Everything You Ever Wanted To Know About Trusts: An Intro
Making sense of the alphabet soup of trusts
To skip the series index and go to the body of this introductory article, click here.
Series Index:
General Info
Structuring and Drafting Concerns
Trustee Powers and Duties
Credit Shelter Trusts
Marital Trusts
Descendants’ Trusts
SLATs
ILITs
Intentionally Defective Grantor Trusts
Valid S Corporation Trusts - ESBT and QSST
Retained-Interest Trusts
Charitable Remainder Trusts (CRATs and CRUTs)
GRATs
Beneficiary Deemed Ownership Trusts
Intro
As mentioned in my article introducing the Wealth Wave, we are poised for a significant shift in wealth into trusts. But, with this shift in wealth comes a need for understanding and education - both for professional advisors, and clients, who interface with trusts.
For years, I taught estate planning to financial advisors in CFP prep programs hosted by the College for Financial Planning and Kaplan. I explored repackaging a similar estate planning basics course for a wider audience, but I came to recognize that the education gap did not correlate to the academic learning objectives promulgated by the CFP Board. Instead, the request I most often received from my audience was a better understanding of the various wealth transfer techniques - especially trusts - that made up a significant chunk of the CFP curriculum.
So, as part of the new subscription and continued office hours I am launching, this will be the first installment in a my attempt to create a comprehensive resource for understanding trusts. While I have already introduced a deep dive course on spousal lifetime access trusts, I will also conduct intros and similar deep dives on some of the other common trusts seen in estate planning. The first few articles on the basics will be free, but more comprehensive explorations of specific trusts will be behind a paywall.
To start with, if you prefer video, I put together a series of videos a while back on some of the introductory topics. But, there is a lot of room for improvement in the videos. In case you prefer to listen, here is a YouTube playlist:
But, before we can even make sense of these videos, we need to tackle the concept of what, exactly, a trust is. Trusts are a concept that even I didn’t understand during law school, which makes it a tall ask to expect clients to understand them. The following is a narrative that might help.
What is a Trust?
As I mentioned above, I confess that I did not even understand trusts when I initially learned about them in law school. So, if you are confused about them, you are in good company.
Part of this confusion, however, stems from the wealth environment in which you have lived for the majority of your life. Growing up, most of our money and wealth lessons are best described by possession. For example, when you first earn an allowance for completing chores, you often get cash in your hand. This is wealth you possess. You might have taken this cash to buy things to enjoy or consume, like toys, video games, or snacks. Again, these things became wealth you possess. The hallmark of possession is that you could use cash, or the things you purchase with that cash, as you wish without anyone to tell you no.
But, there comes a point where possession carries risk. As you accumulate more and more cash, it becomes harder to manage and protect it in physical form. You run the risk that, if your house burns down, you could lose that cash. You also run the risk of theft. If you take out massive amounts of cash in public, you make yourself a target. You could also have cash in a purse or wallet that gets lost. As a solution, many people turn to banks to hold their cash. While banks then possess the cash, it is still yours to take out when you need – whether in the form of actual cash from an ATM, use of a debit card, online payment of a bill, or (for luddites) writing a check. A bank account balance still serves as proof of your potential possession of cash. And, as long as you have a positive balance and there does not appear to be any fraud, the bank can’t say no to your requests for cash.
The same holds true when it comes to investments. Once upon a time, if you purchased or received stock in a company, you got a paper certificate for your shares. Much like cash or coins, these certificates were things you possessed as proof of investment. And again, for security purposes (pun intended), many securities like stocks and bonds are now held in electronic form within an account through a custodian. You still have the same potential possession, not necessarily of the securities themselves but of the cash proceeds of buying and selling them. You also have the power to keep the cash in the account, and direct that it be used to buy new securities.
For larger items, like vehicles or real estate, you also had a written document of title or deed proving ownership. This document was often stored somewhere for safekeeping, and use. possession, and security were preserved by a physical lock and key. As long as you had the key, you could use the property without anyone saying no.
A good way to think of trusts is to recognize them as another evolution of these shifts in possession and security. How? By placing a figurehead between you and possession of wealth, known as a trustee. As long as the trust exists, you will have to go through this figurehead to gain possession of wealth. I use the term figurehead, because the trustee is not always a separate and independent person who has been foisted upon you. It is possible that you can replace the trustee or even become a trustee yourself at some point in the future (if the terms of the trust allow it). You may not always be forced to have a relationship with the trustee that has previously been chosen, or who is acting now. But, this figurehead must remain in place in order for the trust to achieve its security purposes.
Often, the figurehead stands as proof that the wealth is never truly yours unless or until the figurehead says otherwise. The figurehead is, in essence, an extension of the person who once possessed that wealth before transferring it to a trust (who we will define below). In many ways, this can be discouraging. If, as a child, you remember having to ask your parents for money, the trust might represent a similar arrangement. The only difference is that the figurehead - the trustee - is not a parent, and as noted above could even be you in the future. But, if you ever become that figurehead, that is not the same as outright possession of the wealth. You still have certain duties under law, which we will discuss below.
But, the figurehead also creates an additional degree of protection beyond that seen through the use of accounts, and keys, that usually stand between us and possession. Keeping this figurehead in place is a requirement to preserve this protection. As noted by my friend Brandon Henry of Mosaic Advisors in Houston, Texas, this can be protection of trust assets for you, and/or it can be protection of trust assets from you. This protection is usually the basic purpose of the trust.
We will talk about trust purposes in another article, but there is usually a written document creating the trust. In most states, this is called a trust agreement or trust instrument. Sometimes, it may also be called a trust deed or trust indenture. The term used to describe the written document does not matter as much as the actual terms of the trust itself. These terms of a written trust can be confusing, and it is important to remember that they are not necessarily written to be read and understood by you. They are written for an expanded audience which often includes other attorneys, judges, professional trustees, banking and financial professionals, and even creditors. The written trust serves as an instruction manual to the trustee, to you, and to all the other people mentioned in the last sentence as to how the trust should be operated. The purposes for creating the trust are sometimes stated directly in the trust, or they are implied from the way the trust is set up.
We will cover common trust purposes in a later article, but I do want to turn back to the role of the trustee. The trustee’s primary duty is to follow the terms of the written trust. Often, these terms will say if and when you can receive money from the trust, or the use of trust property. Much like the bank example above, you have to make a withdrawal or bill pay request if you want to possess or use money. However, the difference between a bank account and a trust is that the trustee has the power to say no, or to require you to justify the reason for taking money out or using trust property. And, the trustee can limit how much you take out or use. Sometimes, the trustee can say no to every request except for emergency needs. Other times, requests may be broader and could include luxury and entertainment. This all depends on what the written trust says. It can also depend on the trustee’s appetite for risk.
This limitation on how much money you can take out stems not just from the written trust terms, but also from the trustee’s duty to treat everyone named in the trust impartially. As a person who can potentially receive money under the trust, you are referred to under legal terms as a beneficiary. In many cases, you will not be the only beneficiary. There may be fellow beneficiaries along side you right now, such as siblings or even your own children, who also share from the same pool of assets as you. There also may be younger or older individuals, possibly including individuals not yet living, who might be beneficiaries of the trust in the future. Often, but not always, a trustee has to balance the needs of current (sharing) beneficiaries while also preserving assets for future beneficiaries.
Given this framework, we will now jump back into more technical territory to explore what you need to know about trusts.
Required Roles in a Trust
Above, I mentioned the concept of the trustee as a figurehead. This is because the trustee is a role, but not necessarily a distinct person or individual. To have a valid trust, there are three separate and distinct roles that have to be filled, but these roles do not have to be filled by separate and distinct people. These roles are:
Settlor (also sometimes known as Grantor, Trustor, or Trustmaker): This is the person, or people, who create a trust. I will use the term settlor throughout this series, except when we discuss certain income tax principles that use the term grantor. A settlor can also include someone who “gratuitously” transfers property to a trust (i.e., transfers property without receiving an equal exchange) even if that individual is not identified in the written trust. Each original settlor has to sign the trust as settlor, and is usually identified in that capacity.
Trustee: This is the figurehead role I mentioned above who, in essence, serves as an intermediary between the settlor (or settlor’s written instructions) and the trust beneficiaries. There must be at least one trustee named in the trust, but this figurehead role can be occupied by multiple parties (even by the settlor or a beneficiary). The trustee can be an individual, or can even be a bank or trust company. Multiple trustees can even share or delegate functions and duties of the trustee, and there may even be trust advisors, trust protectors, or trust committees falling into or supplementing this broader trustee role and figurehead. Traditionally, legal title to trust property was transferred to the trustee (and not the trust), but under modern legal theories the trust is recognized as a titleholder in the form of a separate legal entity.
Beneficiaries: As mentioned above, beneficiaries are the people who can receive benefits from the trust. The key difference is that beneficiaries, in this role, do not actually hold legal title to trust property - only trustees, or the trust, hold title, which is how the enhanced protections highlighted above are created. For this reason, beneficiaries do not have to sign or accept the trust, but the trust does take on a take-it-or-leave-it tone. It is also possible that the trust could terminate at some point in the future, and the people who would receive trust property in this scenario (either as direct possession or in a new trust) are also beneficiaries. In this vein, we have present or current beneficiaries, and future beneficiaries. A common tension that the trustee has to navigate is the tension between the needs of current beneficiaries and future beneficiaries, from both a distribution and an investment perspective. Beneficiaries can be named individually, as a class (for example, children or descendants of a settlor), or even as non-individuals (like charities).
As mentioned above, to have a valid trust, all three of these roles must be filled. If there is a written trust, it needs to be signed by each initial settlor and each initial trustee. But, while trusts traditionally needed some form of funding to be valid, this is no longer the case in many states - this split is emblematic of the shift from the trustee holding legal title to the trust being recognized as a legal entity capable of holding legal title. Nonetheless, it is common to find older trusts with cash stapled to the back page, or which at least a notation of some small dollar amount being transferred, in order to meet this funding requirement. Trustees also have an obligation to accept or reject the funding of the trust (which can also be an acceptance or rejection of their role as trustee).
And, as we will later explore, the same individual can occupy two of these three roles, and sometimes even all three! The purposes of the trust often dictate whether an individual can serve in multiple roles and, if so, whether their rights and powers must be restricted when compared to someone occupying just one role.
Conclusion
While trusts can be quite confusing, knowing at least the three required roles can be helpful to later determine what type of trust might be involved and even whether the trust itself is valid.
In this vein, I would be remiss if I did not mention that trusts often do not just remain one trust - it is possible that future events can cause a trust to split into separate subtrusts. Alternatively, the trust can terminate and, in effect, “roll” into a new trust. In either case, the initial settlor remains the same, but the trustees may change and future beneficiaries may become present beneficiaries. If this happens, the same original written trust agreement usually continues to apply to each new subtrust. And, in the context of what we described today, the identities of the trustee and beneficiaries under each subtrust may change.
It is also possible to accidentally or unintentionally become a settlor of a trust. For example, if a beneficiary received a distribution but then changed their mind and tried to give it back (without receiving equal value in return), they would then become a settlor. In many scenarios, this can be a bad outcome that violates one or more purposes of the trust. For this reason, the flow of assets should be one-way from settlor, to trustee, to beneficiary. In other words, once the toothpaste is out the tube, it cannot be put back in. But, as with any general principle there are exceptions.
Next time, we will explore the role the settlor plays with respect to when assets go in versus when they come out, and whether assets can flow back to the settlor.
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