A trust is a legal entity that permits one or more people (the “trustee” or “trustees”) to manage property for the benefit of other people (the “beneficiaries”). The third actor in a trust is the person who creates it—the “grantor” or “donor.” To confuse things a bit further, the same person can be a grantor, trustee, and beneficiary, but he can’t be the only one in all three roles. And the property in the trust can be just about anything you can own—real estate, bank accounts, investments, or artwork.
The Terms of the Trust
The trust document sets out the terms that the trustee must follow in managing the property for the beneficiaries. And it sets out the rights of the beneficiaries. Some might be entitled to the income generated by the trust assets, others to live in real estate owned by the trust, and still others to the trust principal when the donor dies. In managing the trust, the trustee must take all of their interests into account.
Trusts can have many purposes, including:
- Avoiding probate to make it easier and less expensive to pass property on to the next generation. Doing so is also more private, since a list of the estate property does not get filed in the probate court.
- Providing for the management of trust property by someone who may be more mature and experienced than one or more trust beneficiaries
- Providing for management in the event of the incapacity of one or more beneficiaries
- Protecting eligibility for public benefits
- Keeping property in the family in the case of the divorce or death of a beneficiary
- Protecting property from creditors
- Reducing or eliminating estate and other taxes
- Centralizing management of property that may be owned by several people
The list can continue and some trusts serve several of these goals. As a result, there are many kinds of trusts and no one can be absolutely certain of the terms of any trust without reading the trust document. Here are a few of the main trust types:
- Revocable. A revocable trust, as its name implies, may be changed (amended) or entirely revoked by its grantor. These trusts are generally used to avoid probate, to provide for management of trust property if the grantor becomes incapacitated, and often have continuing tax and other benefits for other beneficiaries (often called “remaindermen”) after the grantor dies. Interestingly, and often confusingly, is despite their title as “revocable” these trusts become irrevocable after the grantor dies.
- Irrevocable. As its name implies, an irrevocable trust cannot be changed after created by the grantor. Such trusts are often used to remove property from the grantor’s ownership for tax and long-term care planning purposes. Despite their irrevocability, some trusts permit the grantor to change who receives the trust property after her death—a “testamentary power of appointment.” Others permit a third party—a “trust protector”—to make changes to the trust.
- Living. A “living” trust is simply a revocable trust. The term was popularized by Henry W. Abts, III, in a book first published in 1989.
- Special needs. Also sometimes called a “supplemental needs trust,” these trusts permit a beneficiary to qualify for public benefits such as Supplemental Security Income and MassHealth, despite the fact that she can also benefit from the property in trust. The trust will have different terms, depending on whether the trust property originally belonged to the beneficiary or it was funded by someone else, such as a parent or grandparent.
- ILIT. You can use an irrevocable life insurance trust to shelter life insurance proceeds from being taxed in your estate. These are being used much less now that the threshold for federal taxes has been increased from $600,000 to $11.58 million (in 2020). But they’re still used by people with very large estates and in some cases in states, such as Massachusetts, that have lower thresholds for state estate taxes.
- Generation skipping. In the past, and continuing for some of the richest US citizens, affluent estate planners would seek to avoid a second estate tax when their children died by passing their estates directly on to their grandchildren and future generations. In response, Congress enacted a “generation skipping” tax to limit how much could be passed along tax-free in this way. The tax and its calculations are among the most complex in the tax system but, fortunately, apply to very few taxpayers today. However, many parents and grandparents continue to use similar trusts for asset protection purposes. In our practice, we call these “family protection” trusts.
- Credit shelter. As with some of the other tax-oriented trusts, credit shelter trusts are used less today than in the past, for two reasons. First, the threshold for taxation is so high now and, second, for federal tax purposes, Congress adopted “portability,” which permits a surviving spouse to use the unused estate tax credit of the first spouse to die even without any planning. Here’s how that works: Husband dies with an estate of $2.45 million passing to a credit shelter trust, $9.13 million under his estate tax threshold of $11.58 million. Even though he’s so far from having a taxable estate, his bereaved widow can file an estate tax return for him electing portability, which permits her to add his unused $9.13 million credit to her $11.58 million, allowing her to leave $20.71 million tax free at death. (In fact, if he leaves the $2.45 million to her instead of to the trust, she can elect portability and add his entire $11.58 million credit to hers, allowing her to give away $23.16 million tax-free at her death.) While estate planners (including us) can explain other benefits to credit shelter trusts, as you can see, they are much less beneficial for tax planning purposes than in the past. That said, in states such as Massachusetts that have a $1 million estate tax threshold and no portability, credit shelters can still save substantial amounts in estate taxes.
- QTIP. A “qualified terminable interest property” trust is a form of credit shelter trust which permits the surviving spouse to elect the ultimate tax treatment for the trust property. She can choose whether for tax purposes the QTIP trust property is in our out of her estate and can even choose to have some or all of it included in her estate for state purposes and out of her estate for federal purposes (or vice versa). The main rules of a QTIP trust are that the surviving spouse be entitled to the income and have limitations on her ability to distribute principal to herself, there being some flexibility as to the extent of those limits.
- QDOT. While, in most instances, you can give any amount to your spouse estate and gift tax free, this is not true if your spouse is not a US citizen. Gifts in excess of $148,000 (in 2020) to your non-citizen spouse must be reported as taxable gifts. And whatever you leave your non-citizen spouse is taxable. Again, as with many of the other trusts described above, for most people this is not an issue since you can now give anyone, including your non-citizen spouse, up to $11.58 million (in 2020) estate tax free. But for people with larger estates and with more moderate estates in some states, such as Massachusetts, money passing to a non-citizen spouse may be sheltered from estate taxes until his death through the use of a “qualified domestic” trust. These rules apply whether or not the deceased spouse is a US citizen; what matters is the citizenship of the surviving spouse.
- Income-Only. So-called “income only” trusts are often used in MassHealth planning to protect assets from being spent down to achieve eligibility for benefits may be subject to estate recovery by MassHealth upon the beneficiary’s death. These are irrevocable trusts through which the grantor gives up all control over the trust property but may receive income earned, such as interest and dividends on investments or rent from real estate. Funding these trusts causes ineligibility for MassHealth coverage of nursing home care for the subsequent five years. In recent years, MassHealth has been attacking income-only trusts, resulting in significant litigation. Anyone with an older trust should have it reviewed. Newer trusts are being drafted to reflect this reality and avoid MassHealth challenges.
- Spendthrift. Certain of the trusts described above may be “spendthrift” trust, especially generation-skipping or family-protection trusts. Under the “common” or traditional law, parents or grandparents could create trusts for their offspring that would not be subject to claim by the offspring’s creditors. The idea was to protect the family legacy from the bad decisions and unfortunate circumstances future generations might face. In the recent case of Pfannenstiehl v. Phannenstiehl, the Massachusetts Supreme Judicial Court upheld these provisions in a divorce case where clearly the protected spouse was the bad actor in the marriage. Despite his bad character, the probate court could not invade the trust created by his father for the benefit of his ex-spouse. (Read In Pfannenstiehl Case, MA SJC Affirms Use of Asset Protection Trusts to learn more about this seminal case.)
The beauty of trusts is that their total flexibility means that they can be used to achieve many different estate planning goals. But flexibility and creativity can bring complexity. Each client along with her attorney must decide in each case whether the benefits merit the use of a trust.