Introduction to Trusts and Trust Provisions - Module 1 of 6
Short Video: Documents in Planning for Disability - Living Wills, Healthcare Proxies and Powers of Attorney
Module 1: Introduction to Trusts
The Nature of the Trust Agreement
Despite complexities that can arise in the consideration, formation and drafting of the trust document, the trust arrangement is a very simple concept. A trust arrangement merely means that one person is holding property for the benefit of another.
A trust is a division of the ownership of property between its “legal” ownership and its “beneficial” ownership. The “trustee” is the legal owner of the property and he or she is merely holding the property for the benefit of the owner of the beneficial or “equitable” owners. The equitable owner of the trust property is the “beneficiary.” The person who funds the trust in the first place (who is also usually the person who creates the trust) is known as the “grantor” or “settlor.”
The trust agreement, which establishes the trust in the first place, is an agreement between the grantor and the trustee. It is a contractual arrangement whereby the grantor gives the trustee legal title to the trust assets and, in exchange, the trustee agrees to hold those assets for the benefit of the beneficiary. The beneficiary need not be (and usually is not) a party to the trust agreement.
For example, say that Joe wants to set aside $10,000 for his niece, Jane’s, education. As Jane is only 12 years old and is not capable of holding and managing the money pending its expenditure, he does not wish to give the money to Jane outright. Instead, he gives the money to his sister, Claire, who is Jane’s mother, on the condition that Claire hold the money and eventually spend it on Jane’s education. This is a classic trust arrangement, even if the parties don’t call it that.
Joe is the grantor as he is establishing and funding the trust arrangement. Claire is the trustee. She will hold the legal title to the $10,000 until it is spent. She will make decisions on where and how the money is held and when it is spent, although she is bound to spend it in accordance with Joe’s initial instructions. Jane is the beneficiary, that she is the person on whose behalf the money must eventually be spent. At this point, Jane might not even know that the arrangement exists. There’s nothing wrong with that, as beneficiaries often have no idea the trusts are being established on their behalf.
Parties to a Trust
The parties to a trust need not necessarily be individuals. Multiple parties can serve any role. Indeed, it is quite common for multiple people to fulfill each role. Spouses are often co-grantors of trusts for the benefits of their descendants. For reasons we’ll get into later, appointing co-trustees is a good way to establish checks and balances in the administration of a trust. Most trusts have multiple beneficiaries and often, the beneficiaries are not specifically defined by the trust document. For example, trust beneficiaries may be all the children of the person.
Moreover, entities such as corporations, LLC’s and other trusts can fulfill any or all these roles. It is quite common, for example, for banks to serve as trustees. Many banks even have the name “trust company” built into their names because a significant component of their businesses is to serve as trustees (for a fee, of course).
Furthermore, the same party can fulfill two or even all three roles in a trust. For example, the grantor might also serve as the trustee. This is a common arrangement for a “revocable” trust in which the grantor typically serves as trustee until his or her death or disability. Another common example is where one spouse sets up a trust with the other spouse as trustee and with the other spouse and their children as potential beneficiaries. The spouse has legal control over the trust assets and may, under certain circumstances, spend the trust assets on her own behalf.
The only exception to this principle is that the same person cannot be the sole trustee in the sole beneficiary. If this happens, the legal ownership interest of the trustee and the equitable ownership interest of the beneficiary are vested in the same person and thus “merge,” extinguishing the trust arrangement and vesting the entire ownership interest in that person.
Many states require that trust agreements be in writing to be enforceable. Other states allow trusts to be formed orally. Even in states that require trust agreements to be in writing, trusts can arise without a written agreement under some circumstances. As virtually all professionally done trusts are in writing, we will confine our discussion for the most part to written trusts.
A trust arrangement is a contract between the grantor and trustee. Since people have freedom to contract as they please, there is not much in the way of limitation of what a trust can say. Still, there are certain requirements for trusts to be valid instruments under state law.
All trusts are required to contain at least the following elements:
1. Trusts must identify the grantor, trustee and beneficiary. The grantor and trustee must be identified because they are parties to the contract. The beneficiaries can be named individually or they can be named as a class (for example, “the children and grandchildren of the grantor”).
2. The trust “res” must be identified. “Res” is the Latin word for “thing.” That is, to be valid, a trust must have something in it. It doesn’t have to be much, and more can be added later, but at the outset of the trust agreement, something must be transferred to the trust. Typically, people may transfer $10 to a trust at the outset just to ensure this requirement is met. I’ve even seen attorneys ask clients for a $10 bill to tape to the trust agreement to be completely sure. As a practical matter, it’s unlikely that a trust’s validity would be challenged under this requirement, but as they say, “better safe than sorry.”
3. The trust must contain the signature of both the grantor and the trustee. Many states require that the signature be notarized or witnessed by two witnesses, who would then also sign the document as witnesses. Backup trustees, beneficiaries and other parties potentially involved in the trust operations need not sign the document (in fact, they need not know of its existence).
Even if the formalities of trust formation are not adhered to, a trust can sometimes be inferred when justice requires. Various doctrines have been developed by case law that allow courts to establish trusts to prevent injustice. These doctrines, which go by names such as constructive trust, implied trust and resulting trust, are used when the parties intended to form trust relationships or when the situation warrants that one person should hold property for the benefit of another when no formal trust has been established.
A couple of brief examples should serve to illustrate this point:
1. imagine that John and Lisa buy a house together with their son, Don. John and Lisa contribute $200,000 towards the house’s purchase price and Don contributes $200,000 as well. Initially, the deed states that Don owns 50% of the house. To allow his parents to get a mortgage and to allow them to take advantage of certain property tax exemptions, Don transfers his interest in the house to his parents. When his parents passed away, they had never transferred Don’s interest back to him. Once aware of the entire story, a court could award Don half to house. The court would rule that the parents were holding Don’s share for him in a “constructive” trust. They hold legal title, but they were holding it for Don’s eventual benefit. This is a classic trust arrangement even though the parties may never have specified that they intended to create a trust.
2. Cindy and Marsha are partners. Together, they come across an opportunity to purchase an asset that could potentially benefit the partnership. However, because she wants all the profits are herself, Cindy purchases the asset for herself. This could be considered a breach of Cindy’s fiduciary duty of loyalty to her partner. Assume that Cindy completes the deal and earns $100,000 in profit. The court could rule that Marsha is entitled to half of that money because Cindy owed her a fiduciary duty. The court would infer the existence of a trust fund based on the legal fiction that Cindy was holding Marsha’s $50,000 for her. Again, this relationship is comparable to a trust relationship even though the parties never specified or anticipated that a trust would be created.
Types of Trusts
While there are many different types of trusts, trust can be broken down into three broad categories:
1. Revocable Living Trusts
2. Irrevocable Living trusts
3. Testamentary Trusts
A. Revocable Trusts
The most basic type of trust that exists is the revocable trust. That is not to say that revocable trusts cannot be complex. In fact, provisions in revocable trusts can be extremely complex. However, revocable trusts are basic devices because the consequences of setting up revocable trusts are reversible. Aside from the effort and expense to set up a trust in the first place, there is little or no risk in setting up and funding a revocable trust.
This is because, as the name implies, revocable living trusts can be revoked by the grantor at any time. As they can be revoked, they can also be changed, altered or modified by the grantor at any time. As such, the revocable trust is an extremely flexible device. Revocable trusts typically call for their assets to be distributed upon the death of the grantor (or grantors, as is often the case when a married couple creates a joint revocable trust). Due to this feature, the revocable trust is often referred to as a “will substitute.”
It is used as the main estate planning mechanism of a person or couple instead of or in addition to a will. Instead of executing a Will that dictates what will happen to the person’s assets upon death, the trust holds the assets during the person’s lifetime. It provides detailed instructions on how the trust assets will be distributed after death. In this way, it essentially does the same thing as a will.
There are two major advantages of a revocable living trust over a standard Will-based estate plan:
1. Avoiding Probate. Probate is a process by which a court (typically called “probate” court or “surrogate’s” court) grants permission to an administrator (often called an “executor”) to collect, administer and distribute the assets of a deceased person. That is, when a person passes away, assets such as bank accounts and real estate in his or her name cannot be accessed because the person is no longer around to direct their disposition. Displaying a death certificate or even a will is insufficient (in most cases) to force banks, brokerage firms and other institutions to allow another person access to the decedent’s property. After all, the banks have no way of knowing that the will is valid and enforceable. Therefore, after a person passes away, one needs to get official permission from the court to administer that person’s estate. The proceeding by which this is sought is called a “probate proceeding” and the document by which the court gives permission to an administrator to collect the deceased’s assets is referred to as “letters testamentary” or “letters of administration.”
The probate proceeding can be expensive and time-consuming and is public record. Because the proceeding is complex, attorneys usually need to be retained in the process can take months or even years. Probate proceedings require detailed accountings of the person’s assets. This means that posthumously, family, friends, neighbors and even strangers will be able to find out precisely the value of that person’s assets. This does not sit well with many people.
Assets that pass to beneficiaries by “operation of law” such as joint accounts, real estate held jointly, “payable on death” accounts and life insurance proceeds can be paid out without a probate proceeding. In addition, and germane to our discussion, assets held in a revocable trust do not need court permission to be distributed since they are already being held by the trustee. Even if the deceased was the initial trustee and a family member was the successor trustee, banks and institutions will usually allow the successor trustee to take over upon production of the trust document and death certificate.
So, while the execution of a will does nothing to avoid a probate proceeding, the execution and funding of a revocable trust with all a person’s assets will make a probate proceeding unnecessary.
2. Disability Planning. A good estate plan should include a mechanism by which a person’s assets can be administered during lifetime by a trusted relative or friend in the event of disability. The simplest way to do this is for the person to designate another person as his or her “power of attorney.” This is a simple document under which the signer (the “principal”) appoints an agent to act on his or her behalf for financial matters. The principal can even choose whether the agent has the authority to act on the principal’s behalf immediately (called a general durable power of attorney) or only upon disability (a “springing” power of attorney).
While powers of attorney are excellent disability planning tools, they are not always sufficient in and of themselves. To start with, some financial institutions require their own power of attorney forms and may not accept general powers of attorney. Second, requirements of powers of attorney may vary from state to state and so a financial institution in one state may not accept the standard form that works in another state. Third, powers of attorney may not satisfy title insurance companies in real estate transactions. Many title insurance companies will not consider deeds that are authorized only by general power of attorney to be marketable and insurable title.
Placing assets into a revocable trust, on the other hand, is a much more powerful disability planning tool. A trustee has legal title to the trust assets. When the grantor becomes disabled, the trustee can simply administer and distribute those assets in accordance with the trust provisions without having to worry about the weaknesses of a general power of attorney form. Even where the grantor is the initial trustee, a doctor’s note stating that the grantor is disabled is usually sufficient to allow the backup trustee to completely take over the administration of trust assets.
Despite these tremendous advantages, the revocable living trust strategy has a couple weaknesses that must be acknowledged. First, setting up and funding a revocable trust is more expensive than merely having a will drafted. A will can be drafted, executed, put away and forgotten about until the death of the testator (the person who executes the will). The revocable trust, on the other hand, must be funded to be effective. The assets of the grantor must be transferred from the grantor’s name to the trust’s name. This can be a time-consuming and tedious process, especially if the grantor has accounts with many different institutions. Without funding the trust, the document itself is meaningless as the trust only helps for assets that are titled in the trust’s name.
The more serious problem with the revocable trust is that while it’s effective, it may be insufficient to satisfy many estate planning objectives. Because the grantor has the right to revoke the trust and/or withdraw its assets at any time, for substantially all legal purposes, the assets in the trust will be considered as though they are owned by the grantor outright.
For example, for tax purposes, any income earned by the trust is considered income earned by the grantor and must be reported on the grantor’s personal income tax return (Form 1040). For estate tax purposes, the entire value of the revocable trust is considered part of the taxable estate of the grantor. Assets in the revocable trust are also susceptible to the creditors of the grantor, and if the grantor gets sued, these assets will be vulnerable to collection. For means-tested government benefit programs such as Medicaid, all the assets in the revocable trust are considered owned by an available to the grantor.
The revocable trust can serve as a will substitute, help avoid probate and improve disability planning, but it does little more than that. For more complex estate planning goals, such as creditor protection, Medicaid planning and tax planning, other devices may be necessary or advisable.
B. Irrevocable Trusts
Like revocable living trusts, the irrevocable trust is created during the grantor’s lifetime. These trusts, however, cannot be revoked by the grantor in the grantor’s ability to modify, alter or amend irrevocable trusts are usually strictly limited. The grantor can keep some control over the trust assets and the extent to which this is advisable depends on the goals of the estate plan of which the trust is part.
Irrevocable trusts have similar probate avoidance and disability planning benefits as revocable trust do, but can also achieve much more complex goals in areas of asset protection, benefits planning and tax planning. The full extent of the powers of irrevocable trusts and the ways in which to secure these benefits is the central subject of the rest of this course.
C. Testamentary Trusts
Unlike living trusts, which are contracts between the grantors and the trustees, testamentary trusts are established only upon death. A testamentary trust is established by the will of the deceased person (the “testator”). Note that while a will can distribute all assets upon the death of the testator, it can also dictate that some of the assets be held for future purposes that are specified and outlined in the will. This is the purpose and effect of the testamentary trust.
The requirements discussed earlier for living trusts do not apply. The trustee need not sign or even know of the trust at the time that the will is executed. There is also no requirement that there be a trust “res” at the time that the will is signed, as testamentary trusts, by their nature, are not funded until the death of the testator.
A testamentary trust is established during a probate proceeding. Once satisfied that the will is valid and the trust provision is enforceable, the probate judge will order that the trust be established and grant “letters of trusteeship” (the name may vary by jurisdiction) that empowers the appointed trustee with the authority to set up a trust and administer its assets. From that point on, it behaves like any other living trust.