Stephen A. Kosa is a trust attorney in Hudson, WI serving western Wisconsin and Minnesota.
Definition of a Trust, Trustor and Trustee
A trust is an arrangement whereby a person, (typically referred to as the Grantor, Settlor, or Trustor) transfers property to another person (the Trustee) who holds and manages the trust property for the benefit of a certain person or persons (the Beneficiaries). Under certain circumstances, a single person can fill all of these roles at the same time. The trust is evidenced by a document that resembles a contract, which contains the terms of the trust as approved by the grantor and the trustee. The terms of the trust instrument will designate the conditions under which the trust property may be distributed, the purposes for which the assets may be used, and the applicable ages of distribution (if any) that apply to the beneficiaries receiving the property. Trusts serve many important functions, including the avoidance of a probate proceeding upon a person’s death.
What are the primary functions of a trust?
In the absence of a trust, a probate proceeding may be necessary to administer a person’s estate, depending upon the value of the decedent’s assets at the time of death. Probate can involve significant cost and delay, and requires public disclosure of the decedent’s financial information. Probate may also require judicial oversight and administration depending upon the type of probate involved. In contrast, assets held in a trust upon a grantor’s death can be administered and distributed by the trustee according to the terms of the trust, and this can usually be done without court supervision depending upon the type of trust involved.
A trust can provide for the management and control of property, now or in the future, for a beneficiary who is unable or unwilling to assume the responsibility of ownership. This could include minor children, the elderly, or the incapacitated. If established by a grantor during his or her lifetime, a trust may also serve as an alternative to a guardianship or conservatorship.
Splitting Interests in Property
A trust allows a grantor to “split” interests in the property transferred to the trust. For example, a trust may provide income from trust property to one beneficiary for his or her lifetime, while ensuring that a second beneficiary will eventually receive the remainder of the property. This is often used in second marriage situations to provide a surviving spouse the lifetime use of a residence or other property, with a transfer to the children from the first marriage upon the death of the surviving spouse.
Restricting the Use of Assets
A grantor can designate the manner in which trust property may be used or distributed. For example, the trust might require that trust assets be used primarily for the beneficiary’s education, with discretionary distributions for the beneficiary’s health, maintenance or support. Another example would be the establishment of a special needs trust to supplement the government benefits received by a disabled beneficiary.
Protecting Assets Against Creditors
A trust containing a properly drafted spendthrift provision can shelter trust assets from the creditors of the beneficiaries, and can prohibit the beneficiaries from assigning trust assets to a third party. Spendthrift provisions also typically allow a trustee to withhold distributions to a beneficiary if the trustee believes the distribution is threatened to be diverted from the purpose for which the trust was created.
Estate Tax Planning
Depending upon the size of a person’s estate at the time of death, the estate may be subject to federal and/or state estate taxation. These tax rates are quite high and careful planning is necessary to minimize or eliminate them. Transfers to certain types of irrevocable trusts will remove the assets and future appreciation from the estate for tax purposes.
Sheltering Estate Tax Exemptions
Historically, an individual’s estate has been allowed a federal and state exemption from inheritance taxes. These exemptions (or credits) allow individuals to transfer a certain amount of assets upon their death without the transfer being subject to estate taxation. Due to changes in the tax laws over the years, the federal estate tax credits have been subject to various changes. In June of 2001, President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which called for the gradual increase of the federal estate tax credit from $675,000 in 2001, to $3.5 million in 2009. The congressional intent was to eventually phase out the federal estate tax by gradually increasing the credit, with 2010 being the first year with no federal estate tax. However, EGTRRA also contained a sunset clause that basically called for EGTRRA to expire at the end of 2010. This would have caused the federal estate tax credit to revert back to $1 million on January 1, 2011 unless Congress passed additional legislation. Congress did pass new legislation late in December of 2010 to address the estate tax issue, but rather than abolishing the federal estate tax, they increased the federal estate tax credit to $5 Million for individuals dying in 2011, and $5.12 (as indexed for inflation) for those dying in 2012. However, the federal credit was once again scheduled to revert back to $1 million at the end of 2012 unless additional legislation was passed.
On January 2, 2013 President Obama signed the American Taxpayer Relief Act (ATRA), which made further changes to the federal tax laws. Under ATRA, the federal estate tax credit for individuals dying in 2013 is $5.25 million. The unified exemptions (credits) will continue to be indexed for inflation in 2014 and later years.
An individual’s estate may also be subject to state inheritance taxes. Presently, Wisconsin does not have an estate tax. However, this is always subject to change. Furthermore, individuals in other states should consult with an attorney in their state to determine the tax laws in that jurisdiction.
Due to the constant changes in the laws pertaining to estate taxation, careful planning is essential to ensure the flexibility necessary to maximize the available tax credits. Depending upon the value of a couple’s estate, we often recommend a credit shelter trust to ensure that the first spouse to die fully utilizes (and shelters) the exemptions that are available upon his or her death. The assets (and appreciation) sheltered in a properly drafted credit shelter trust can be used for the benefit of the surviving spouse and children, and are not subject to estate tax upon the surviving spouse’s death.
In some cases credit shelter trusts may not be necessary, as the federal tax law now allows married couples to add any unused portion of the federal estate tax exemption of the first spouse to die to the surviving spouse’s estate tax exemption. This is often referred to as “portability” of the estate tax exemption. There are specific and time sensitive rules that must be followed to exercise this portability election, and portability may not be the best option in all situations. For example, credit shelter trusts can still be beneficial in cases where: (1) it is important to protect assets from creditors, (2) the surviving spouse might remarry, potentially losing the portability option, or (3) assets are expected to significantly appreciate.
What is the difference between a Living Trust and a Testamentary Trust?
A testamentary trust is created by the terms of a person’s Last Will and Testament, and becomes activated at the time of his or her death. Testamentary trusts are subject to the ongoing jurisdiction of the probate court.
A living trust is also referred to as an inter vivos trust, which literally means a trust “between the living”. By statutory definition, these are any trusts which do not meet the definition of a testamentary trust. These trusts are established by the grantor during his or her lifetime. They do not require a probate proceeding and they are typically not subject to the ongoing supervision of the court.
What is the difference between a Revocable Trust and an Irrevocable Trust?
A revocable trust may be revoked, altered, amended or terminated by the grantor without the consent of any other person.
An irrevocable trust may not be revoked, altered, amended or terminated by the grantor. These trusts are often used for tax purposes to remove the assets transferred to the trustee from the grantor’s taxable estate, and to remove the income earned by the trust assets from the grantor’s taxable income.
What administrative powers does a trustee possess?
A trustee’s powers to administer a trust are established by the terms of the trust instrument and by Wisconsin statute. Because the statutory powers are fairly broad, most attorneys draft trusts which address the trustee’s powers in greater detail. A trustee is typically given specific powers related to investments, distributions of principal and income, management of property and real estate, employment of agents, purchasing of insurance, borrowing or lending money, execution of contracts, etc. This allows third parties such as transfer agents, financial institutions, title companies, and purchasers of property to determine whether the trustee has the power necessary to handle the specific transaction in question.
What distributions can a trustee make from a trust?
The trust instrument establishes the distributions that a trustee may make from the trust. The instrument should address the following:
Who: The trust should identify the beneficiaries to whom the distribution may be made.
What: What form of property may be distributed? (Cash, securities, real estate, etc).
When: When may distributions be made? (At what age, upon what event, etc).
Where: From where may the funds be distributed? (Principal and/or interest).
Why: For what purposes may the distributions be made? (Health, education, welfare, support).
Note: Some trusts contain very specific terms as to the circumstances surrounding permitted distributions, whereas others are worded very broadly to give the trustee more discretion in such matters. A good trust is drafted to provide enough detail to give the trustee specific powers and guidance, but broad enough to allow the trustee to accomplish the purposes of the trust.
Does the establishment of a trust change a person’s tax status?
Under most circumstances a revocable trust does not change the tax status of the grantor. The trust does not file income tax returns and the trust’s income is reported on the grantor’s tax returns.
Once the trust is funded it must obtain its own tax identification number and file an annual income tax return. However, it may qualify for certain deductions under the tax code to help reduce this tax. Furthermore, because a trust is taxed at a higher rate than an individual, the trustee often distributes income out to the beneficiaries during each tax year. The income distributed is then reported by the beneficiary on his or her tax return, and is taxed at that beneficiary’s tax rate.
What fiduciary duties or responsibilities are imposed upon a trustee?
The trustee may use the trust assets only for the purposes permitted by the trust instrument. A trustee may not self-deal, or make gifts or advancements to persons other than the named beneficiaries. The trustee is under a duty of loyalty to the beneficiaries and should not otherwise administer the trust in the interest of any third person.
In Wisconsin, a trustee’s standard of care with respect to investments is governed in part by the Wisconsin Prudent Investor Act. The Act states that “A fiduciary shall invest and manage assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the estate, trust, conservatorship, or guardianship. In satisfying this standard, the fiduciary shall exercise reasonable care, skill and caution.”
The prudent investor rule may be expanded, restricted, eliminated, or otherwise altered by the provisions of a will, trust, or court order. However, the Wisconsin Prudent Investor Act identifies various common phrases, which if used in a trust instrument will invoke the prudent investor rules. Therefore, a trustee should be aware of the provisions contained within the trust, and familiar with his or her responsibilities under the Act.
How are assets transferred into, or out of, a trust?
A trust owns and controls only those assets which are transferred to it. Transfers of real estate are done by deed, much like they would be if transferring to an individual. In the case of personal property, (i.e. stocks, bonds, investment accounts, certificates, tangible goods, etc.), transfers are usually done by assignment, bill of sale, letter of instruction, or execution of certain documents provided by a broker or financial institution. In the case of a bank account, most financial institutions will change the ownership of an individual’s account to the name of their trust upon receipt of a letter of instruction and the relevant pages of the trust document. To ensure proper titling and to be certain that all tax consequences have been considered, an attorney should be consulted when transferring property to a trust.
A trust may also be named as the beneficiary of a person’s life insurance policy or retirement account. An attorney or financial advisor should be consulted before making any such beneficiary designations to ensure that all tax consequences are considered.
Property and assets may also pass to a trust through a person’s Last Will & Testament. This is typically what we refer to as a “pour-over will”. The administration of the will requires a probate proceeding, which can result in additional legal fees for the estate. Therefore, proper funding of the trust during a person’s lifetime is often the best approach.
When does a trust end?
Generally, a trust ends when the assets have all been distributed, when the purpose for which it was created has been accomplished, or when the period for which it was created has expired.