Living Trusts in a Nutshell

Updated: Apr 5, 2019


What is a Trust?

  • A trust is an entity, similar to a corporation or a limited liability company (LLC), used for the purpose of holding and managing a person's property. It is formed under state law and has three essential persons: the grantor, the beneficiary and the trustee.

  • The grantor is the person who creates the trust (also called a settlor or a trustor). The grantor creates his/her trust by signing a written document, which explains how the trust property is to be managed and who shall benefit from the trust. The grantor then contributes property (money, stock, personal effects, and real estate) to the trust. Title to the trust property is held in the name of the trust. For example, a bank account might be held in the name of the John Doe Family Trust.

  • The beneficiary is a person who benefits from the use and enjoyment of the trust property. A beneficiary's interest is called a "beneficial interest." This beneficial interest can be either immediate or in the future or both and can be either a right to enjoy the trust income or principal or both. In contrast with a stockholder of a corporation or a member of an LLC, a trust beneficiary rarely has any voting rights.

  • The trustee manages and retains or distributes the trust property in accordance with the trust instrument. A trustee can simultaneously serve with another a co-trustee or later serve as a successor to another trustee who has died or has resigned his duties. A trustee can be an individual person or an institution, e.g. a bank or trust company. A trust will never fail for want of a tmstee. If a successor is not named, a court will appoint one.

  • The trustee and successor trustees should be persons with whom the grantor has confidence. These persons should be competent and disinterested; i.e. having no present or future interest in the trust property and capable of managing the trust property and of responding to the interests of the trust beneficiaries. For this reason, some grantors will prefer a professional trustee (a bank or trust company) in order to avoid any risk of having the trust property mismanaged or worse yet, taken by a less than partial trustee, who could favor his/her own interests over the interests of other beneficiaries! An estate planning professional should offer helpful advice in selecting trustees.

  • Like a corporation and an LLC, a trust can exist a long time. A trust will terminate when its property has been distributed, but not later than when the trust requires final distributions be made. Unlike a corporation, most states will not permit a non-charitable trust to exist indefinitely. In Montana, a non-charitable trust can exist for at least 90 years (or even longer as permitted by Montana's statutory rule against perpetuities, a rule far too complex to discuss in this article). For most non-charitable trusts, 90 years will be far longer than needed to accomplish the grantor's goals.


Living Trust vs. Testamentary Trust

  • The living trust is a trust that exists during its grantor's life. It is also called an inter vivos trust (means "among the living" in Latin). In contrast, a testamentary trust has life only when its creator dies, because the testamentary trust derives from the probate of a person's will. Many estate plans will involve either a living trust or a testamentary trust, or even both. With very few disadvantages, the living trust offers some significant advantages over the testamentary trust. The remainder of this article explains why and how these living trusts can be used in estate plans.


Revocable Trust vs. Irrevocable Trust

  • A living trust can be revocable or irrevocable. A revocable trust is similar to a person's will, because it can be changed any time before the grantor dies. The revocable trust is not a device to avoid paying the grantor's creditors. An irrevocable trust cannot be changed and is intentionally used to make permanent, irreversible gifts to individuals or charities. An irrevocable trust is typically used for making tax advantaged charitable gifts, for optimizing tax free or tax minimized gifts to heirs, and for assuring the lifetime care for a special person in need.

  • Neither the revocable and irrevocable trust can be used to circumvent paying the grantor's debts. However, both can be used to protect the interest of beneficiaries other than the grantor.

  • Most estate plans involve revocable trusts, as opposed to irrevocable trusts, since most people are not willing to give up ownership of their property until they die. The remainder of this article explains how the revocable trust can be used in estate plans.

A revocable trust cares for the grantor's

survivors & avoids probate

  • The I.R.S. disregards the revocable trust as a separate identity for tax purposes and requires the grantor to use his/her own social security number for the trust. Nevertheless, all states, including Montana, will respect a revocable trust as an entity for holding property. When a grantor dies, his/her revocable trust remains alive! On the grantor's death, the property in the trust will simply pass free of probate to its named beneficiaries (just like insurance proceeds can pass directly to a beneficiary without going through probate). To successfully avoid probate, the grantor's property must be held in his/her trust at the time of death. In contrast with the revocable trust, a testamentary trust cannot avoid probate, since it originates from the probate of a person's will.

  • In most cases, the fear of paying extravagant probate fees may be more overblown than real. Yet, it is generally easier to account for and transfer a person's property to a revocable trust during his/her life than through probate. Even though the cost of setting up a revocable trust and transferring property to it will be incurred while the grantor alive, the alternative of deferring those costs is likely to be outweighed by the costly burden of having to clean-up a person's affairs in a formal judicial proceeding (probate) after he/she has died. The revocable trust is a valid mechanism for avoiding a probate.

Warning: Probate avoidance cannot be guaranteed

  • Although probate avoidance is often sought-after, no professional can guarantee complete probate avoidance. For example, suppose a person dies in a car accident. There is no effective way to assign his/her estate's wrongful death claim to his/her revocable trust. The dying man's last dying gasp (likely out the anyone's presence) is not likely to be: "I assign all of my right, title, and interest in my estate's wrongful death claim to my revocable, living trust." Or, when a person dies while reading the winning numbers on his/her lottery ticket, did he/she remember to tell the grocery clerk that he/she had purchased the winning ticket in the name of his/her revocable living trust? Or how would a person know to assign his/her inheritance to his/her trust, when coming from a great aunt that had died a few minutes earlier? In these situations, there is little that can be done to avoid a probate. The problem of a potential probate is solved by a pour-over will, as explained later in this article.

Optimizing the estate tax exemption

with a revocable trust

  • The imposition of the estate tax falls on a deceased person's estate, which includes life insurance, IRAs, pension plans, jointly held property, assets held by a revocable trust, assets passing through probate, and various other non-probate assets. The tax is 40% of the taxable estate (the total estate less deductions for expenses, debts, qualified marital gifts, qualified charitable gifts, and the estate tax exemption). The present exemption is $5,340,000 (applicable in 2013, and an amount that changes annually and up from $5,000,000 in 2010).

  • The revocable trust (as well as the testamentary trust) can be used to minimize the imposition of federal estate tax and with properly implemented estate plans. Married persons can combine their exemptions, and thus allow a tax free passage of $10,680,000, if properly implemented. This can be accomplished through the use of the new portability rules together with properly planned spousal and non-spousal sub-trusts, (trusts within a trust).

Portability Rules:

  • Since 2010, a deceased spouse's unused exemption can be "ported over" to a surviving spouse, but only if an estate tax return is filed in the deceased spouse's estate (this is required even if the deceased spouse has no assets)! Portability elections are available to even if a deceased spouse had no assets or where a deceased spouse passed his/her assets to a spouse (which would have been a qualified tax free transfer anyway).

  • The marital sub-trust will hold property for a surviving spouse and qualifies for a marital deduction and is for the benefit of a surviving spouse. This property will pass tax free to the surviving spouse and will not be taxable in the deceased spouse's estate, but will be later taxable in the surviving spouse's estate.

  • The non-marital sub-trust (sometimes called a credit shelter sub-trust) will hold property for the benefit a spouse and/or others. This property will be taxable in the grantor's estate, but without an adverse consequences, since the assets in this trust usually are limited to the deceased taxpayer's unused exemption [which is the exemption less all tax reportable gifts were made during the grantor's life]. Any trust property in excess of the exemption will be diverted to the estate tax free marital sub-trust. This trust can be useful for parking assets that might appreciate in value after a person dies. The idea is to keep all post-death increases in asset values from bulging the size of a surviving spouse's estate. (this is called asset freezing).

  • The QTIP sub-trust ("qualified terminal interest property") holds property for the benefit of the surviving spouse and as single trust may (but does not have to) double for both the marital and non-marital trust.

  • The disclaimer sub-trust holds property for the benefit of a surviving spouse who has refused to accept all or part of a deceased spouse's outright gifts, purposely keeping property from passing over to and bunching up inside the survivor's estate; this sub-trust is particularly useful in allowing post mortem estate planning by the surviving spouse, especially considering the uncertainty of when a person is going to die in relation to the programmed changes in the estate tax exemptions.

The Revocable Trust:Equal is not always fair

  • In a revocable trust (and also in a testamentary trust), the children's and grandchildren's sub-trust (sometimes called a surrogate sub-trust) is used to protect a younger beneficiary or beneficiaries from prematurely inheriting property. A person needs to consider what happens without a surrogate sub-trust.

Often, a person without a will designates his/her spouse as the principal beneficiary of his/her life insurance and then leaves the remainder "equally to each of my children, if my spouse does not survive me." This is a poor man's estate plan. In some instances, the insured would be better off without the insurance. Why?

  • First, a young person may lack the maturity to handle large sums of money, when reaching the age of emancipation, 18 years of age. No person alive can predict how mature his/her own 3 and 5 year old children might be, when later reaching the age of 18. An unprotected gift to an inexperienced 18 year might even be used as an excuse for not having to go to college (the very reason for the gift)!

  • Second, if both parents die (e.g. in a car accident), "equal" is not always fair or what a person should really want. For example, assume it costs $1,000 per year to raise a child. An insured and his/her spouse die in an auto accident leaving 3 minor children, aged 13, 8, and 3 as equal beneficiaries of a single $30,000 life insurance policy. The 13 year old will be $5,000 ahead, when he/she reaches 18, the age of emancipation (not necessarily the age of maturity). The 8 year old will break even and the 3 year old will be $5,000 in the hole. These amounts are used for simplicity of illustration and not to suggest that a $30,000 life insurance policy would be adequate to care for such a family. Or suppose one child needs an expensive medical procedure. Would anyone write a will that reduced that child's inheritance simply because his care as a child cost more than his siblings?

  • The surrogate sub-trust can defer, slow down, or otherwise control the premature disbursement of funds to a beneficiary who might otherwise be a spendthrift, inexperienced, or imprudent with money. This sub-trust can also provide a more equitable division of benefits among a person's children or grandchildren, taking into consideration the diversity of the age, health and needs of all of the beneficiaries within the group (called a class). In solving these problems, the experienced estate planner must listen to his/her client's needs and then offer choices and recommendations. Then, the client chooses which fits his/her own needs the best.

The Revocable Trust:

Enhanced with a pour-over Power of Attorney

What if a person becomes incapacitated before his/her property has been transferred to the revocable trust?

  • This problem is solved by using a "pour-over" power of attorney, authorizing the incapacitated person's agent to transfer his/her property to the revocable trust! The pour-over power of attorney performs the same function as a pour-over will, except it has vitality while the grantor is alive as opposed to after he/she has died. In contrast with a will, a power of attorney dies, when its principal dies.


The Revocable Trust:

Enhanced with a pour-over Will

  • To protect against the unexpected possibility of a probate, a proper estate plan will include a pour-over will. The pour-over will passes all probate property into the grantor's revocable trust. This is the essential purpose of the pour-over will and assures consistency in the estate plan.


Living Wills

  • A living will is not a will. It is an important component of the estate planning. However, the living will has nothing to do with disposing of property. It is simply used to direct how a person wants to be treated by his/her physician and health care providers, when terminally ill and can authorize persons (usually a spouse or other family members) to make those health care decisions. It is simple and a good idea.

Charitable Gifts

Charitable gifts are usually more advantageous, tax wise,

if made during a person's life.

  • Charitable trusts commonly offer the donor the opportunity "to have his/her cake and eat it, too." Charitable trusts have created a whole new vocabulary of crazy acronyms; such as: the CRAT (charitable remainder annuity trust, CRUT (charitable remainder uni-trust), CLAT (charitable lead annuity trust) and CLUT (charitable lead uni-trust). Charitable trusts divide property interests in a single property between the charity(ies) and the donor, usually leaving the charity with an income interest or with a remainder interest and the donor, with the other part. These planned gifts are irrevocably made during a person's life and are too complex to discuss in this article.

  • If properly made, a charitable gift can qualify for a Montana Endowment tax credit, which can offset up to $10,000 in state income taxes for a year. To do this, the credit will equal 40% of qualified gifts from individuals and 20% of any kind of a gift from entities. In addition, the donor will receive a federal tax deduction for the same gift. In addition, if the gift is of appreciated property, the donor will often be able to deduct the full value of the gift even though the donor's tax basis is substantially lower. For example, a donor may have paid $1,000 for Microsoft stock now worth $25,000. The donor will not have to pay income tax on the $24,000 capital gain but still be entitled to deduct the whole $25,000. If the gift is structured to qualify for a Montana Endowment tax credit, a donor could end up getting a tax benefit back as much as 80% or more of the donated property!

  • There are other kinds of non-charitable trusts, too. The generation skipping trust or sub-trust is used to bypass at least one generation of heirs and to avoid one or more generations of estate taxes. The GRIT (grantor retained income trust) is designed to downsize the taxable value of taxable gifts in very large estates. The Crummey trust (named after Mr. Crummey) is not crummy, but in fact very useful for making tax excludable gifts that protect premature distributions to younger beneficiaries. However, the "Offshore" trust can be a legitimate entity, but is not a legitimate device to escape income tax. Read "Don't believe in the tax fairy" in "Your Turn" of the Independent Record on 2/13/2003. The "business" trust is a legitimate entity, but is far less favored than the LLC and the corporation for conducting an active trade or business (in Montana a "business" trust is treated like, and presumably taxed like a corporation)!


In Conclusion

Although some people perceive the living trust to be a tool of the rich and only for those who can afford pricey lawyers, that perception is incorrect. Contrary to this common misconception, an able estate planner should and will seriously consider a revocable trust as the centerpiece of his/her client's estate plan. But a good estate planner will want to spend time with his/her client, gathering essential information and analyzing his/her client's needs. This process could take several meetings and will likely require the client to do some homework. Bottom line, a good estate planner will not try to fit everyone in the same size shoe. Cheap estate plans do. Cookie-cutter estate plans and mail-order, computerized software programs will likewise fail to provide the needed wisdom and insight that an experienced estate planner can offer. A conscientious person will want to wear a "shoe that fits." That person should give serious thought to using the living trust in implementing his/her own successful estate plan.

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