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By Steven Wolter, JD, MBA, ChFC®, Kaplan Senior Content SpecialistPublished August 2015
A trust is a legal arrangement in which one person transfers property to a trustee, who manages the property for the benefit of one or more trust beneficiaries. The person who establishes the trust is known as the grantor, and the property the grantor transfers to the trust is known as the trust corpus. For example, assume a grandmother transfers ownership of stocks and bonds to a bank to manage for the benefit of her grandchildren. In this case, the grandmother is the grantor, the bank is the trustee, the grandchildren are the beneficiaries, and the stocks and bonds are the trust corpus.
The corpus of a trust often generates income, which can include items such as interest and dividends, or rent if the corpus is real estate. The trustee distributes the trust income and corpus to the trust beneficiaries as directed by the trust document. The trust document can direct the trustee to distribute the trust corpus and the trust income to different beneficiaries, sometimes at different times.
A grantor can make himself a beneficiary of the trust and set up the trust so that he receives distributions of trust income or corpus. This provides tremendous flexibility in the way the distributions are made and can give rise to a host of wealth management opportunities.
Utilizing Trustee's Management Expertise
Trustees, such as banks and investment advisors, have experience in managing investments that the grantor or trust beneficiaries typically can't match. Grantors often establish trusts to take advantage of the trustee's management expertise, especially when the value of the trust corpus is large or the corpus includes complex investments. The trustee charges a fee for its services, but the grantor is assured that the trust property will be managed professionally and competently. This is especially important if the trust beneficiaries are young children or adults with no experience handling complicated investments.
Once the grantor transfers property to a trust, the trustee holds legal title to the property. Because the grantor no longer owns legal title to the trust property, the property avoids probate when the grantor dies. To achieve the goal of probate avoidance, the grantor has to transfer the property to the trust before he dies. As mentioned previously, however, the grantor can make himself a beneficiary of the trust and continue to benefit from the trust property by receiving distributions of trust income or corpus. Trusts set up to avoid probate are known as living trusts because they are established and funded with trust property while the grantor is still alive.
Because the grantor no longer owns legal title to the trust property after it is transferred to the trust, trusts can also provide protection again claims of the grantor's creditors. A creditor with a claim against the grantor might be able to attach the grantor's assets to satisfy the claim, but assets the grantor has already transferred to a trust can sometimes be exempt from these claims.
There are limits on a grantor's ability to avoid creditor claims by using a trust, especially when the grantor is also a trust beneficiary. The debtor-protection laws are sometimes more favorable in foreign countries, so these trusts are often established in other countries and known as off-shore trusts. Off-shore trusts are usually used only by the wealthy because they can be expensive to establish and maintain.
The ability to split trust distributions between trust income and trust corpus makes trusts ideal for charitable giving. Sometimes a grantor wants to make a charitable gift when he dies but still needs income to live on while he's alive. To achieve both goals, the grantor can establish a charitable remainder trust, which will pay the grantor an income during his life and then distribute the trust corpus to a designated charity at the grantor's death.
The grantor could just keep the property until he died and leave it to the charity in his will instead of using a charitable remainder trust. If he did, his estate would receive an estate tax charitable deduction, but he wouldn't receive an income tax charitable deduction during his life. One advantage of using a charitable remainder trust is that the grantor is eligible for an income tax charitable deduction when the trust is established, while he is still alive.
Providing for Surviving Spouse
Trusts can also be used to ensure that the grantor's surviving spouse is taken care of after the grantor dies. These marital trusts can be set up in a variety of ways. They can simply pay the surviving spouse the trust income during his life, or they can allow the trustee to distribute trust corpus as well if needed for the surviving spouse's support.
Another planning option with these trusts involves determining who will receive the remaining trust corpus when the surviving spouse dies. The grantor can either specify who will receive the trust corpus in the trust document or give this power to the surviving spouse. One common situation when the grantor wants to make this determination is when the grantor has children from a prior marriage and wants to ensure that they receive the trust corpus instead of someone else who might be named by the surviving spouse.
Besides providing the advantages of probate avoidance and management expertise for the trust assets, marital trusts can also provide estate tax savings. They can be arranged in such a way that the trust corpus escapes estate taxes when the grantor dies and then again when the surviving spouse dies. This is especially important for the wealthy.
Transferring Property to Younger Family Members
Trusts are often used to achieve tax savings when transferring property to younger family members. For example, a father who owns a house might want the house to pass to his children when he dies but may still need to live in the house during his life. However, making an outright transfer of the house to his children could require the payment of transfer taxes. If he transfers ownership of the house while he's alive, the transfer may be subject to gift taxes. If he retains ownership of the house until he dies and leaves it to the children in his will, the house may be subject to estate taxes and will pass through probate.
Instead of making an outright transfer to the children, the father can transfer ownership of the house to a trust. The trust document will provide that the father can continue living in the house for a specified number of years and at the end of that period, ownership of the house will pass from the trust to his children.
Such a trust is usually set up so that the period the grantor can live in the house will end shortly before the grantor is expected to die. This is because the grantor must outlive the trust period for the house to escape estate taxes. If the trust is arranged properly, there won't be any gift tax when the house is transferred to the trust and there won't be any estate taxes at the father' death. In addition, because the father no longer has title to the house when he dies, the house doesn't pass through probate.
A similar approach can be used with property other than houses. In this case, the father would receive income from the trust instead of the right to live in a house, and at the end of a specified period the trust property would pass to his children. As with the transfer of the house, if the trust is arranged properly there won't be any gift tax or estate tax due.
Steven Wolter, JD, MBA, ChFC®, is a senior content specialist at Kaplan. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.
The contents of this article are presented for informational purposes only. Always check with a professional regarding any questions you may have regarding financial, investment, or estate planning services.
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