Estate planning involves many considerations and various legal devices to make sure your heirs (beneficiaries) receive your property according to your wishes. This pamphlet is intended to provide you with general information about trusts, a popular - but sometimes complex - estate planning tool. The contents are based on trust statutes of the state of California, which were modified in 1984, and on the Tax Reform Act of 1986.

Defining a Trust

A trust is an agreement under which money or other assets are held and managed by one person for the benefit of another. Different types of trusts may be created to accomplish specific goals. Each kind may vary in the degree of flexibility and control it offers.

The common benefits that trust arrangements offer include:

  • Providing personal and financial safeguards for family and other beneficiaries
  • Postponing or avoiding unnecessary taxes
  • Establishing a means of controlling or administering property
  • Meeting other social or commercial goals

Creating a Trust

Certain elements are necessary to create a legal trust, including a trustor, trustee, beneficiary, trust property and trust agreement.

The person who provides property and creates a trust is called a trustor. This person may also be referred to as the "grantor," "donor" or "settlor."

The trustee is the individual, institution or organization that holds legal title to the trust property and is responsible for managing and administering those assets. If not designated by name, a trustee will be appointed by the court. In some cases, a trustor can serve as the trustee. It is also possible for two or more trustees to serve together, or for both an individual and an organization to act as co-trustees. Separate trustees may also be named to manage different parts of a trust estate.

The beneficiary is the person who is to receive the benefits or advantages (such as income) of a trust. In general, any person or entity may be a beneficiary, including individuals, corporations, associations or units of government.

To be valid, a trust must hold some property to be administered. The trust property may be any asset, such as stocks, real estate, cash, a business or insurance. In other words, either "real" or "personal" property may constitute trust property (which may also be called the "trust corpus," "trust res," "trust estate" or "trust principal"). Trust property may also include some future interest or right to future ownership, such as the right to receive proceeds under a life-insurance policy when the insured dies (discussed under "Insurance Trusts"). Property is made subject to the trust by transfer to the trustee, commonly called a "gift in trust."

The trust agreement is a contract that formally expresses the understanding between the trustor and trustee. It generally contains a set of instructions to describe the manner in which the trust property is to be held and invested, the purposes for which its benefits (such as income or principal) are to be used, and the duration of the agreement.

Trust agreements may be expressed in writing, by oral agreement or may be implied, and the trustor usually has considerable latitude in setting the terms of the trust. To be enforceable, a trust involving an interest in land must be in writing.

Types of Trusts

Many kinds of trusts are available. Trusts may be classified by their purposes, by the ways in which they are created, by the nature of the property they contain, and by their duration. One common way to describe trusts is by their relationship to the trustor's life. In this regard, trusts are generally classified as either living trusts ("inter vivos" trusts), or testamentary trusts.

Living trusts are created during the lifetime of the trustor. Property held in a living trust is not normally subject to probate (the court-supervised process to validate a will and transfer property on the death of the trustor). In California, because such property is not subject to probate, it need not be disclosed in the court record and confidentiality may be maintained. Such trusts are widely used because they allow the trustor to designate a trustee to provide professional management.

Under some circumstances, living trusts will allow income to be taxed to a beneficiary and result in income tax savings to the trustor. However, it should be noted that income earned by a trust established for a beneficiary under the age of 14 may be taxed at the beneficiary's parent's tax rate. The transfer of property to a living trust may also be subject to a gift tax.

Testamentary trusts are created as part of a will and must conform to the statutory requirements that govern wills. This type of trust becomes effective upon the death of the person making the will (the "decedent") and is commonly used to conserve or transfer wealth. The will provides that part or all of the decedent's estate will go to a trustee who is charged with administering the trust property and making distributions to designated beneficiaries according to the provisions of the trust.

Before the trust property becomes subject to the testamentary trust, it will normally pass through the decedent's estate. When the estate is probated, those trust assets will be subject to probate. The assets, which will form the corpus of a testamentary trust, also are potentially subject to an estate and generation-skipping transfer tax at the time of the decedent's death.

A testamentary trust gives the trustor substantial control over his or her estate distribution. It also may be used to achieve significant savings in the future. For example, by using a testamentary trust, a trustor can provide for a child's education or can delay the receipt of property by a child until the child gains financial maturity. Moreover, given the proper form of trust, property may be exempted from death taxation on the later death of a trust beneficiary. However, a generation-skipping transfer tax may still apply.

Living Trusts

Living Trusts can be "revocable" or "irrevocable." The trustor may change the terms or cancel a revocable living trust. Upon revocation, the trustor resumes ownership of the trust property.

In general, a revocable living trust is used when the trustor does not want to lose permanent control of the trust property, is unsure of how well the trust will be administered, or is uncertain of the proper duration for the trust. With a properly drafted revocable trust, you may:

  • Add or withdraw some assets from the trust during your lifetime
  • Change the terms and the manner of administration of the trust
  • Retain the right to make the trust irrevocable at some future time

The assets in this type of trust will generally be includable in the trustor's taxable estate, but may not be subject to probate.

An irrevocable living trust may not be altered or terminated by the trustor once the agreement is signed. There are two distinct advantages of irrevocable trusts:

The income may not be taxable to the trustor; and The trust assets may not be subject to death taxes in the trustor's estates. However, these benefits will be lost if the trustor is entitled to (1) receive any income; (2) use the trust assets; or (3) otherwise control the administration of the trust in a manner that is inconsistent with the requirements of the Internal Revenue Code.

Since a will may be revoked or amended at any time prior to death, a testamentary trust may be changed or canceled. Revisions can be made by drafting a new will or by using a simple document called a "codicil" to make changes or additions to your will. However, to be effective, any such modifications must be executed in the same manner required for wills. The trust instrument should be explicit regarding revocability or irrevocability. If it is not, the trust will be considered irrevocable.

Establishing a Trust

Depending on a number of circumstances, trusts may be established orally, in writing or by conduct. Most trusts involve a number of technical legal concepts relating to ownership, taxes and control. We can assist in explaining options, considering contingencies and preparing documents.

In creating a trust, you should consider several factors and obligations, including:

  • Your personal situation, including age, health and financial status
  • Your family relationships and your family's financial circumstances
  • Personal financial data: personal property, real estate holdings, securities, and other property -- as well as your tax situation and any debts or obligations
  • The purpose of the trust: your goals, or what you hope to accomplish by the arrangement
  • The type of trust, and how versatile or flexible your plans are
  • The amount and type of property it will contain
  • The duration, or how long the trust will last
  • The beneficiaries and their specific needs
  • Any conditions that must be met by a beneficiary to receive benefits (such as attaining a certain age)
  • Alternatives for disposing of assets in case the trust conditions are not met or circumstances change
  • The trustee, and the conditions or guidelines under which he or she will function

Dependency exemptions, capital gains and losses, income, gift, estate and generation-skipping transfer taxes also should be considered when planning certain types of trusts. Likewise, you may want to think about naming alternative or contingent beneficiaries and trustees.

Once a trust has been established, a periodic review of the status of the trust is advisable; you may want to obtain professional assistance appropriate to the requirements of the trust.

Duties and Obligations of a Trustee

A trustee (whether an individual or institution) holds legal title to the trust property and is given broad powers over maintenance and investment. To ensure that these duties are properly carried out, the law requires that the trustee act in a certain manner. In general, a trustee must:

  • Act in accord with the express terms of the trust instrument
  • Act impartially, administering the trust for the benefit of all trust beneficiaries
  • Administer the trust property with reasonable care and skill, considering both its safety and the amount of income it produces
  • Maintain complete accounts and records
  • Perform taxpayer duties, such as filing tax returns for the trust and paying required taxes

The trustee must administer the trust property only for the designated beneficiaries and may not use trust principal or income for his or her own benefit. In other words, a trustee is usually prohibited from borrowing or buying from the trust, from selling his or her own property to it, and from using the trust assets as collateral for a personal debt.

In selecting a trustee you should consider the potential trustee's competence and experience in managing business or financial matters and the potential trustee's availability and willingness to serve.

Individuals and certain corporations (or a combination of both) may serve as trustee. Each selection offers distinct advantages and drawbacks that should be considered. For example, an institution, such as a bank, usually offers specially trained managers to provide administrative, counseling and tax services. Other typical advantages include the institution's continuity and reliability of service, and its ready availability. Most banks charge a fee for trust services, and some may not want to manage small trusts, so you may want to compare options.

As an alternative, an individual, such as a relative, family friend or business associate, may serve as trustee. An individual, unlike an institution, may be willing to serve for little or no fee. Furthermore, this person could add a more personal touch for special understanding to the needs of the beneficiaries. However, you will want to be certain that any nominated individual has the skill and experience necessary to properly manage the trust property.

Insurance Trusts

Insurance trusts may take various forms, such as business insurance trusts (which may be used to protect the "key men," proprietor or partners of a business), or personal insurance trusts (which involve no business interests). These types of trusts are usually intended to provide assistance in the management of insurance proceeds from estate taxation. Insurance trusts may be revocable or irrevocable, and various types of agreements are available to accommodate an individual's circumstances and desires, or the requirements of a business.

Another form of insurance trust is the life-insurance trust. This trust, similar to a living trust, is created to receive proceeds payable under a life-insurance policy. It is normally established to exclude those proceeds from taxation in the decedent's estate. A life-insurance trust can also be used to provide a vehicle for continued management and distribution of insurance proceeds for a beneficiary who may need assistance in those matters.

To obtain the tax benefits of having the proceeds excluded from the decedent's estate, it is imperative that the insured divest himself or herself of all interest in the policy, and place those rights in the hands of the trustee. For this reason, it is preferable to have an individual other than the insured act as trustee.

This type of trust cannot be revocable, and the insured cannot retain any right to trust income. To ensure the tax advantages are retained, it is important that the document be properly drafted. The tax rules in this area are quite complex, so professional legal assistance may be helpful in the preparation of such a document.

Charitable Trusts

A charitable trust is also called a "public trust," because it benefits immediately or eventually, members of the general public through charitable means. It can offer many tax advantages to the trustor not available to other "private" trusts. Unlike private trusts, it can be established to last indefinitely.

Although sometimes complicated in their arrangement, charitable trusts offer considerable flexibility in providing benefits from the trustor or other trust beneficiaries, while at the same time meeting charitable goals. Charitable trusts must be carefully drafted, however, to ensure advantageous tax treatment. A commonly used charitable trust is the "charitable remainder trust."