What Is Trust Law?
Trust law refers to laws governing the creation and implementation of trusts, which are fiduciary relationships. In this type of relationship, one party (called the trustor) gives a second party (called the trustee) the right to hold title to assets or property for the benefit of a third party (called the beneficiary). In finance, trusts can include closed-end funds built as public limited companies.
Trust can be established to:
- Offer legal protection for the assets of a trustor
- Ensure those assets are distributed following the trustor's wishes
- Save time
- Cut down on paperwork
- Reduce or altogether avoid estate or inheritance taxes
Why Use a Trust?
Various reasons for using a trust exist. Some common reasons for establishing a trust include:
- Avoiding taxes and probate
- Determining how an individual's money should be distributed and managed, either while that individual is alive or after their death
- Dictating terms of an inheritance to beneficiaries
- Protecting assets from creditors
- Providing for a beneficiary who cannot easily manage their finances, such as an underage beneficiary or a beneficiary who has a mental disability
Trusts do have some disadvantages as well. Some downsides of trusts include:
- Requiring an investment of time to create
- Requiring money to create
- Being difficult to revoke
Categories of Trusts
Many types of trusts exist under trust law. However, each specific type of trust fits into one or multiple categories.
Living or Testamentary Trusts
Also known as inter-vivos trusts, living trusts are written documents that provide an individual's assets as a trust for their benefit and use during their lifetime. After that individual dies, the assets are transferred to their beneficiaries. The individual has a successor trustee with these types of trusts. The successor trustee is responsible for transferring the assets.
Testamentary trusts are also known as will trusts. These types of trusts specify how the individual's assets are designated once that individual dies.
Revocable or Irrevocable Trusts
A trustor can change or even terminate a revocable trust during their lifetime. However, a trustor cannot alter an irrevocable trust once they establish the trust. Trusts may also become irrevocable upon the death of the trustor. A living trust may be irrevocable or revocable, but a testamentary trust may only be irrevocable.
Typically, irrevocable trusts are more desirable. This is because irrevocable trusts cannot be changed, and they contain assets that have permanently been moved out of the possession of the trustor, which allows for minimizing or avoiding estate taxes.
Funded or Unfunded Trusts
A trustor puts assets into a funded trust during their lifetime. An unfunded trust, on the other hand, is just a trust agreement — it does not include funding.
An unfunded trust may become funded upon the death of the trustor, but it might also stay unfunded. As an unfunded trust would expose the trustor's assets to many of the issues a trust would usually avoid, it is essential to make sure there is proper funding when using an unfunded trust.
Common Types of Trusts Funds
You'll find a wide variety of trusts designed for different situations. Some of the most common kinds of trust funds include:
- Blind trusts: These trusts create a way for trustees to handle the trust's assets without the beneficiaries' knowledge. These trusts may be helpful if a beneficiary must avoid conflict of interest situations. ( Here is an article about blind trusts.)
These trusts are established to benefit a specific nonprofit organization or charity. Charitable trusts are usually created as part of an estate plan as they help reduce or even completely avoid gift and estate taxes. Types of charitable trusts include:
- Charitable lead trusts: These charitable trusts allow certain benefits to go to a given charity and the remainder of the benefits to go to a trustor's beneficiaries.
- Charitable remainder trusts: These trusts are funded during the lifetime of the trustor. The trusts disperse income to beneficiaries such as a spouse or children for a predetermined period of time before donating the remaining assets to the specified charity.
- Credit shelter trusts: These trusts are sometimes called family trusts, bypass trusts, or "B" trusts. This type of trust allows someone to bequeath a sum up to, but not exceeding, the estate-tax exemption. The rest of that person's estate would then pass tax-free to a spouse. Funds that you place in a credit shelter trust are perpetually free of estate taxes, even if the funds grow.
- Generation-skipping trusts: These trusts let someone transfer their assets to beneficiaries tax-free. The beneficiaries must be at least two generations younger than the trustor. This type of trust is used frequently to transfer assets to grandchildren. ( Here is an article about the generation-skipping tax exemption.)
- Insurance trusts: These trusts protect life insurance policies that exist within a trust. Insurance trusts are irrevocable trusts. They remove life insurance policies from taxable estates. The action may prevent the trustor from borrowing against the life insurance policy or changing beneficiaries, but after that person dies, proceeds can be used to cover estate costs.
- Marital trusts: Also known as "A" trusts, marital trusts give benefits to a surviving spouse. These benefits are usually included in the surviving spouse's taxable estate.
- Qualified personal residence trusts: If a property is likely to greatly appreciate, a qualified personal residence trust may be useful. These trusts remove someone's home (or their vacation home) from the estate.
- Qualified terminable interest property trusts: These trusts let someone direct assets to certain beneficiaries (who will be their survivors) at different times. A typical scenario would be a trust that provides income to the trustor's spouse, with the trustor's children then receiving whatever remains in the trust once that spouse dies.
- Separate share trusts: These trusts allow a parent to establish a trust that has different features for different beneficiaries, typically children of the trustor.
- Special needs trusts: These trusts are designed for dependents receiving government benefits, for example, Social Security disability benefits. By setting up this type of trust, the individual with a disability can receive income without affecting their government benefits or even causing them to forfeit their government payments.
Spendthrift trusts fulfill a few key functions:
- These trusts prevent creditors from claiming the assets the trustor places in the trust.
- These trusts allow independent trustees to manage the assets in the trust.
- These trusts forbid beneficiaries from selling their interest in the trust.
Also called payable-on-death accounts, these trusts are less complex than other types of trusts. A trustor creates a Totten trust during their lifetime and also acts as the trust's trustee. Typically, this type of trust is used for bank accounts. Totten trusts cannot include physical property.
Totten trusts offer the major advantage of allowing assets included in the trust to avoid probate when the trustor dies. A Totten trust does not require a specific written document and often doesn't cost anything to establish. Instead, the only thing needed to create a Totten trust is having identifiable language included in the title on an account. Examples of this language include:
- "As Trustee For"
- "In Trust For"
- "Payable on Death To"
If you are considering creating a trust, it is important to work with an experienced lawyer who understands the intricacies of trust law. A lawyer can help you decide the right type of trust to fit your unique needs and create an effective document that distributes your assets the way you intend.