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How Trusts Work

by Melissa Phipps
Browse the article How Trusts Work

Trusts can be established to provide financial security for your family's future generations.
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Introduction to How Trusts Work

"Trust fund" became a popular modifier in the 2000s as a way of describing a certain type of
undeserving rich person: trust funder, trust fund baby, trustafarian. But a trust is much more than
a money spout for entitled brats; it's an instrument that holds and distributes your assets
according to your own instructions when you aren't around to dole them out yourself.
A trust is not really an account, but a legal document that holds ownership of assets. Individuals
place assets in trusts for a variety of reasons. Some people use trusts to keep property out of
probate (the time-consuming and costly process of settling someone's will) before being passed
to beneficiaries. And sometimes a trust can shield assets from creditors. Assets held in trust are
exempt from the estate tax, which makes trusts handy tools for people with estates worth more
than $5.64 million.
A trust can be set up to provide income and instructions for a family member in need, or to
support any heir or associate, in a consistent way, over time. The document can be written to
include specific terms dictating that beneficiaries receive property only if they meet certain goals
or requirements. So-called incentive trusts can be used to attach strings to a child's inheritance,
such as body weight restrictions or job choices. About 30 percent of high-net-worth individuals
who use trusts have conditions attached [source: Frank].

It might help to think of a trust as an objective, reliable third party that watches your money
when you can't. Trusts are managed by a trustee a person or organization that oversees the
assets and property in the trust. The trustee is paid annually for this work, which is just one of the
reasons complex trusts in particular can be expensive to set up and maintain. The most common
types of trusts are living trusts, which are like wills that don't go through probate. They're often
used as a means of transferring a house to beneficiaries. We'll discuss more about living trusts in
a minute.
First, let's take a look at how different types of trusts work, how to set one up and why you'd
want one.

Trusts can help wealthy families protect their significant assets for future generations, and
average families can use them to avoid the stress of probate court after a grantor's death
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Putting Trusts into Perspective

Trusts might be sold as a tax tool, but they're much more than that. Modern trusts are touted as a
way to shield the assets of the super wealthy from estate taxes, but the U.S. federal estate tax has
only been around since 1916 [source: Mider]. Trusts, on the other hand, have been around in
some form for centuries. Some scholars say that ancient Romans first developed trust-like laws
for transferring assets from one generation to another, and the trust as we know it today is said to
have been developed in the Middle Ages [source: Langbein].
A trust is also a way to create a legacy that extends beyond one's lifetime. If you're substantially
wealthy, a trust offers a way to keep your money working for future generations. Average
families use them to transfer the ownership of a home or other assets without having to go
through probate. They are used to make the most of what our loved ones leave behind.
Private trust funds should not to be confused with federal trust funds, which are set up to collect
funds and pay for various federal programs, including bond dividends, Social Security, Medicare

and government grants. Private trusts are set up by individuals through estate-planning attorneys.
They are detailed documents containing instructions for how the assets and property should be
handled in the future. Trusts do not have to be large, but they make the most sense for large
estates, and some can be pretty substantial.
Trusts are typically set up to continue to create wealth for future generations. Investment
portfolios, real estate or businesses placed into the trust may grow and prosper, even as the trusts
make regular payments to beneficiaries. Over time, large family trusts have even turned into
national trust companies. For example, Wilmington Trust (now part of M&T Bank Corp.) began
as a multi-generational trust for Delaware's prestigious du Pont family [source: Mildenberg and
Mider].
A trust is a legal entity, separate from you or your estate, which is why it allows you to remove
those assets from the estate and any related estate tax consequences once you give up control of
them. Beyond that, the tax benefits of a trust are minimal. A trust requires annual income tax
filing, and higher tax brackets kick in at much lower rates within a trust. A trust with just $12,150
would have been in the maximum 39.6 percent income tax bracket in 2014 [source: TurboTax].
Income distributed from a trust is reported by the grantor, trustee or beneficiary, depending on
the circumstances of the payment. Before setting up a trust, it helps to discuss the tax
implications with a professional.
Trusts can also be created to distribute all assets in lump sums. Regardless of how the money and
property leave the trust, once everything is distributed, the trust will come to an end. This is
known as winding up or terminating the trust. A trust that is designed to last for several
generations is known as a dynasty trust [source: Randolph].
Money in a trust may also be considered separate from the estate in a divorce proceeding, but if
the trust is revocable, its part of a couple's shared assets. Trusts can also be used in a similar way
to prenuptial agreements, removing certain assets from shared marital ownership before the
marriage takes place.

There are several important terms and definitions you should know if you're thinking about
setting up a trust.
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Common Trust Terms

To really understand how trusts work, it helps to know a few terms.
A grantor is the person or family that sets up and funds the trust. The grantor may also be called
a settlor or donor, but whatever term you choose, this is basically the money source.
The beneficiary is the person, or persons, who will get assets or property from the trust. The
trustafarians we mentioned earlier? Those would be the beneficiaries.
The trustee is the third party, either a person or organization that manages the trust according to
the grantor's instructions. The grantor may be the trustee when the trust is first set up and then
name a successor trustee for the life of the trust. The grantor may also be a beneficiary of a trust
at the beginning. These are called grantor trusts. Until the grantor is no longer able to make
decisions, the trust can exist for his or her benefit.
Whether an individual or a trust company, the trustee is a fiduciary, meaning the trustee should
manage the assets according to the instructions in the trust.
The trust instrument is the written document that spells out the terms of the trust.
Revocable trusts are those that can be changed or revoked by the grantor after it is set up. That
means the grantor retains control of the assets. In a revocable trust, any income generated is
taxable to the grantor, who pays taxes on distributions and any capital gains.
Irrevocable trusts generally can't be changed once they are set up. The grantor loses control of
the assets to receive full tax benefits. Trusts may start out as revocable and become irrevocable
upon the death of the grantor.
The distinction between revocable and irrevocable is important. Typically, there are no tax or
asset protection benefits to a trust that you can still control, or a revocable trust. You can end and
liquidate a revocable trust to pay a creditor, for example. An irrevocable trust, on the other hand,
can't be stopped or changed once it's funded. This lack of control makes it easier to prove it's out
of your estate should a creditor come knocking.

There are many reasons to start a trust, one of which is to protect your assets before you get
married in case you two split later down the road.
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Life insurance trusts If the family is expecting a substantial life insurance policy that could
put your net worth in the estate-tax zone (estates of nearly $5.5 million or more in 2015 for
federal taxes; states may tax smaller estates), a life insurance trust can be used to remove life
insurance assets from the estate. These trusts must be irrevocable (they are sometimes known as
ILITs), must be set up before the grantor's death and must have a grantor other than the trustee
[source: Hannibal].
Living trust Also known as an inter vivos trust, it's any trust that allows you to put assets in
while you're alive. Revocable living trusts allow you to manage the assets in the trust and even
change the trust during your lifetime. Revocable living trusts have a spot on the IRS scams list,
not because they're illegal, but because they're often oversold and unnecessary.
Charitable remainder trust Wealthy folks can transfer wealth via charitable trusts. The
money is placed into the trust, and the grantor and beneficiaries can continue to receive the
distributions from the trust over a period of time. At the end of that period, the remainder goes to
charity.

Bob Marley's son Rohan holds up a set of speakers sold under the Marley family name.
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Who Needs a Trust?

To illustrate why you might want a trust, it's fun to look at a celebrity example. Take Bob Marley,
who was married with at least 11 children and who had no trust, or even a will, when he died
in 1981. The estate was worth $30 million then and is estimated to be worth $130 million now
(and this is before the deal to put the Marley name on weed) [source: Mayoras]. But fights over
control of the trust and what Marley would have wanted to have done in his name have been
expensive and painful for the family. Some estimate that unauthorized Marley merchandise is a
$600-million-a-year business [source: Kenner].
A modern-day music icon living under U.S. (rather than Jamaican) law could take steps to avoid
unforeseen problems like these. He could set up a trust to outline ownership and protect his
children and their children for generations. With a trust or a series of trusts, he could have helped
his heirs avoid any estate taxes upon his death. A trust would allow him to shield those assets
from false creditors by making it clear who controls the assets once the superstar is gone. It could
allow him to provide regular dividend payments for each family member, succession plans for
any businesses the icon invested in and a growth strategy for his legacy. With it, he could dictate
clearly what could or could not be done with his likeness, image and name to ensure future
generations would be able to understand his values and act as he would. It could also include
instructions on what his kids must achieve before they inherit a full share of the empire. It would
likely help keep his business private, instead of being aired in public after his death.
Similar problems could have been avoided by the family of Michael Jackson, the family and
long-time girlfriend of novelist Stieg Larsson, and the family of Lou Reed [sources: Bostwick,
Mayoras].
For the average person, trusts are typically used to avoid probate. Living trusts let you transfer
your house, for example, or other property that doesn't have a beneficiary named to it already.

Living trusts are like wills with built-in probate avoidance. But they can be more expensive than
wills to set up and administer, so be sure to weigh the costs of establishing a living trust against
the costs of probate. (Plus, if you have a living trust, you need a will, too.)
Then there are other ways to avoid probate like holding a house in your own name and the
name of your spouse or a joint tenancy with your beneficiary. Or keeping money in accounts that
are payable on death or include named beneficiaries. Or keeping accurate records. All of these
tactics should make probate either nonexistent or relatively easy. According to the AARP,
revocable living trusts have become so widely sold to individuals who are least likely to need
them that the Internal Revenue Service has flagged these trusts as a scam. The benefits being
touted to sell these trusts might be misleading or inappropriate for individuals or families with
modest savings and income [source: Nolo].
However, if you are a family that has substantial assets and/or complicated dynamics, a family
member with special needs or a property owner in more than one state, a living or other type of
trust could make sense. Whenever the legitimacy of an estate could be called into question, a
trust might help sort out unnecessary disputes. Families setting up these trusts should look for
experienced attorneys who understand the laws in your state. The trust instrument should be
personalized, drafted to the needs of your family, instead of boilerplate. Costs should always be
considered when weighing the benefits of the trust.

Lots More Information

Author's Note: How Trusts Work
It's hard to warn against trust scams without casting a negative light on all trusts. But I hope this
article has managed to do that. Trusts are incredibly useful tools for some people while being
only mildly or not-at-all useful for others. In the IRS's annual list of "Dirty Dozen Tax Scams,"
there's usually something about trusts. Scammers promise tax savings that don't materialize, or
simply push an expensive trust on you that you don't need. As with anything else, avoid rushing
into a trust without careful consideration and advice from a trusted professional.
Related articles

What is a charitable trust?

How Estate Planning Works

How Tax Shelters Work

Trust Funds: Fact or Fiction

How Wills Work

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