Understanding the Foundational Elements of a Trust

Posted by Deb Elfers and Phi Bui

Becoming familiar with the basic elements of a trust is essential to understanding how they are used in estate planning. Below we share an overview of commonly used trust structures and key distinctions to help you begin building your trust foundational knowledge.

What is a Living Trust?

A living trust is established during an individual’s lifetime to manage, protect and distribute assets. The person who creates the trust, referred to as the grantor, typically retains control over the trust assets while alive.

A living trust is:

• Not recognized for income tax purposes. The grantor retains certain rights and is treated as the owner of the trust for income tax purposes. Trust income is passed through and reported on the grantor’s personal income tax return.
• Typically set up as a revocable trust. Understanding the distinction between revocable and irrevocable trusts is a critical next step in determining which type of trust best aligns with your planning objectives

What Are Revocable and Irrevocable Trusts?

Revocable Trusts

A revocable living trust allows the grantor to amend or revoke the trust and transfer assets in and out as circumstances change. Upon the grantor’s death, the trust typically becomes irrevocable, and assets are distributed to beneficiaries according to the trust’s terms.

While assets held in a revocable trust generally avoid probate at death, they remain part of the grantor’s taxable estate, because the grantor retained control during life.

Irrevocable Trusts

Once established, an irrevocable trust generally cannot be modified or revoked. Assets transferred to the trust are considered completed gifts for gift tax purposes and are removed from the grantor’s taxable estate.

Because the grantor relinquishes control, irrevocable trusts are commonly used to minimize estate taxes, protect assets from creditors and remove future appreciation from the estate. However, income retained by the trust is often subject to compressed trust income tax brackets.

What Are Simple vs. Complex Trusts?

An irrevocable trust is designated as simple or complex for income tax purposes based on its trust agreement provisions.

Simple Trusts

A simple trust is a type of irrevocable trust that has fewer tax and administrative requirements than a complex trust. A simple trust:

• Is required to distribute its “income” to beneficiaries each year and issues tax reporting to the beneficiary(ies) in the form of a K-1, so they pay tax on the income. Capital gain, on the other hand, is considered part of the “principal” of the trust and is retained and taxed to the trust.
• The trustee may distribute principal in certain circumstances but has no obligation to do so.
• Cannot allocate amounts to charitable purposes.
• Has a $300 exemption and can take a distribution deduction for any amounts distributed to beneficiaries.

Complex Trusts

A complex trust is an irrevocable trust that does not meet the guidelines of a simple trust. As a result, a complex trust:

• Accumulates or distributes income at the trustee’s discretion. Any income not distributed is taxable to the trust.
• Can make distributions to charitable organizations, if the trust provisions allow it.
• Has a $100 exemption and can take a distribution deduction for any amounts distributed to beneficiaries.

Some common types of simple and complex trusts include marital, family and gifting trusts:

• A marital trust is an irrevocable trust that allows the transfer of a deceased spouse’s assets to the trust for the surviving spouse without any estate taxes, due to a “marital deduction” on the estate tax return. The surviving spouse is required to receive all trust “income” to qualify for this treatment.
• A family trust generally receives a decedent’s assets protected from estate tax by the estate tax exemption. The trust terms dictate who receives assets from the trust after it is funded.
• A gifting trust is created to pass wealth on from one generation to another during the grantor’s lifetime. Normally this would be structured to avoid any gift taxes at the time of the gift.

What is a Testamentary Trust?

Unlike a living trust, a testamentary trust comes into existence after the grantor’s death and is often created according to terms detailed in the last will and testament. Since this trust is established upon death, the assets are subject to probate and included in the decedent’s taxable estate. The trustee/executor manages the assets and distributes them to the beneficiary(ies) according to the will and trust language.

What Are the Advantages and Disadvantages of Using a Trust?

Advantages

Everyone’s situation is different, but there are some meaningful benefits to placing assets in a trust:

• Avoid the often costly and time-intensive probate process.
• Have a higher level of privacy, as trusts are not subject to public record like probate assets.
• Can provide asset protection from creditors, lawsuits and potential beneficiaries’ financial mismanagement.
• Can offer tax benefits, such as with irrevocable trusts, by removing assets and future asset appreciation from the grantor's taxable estate.

Disadvantages

There are some downsides to using a trust:

• Can be more complex than wills to establish and administer, requiring more time and expertise to establish and manage.
• Require ongoing record keeping, and some trusts can carry potential tax burdens.
• Have higher costs to create and maintain than a will.
• May not allow grantors to control the assets or modify trust terms, such as with an irrevocable trust.

While trusts can be complex, it’s important to understand there are multiple types that allow you to protect various assets in different ways. Begin exploring your options with your legal and tax advisers.

Contact Deb Elfers, Phi Bui or a member of your service team to discuss this topic further.

In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.