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Trusts

Perhaps the most popular and versatile estate planning tool is the trust. A trust is an arrangement that splits a property’s legal title from the benefits of ownership. The person establishing the trust is the grantor (or settlor). A trustee holds legal (nominal) title to the assets and manages them according to the trust document. The beneficiaries enjoy the benefits of the trust property (beneficial ownership).

The grantor vests the trustee with specific powers to manage property and make distributions. The grantor may also serve as the initial trustee and primary beneficiary during their lifetime — a flexibility that makes trusts particularly powerful for large or complex estates.

Duties & Powers of the Trustee

The trustee manages trust property on behalf of the beneficiaries and owes them a fiduciary duty. Primary obligations include:

  • Carry out the terms of the trust — this duty cannot be delegated
  • Exercise reasonable skill and care (the prudent person standard)
  • Act with undivided loyalty to the beneficiaries; cannot show favoritism
  • Keep trust property separate from personal assets (no commingling)
  • Exercise only the powers specifically granted by the trust document

Common powers granted to a trustee include: collecting trust property and receiving additional contributions; settling claims; suing and being sued; acquiring, managing, and selling property; borrowing money and pledging trust assets as collateral; entering into contracts; and making income payments and principal distributions to beneficiaries.

Types of Trusts

Revocable Living Trust
Created during grantor’s lifetime; grantor retains right to alter, amend, or cancel. Avoids probate but provides no estate or income tax benefits — treated as grantor’s property for all tax purposes.
Irrevocable Living Trust
Created during grantor’s lifetime; cannot be altered or revoked. If properly structured, can provide income, gift, and estate tax benefits at the cost of permanent loss of control.
Testamentary Trust
Created by the testator’s will after death. Always irrevocable. Does not avoid probate (property must pass through the estate first). Useful for long-term asset management.
Pour-Over Trust
Living trust funded at death by a pour-over will. Unifies administration of the total estate; provides privacy for the ultimate disposition of assets outside probate’s public record.

Living Trusts — Probate Avoidance

All trusts created during the grantor’s lifetime share one major advantage: property placed in a living trust avoids the probate process at death. The trust continues to operate after the grantor’s death, eventually passing property to beneficiaries named in the trust. Benefits of living trusts include:

  • Elimination of probate costs on property passing through the trust
  • Avoidance of delays — the trust continues uninterrupted by the grantor’s death
  • Avoidance of ancillary probate in other states for out-of-state property held in the trust
  • Property transfers take place privately — outside the public record of probate
  • Trust distributions are more difficult to contest than will bequests
  • Creditors cannot attach trust property for claims arising after the trust’s creation

Revocable Living Trusts

The revocable living trust offers all of the probate avoidance benefits above, plus the flexibility to alter the trust’s terms as circumstances change. The grantor can cancel the trust entirely and reclaim the property at any time.

Tax treatment: because the grantor retains control, the IRS treats the revocable trust as a grantor trust — all income earned by the trust is taxable to the grantor. There are no income tax advantages. Property placed in a revocable trust is not a completed gift (the grantor did not relinquish control), so it does not qualify for the annual gift exclusion. The trust property also remains in the grantor’s taxable estate. In short, the revocable living trust avoids probate but provides no tax benefits.

Irrevocable Living Trusts

An irrevocable trust sacrifices flexibility for tax benefits. If the grantor truly relinquishes control and receives no benefits from the trust, significant advantages become available:

Income tax: if the grantor holds no retained interests or powers over the trust, the IRS treats the trust as a separate taxable entity. Income distributed to beneficiaries is taxed to them; income accumulated within the trust is taxed to the trust. This may allow income shifting to beneficiaries in lower tax brackets. Note: trusts reach the highest income tax brackets at very low income levels, so the tax benefits of accumulation within the trust are limited.

Gift tax: funding an irrevocable trust is a completed gift — subject to gift tax. Gifts to an irrevocable trust are generally future interests and do not qualify for the annual exclusion unless a Crummey power is included (discussed in Module 1). The IRS provides tables to determine what portion of a gift qualifies as a present interest if the trust distributes current income to beneficiaries.

Estate tax: if the grantor retains no incidents of ownership, control, or right to income, the trust assets are excluded from the grantor’s taxable estate. The grantor’s estate includes trust assets if the grantor retained any right to alter or revoke the trust, any right to income, any power of appointment, any reversionary interest exceeding 5%, or any direct or indirect control over the property.

Life insurance in irrevocable trusts: Life insurance policies transferred into an irrevocable trust may still be included in the grantor’s taxable estate if the policy was transferred within three years of death, or if the grantor retained any incidents of ownership after the transfer. For this reason, it is generally preferable to fund insurance trusts with newly purchased policies rather than transfers of existing policies.

Testamentary Trusts

A testamentary trust is created by a provision in the testator’s will and takes effect after death. All testamentary trusts are irrevocable. Unlike irrevocable living trusts, they do not avoid probate or provide significant tax savings — the property must pass through the probate and taxable estate first. However, testamentary trusts are well-suited for long-term asset management needs: providing for incapacitated family members, continuing operation of a family business, or distributing assets to young beneficiaries over time without keeping the probate estate open indefinitely.

Pour-Over Trusts

In a pour-over arrangement, the estateholder creates a living trust during their lifetime (revocable or irrevocable). Upon death, the testator’s will directs that assets in the probate estate pour into the trust rather than passing to individual beneficiaries. This is a pour-over will. Benefits include:

  • Efficient handling of the residual estate and avoidance of partial intestacy
  • Unified administration of the total estate through one document
  • Privacy — the trust document specifying ultimate disposition is not part of the public probate record
  • The trust may also accept life insurance death benefits and retirement plan distributions, providing comprehensive administration of the entire estate

Spray / Sprinkling Trusts

Some trusts grant the trustee discretion over the amount and timing of distributions, or the ability to select which beneficiaries receive a distribution — these are spray or sprinkling trusts. This allows the trustee to apportion distributions to meet each beneficiary’s individual needs and tax circumstances. Because the value of the present interest cannot be determined (it is at the trustee’s discretion), property placed in a sprinkling trust does not qualify for the gift tax annual exclusion.

Power of Appointment

A power of appointment is a right granted to one person (the donee) to direct who will ultimately receive property held by another (the donor). Powers of appointment arise in trust documents or wills to add flexibility to a plan.

General Power of Appointment
The donee has total discretion, including the ability to name themselves as recipient. Treated as equivalent to outright ownership. Adverse estate tax consequence: any property subject to a general power of appointment at the donee’s death must be included in the donee’s taxable estate.
Special (Limited) Power of Appointment
The donee may only name recipients from a list specified by the donor; the donee cannot name themselves. If properly drafted, trust property subject to a special power is not included in the donee’s taxable estate. Not subject to gift taxation.
Rule Against Perpetuities: Common law prohibits trusts with an infinite lifespan. Most trusts must terminate no later than the lifetime of a person alive at the time of the trust’s creation, plus 21 years. One exception: charitable trusts may have a perpetual or indefinite lifetime. The rule is highly complex; expert legal advice is required for trusts designed to distribute property far into the future.
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