A trust is a legal arrangement through which one person (or an institution, such as a bank or law firm), called a “trustee,” holds legal title to property for the benefit of another person, called a “beneficiary.” The trustee is responsible for managing, investing and distributing the property in the trust. The rules or instructions under which the trustee operates are set out in the trust instrument.
A trust can be either a testamentary trust or a living trust. A testamentary trust is created by will and transfers property to the trust only after your death. With a testamentary trust, a court will oversee your trustee’s activities and the assets held in such trust do not avoid probate. A living trust is created during your life and can be funded while you are living or after your death. A living trust is private, there is no court oversight, and there is no probate of assets in the trust.
Uses of Trusts
Depending upon your situation, there can be several advantages to establishing a trust. One of the principal advantages of a living trust is avoiding the cost and delay of probate. Certain trusts can also result in tax advantages both for the donor and the beneficiary. These are often referred to as “credit shelter” or “life insurance” trusts. Other trusts may be used to control use or disposition of property long after the donor is deceased, to provide for children or any other person you wish to inherit during minority or if disabled, to protect property from creditors, to avoid ancillary probate for property located in another state, or to help the donor qualify for Medicaid. Unlike wills, trusts are private documents and only those individuals with a direct interest in the trust need know of trust assets and distribution. Provided they are well-drafted, another advantage of trusts is their continuing effectiveness even if the donor dies or becomes incapacitated.
Disadvantages of Trusts
One of the most important potential disadvantages of a trust is the possibility for mismanagement by a trustee because of the lack of court supervision that would otherwise apply to the probate of a will. However, careful selection of trustees and requiring regular and detailed accountings to the beneficiaries under the terms of the trust agreement can minimize the risk of trustee mismanagement or malfeasance. Legal fees for drafting the trust instrument and assisting in funding the trust are more costly than those for drafting a will. All of your property being transferred to the trust must be re-titled in your trustee’s name. Some trusts may require periodic maintenance during your lifetime, result in loss of flexibility and/or control over your property, may complicate subsequent dealings with the property in the trust, and may have an adverse impact on eligibility for public benefits such as Medicaid.
Types of Trusts
Revocable Trusts
Revocable trusts are often referred to as “living” trusts. With a revocable trust, the donor maintains complete control over the trust and may amend, revoke or terminate the trust at any time. This means that the donor can take back the funds put into the trust. Or, if the donor has second thoughts about a provision in the trust or changes his or her mind about a trust beneficiary or fiduciary, then he or she can modify the terms of the trust. Or, if the donor decides that he or she no longer likes anything about the trust at all, then the donor can either revoke the entire agreement or change the entire contents. Thus, the donor is able to reap the benefits of the trust arrangement while maintaining the ability to change the trust at any time prior to death.
Revocable Trusts are generally used for asset management, probate avoidance and tax planning purposes. They permit the named trustee to administer and invest the property for the benefit of one or more beneficiaries. At your death, the trust property passes outside of probate to whoever is named in the trust and in accordance with the trust terms you’ve set out. Revocable trusts protect the privacy of your property and beneficiaries after you die. The property in a Revocable Trust will be included in your estate for tax purposes but can be drafted so that the assets will not be included in the estates of your beneficiaries, thus avoiding taxes when the beneficiaries die.
The down side to a revocable trust is that assets funded into the trust will still be considered the donor’s personal assets for creditor and estate tax purposes. This means that a revocable trust offers no creditor protection if the donor is sued and all assets held in the name of the trust at the time of his or her death will be subject to both state and federal estate taxes. Further, a Revocable Trust will not protect your assets from Medicaid. Assets in Revocable Trusts are considered “available” under the Medicaid rules. An applicant will not be eligible for Medicaid benefits until the assets are removed from the trust and spent-down.
Irrevocable Trusts
An irrevocable trust is a permanent trust. It cannot be changed, amended or revoked by the donor after the agreement is signed. With an Irrevocable Trust the donor departs with ownership and control of the property. Any property placed into the trust may only be distributed by the trustee as provided for in the trust document itself. The trust stands as a separate taxable entity and pays tax on its accumulated income. A typical Revocable Trust will become irrevocable when the grantor dies and can be designed to break into separate irrevocable trusts for the benefit of a surviving spouse or into multiple irrevocable lifetime trusts for the benefit of children or other beneficiaries.
Irrevocable trusts can take on many forms and be used to accomplish a variety of estate planning goals, including estate tax reduction, asset protection, and charitable gifting. An Irrevocable Trust is commonly made for the benefit of the surviving spouse, as well as children and grandchildren. Because it cannot be changed, it is off limits to your surviving spouse’s new spouse, the creditors of your spouse and children, and will not be lost to spendthrift, irresponsible offspring or their ex-spouses. The trust can be made discretionary, such as providing that no distributions will be made if the beneficiary is addicted to alcohol or drugs. By placing assets into an Irrevocable Trust, however, you give up complete control over, and access to, the trust assets. One advantage of an Irrevocable Trust is that the trust assets cannot be reached by your creditors. Further, because you do not have an ownership interest in the trust property and the property passes outside of probate by operation of law, it may not be subject to a Medicaid claim.
Credit Shelter Trusts
Also called a “bypass trust,” a credit shelter trust is normally established to take advantage of the applicable federal and/or state estate tax exclusion amount. This is the amount you can pass free from tax for federal and/or state estate tax purposes. The credit shelter trust is normally established upon the death of the first spouse to die and the estate is divided into two parts: one part (up to the maximum estate tax exclusion amount) is placed in the credit shelter trust to benefit the surviving spouse and/or other family members without being subject to tax at his or her death or at the death of the surviving spouse. The surviving spouse can receive income from the trust, but as long as he or she does not control the principal, the money will not be included in the surviving spouse’s estate when he or she passes away. The other part (assets in excess of the estate tax exclusion amount) is passed outright to the surviving spouse or is placed into a marital deduction trust for which the spouse is the sole beneficiary.
None of the trust assets in a credit shelter trust are subject to estate tax at the death of the first spouse. The assets passing to the credit shelter trust are sheltered by the decedent spouse’s exemption amount and will pass estate tax free to the final beneficiaries. This can provide a significant windfall to the final beneficiaries if the surviving spouse does not need to use the assets from the credit shelter trust and they continue to appreciate in value during the surviving spouse’s remaining lifetime. The assets passing outright to the surviving spouse or to a marital trust are sheltered by the marital deduction. Whatever passes from the deceased spouse to the surviving spouse in a manner that qualifies for the estate tax marital deduction is allowed to be claimed as a deduction and is not subject to tax in the estate of the first spouse to die. The property that passes from the first spouse to die to the surviving spouse is fully includible in the surviving spouse’s subsequent estate for estate tax purposes, except to the extent the subject property is expended during the second spouse’s survivorship years. Thus, the use of the estate tax marital deduction does not necessarily avoid tax, but rather postpones exposure to estate tax until the second death. However, the surviving spouse will still have his or her estate tax exemption.
Life Insurance Trust
An Irrevocable Life Insurance Trust generally prevents life insurance proceeds from being subject to estate tax. The proceeds on any life insurance policy under which you are insured will not be included in your taxable estate provided that the proceeds are not paid to your estate, you do not own the policy and you have no “incidents of ownership” over the policy. Incidents of ownership include the right to change or add beneficiaries, the right to borrow against the policy’s cash value or to cancel or surrender the policy. By establishing an irrevocable life insurance trust, the insurance will be excluded from your estate because you will not own the insurance at the time of your death; rather, the trust will own the insurance.
Testamentary Trusts
As noted above, a testamentary trust is a trust created by a will. Such a trust has no power or effect until the will of the donor is probated. Although a testamentary trust will not avoid the need for probate and will become a public document as it is a part of the will, it can be useful in accomplishing other estate planning goals. For instance, the testamentary trust can be used to reduce estate taxes on the death of a spouse, protect assets for a surviving spouse from being spent on nursing home care, or provide for the care of a child without effecting the disabled child’s eligibility for public benefits such as Supplemental Security Income, Medicaid and low-income housing.
Supplemental Needs Trusts
Supplemental needs trusts (also known as “special needs” trusts) are drafted to enable the donor to provide for the continuing care of a disabled spouse, child, relative or friend. If a disabled beneficiary is left an outright gift, either by will or through the intestate laws, he or she would lose eligibility for many public benefits until the funds are spend down to the allowable limit. Under a well-drafted trust, the funds will not be considered to belong to the beneficiary in determining his or her eligibility for public benefits, such as, Supplemental Security Income (SSI), Medicaid, or public housing. Supplemental needs trusts can be used to protect personal injury settlements or judgments from jeopardizing government benefit eligibility. Most importantly, they can help parents coordinate their estate plans and provide peace of mind that their child will be provided for.
Supplemental needs trusts are designed not to provide basic support, but instead to pay for comforts and luxuries that could not be paid for by public assistance funds, such as education, recreation, counseling, and medical attention beyond what is required simply to maintain an individual. A supplemental needs trust can be created by the donor during life or be part of a will. Further, such a trust can be set up by anyone for the benefit of a disabled individual. Very often supplemental needs trusts are created by a parent or other family member for a disabled child (even though the child may be an adult by the time the trust is created or funded). But the disabled individual can often create the trust himself or herself, depending on the program for which he or she seeks benefits.
Spendthrift Trust
A spendthrift trust is specifically designed to benefit one or more beneficiaries, while at the same time protecting the trust’s assets, and/or the beneficiary’s interest in those assets, from the beneficiary’s creditors. Most trusts have a spendthrift clause, simply to protect the assets in the trust from the beneficiary’s current or future creditors, or from money judgments that might attempt to attach the trust proceeds. On the other hand, a spendthrift trust can be used to curb a spendthrift beneficiary’s customarily poor spending habits. By appointing a trustee with the power to disburse assets to the beneficiary only as he or she sees fit, the settler, or the person establishing the trust, can prevent the spendthrift beneficiary from immediately spending all of the trust proceeds, without retaining any assets for the long-term.
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