
Trusts will be either revocable or irrevocable. If revocable, the grantor (Grandmother in our example above) can change her mind about any facet of the trust – who it benefits, what it provides for, even its very existence can be terminated. However, if the trust is irrevocable, the grantor has forever disclaimed the right to make a change to the trust agreement he or she has established. It is very difficult to make a change to an irrevocable trust once it has been established and generally requires approval of all interested parties and the court.
Trusts can be created during life or upon death if so provided for in a person’s last will and testament. Trusts created upon the death of the grantor are referred to as testamentary trusts and are always irrevocable. Trusts created during life are often call inter vivos or living trusts.
One of the characteristics of a trust that make it so useful in estate planning is the ability to bifurcate the assets from the income the assets produce and have different parties benefit. This characteristic is particularly useful in today’s culture of multiple marriages where one spouse may have children from a previous marriage to which they wish to leave their assets, but also want to take care of their second spouse during his or her life. This duel accountability for the income and assets (also known as principal or corpus) is also one reason why trusts are often viewed as complex and hard to understand. However, if one can separate the tree, from the fruit that it bears, they will be able to understand trusts.
Taxes create a whole new dimension for trusts and it is important to know when a trust may have a legal obligation to file a tax return. Generally, if a trust is established and it benefits the grantor who established it, i.e. a grantor trust, it is disregarded for tax purposes. All the income generated by the trust will be reported directly by the grantor as if the trust did not exist. But remember, the trust is only disregarded for tax purposes. In all other cases, it is a legally recognized entity.
All other trusts are required to obtain a taxpayer identification number and file a tax return if they have gross income of more than $600 during the year, have any taxable income, or if they have a foreign beneficiary. Here is where the taxation of trusts becomes complicated and where you need to seek professional advice. If the trust is providing a current benefit to an individual from the income its assets have earned, it is required to report a share of that income to the person who received it. However, if the income is retained or the trust realizes a capital gain or loss, the trust itself will report the income and pay the associated tax liability. Often, both the trust and its beneficiary are sharing the burden of the tax and it is the trustee’s responsibility to ensure that burden is equitable and follows the regulations set forth in the tax code.
Trusts serve many different purposes and have become an essential tool in estate planning by enabling individuals to transfer assets out of their estates (thus achieving significant tax savings) while still maintaining a level of control over who benefits from those assets as well as how those assets are used.