Chapter 7 Trusts Explained from A to Z

What is a Revocable Living Trust (RLT)?

A trust is a legal entity recognized by all fifty states. It is evidenced by a written agreement (the “trust agreement”) signed by the trustmaker(s) and the trustee(s). The trustee is obligated to hold and administer the assets owned by the trust for the benefit of one or more people called “beneficiaries.” If the trust agreement provides that the trustmaker can amend the trust agreement, the trust is revocable. Most trusts created for the benefit of the trustmaker are revocable when first created. If your trust owns an asset you do not own the asset, but if you are the trustee you have control of the asset inside the trust. Note: A revocable trust does not give any asset protection.

What is an Irrevocable Trust?

An irrevocable trust is a trust that cannot be amended by the trustmaker. Many revocable living trusts become an irrevocable trust when the trustmaker dies or becomes incapacitated. The reason the trustmaker wants the trust to become irrevocable after death or incapacity is because the trustmaker does not want anybody to alter the asset management and distribution plan he or she creates in the trust agreement.

Some trusts are created as irrevocable trusts from day one. The two most common types of irrevocable trusts are the Gift Trust and the Irrevocable Life Insurance Trust. People create a Gift Trust when they want to give valuable property to children, grandchildren or loved ones. A well designed Gift Trust allows people to give away property in a life-time asset protected trust that protects the property from the beneficiaries’ creditors, ex-spouses and predators and a beneficiary’s youth and inexperience. For more about Gift Trusts read Chapter 13 The Gift Trust: How & Why to Give Property to Kids in a Trust that Gives Life-time Asset Protection.

The Irrevocable Life Insurance Trust (aka ILIT) has a special purpose of taking life insurance proceeds out of the estate of a person whose net worth (assets + life insurance owned by the person – debts) at the time of death would exceed $13,610,000. For more on this type of trust read Chapter 15 How to Prevent the IRS from Getting 40% of Life Insurance.

Primary Reason to Create a Trust

If drafted with the proper provisions your trust can give excellent life-time asset protection for the assets you leave after death to your spouse and loved ones and protect their inheritance from creditors, predators and ex-spouses.

Trust Agreement

A written contract signed by the trustmaker (a single person) or trustmakers (a married couple) that contains instructions to a trustee or co-trustees to hold assets transferred to the trust and administer the assets for the benefit of one or more people or entities called “beneficiaries.” Trustees have a legal obligation to follow the trust agreement and can be sued by the beneficiaries if they do not or if they breach any fiduciary duty owed to the beneficiaries.

Trustmaker

The trustmaker is the person who creates a trust and who transfers ownership of his or her assets to the trust. You and your spouse (if married) would be the trustmaker(s) of your joint trust. The trustmaker may sometimes be called the “settlor” or “grantor.”

Trustee

The trustee is the person, people (co-trustees) or institutional trust company named in the trust agreement who has the legal obligation to follow the instructions set forth in the trust agreement. You and your spouse (if married) would be the trustee(s) of your trust.  The trustee(s) has total control of the assets held in trust and is responsible for managing all of the trust’s assets.

Beneficiary

A beneficiary is a person or entity named in the trust agreement that may benefit from the assets held in trust. Your trust agreement names two types of beneficiaries: (i) current, and (ii) future or contingent beneficiaries.

Current Beneficiary

The trust agreement names you (and your spouse if you are married) as the current beneficiaries. You are free to use as much or as little of the assets as you desire while alive. If you are incapacitated your trust becomes irrevocable, your spouse or a successor trustee, if you are not married, will administer the assets for your benefit and care.

Future Beneficiaries

After your death, the trustee follows your instructions in the trust agreement as to who becomes the current beneficiary or beneficiaries after your death. If you are married the future beneficiary would probably be your spouse and after his/her death your children. If you are not married your future beneficiaries would be your children or other loved ones.

Taxation of the Revocable Living Trust before Incapacity or Death

The revocable living trust you create for estate planning is what the IRS calls a “grantor” trust. One of the factors that causes a trust to be a grantor trust is that the trust is revocable. The IRS treats grantor trusts as if they do not exist, which means that the revocable living trust you create for estate planning purposes does not file a federal income tax return and it is not a tax-paying entity. All income, expenses, deductions and other tax items of the trust are reported on the IRS Form 1040 of the single trustmaker or the married couple that files a joint tax return. A revocable living trust does not file a federal income tax return or pay federal income taxes.  It is the maker or makers of the revocable trust that file a federal income tax return and pay federal income tax.

Taxation of the Trust after Incapacity or Death

At the point in time when the revocable living trust becomes irrevocable (usually when the trustmaker becomes incapacitated or dies) the trust ceases to be characterized by the IRS as a grantor trust and becomes a tax-paying entity. At that time the trustee must obtain a federal employer identification number from the IRS and file a U.S. income tax return every year. Once the trust becomes a tax-paying entity the general rules are:

• The trust pays income tax on all income earned during a tax year that is retained in the trust.

• Income that is earned during the year and paid to or for the benefit of the beneficiaries is reported on the beneficiaries’ tax returns and the beneficiaries pay the tax on that income.

What Happens After Your Death to Assets Held in Trust

The trust agreement contains your instructions to your successor trustee(s) as to what to do with the assets held in the trust. You will instruct the trustee(s) to: (1) distribute all or a portion of the assets held for a beneficiary to the beneficiary immediately after your death, (2) hold all or a portion of the assets in the trust for a period of years and pay to a beneficiary as needed, or (3) hold all or a portion of the assets in the trust for the life of the beneficiary and distribute to the beneficiary as necessary. Option 3 is the primary reason to create a trust – To give your loved ones life-time asset protection from creditors, ex-spouses, predators and the bankruptcy court.

Trust Benefits

• The trust protects your family, your most important asset.

• If you become incompetent and cannot manage your assets your co-trustee or successor takes over. This avoids the need for your family to hire a lawyer ($3,000+) to go to court and get a judge to issue an order appointing a family member as the conservator of your assets.

• After your death your assets go to the people you select, not the people the State of Arizona selects. If you do not have a Will or a trust, the state of your residence and the state(s) where you own real property at the time of your death will determine who inherits your property. You must have a Will or a trust to insure that your assets are inherited by the people you want. A Will or a trust can name contingent heirs in case the person you want to give your property to dies before you.

• It avoids costly, public & lengthy probate. I do simple uncontested Arizona probates for $2,500 – $3,500, but many lawyers charge $5,000+. A trust can save your family the cost of a probate. A trust is especially important for people who own real estate in states other than their state of residence. A person who owns real estate in three states and who does not create a trust to own the real estate will cause his or her family to pay for three probates, which could easily exceed $15,000 just to transfer title to the heirs.

• It allows a trustee to administer assets for heirs who are too young or who cannot handle money.

• Its single most important benefit – a life-time beneficiary controlled trust for your loved ones to protect the inheritance from creditors, ex-spouses, predators & bankruptcy.