What is a Trust?
A trust is a relationship in which A (variously called the trustor, settlor or grantor) gives property to B (the trustee), to own and manage for the benefit of C (the beneficiary). There may be multiple persons wearing a hat, and a person may wear more than one hat. B is legally the owner of the assets comprising the trust, but he has an obligation to use them for C's benefit.
Example: A gives B money to invest and pay the income to C for life. At C's death, the principal goes to D (could be C's children). Notice that there's already a potential strain in the existence of two different beneficiaries -- C and D. If B invests primarily for high income, perhaps risking principal, or not getting growth of principal, he may be violating his fiduciary duty to D. On the other hand, if he invests primarily for growth and has low income, he is violating his duty to C. (hint -- violating his duty may mean he gets sued by the injured party).
The trust may provide that C gets the principal at 40 -- or 30 -- or part at 30 and the rest at 40. Etc., etc., and so forth.
It's More Than a Tax-Saving Device
Congress may have done the middle class a disservice with its tax cutting. 30 years ago, if a couple had $70,000, they faced potential estate tax. Trusts were used to reduce the tax. Along the way, they got management of assets, protection from creditors, and delayed distribution until beneficiaries were old enough to handle money. Today, there is no potential federal estate tax until the estate passes $1,000,000 [actually, it varies by years. Those non-tax issues may still be present, but without tax saving people don't look at trusts.
Let me direct a simple question at parents of teenagers or younger:
Does Congress's decision not to tax estates under $1,000,000 make *your* teenager able to handle $1,000,000 at 21? Does your children's maturity vary according to Congressional tax levels?
Without taxes, there are still major issues to deal with.
How are They Created?
There may be circumstances in which the relationship of the parties and facts may create a trust relationship. For the most part, trusts arise under documents, and those documents set out the rules and principles of the particular trust. Although there are broad statements of law concerning trusts, the underlying principle of most of them is -- this is what happens if the document doesn't cover the subject. The document can negate most general rules.
A may transfer assets to B to create a trust during A's lifetime -- an inter vivos trust. The trust may be revocable or irrevocable.
Or A may leave assets under his will -- a testamentary trust.
Or A may set out the terms of a trust to take effect at his death -- the variations of the living trust or pour-over trust.
Standards
Not only does the trustee need guidance in weighing the respective interests of C and D for investment purposes. The trust may also provide that the trustee has discretion in payments. Perhaps he has discretion in whether to pay any income. Perhaps he's required to pay all income, but has discretion to pay principal sometimes.
Now realize that whatever he *doesn't* pay to C will be left to go to D. Therefore, every time he exercises his discretion in favor of paying money to C, he's potentially taking money from D's pocket. So D may have the right to sue him for doing so. On the other hand, C may have the right to sue him for not doing so. So the trustee wants to look for standards -- wording in the document that tells him under what conditions he may distribute.
For example, the document may say to distribute for medical emergencies. It may say for support. These are terms which are often referred to as ascertainable standards -- there is enough legal background on the use of these terms that a court can say whether particular actions fit within the terms. Even then, there's usually a broad range of discretion left to the trustee. He might be able to distribute between $1,000 and $5,000. C might not be able to compel more than $1,000 -- D might not be able to compel less than $5,000. In between is the trustee's call.
On the other hand, there are terms like "welfare", "comfort", "best interests" in which the courts say, in effect, "the trustor left it up to the trustee, not to us -- he used broad terms to give the trustee broad discretion". So the trustee might be unlimited in how high he can go, and D unable to stop him. Although this has sometimes also meant he was unlimited in how low he could go, in recent years courts have tended to enforce some degree of minimum distribution when the beneficiary needed it.
The Power of Appointment
The power of appointment is one of the most powerful instruments in estate planning. Simply put, a power of appointment is the right to tell the trustee to pay money from the trust to someone.
To whom? That is the question. How to exercise? That is a secondary question.
Example: we said that at C's death the principal would go to D. But C might be given the power to appoint (perhaps a portion of ) the trust among his descendants by will. Thus, even if there are multiple Ds, all C's children, C can vary their shares. This is the minimum power which I strongly recommend, because it gives C a chance to see what the respective needs of his children are. It gives him a chance to adapt the trust for the needs of his family.
Going further, C might be given a power to appoint during life as well as at death.
he tax effects, and implications, are discussed elsewhere.
The Range of Possibilities
On the one hand, a trust could be created in which B, the trustee, has complete discretion whether to pay any income or principal to the beneficiary, with the beneficiary having no say at all.
On the other hand, a beneficiary can have all the income for life (for various reasons discretion is better);
principal as the trustee determines necessary for their health, education, maintenance and support;
be, or have the right to name [including unrestricted power to change], the trustee who determines what is necessary for their health, education, maintenance and support;
have the right to name [including unrestricted power to change] the trustee who determines what is necessary for their or their dependents best interests;
have a "quasi-general" power of appointment -- a right in life or at death to appoint to anyone other than themselves, their estate, their creditors, or the creditors of their estate;
all of this without inclusion in their estate, without being subject to the claims of their spouse or creditors.
And these differences can be varied over time and circumstances.
Consider This Possibility:
Until C reaches 21, the trustee pays out income or principal as needed.
After 21, C gets all income -- trustee has discretion on principal.
At 25, 30 and 35 parts of the trust are distributed to a second trust C controls.
When C gets a degree, or an advanced degree, she gets an advance distribution -- educational incentive.
The trustee may advance C money to buy a home, go into business, pay for a wedding.
Who Should You Name as Trustee?
That depends. As noted, the beneficiary can be trustee if you want to give them great flexibility. If you don't want to go that far, you can choose among family members, friends, etc. Realize that while you may trust X's honesty -- do you trust their business or investment judgment? Do you trust their discretion on distributions? Is it fair to burden them? How long will they be around? You may find multiple trustees, with responsibilities in different areas, desirable.
In some cases. a corporate trustee may be appropriate. They can provide long term stability and investment expertise. I have often found the combination of a corporate trustee and an individual trustee very useful. The corporate trustee can handle the investments and the minutiae and paperwork. The individual may have a better feel for your desires, the circumstances under which you would want discretionary distributions. And the individual can be given power to change corporate trustees in dissatisfied with their performance.
An Illustrative Case
I like to use John Doe as an illustration of the possibilities and choices in a "simple case". John had four sons (adults to teenagers) by his first marriage. He loved and wanted to provide for his second wife, as well as his children. He had enough to leave the non-marital amount to his children (see below) and the marital portion in trust for his wife.
His wife will receive the income for life. But there were two minimums established -- if the income wasn't enough, payments would be made from principal. One minimum was that the trust must annually pay at least X% of the value as of the previous December 31. It must also pay at least $Y per year -- and $Y is to be annually adjusted for inflation. The trustees are a corporate trustee, his wife and one of his sons. The individual trustees together may change the corporate trustee but must always have a corporate trustee.
At his wife's death, the marital trust goes to his sons, as did the non-marital portion -- but in each case only to two of them. It's not that he doesn't love the other two. One has been very successful financially and doesn't need it. The other is a Jesuit priest under a vow of poverty. The client's comment: "if I want to leave it to the Church, I'll do it directly" (actually, there is also a large charitable gift, but that's a side matter). However, I pointed out that these days many priests do leave the priesthood. If he has left the priesthood before division, he shares in the division. If he does so afterwards -- well, his father did his best.
When the two sons get their shares, they're in trust with phased distribution as they mature -- and when they do get control, it remains in trusts they control rather than outright.
Whose Money is it, Anyway?
This can be both a legal and a psychological issue.
Let's remember that this started off as A's money. He didn't give it to C -- he gave it to B as trustee. It doesn't belong to C. It is no more C's money than is the money in X's bank account, or Z's stock portfolio. Therefore, as a general rule -- except as special legislation covers the subject -- it's not treated as C's money. It is not included in C's estate at death, it isn't his property to be claimed by his spouse on his divorce, it isn't subject to the claims of his creditors. And so C may be better off for not receiving the money outright -- especially if he can have some degree of control over it.
It is also a psychological issue. From A's standpoint -- is it his money, which he is continuing to control (whether during life with a friendly trustee or from the grave) -- or is it C's money which he is retaining in trust just for C's protection from taxes, spouse and creditors, but he is willing to give C control? There is no right answer, and it need not be all or nothing. But this is the psychological choice that may govern the drafting, and require a balancing act.
How Long Can a Trust Last?
By traditional common law, a trust would have to end within a period of "a life in being" plus 21 years. While the life in being did not really have to relate to the beneficiaries (at the turn of the century there were documents drawn relating to every living descendant of Queen Victoria [the theory being that this was a well known enough group to keep track of] they usually do. This is known as the Rule against Perpetuities. Thus a man in his 80's could have great grandchildren. He could set up a trust to pay income to his children for their lives, to his grandchildren for their lives, to his great grandchildren for their lives, and then to his great great grandchildren, but terminating 21 years after the death of his last great grandchild [and then distributed outright].
A number of states have begun to abolish the Rule, or allow persons to opt out of them. Illinois, for example, has enacted legislation allowing trustors to elect not to have the rule apply. Such trusts could theoretically go on forever. For very complicated reasons relating to other legal issues, I believe a termination date is necessary. I've adopted 500 years for the trusts I create.
Irrevocable Insurance Trust
The irrevocable insurance trust is a tax-oriented planning tool. If analysis indicates potential estate tax, it should be the first tool considered by an individual, the second by a couple after appropriate use of the credit shelter. See Tax-saving Estate Planning
Insurance plays an important role in many estate plans. It may provide liquidity for a family and estate to enable family support. In larger estates, it may be purchased as a potential resource for paying estate taxes.
Yet insurance over which you have "incidents of ownership" will be included in your estate (See The Federal Estate Tax). Therefore, as much as half such insurance may be used to pay the tax thereon, cutting its effectiveness.
One solution used to be to have the insurance owned by your spouse. Even in the past, it was not as effective as the irrevocable insurance trust, since the proceeds wound up in your spouse's estate. Today, with an unlimited marital deduction, that accomplishes no more than to name your spouse as beneficiary of your insurance.
You might have the insurance owned by your children or other beneficiaries. Not only does this lose the opportunity to provide trusts for the benefit of your family (See An Introduction to Trusts and Give the Advantages of Trusts. It provides potential conflicts unless owned in the same proportion as the benefits of your estate plan, and opens multiple doors for confusion.
Give the Advantages of Trusts
I'll give you a choice.
I'll give or leave you $1,000,000 (remember, this is all hypothetical for illustration purposes only!).
You can have it in your own pocket. At your death, it will be subject to estate tax. If you have marital problems, your spouse may have a claim on it. If you run into financial troubles, your creditors can go after it. If your kid has an accident while driving your car, the injured parties can go after that money.
Alternatively, I'll put it in trust. It's not yours. It can pass tax-free at your death. Your creditors can't get at it. If you have financial losses, it's there to give you a fresh start.
Which would you prefer? And which would you prefer to provide for your beneficiaries?
Well, you may respond, granted that a trust doesn't have some of the disadvantages (which you hadn't realized existed) of owning the money directly, are the *benefits* comparable? It doesn't do any good to keep the money away from IRS or creditors if it can't be affirmatively used for the beneficiary.
Aside from a QTIP deducted by one spouse and included in the survivor's estate, a trust created by A will only be included in C's federal estate if C is given a general power of appointment. No other restrictions on C's power are required for federal tax purposes. A may want to put on other restrictions for non-tax purposes (see Introduction to Trusts), but they are not required to avoid taxation.
A beneficiary can have:
all the income for life (for various reasons discretion is better);
principal as the trustee determines necessary for their health, education, maintenance and support;
be, or have the right to name, the trustee who determines what is necessary for their health, education, maintenance and support;
principal as the trustee determines necessary for their "best interests";
have the right to name [including broad power to change, but not be themselves] the trustee who determines what is necessary for their or their dependents best interests;
have a "quasi-general" power of appointment -- a right in life or at death to appoint to anyone other than themselves, their estate, their creditors, or the creditors of their estate;
all of this without inclusion in their estate.
On the other hand, a trust could be created in which B, the trustee, has complete discretion whether to pay any income or principal to the beneficiary, with the beneficiary having no say at all.
And these differences can be varied over time and circumstances.
Now let's look at the real-life practical consequences of giving a beneficiary a "quasi-general" power of appointment and making them trustee.
The trust will not be included in C's estate when he dies. It will not be subject to the claims of his spouse upon divorce, and it will not be subject to claims of his creditors.
Does he want a house? The trust can buy a house for him to live in, still without putting it into his name.
In many cases, a beneficiary can benefit without ever taking a dime from his trust. Think how much saving is done as protection from a "rainy day". But how much more can you afford to spend, how much can your living standard be increased, if you know there's an umbrella in the closet?
Suppose C insists on getting money out of the trust, other than regular distributions. She can appoint part or all of the trust to another trust for Y (if it were outright, then Y would later make a taxable gift), whom she trusts to then appoint to her. And if she's hesitant about Y, she can appoint 10% to Y, and only appoint the next 10% after Y has acted.
Remember that C can have a power to appoint to himself if it's for his health, education, maintenance and support. Theoretically if he exceeds those standards D can sue to stop him. Now suppose D comes to C and says "Dad, grandpa A [or Mom, Dad] said that you could use the trust for your health, education, maintenance and support. I really don't think that includes monthly trips to Acapulco."
To which C replies "you may be right, son. You might be able to sue to stop me from that spending. Just remember that I decide who gets what's left at my death. Now [assuming three children] -- do you want 1/3 of the pie that's left after my trips, or none of a large pie without trips?"
From this concept, you can play continuing variations. If, for non-tax reasons, you want more restrictions on the beneficiary, you can give those powers to outside trustees who can provide similar benefits without giving control to the beneficiaries. And the shadings are innumerable.
The real limitations are not legal but human. You cannot give a beneficiary virtually unlimited control -- and try to restrict them. Are you afraid they'll give some to their spouse rather than their descendants (your descendants)? Then you have to tie them up, restrict their powers of appointment, and face potential resentment from them. If you want to go through that, there are ways to find intervening points.
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