Trusts are described in multiple ways, including: living or testamentary, revocable or irrevocable and grantor or non-grantor. These terms are not always mutually exclusive. A trust can be living, revocable and a grantor trust all at the same time. Other trusts can be living, irrevocable and either grantor or non-grantor.
In this installment in our trust series, we will shed some light on the meaning of these different ways we refer to trusts. In the third and final installment, we will describe some of the different kinds of trusts.
Strictly speaking, a “living trust” refers to any trust that is established by an individual, known as the settlor, while the settlor is alive. This type of trust is also known as an “inter vivos” trust.
However, the term “living trust” most commonly refers to a trust that is created by the settlor during their lifetime and which is revocable during the settlor’s lifetime, is controlled by the settlor and is the central document in the settlor’s estate plan. Although a settlor of a revocable trust also will have a will, the living trust is the document that sets forth the settlor’s plan for disposing of assets following death. For this reason, we sometimes refer to the living trust as a “will substitute.”
An important reason for creating and funding this kind of living trust during the settlor’s lifetime is that assets held subject to the living trust are not subject to the probate court’s process following the settlor’s death. Instead, if there are no assets subject to probate, the trustee of the living trust is responsible for settling the decedent’s affairs and making distributions in accordance with the terms of the trust.
Using a trust to skip the probate process can save money and possibly time for the settlor’s heirs. And, because probate court proceedings are a matter of public record, using a trust also provides privacy for the family and their assets.
Testamentary Trusts
A testamentary trust is a trust created under the terms of a person’s will and takes effect after the will has been admitted to probate (i.e., recognized by the probate court as the decedent’s “official” will). Because these trusts are created after the death of the testator (the person whose will is in question), the trusts will be created and funded as part of the probate process for the estate. A will can create testamentary trusts that serve some of the same purposes as the kinds of trusts created under the terms of an agreement establishing a revocable trust.
During the settlor’s lifetime, the settlor can change the terms of the testamentary trust, just as they can with a revocable trust. The settlor simply amends the existing will or revokes the old will and creates a new one.
In some parts of the country (New York, for example), living trusts are used infrequently and testamentary trusts are very common. In Michigan, however, the custom has evolved to create living trusts; the will simply “pours over” the assets of any probate estate to the trust.
Revocable Trusts
Trusts created by the settlor during their lifetime can be created as revocable or irrevocable trusts.
A revocable trust allows the settlor to act as the trustee and manage the assets. Because the settlor retains a power to “revoke” or dissolve the trust during the settlor’s lifetime, assets in this type of trust are still considered the property of the settlor. The trust’s assets are subject to estate tax if the settlor’s gross estate is large enough to be taxable. Income earned from the assets in a revocable trust is also taxable to the settlor.
In addition to the ability to revoke the trust during the settlor’s lifetime, a settlor also can amend or change the trust terms for any reason, including to add or remove beneficiaries, change a trustee or change trust provisions. Note that you don’t need to legally amend a trust to add or remove property from the trust – you simply retitle the property into or out of the trust. At the death of the settlor, these trusts typically become irrevocable trusts.
Irrevocable Trusts
Trusts created during the settlor’s lifetime can also be established as irrevocable trusts. This type of trust generally cannot be changed or revoked by the settlor once it is created (although other means may exist to modify or terminate the trust). In this type of trust, a third-party trustee typically takes ownership and control of the assets, and the settlor either has very limited or no control over the assets.
While it may sound strange to give someone else control over your assets, giving up control using a trust can provide tax and other benefits for trust settlors. In a properly designed irrevocable trust, the trust assets will not be included the settlor’s taxable estate. For families with significant wealth, it may make sense to give up control of the assets to the trustee in exchange for considerable tax savings.
Testamentary trusts documented in the settlor’s will are always created as irrevocable trusts because they are created after the settlor’s death, when the settlor can no longer make changes to the trust. These trusts do not have the advantage of removing assets from the settlor’s estate before their death. Thus, testamentary trusts will not prevent the settlor’s creditors from coming after the assets at death, and they will not reduce the estate tax due on the assets or the income tax due on the growth of the trust assets.
Grantor Trusts
The term “grantor trust” can refer to different kinds of trust arrangements. When a trust settlor (who is also sometimes referred to as a grantor) sets up a living trust where they retain the power to revoke the trust, the living trust is sometimes referred to as a grantor trust.
Grantor trust also has a special meaning in the context of income taxes. For income tax purposes, trusts can be “simple trusts,” “complex trusts” and “grantor trusts.” In the income tax context, the term grantor trust refers to a trust for which the income is reported on the settlor’s personal income tax return.
Treatment as a grantor trust often is caused intentionally with respect to an irrevocable trust precisely because it causes the income to be taxed to the settlor and not to the trust while the settlor is alive. Although the effect (from the perspective of the trust) of the grantor’s payment of the trust’s income taxes is the same as making a gift to a complex or simple trust to pay the trust’s taxes, the IRS does not see it this way. In the case of a grantor trust, the settlor’s reporting of the income on the settlor’s tax return and their payment of taxes on this income means the trust assets are not dissipated from paying taxes. In the case of a settlor with a large and taxable estate, the settlor’s payment of the trust’s taxes also diminishes the size of the settlor’s estate, which will reduce estate taxes due upon the settlor’s death.
The grantor trust rules are extremely complex. As a result, grantor trust treatment sometimes occurs unintentionally when the wrong combination of trust terms is used. Care must be taken in the design of an irrevocable trust that the settlor does not want treated as a grantor trust during the settlor’s lifetime.
The term “non-grantor trust” typically refers to a trust that is not a grantor trust for income tax purposes. In other words, the trust is taxed as a simple or complex trust.
Directed Trusts
A directed trust provides for a trust director (sometimes referred to as a trust protector), who is designated by the settlor, to direct the trustees to perform certain duties and make certain decisions. This trust structure is often used to provide separation of the trust’s investment, distribution and other powers and duties. Properly used, this structure means that a trustee of a directed trust is not responsible for and not liable for the decisions or lack of actions on the part of the trust director or the trust’s other trustees.
Purpose Trusts
As the name suggests, a purpose trust is drafted to achieve a specific purpose. This trust is different in that it has no current beneficiaries. Purpose trusts are often used to hold title to family real estate, arrange for the needs of pets or manage a collection that requires specific expertise, such as a wine collection.
Purpose trusts in Michigan are rare because their duration is limited to 21 years. The most common use is for trusts to care for animals after the settlor’s death. A handful of other states, however, allow purpose trusts for longer durations, and these trusts are sometimes used in conjunction with planning for the ownership of a family business or private trust company.
Trust Education for the Next Generation
Teaching the next generation about their trusts is a great way to build their financial literacy and prepare them to manage wealth. Our attorneys have created a variety of activities to help families provide their next generation members with an age-appropriate understanding of trusts. Contact your Warner attorney or contact Mark Harder at mharder@wnj.com or 616.396.3225 to discuss options for personalized trust education for your family.
