- A trust can provide a means to hold and manage your property. Think of a trust as a bucket into which you place your assets for protection.
- Any type of property can go in a trust.
- It can be custom designed for your situation.
- There are numerous types of trusts that could be utilized in a farm transition plan.
What is a trust?
A trust has basically four elements:
- A trustee
- Trust property
- Instructions and guidelines
Any type of property such as cash, personal property or real estate, business entity ownership shares, etc. can be placed in a trust.
Transferring assets to a trust is a formal process and titled assets must be changed from individual ownership to trust ownership. This is referred to as “funding the trust” and is a critical part of the process.
Grantor, trustee and beneficiaries
As grantor of the trust, you may name yourself as trustee and beneficiary of the trust. As trustee, you hold and manage the property in the trust in accordance with the instructions, rules and guidelines you write into the trust instrument.
In your trust, you can name a successor or disability trustee who would take over your trust management in the event you become disabled or incapacitated. This trustee can be an individual or an institution such as a bank trust department. This trustee should be someone you trust to serve in that capacity and should be astute in business matters and have high ethics.
The beneficiaries are the people for whom the property is managed. They can receive annual earnings distributions and eventually will receive the entire trust principal ("corpus") when the trust is terminated.
The trust instrument is an important document. Its creation and content should be carefully thought out. Consider all contingencies that could arise regarding you or the beneficiaries, and plan accordingly. The trust instrument is a complete set of guidelines for the operation of the trust. A person can be very flexible in the design of the trust. The trust instrument may specify the powers, responsibilities and latitude of the trustee. The trust instrument also directs paying out of trust income to beneficiaries, lists instructions as to timing of final distribution, and trust termination. Extreme care should be taken to design the trust so that it accomplishes the objectives and goals of the individual (grantor) establishing the trust.
How are trusts used?
Trusts are used for many purposes including the management of assets for minors, elderly persons or handicapped persons, as well as protecting assets from lawsuits and other adverse actions.
Trusts are also used to manage property for a surviving spouse who prefers to have someone else (trustee) manage the assets. A trust may also be used to leave someone a limited interest in property or to transfer a farm business. Trusts can also be established to reduce the size of an estate or to minimize estate and probate costs.
Types of trusts
There are many different types of trusts. However, there are two main categories of trusts: living trusts and testamentary trusts.
Living trusts are established during the grantor's lifetime and may continue after death. A living trust can be either a revocable living trust (changeable) or an irrevocable trust (unchangeable).
Living trusts are often set up to avoid probate costs at death, since living trust assets do not need to be probated. Unlike a will, living trust assets are not subject to public disclosure during and after the trust “administrative” process. A living trust can be useful in providing management through a trustee for older family members as they advance in age or for anyone who may be disabled or incapacitated.
Individuals who use the revocable living trust (RLT), transfer title of their property into the trust. They, as grantor, appoint themselves as the trustee (manager of the trust) and the beneficiary (receiver of the income and/or assets). To set up a living trust, they transfer the title of their assets into the trust from themselves as an individual, to themselves as trustee of the trust. No income taxes are due on this transfer. In addition, the assets in the trust are still under the trustee’s control and remain as part of your estate. Therefore, the trust assets receive a stepped up tax basis upon your death, if that provision remains in the tax law at time of death. Basis is the amount of capital in a property at acquisition recognized for tax purposes. A step up in basis is important because the heirs’ basis will become equal to the asset’s fair market value of the property at the decedent’s death.
Placing assets into a “protective trust” in the form of “lifetime trust shares” within the RLT can protect those assets from lawsuits and other adverse actions when the assets pass to the heirs.
Upon the death of the trust grantor, the RLT becomes an irrevocable trust and requires its own IRS tax ID number.
An irrevocable trust (IT) is designed mainly to save estate taxes. The grantor can write the provisions of the trust, however, they are neither the trustee nor beneficiary of the trust. After a given period of time, the grantor no longer has access to the trust assets. The trust assets will not be included in the grantor's estate and do not receive a stepped up tax basis at the decedent’s death. Irrevocable trusts may also reduce probate costs since assets put into the trust are treated as a gift and are removed from the estate of the grantor. Creating an IT may have gift tax ramifications if the gift exceeds the lifetime exclusion amounts or in Minnesota the gift occurs within the three years prior to the decedent's death. All rules regarding the IT must be followed. Any access by the grantor to the assets in the trust violates the rules, and the trust is no longer irrevocable.
There are several other trusts that may be useful in estate planning. The irrevocable life insurance trust (ILET), the generation skipping trust, charitable remainder trust and others may offer possibilities for estate planning. Before choosing any trust, thoroughly investigate its ramifications and seek good legal counsel when drafting your trust.
A Charitable Remainder Trust (CRT) can be established to transfer assets to a charity while retaining an income stream during your lifetime and your spouse’s lifetime. It acts much like an annuity. Upon the death of the surviving spouse, or the end of the life of the trust, the property passes to the charity.
A revocable living trust (RLT) can have some distinct advantages over a will when used in estate planning. A traditional will is actually a letter to the court and automatically triggers the probate process. A RLT by-passes the probate process. This article addresses advantages and disadvantages to RLT.
What is a revocable living trust (RLT)?
Trusts established during a person's life are called living trusts. They can be revocable or irrevocable. The RLT can be amended or discontinued at any time. An irrevocable trust (IT) cannot be modified or discontinued once established.
In a RLT, individuals transfer title of their property into the trust. This is called “funding” the trust. They, as grantor, typically appoint themselves as the trustee (manager of the trust) and the beneficiary (receiver trust income or assets).
To establish a RLT, you transfer the title of your assets into the RLT from you as an individual, to yourself as trustee of the trust. No income taxes are due on this transfer. Setting up a RLT does not constitute a gift, so there are no gift taxes. Also, you still own the assets but within the trust.
Once established, everything transferred to the RLT then belongs to the trust. As trustee, you maintain control. You can buy, sell, trade or gift trust assets. If you choose to gift assets from the trust, gift them to yourself and then pass them on to the recipient. This will avoid possible tax issues.
Positive aspects to using the RLT
There are a number of positive aspects to using a RLT in your estate plan.
RLT assets are not subject to the probate process. Having property in an RLT will avoid heirs having to disclose your holdings in the public probate process. The RLT is a private document, not open to the public.
The trust must go through an administration phase. However, this process is generally less time consuming and less expensive than probate. Your heirs may save considerable estate settlement time and costs. The majority of estate settlement cost is the filing of estate tax returns and asset transfer costs, which must be done with or without a trust.
The trust can continue after your death, with income and principal distributed as described in the trust instrument.
A RLT can provide for management of assets during the grantor’s declining years when they may not be able to physically or mentally manage their assets. A successor or disability trustee is named in the trust document that can manage, invest, sell and liquidate your assets.
Select a successor or disability trustee in whom you have confidence. Make sure your trust document stipulates any restrictions, conditions or intentions you wish to make known to the successor trustee.
If you die owning property in more than one state and you have a will, assets must be probated in each of those states. With a RLT, all your property is dealt with in the state of the deceased person's residence, subject to their RLT.
An RLT can provide an excellent vehicle to allow a farming heir the opportunity to gradually buy into the farm business. Purchase agreements or buy-out provisions can be written into the RLT, which allow the farming heir the right to purchase machinery, breeding livestock or other assets over a period of years.
You might also give the farming heir the right to rent the land for a number of years at a given amount of rent. In addition, the farming heir might have the right (option) to purchase the farm from the other heirs over a predetermined time and at specified terms.
A protection provision in an RLT can prevent the farming heir from having to buy-out the non-farming heirs with a lump sum purchase, which may not be financially possible.
The RLT can protect your family’s inheritance from lawsuits and other adverse actions. Place assets into a “protective trust” within the RLT in the form of lifetime trust shares. Upon the death of both parents, the children must elect the protective trust provision and if they do so, the assets are protected from any lawsuits or other adverse actions the children may encounter.
Disadvantages of the RLT
While there are many advantages to RLT, there are also potential drawbacks. You should carefully analyze if a RLT is right for your situation.
You do not save federal or state estate taxes. The IRS views you as full owner of any property held in a RLT. Consequently, assets in your trust do receive stepped up tax basis at your death, if tax law allows. Heirs can immediately sell the property if desired, with little or no tax consequence.
The cost of setting up and maintaining the trust is immediate, whereas probate costs associated with wills are not paid until after your death. The costs of creating a trust can reach several thousand dollars and are paid upon completion of the trust documents.
Trusts require ongoing management while you are alive or incapacitated.
If titled assets are not properly titled in the name of the trust – “funding the trust”– the trust document is nothing more than a pile of paper.
Probate costs and procedures can vary greatly by situation. Be sure to get counsel from an attorney as to the best approach for your particular situation.
Critical steps for establishing a RLT
The drafting of the trust document is a very important function. It should include all your wishes regarding the management and distribution of your property. Attorney fees for setting up a RLT will generally be higher than for establishing a will. Much lower estate settlement fees and the elimination of probate fees usually offset higher initial costs.
It is important to formally transfer all desired assets into the trust. This is called “funding the trust” and it is critical to the process. This can be a time consuming task. Many estate attorneys will do this for you to make sure the process is complete. Most assets can be transferred into the trust without adverse tax consequences.
Form 1041, U.S. Tax Return for Estates and Trusts, has to be filed for the trust unless the grantor is both beneficiary and trustee. In that case, it is not necessary to file Form 1041 and all income and expenses are shown on the individual tax return of the grantor.
Anyone with an RLT also should consider a “pour over” will. The pour over will transfers assets into the trust not previously transferred as well as newly acquired assets that were perhaps neglected and not placed or “funded” into the trust. However, pour over will assets require probate so make sure all assets are funded into the trust initially and newly acquired assets are funded into the trust as well.
Along with the RLT, the grantor should also have granted durable common law power-of-attorney, completed a health care directive with HIPAA authorization, designated guardianship and conservatorship (if applicable) and created a disability panel. These items will ensure that the wishes of the grantor will be implemented if they are incapacitated or disabled.
A RLT can be a valuable tool but takes knowledge to complete. Trying to do a trust yourself by getting a from off the Internet or a piece of software is not recommended. Any small mistake can result in assets going where you never intended or create unnecessary tax consequences. See a qualified attorney for assistance.
Example of an RLT used in a farming context
Sue established a RLT with a provision protecting her farming son, Sam. The trust document stated that Sam would have the option to buy Sue’s machinery at her death at 10 percent under the appraised price. Payments could be spread out over seven years and would include a 5 percent interest rate.
She also gave Sam the right to rent the land from the RLT for five years following her death at 75 percent of the going rate in the area. The RLT document also gave Sam the right to purchase any portion of her land at any time during this five-year period at 80 percent of the real estate taxable value determined at the time of death.
The trust was required to finance the sale over a ten-year period with a 7.5 percent interest, 1-5 percent principal payment annually and a balloon payment in the tenth year. All rents and sales income would be distributed annually to the heirs equally over the life of the trust.
Note: these reductions in purchase value may result in federal and Minnesota gift tax issues and may also affect Medicaid eligibility of the individual so check with a qualified attorney and accountant.
Taxation of trusts
Simple trusts are required to distribute all of their income to the beneficiaries. The beneficiaries generally pay the income tax on their share of trust income. Complex trusts may themselves pay taxes on undistributed income. This income is reported on Form 1041, U.S. Income Tax Return for Estates and Trusts.
In Minnesota, an irrevocable trust (IT) funded by the assets or income of an individual on or after July 1, 2005 will not protect the IT assets from the Medicaid/Medical Assistance (MA) spend-down calculation even if 60 months has passed before the individual applies for MA. If you have MA questions check with an attorney who practices elder law for details specific to your situation.
Various trust titles established within the Complex Will include the following: A-B Trusts, By-Pass Trusts, Testamentary Trusts or Credit Shelter Trusts. They become effective at first death. These trusts do not save probate fees because upon the first death, the Will directs the estate to probate and this then establishes the trust. The main purpose of a trust like this is to reduce estate taxes and preserve income for the surviving spouse. This process can keep asset amounts below the applicable lifetime estate tax and gifting exclusion amounts, thus reducing or eliminating estate taxes. A “protected trust” can be established within the testamentary trust to protect assets from lawsuits and other adverse actions once those assets pass to the heirs.
Caution: This publication is offered as educational information. It does not offer legal advice. If you have questions on this information, contact an attorney.
Reviewed in 2018