How a Trust Works | The Advantages and Disadvantages of a Trust
When you’ve worked hard to build a significant net worth, you want to take measures to ensure that as much of your estate passes to your beneficiaries as possible. Though a will can help maximize your control over the division of your property, all assets that pass through a will must go through the probate process, which can take a fair amount of time and money (up to 7% of the value of your estate). With a trust, you can transfer property immediately, protect your assets from creditors, and avoid probate, as well as most tax consequences.
What Is a Trust?
A trust is a separate legal entity, most often created by a trust document, whereby a person or organization (known as a “trustee”) holds and manages property given by the person creating the trust (the “grantor” or “settlor”) for the benefit of either the grantor themself or other third-party beneficiaries.
Laws Governing Trusts
The formation, administration, and management of personal trusts are governed by state law, primarily in the form of statutes. Many states have adopted some or all of the provisions of the Uniform Trust Code, which incorporates the commonly accepted principles of trust law formulated over the past few centuries through the common law of England and the United States.
How Do You Create a Trust?
There are three ways that a trust may be created:
- Pursuant to a document executed by the grantor—either one that creates the trust during the lifetime of the grantor (an “inter vivos trust”) or a will or other legal document providing that the trust is created upon the death of the grantor (a “testamentary trust”)
- On the statement or declaration of a property owner that they are holding specifically identified property in trust as trustee
- Pursuant to the exercise of a power of appointment in favor of a trustee
The longstanding legal principle has been that a trust will not have legal effect until some property is conveyed to it. There is no requirement that such property have a certain minimum value.
Basic Characteristics of a Trust
The primary function of a trust is to separate legal ownership from beneficial interest. A valid trust includes three principals:
- The grantor (sometimes known as the ‘settlor’ or ‘trustor’)—the person who creates the trust, transferring their personal assets into the separate legal entity
- The trustee—the person or organization charged with managing the assets in the trust and administering the trust, ensuring that its terms are met
- One or more beneficiaries—the person(s) receiving benefit from the assets in the trust
Goals of a Trust
Trusts can have a variety of purposes. One of the primary goals of a trust is to protect assets from creditors or others who would seek access to them. A trust can also serve as an estate planning tool, helping ensure that the grantor’s estate is divided according to their wishes. Property transferred to an inter vivos trust is no longer owned by the grantor and it is entirely unaffected by the death of the grantor. Property in an inter vivos trust isn’t subject to probate and usually is not exposed to estate tax consequences.
Different Types of Trusts
Though there are many kinds of trusts to accomplish specific objectives—marital trusts, spendthrift trusts, generation-skipping trusts, charitable trusts, and special needs trusts, to name a few—all trusts are either:
- Revocable or irrevocable—A revocable trust may have its terms amended or may be revoked or terminated at any time prior to the death of the grantor. An irrevocable trust may not be changed or revoked. Because an irrevocable trust permanently transfers property, the grantor is not subject to income tax on any earnings of the trust, and the trust won’t incur estate tax liability on the death of the trustor.
- Inter vivos or testamentary—An inter vivos trust is one created either during the grantor’s lifetime, with a corresponding transfer of property. A testamentary trust is created upon the death of the grantor pursuant to the terms of their will.
Rights and Powers of a Trustee
The trustee’s rights and powers of a trustee are set forth in the trust agreement but generally include the following:
- The right to represent the trust in all legal proceedings;
- The right to manage the affairs of the trust, invest trust assets, and oversee access to trust property;
- The ability to serve as the trust’s liaison with government agencies and officials; and
- The right to prepare and convey any notifications on behalf of the trust.
Benefits of a Trust
There are many advantages to creating and funding a trust:
- Any assets in the trust pass outside of probate, thereby avoiding a process that can take months or years and be extremely expensive. In addition, the probate process is public, so anyone can look at your debts and assets; a trust, in comparison, keeps personal and financial matters private.
- You can set up provisions in your trust that limit beneficiaries’ ability to access assets or income, for example by requiring that they reach a certain age. You can also allow withdrawals only for specific purposes, like education or healthcare.
- Trusts are customarily more difficult to challenge than wills.
- With a trust, you transfer title to property to a trustee, who has the legal authority to handle your affairs in the event you have competency issues. A family member or other person may not petition the court to request the power to manage your financial affairs that are in the hands of the trustee.
Disadvantages of a Trust
From the grantor’s perspective, there are few disadvantages to creating a trust:
- There are costs associated with having an attorney draft the trust document.
- There can be a good bit of paperwork involved in transferring title to property into the trust.
- If you transfer property in and out of the trust, you’ll need to keep very accurate records.
Income Tax Implications of a Trust
The beneficiaries of a trust are typically subject to income tax on any distributions of trust income but not on distributions of principal. A trust with a large amount of assets may have additional tax consequences, so you should consult a qualified tax or estate attorney for advice.
Terminating a Trust
A trust may be legally terminated under several circumstances:
- The terms of the trust agreement—The trust document may state that the trust will automatically be terminated after a period of years or on a specific date.
- The distribution of all trust assets—Just as a trust cannot come into being until it holds assets, a trust must hold assets to remain viable. If all assets are distributed or otherwise removed from the trust, the trust will terminate.
- The trust engages in an illegal act—By law, a trust that is used for or involves the commission of a crime or any illegal activity will be terminated.
- The trustee violates their fiduciary duty—A trust may be terminated if the trustee engages in a conflict of interest, misappropriates trust assets, or otherwise violates their obligation to act in the best interests of the trust and its beneficiaries.
- A beneficiary of the trust files a legal claim against another beneficiary or against the trust—Depending on the circumstances, a court may decide that a trust should be terminated.
A trust offers considerable advantage over other forms of estate planning, allowing the owner of property to transfer assets to a separate legal entity, thereby protecting those assets from creditors, and avoiding probate and estate tax consequences.