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Trusts

Basic Concept of a Trust

A trust is nothing more than an arrangement whereby one person agrees to hold property (in trust) for the benefit of another. We create trusts all the time without even knowing it.

For example, if you give money to a babysitter in case he or she needs something for the kids while you are away, that creates a trust. In a strictly legal sense, your babysitter accepted the money and agreed to hold onto it and use it for the children’s benefit, not her own. That is the essence of a trust – someone agrees to hold money or property for the benefit of someone else. Without entering into a formal agreement, you trusted your babysitter to hold onto the money and use it for the benefit of your kids, with the understanding that whatever was not spent on the kids would be returned to you.

Every type of trust has these same basic components. We call the person that creates the trust the “grantor,” or the “settlor.” All These terms are used interchangeably. In our baby sitter example, you were the grantor because you created the trust between yourself and your babysitter.

The person or entity that agrees to hold the money and/or property for the benefit of someone else is called the “Trustee.” In our babysitter example, your babysitter is the trustee.

The person or people that benefit from the trust are called the “beneficiaries” of the trust. In our babysitter example, your children are the Beneficiaries of the trust.

1. Living Trusts vs. Testamentary Trusts

One of the most basic classifications of trusts is when they become effective. A trust that becomes effective during the grantor’s lifetime is called a “living trust.” Living trusts are created by a written document called a “trust agreement.”

On the other hand, a trust that is created under a Last Will and Testament is called a “testamentary trust.” A testamentary trust, by definition, only becomes effective upon the testator’s death because the Last Will and Testament does not become legally binding until death occurs.

Testamentary trusts do not avoid probate. Living trusts on the other hand, may help to avoid probate if properly created during the grantor’s lifetime. As a practical matter, living trusts rarely avoid probate entirely because, invariably, not all of your assets are held or titled in the name of the living trust. Your car would be an example.

There are more formalities to creating and changing a testamentary trust than a living trust. Testamentary trusts are also more public than a living trust because a testamentary trust is part of a Last Will and Testament, which is a public document recorded with the County Surrogate. Cost is also a factor because a living trust requires a separate document and the retitling of assets, whereas a testamentary trust is almost always part of your Last Will and Testament.

2. Revocable Trusts vs. Irrevocable Trusts

Another very basic classification of trusts is whether the trust is revocable or irrevocable. If the grantor reserves the right to revoke the trust even after it becomes effective, including the right to change the trustee or beneficiaries of the trust, then the trust is said to be a “revocable trust.” If the grantor gives up the right to revoke the trust after it becomes effective, the trust is said to be an “irrevocable trust.” This means that the grantor cannot change anything, not even the trustee or beneficiaries of the irrevocable trust.

Please note that a testamentary trust is always revocable during a testator’s lifetime, because a Last Will and Testament can be changed at any time prior to death. Once a testator has died and his or her Last Will and Testament has been admitted to probate, the underlying testamentary trust becomes irrevocable because the only person who could have revoked it or terminated it is no longer living.

So, what is the significance of this? If you put some or all of your property into a revocable trust, you can get the property back any time you want. You can also change the terms and conditions upon which some or all of the beneficiaries will receive benefits under the trust. Because you still retain all the “incidents of ownership” to the property held in the revocable trust, you are still treated as though you are still the legal owner of the property for tax purposes. On the other hand, if you transfer some or all of your property to an irrevocable living trust, you are giving up all your rights to that property, which has the same legal effect as giving the property to another person or entity with no strings attached.

One common reason for creating an irrevocable trust is to satisfy a property settlement as a result of a divorce or some other court decree. Property settlement agreements often mandate that certain property be placed in trust, especially when minor children are the intended beneficiaries.

Elderly persons concerned about the high cost of nursing homes and long term care, also sometimes transfer their property to an irrevocable trust before applying for Medicaid. In order to qualify, the property must be transferred to an irrevocable trust at least five years prior to the filing the application. Other requirements must be met as well. Thus, irrevocable trusts are frequently used by elderly persons in an effort to avoid depleting their estate due to the high cost of a nursing home stay.

Perhaps one of the most common uses for an irrevocable living trust is the avoidance of (or delay in paying) federal estate taxes. Individuals with estates larger than $675,000 (including life insurance) can be subject to estate taxes as high as 55% in New Jersey. One of the more common techniques to reduce the estate tax is to transfer property to an irrevocable trust. Transferring property to an irrevocable trust is the equivalent of making a complete gift of that property, since you no longer have any right to get the property back or to alter or affect its use in any way once the transfer is made.

We generally do not recommend large transfers into an irrevocable trust due to gift tax consequences, which is a complex topic outside the scope of this analysis. However, property that is appreciating in value is often a good candidate for this type of transfer because the appreciation in value from the date of transfer to the date of death will be exempt from both gift tax and the estate taxes.

With this concept in mind, a life insurance policy on the grantor’s life is often placed into an irrevocable trust. The death benefit payable upon the death of the insured is subject to estate taxes. If your estate is large enough to be subject to the New Jersey or federal estate tax, then owning a life insurance policy on your life can cause the death benefit payable to your designated beneficiaries to be taxed. For example, if you have a $1,000,000 insurance policy on your life and you die owning the policy, assuming a 35% tax rate, the estate tax payable on that $1,000,000 death benefit will be approximately $350,000 – leaving only $650,000 for your beneficiaries. Of course, this assumes that your estate is larger than the applicable exclusion amount in the year of your death ($5,120,000 for 2012 for federal estate tax, and $675,000 for New Jersey).

This result can be avoided by purchasing the life insurance policy through an irrevocable living trust (or by transferring the policy to an irrevocable trust after the trust has been established). As suggested above, the premium payments on the life insurance policy are considered to be gifts to the trust at the time of the transfer and may be subject to the gift taxes. Upon your death, the entire death proceeds will be estate-tax free because you do not own the policy. Using our example above, if the $1,000,000 insurance policy on your life is transferred to an irrevocable trust prior to your death, then the entire $1,000,000 would be payable to your beneficiaries and nothing would be payable to the U.S. Treasury – a savings of approximately $460,000.

3. Classification of Trusts by Purpose

While the two basic classifications of trusts (i.e., living vs. testamentary and revocable vs. irrevocable) cover the various types of trusts in existence today, the purpose of the trust can be considered a sub-category. Every trust is established for a specific purpose, and that purpose will dictate the form and the basic provisions of the trust. The purpose of a trust is often stated in the name of the trust.

Common examples would be a trust for minor beneficiaries, a spendthrift trust to prevent a beneficiary from wasting or frivolously spending the money, and a Special Needs Trust for beneficiaries that may be on public assistance.

REVOCABLE TRUST

A “Revocable Trust” is a type of living trust in which the grantor retains the right, during his or her lifetime, to amend, change, revoke or terminate the trust within his or her sole discretion. A Revocable Trust is the type of living trust that is generally created when the objective is to avoid probate or to provide for continuity of management of one’s assets in the event of incompetence.

TESTAMENTARY TRUST

A “Testamentary Trust” is a trust created under a Last Will and Testament. As such, a Testamentary Trust is amendable and revocable at any time during the testator’s lifetime, but becomes irrevocable upon the testator’s death. Unlike a Living Trust, a Testamentary Trust does not come into existence until the testator’s death and, accordingly, cannot be used to avoid probate or to provide continuity of management of the testator’s property in the event of his or her incapacity.

SPENDTHRIFT TRUST

A “Spendthrift Trust” is any kind of trust that includes certain language giving the trustee wide latitude to avoid making distributions to beneficiaries when the distribution would either end up going to creditors, or when the trustee fears that the distribution would be wasted by the beneficiary.

Unfortunately, children sometimes have substance abuse issues, or simply are not good with money. In these cases, any inheritance would be quickly wasted or spent on frivolous things. A spend thrift trust is a good way to make sure the money lasts and is used for its intended purpose, i.e., for their health, education, maintenance and support.

A spend thrift can also be used in situation in which the grantor-parent has concerns about their adult child’s spouse, either because that spouse would waste all the money in a short period of time, or in the event their adult child dies, everything would go to the son or daughter-in-law, and would not be used for the benefit of the grandchildren.

SPECIAL NEEDS TRUST

A “Special Needs Trust” is a trust that is most often established for a person who is receiving government benefits. The intent of a Special Needs Trust is to provide a source of funds for such person without disqualifying them from receiving government benefits in the future. Without a Special Needs Trust, when a person is receiving government benefits, an inheritance or a gift or even the receipt of a sum of money for damages in a personal injury law suit will reduce or eliminate the person’s eligibility for such benefits. With a Special Needs Trust, a beneficiary can obtain certain luxuries and other benefits without defeating his or her eligibility for government benefits. Often a Special Needs Trust will include a provision that terminates the Trust if it makes the beneficiary ineligible for government benefits.

A Special Needs Trust may be created under a revocable or irrevocable living trust, or a testamentary trust.