The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Trusts are an increasingly popular – and important – tax-planning tool. But what exactly is a trust? How does it work? What are the benefits and disadvantages of creating one? Should you have a trust? In this article, we will explain the basics of trusts starting with defining key terms and discussing the different types of trusts and their benefits.
A trust is a legal arrangement in which one person (the grantor) transfers property to a person or entity (the trustee), who holds legal title to property for the benefit of another person (the beneficiary). Think of it as a contract between the grantor and the trustee for the beneficiary’s benefit. The grantor creates the trust and includes whatever terms in the trust document he or she believes will achieve the grantor’s goals. The trustee is legally bound to act in the beneficiary’s best interests and to follow the terms of the trust agreement. Sometimes, the grantor, the trustee, and the beneficiary are all the same person. Other times, they must all be different people.
An early version of the trust was developed in ancient Rome. Known as the fideicommissa, these early trusts allowed Roman nobles to control who inherited their property. The trust began to appear in something like its modern form in medieval England, when landowners began using trusts to transfer land to family members who otherwise would not have been able to inherit under the laws of that era. Over the centuries, the trust evolved into a powerful, amazingly flexible legal tool for managing and transferring wealth. While the trust is often thought of largely as a tax-planning tool, which it is, it also allows individuals to manage investments, shield assets from creditors, support charitable goals, preserve privacy, and pass wealth to future generations.
There are many different types of trusts in the US legal system, and each serves different purposes. Let’s go over some of the most common types. Note that many trusts can fall into more than one of these categories.
A revocable trust (also known as a living trust, a family revocable trust or a revocable living trust) is a type of trust that most people create during their lifetimes in order to plan for their deaths and what happens to their assets. This is probably the most common type of trust in the United States, as millions of Americans’ use it for their estate plans to ensure their wishes for their assets are followed after they pass away. A revocable trust is a “will substitute” — that is, it performs the functions that many people associate with wills, like naming fiduciaries and directing where, and to whom, assets should go upon a person’s death. As the name implies, a revocable trust can be changed or canceled by the person who created it, called the grantor, at any time, just like a will can be amended or revoked during the testator’s life. But unlike a will, a revocable trust can avoid “probate” — the legal process by which courts determine where assets pass upon a person’s death. This probate avoidance feature is the reason that revocable trusts have become so popular over the past few decades.
Revocable trusts are fundamentally different from the other trusts described in this article in one important respect: while the grantor is alive, they have no unique tax attributes or advantages. Not only are they ignored for income tax purposes, but they are ignored for gift tax purposes, property tax purposes and all other purposes. They also do not protect assets from a grantor’s creditors.
Because revocable trusts have no impact during their grantors’ lifetimes, their grantors have full, unfettered access to the assets inside of them. Revocable trusts become irrevocable upon the grantor’s death, at which point they turn into irrevocable trusts. But as we will mention below, irrevocable trusts are in large part tax-planning tools, which means they’re subject to various tax laws and regulations that limit the grantor’s ability to revoke them.
An irrevocable trust is a type of trust that cannot be canceled by the person who created it. Historically, they were difficult to modify, but that is less true today due to legal innovation. Generally, it is not advisable for the grantor to be the beneficiary of the irrevocable trust he or she created, though there are exceptions where that may make sense such as charitable remainder trusts. Irrevocable trusts are most often used to make gifts to individuals or, in some cases, charities, in a way that is tax efficient and creditor protected.
The following are common types of irrevocable trusts.
A life insurance trust, also known as an irrevocable life insurance trust or “ILIT,” is a type of trust that is designed to hold a life insurance policy and geared towards families who are worried about the estate tax and/or want to protect their assets from potential creditors. Often, but not always, that life insurance policy is on the life of the grantor. When the grantor dies, the policy pays out, generating liquidity that the grantor’s heirs may need in order to pay estate tax, acquire assets, or pay down debt. People set up life insurance trusts so that a life insurance policy can be owned by something (the trust) that is outside of their taxable estate and the policy payout avoids the 40% federal estate tax.
A charitable remainder trust (or CRT) is designed to benefit both (a) charity and (b) individuals. CRTs last for a defined length of time, either a term of years (not to exceed 20 years) or one or more people’s lives (or a combination of the two). During this term, a person (usually the grantor) receives annual payments from the trust. The most common version of the CRT, known as a charitable remainder unitrust (or CRUT), pays the grantor a percentage of the trust value each year; as the value of the trust’s assets appreciate, the size of the payments increase proportionately. At the end of the term, whatever is left over goes to a charity or charities of the grantor’s choosing.
Charitable remainder unitrusts work particularly well for individuals when funded with appreciated assets. The grantor receives an immediate income tax deduction after transferring assets to the trust. Then, when an asset inside the trust is sold, the tax payments are deferred until the grantor receives a distribution of the trust asset. So, for example, if the trust recognizes $1,000,000 of gain in Year 1, and the grantor gets a $100,000 distribution every year for the next 10 years, the grantor will pay the tax on that $1,000,000 gain over the course of those 10 years, rather than all at once. This allows the grantor to re-invest the trust principal that would otherwise have been lost to taxes and then benefit from the growth on those tax dollars.
Valur’s CRTs are optimized such that, notwithstanding the grantor’s generous charitable gift, the grantor usually winds up with significantly more assets than he or she would have had without the CRT. You can estimate your potential returns from a CRUT here.
A charitable lead trust (or CLT) is the second most common type of charitable split-interest trust. It is the mirror image of its cousin, the charitable remainder trust: rather than paying the grantor regularly until the end of its term and then paying the remainder to charity, the CLT makes annual payments to charity before leaving the remainder to the grantor or some other individuals selected by the grantor (usually the grantor’s children).
The most common form of charitable lead trust is called the charitable lead annuity trust (also known as a CLAT). CLATs pay charities a fixed amount each year. The charitable annuity payments are usually calculated to be equal to the value of the assets transferred to the trust, divided by the term of the trust, plus a predetermined IRS interest rate. If the asset appreciates faster than the IRS’s predetermined hurdle rate (usually between 3% and 5%), the excess passes to the non-charitable remainder beneficiary. For example, if the IRS hurdle rate is 4% and the assets generate an 9% annual return over the course of a 20-year term, at the end of the term, the amount passing to the grantor’s non-charitable beneficiaries would exceed the amount with which the trust was initially funded, all free of gift tax. The grantor of a CLAT may also get a large upfront charitable deduction. You can estimate your potential returns from a CLAT here.
A grantor retained annuity trust (GRAT) is a type of trust that helps minimize estate taxes. It allows the grantor to receive fixed payments for a period of time, after which the remaining assets pass to the named beneficiaries, usually the grantor’s children. As with CLATs, the annual payments for GRATs are determined with reference to IRS interest rates at the time of funding. So, if a GRAT is funded with assets that outperform the IRS interest rate, the excess will pass to the GRAT’s beneficiaries (who are typically the grantor’s children) gift tax free. Unlike CLATs, GRATs do not have a charitable component. GRATs are extremely powerful tools for minimizing gift and estate taxes and are used by 99 out of the 100 richest American families. You can estimate your potential estate tax savings from using a GRAT here.
An intentionally defective grantor trust (IDGT) is an irrevocable grantor trust. A number of the trusts described on this list can be structured as IDGTs. The “defect” alluded to in the name is actually not a defect at all — rather, it is a reference to the fact that this type of trust exploits the inconsistencies between the income tax system and the estate and gift tax system to maximize how much families pass on to future generations and minimize taxes. The general idea is that the trust is ignored for income tax purposes but not for estate and gift tax purposes. IDGTs are one of the most powerful structures to minimize estate taxes.
A dynasty trust (also known as a perpetual trust or a generation-skipping trust) is an umbrella term for any type of trust that is designed to last for a long period of time, often hundreds of years or more.
A special needs trust is a type of trust that is used to provide for the care of a beneficiary with disabilities. The trust can be used to pay for things like education, housing, and medical expenses that are not covered by government benefits.
A qualified personal residence trust (QPRT) is a type of trust that is used to transfer a residence to heirs in a tax-efficient way. QPRTs are designed to be for the benefit of the grantor for a certain period of time, after which the remainder passes to beneficiaries (often the grantor’s children). Because it is only a gift of a remainder interest in the residence (the grantor gets to stay in the house during the initial term, and the remainder beneficiaries only get the house later), the initial gift is discounted by a significant amount, sometimes more than 50%. This means that a grantor can effectively transfer a $4 million house to his or her children while using perhaps $2 million of gift tax exemption (the exact discount will depend on various factors).
In sum, trusts are highly versatile and can be used to accomplish a variety of objectives, but here are the main benefits:
Trusts are generally taxed as either grantor trusts or non-grantor trusts. Grantor trusts are ignored for income and capital gains tax purposes, which means the income is passed through to the grantor. Non-grantor trusts are treated like separate taxpayers that pay their own taxes. You can read more about the differences between how grantor trusts are taxed and how non-grantor trusts are taxed here and here.
And that’s a wrap! Hope our guide on trusts 101 helped you understand the key concepts. If not, you can always read more about trusts agreements, or contact our team of experts who can help you out find what’s best for you!
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