Trusts are a useful tool in both estate and tax planning. A trust is a fiduciary arrangement that allows a trustee to hold assets on behalf of beneficiaries. These assets are often placed there with the intent to segregate them from the estate and allow them to grow outside of the caps placed on gift taxes.
Importantly, a trust dictates how and when the beneficiaries receive the assets placed inside the trust.
Trusts are often seen in situations where the beneficiary does not always make the best life choices and the person granting the assets into the trust wants to ensure that they are protected from those choices. This means creditors, ex-spouses (or future ex-spouses), or just lifestyle choices that will hopefully change with age.
There are many types of trusts: Marital or “A” Trusts, Bypass or “B” Trusts, Testamentary Trusts, Irrevocable Life Insurance Trusts, Charitable Lead Trusts, Charitable Remainder Trusts, Generation Skipping Trusts, Qualified Terminable Interest Property (QTIP) Trusts, Grantor Retained Annuity Trust (GRAT), etc. However, if you understand two distinct features of trusts this will go a long way to understanding the trust types above.
Trusts are either revocable or irrevocable. The distinction makes all the difference in the world to the tax man and to those on the outside trying to take your stuff.
Revocable Trust
A revocable trust is also known as a “living trust.” This type of trust will help assets pass outside of probate (the difficult process that occurs upon death of the asset owner), yet a revocable trust allows the grantor to retain control of his or her assets during their lifetime. A revocable trust is flexible and can be dissolved at any time, should the grantors circumstances or intentions change. A revocable trust typically becomes irrevocable (discussed below) upon the death of the grantor.
The grantor can name himself/herself as trustee (or co-trustee) and retain ownership and control over the revocable trust while they are still alive. This includes the terms and assets. It also makes provisions for a successor trustee to manage the assets in the event of the grantors incapacity or death.
It’s important to note that a revocable trust will help avoid probate, but it is still usually subject to estate taxes. This means that during the grantor’s lifetime, the trust is treated like any other asset they own.
Irrevocable Trusts
This is the ‘big daddy’ of trusts. An irrevocable trust transfers the grantors assets out of the estate completely and normally out of the reach of estate taxes, creditors and probate. The major downside is that an irrevocable trust cannot be altered by the grantor after it has been executed. Therefore, once the grantor sets up the trust, they will lose control over the assets and cannot change any terms or conditions nor can they dissolve the trust.
An irrevocable trust reduces the amount subject to estate taxes by removing assets from the grantor’s estate completely. And, because the assets have been transferred to the trust, the grantor is relieved of the tax liability. It may/usually be protected in the event of a legal judgment against the grantor.
Irrevocable trusts are excellent for placing assets the grantor is highly confident will grow in value over time, because the assets can be placed in at a lower value and through sweat, skill or luck become very large. These often include businesses, rare investments, and securities to name just a few.
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