Timing of Creating Trusts
A basic lesson on types of trusts
This is another installment of my series, everything you ever wanted to know about trusts. This material has a difficulty level of 3 out of 10. For a series index, click here.
Table of Contents:
Previously, I discussed the three main “figurehead” roles in a trust. These include settlor, trustee, and beneficiary. As a refresher, the same individual or individuals can occupy multiple roles. In fact, this is one of the variables that will control the creation of certain types of trusts we will later discuss.
For now, however, it is important to note that trusts are often classified based on when they are created and/or funded. In this vein, the classic question is whether a settlor is living at the time of the creation of the trust.
Inter Vivos Trusts
Trusts created during the lifetime of the settlor are often called inter vivos trusts. This classification is important, as it helps you know which transfer tax and income tax rules will apply to the trust both during the settlor’s life, and at the settlor’s death. As we will later find out, the universe of funding options is higher for an inter vivos trust than for its alternative - a trust created at the settlor’s death.
Inter vivos trusts usually require, at the minimum, a settlor’s execution of a written trust instrument during life. Depending on the state, there may not be a valid trust unless or until the settlor funds the trust - even perhaps with a nominal amount such as $1.00. Even in states where trusts do not have to be funded to be valid, having some level of nominal funding at the time of executing a trust can create a safe harbor to make sure the trust is respected in all states. (Later, we will discuss which state’s or states’ laws govern the interpretation of the trust, and the administration of the trust.)
While taxes will be covered in great detail as we walk through this series, the funding of an inter vivos trust carries the following considerations:
Gift tax and its related deductions and credits can apply to transfers that cannot be revoked by the settlor, unless there is an incomplete gift;
Tax basis usually will not change unless there is a taxable sale, or unless the gift tax value of transferred assets is lower than the basis on the date of trust funding;
Income tax can apply to the trust itself after funding or, alternatively, there may be no change from an income tax perspective if the inter vivos trust is a grantor trust;
GST tax comes into play through the automatic or manual allocation of GST exemption to an irrevocable trust or, if the exemption has been used, the possibility of actual GST tax;
Creditor claims against the settlor may be collected from the trust depending on powers retained, fraudulent/voidable transfer rules, and state of trust administration; and
Rules against perpetuities may be determined based on date of trust creation and not the settlor’s death.
Testamentary Trusts
Before I dive into our next topic, I want to note that the naming convention is unsettled for trusts created at the settlor’s death. Often, the term used is a testamentary trust. But, the classic definition of a testamentary trust is a trust created under a will - hence the term “testamentary.” It is possible, however, for an inter vivos trust instrument to call for the creation and funding of subtrusts at the death of a settlor. Especially for a revocable inter vivos trust, the subtrusts created at a settlor’s death are the functional equivalent of testamentary trusts and could be worthy of having that label attached as well.
In either case, the testator of the will or settlor of the revocable trust is the settlor of the “testamentary” trust. The difference from an inter vivos trust, however, is that the trust is neither created nor funded until the settlor’s death. You could certainly have a transfer under a will to an inter vivos trust that already existed at the settlor’s death, but this type of a transfer is often called a pourover and is not by itself the same as the creation of a new trust at the settlor’s death.
We will discuss revocable versus irrevocable trusts in the next article, but a trust created at the settlor’s death will always be irrevocable. Why? Because a deceased settlor cannot revoke a trust or revoke transfers to a trust.
Note, however, that an inter vivos trust that was already irrevocable at the settlor’s death but which divides into subtrusts may not operate under the outcomes described below. These subtrusts cannot really be classified as testamentary trusts.
A trust created at the settlor’s death carries somewhat complimentary funding considerations to be later discussed, such as:
Estate tax and its related deductions and credits may apply, depending on the size of the deceased settlor’s gross estate;
Tax basis will often be determined based on the estate tax value for a trust created under a will or revocable trust, even if no estate tax is owed, under the basis adjustment rules of IRC Section 1014 or, alternatively, as a new cost basis on a sale to a grantor trust that becomes taxable at the death of a settlor;
Income tax will apply separately to the trusts depending on certain elections (such as the 645 election for a combined probate estate/revocable trust) and lifetime grantor trust status will terminate at settlor’s death; but the grantor trust rules could apply to cause a beneficiary of a trust to be a deemed income tax owner under IRC Section 678;
GST tax comes into play through a different set of allocation rules applying at the settlor’s death, net of estate tax and taking into account certain ordering rules between inter vivos trusts and testamentary trusts;
Creditor claims against the settlor or settlor’s estate are often settled or disallowed before funding a testamentary trust regardless of state of administration, and spendthrift clauses and distribution terms often protect trust assets or income from claims against beneficiaries after the settlor’s death; and
Rules against perpetuities are usually determined from the date of settlor’s death for a testamentary trust created under a will, but the rules may be a bit muddier for a revocable trust depending on the state.
Conclusion
Knowing the timing of the creation of the trust can be important to determine what type of trust is involved, and what types of rules apply. Certain trusts, such as ILITs, GRATs and QPRTs, may only be inter vivos trusts. However, certain trusts such as QTIPs and CLATs can be either inter vivos or testamentary. And, some trusts may be complimentary depending on timing classification; for example, a SLAT is usually an inter vivos version of a common testamentary trust - the credit shelter/bypass trust.
Next time, we will discuss the ways property goes into a trust while introducing how the settlor’s power to get that property back out might control the classification of the trust.