Estate Planning No. 3: What is a Trust?

Genta Hataoka
Attorney and Counselor at Law
Investment Analyst
Law Office of Walter Wm. Hofheinz
© 2000 Genta Hataoka

I. Introduction

A. Many clients have heard about the term "trust" on several occasions. Unless you are actively involved with investments in U.S. utilizing trusts as a part of your investment strategy, or are a financial professional dealing with trust instruments, the notion of a "trust" is a foreign concept to many, especially the Japanese individual.
B. In order to utilize this tool for a particular purpose with adequate understanding, it is important to understand the concept as well as the mechanism of trust before utilizing this tool to implement a specific strategy into your overall estate.
C. This article discusses what a trust is generally, how a trust works, and how a trust can be used for various purposes

II. Trusts generally

A. A trust is an entity, which holds legal title to personal or real property for the benefit of another, i.e., legal title and beneficial title are separate.

• Trustee owns the legal interest, and beneficiary owns the equitable interest. Neither owns the property to the exclusion of the other, but each owns a different interest in the property.
• Trust could be for charitable purpose, pensions, managing giant investment fund, holding security for loan, or the benefit of individual beneficiaries (private express trust).

B. Types of trust that relate to wills and estate planning

• An intervivos trust (also known as "during life" or "living" trust) is one where a person creates the trust during her or his lifetime. An intervivos trust may be either revocable or irrevocable.
• A testamentary trust arises by operation of the a person's will at the time the person dies, when legal title passes to the Trustee, and beneficial title is vested in the beneficiaries.
• A revocable trust is an intervivos trust in which the person creating the trust (called "Grantor," "Settlor," or "Trustor"; all mean the same thing) reserves the right to amend or revoke the trust.
• An irrevocable trust is any trust for which the Grantor has no power to amend or revoke. All testamentary trusts are irrevocable since the person creating the trust has died. In jurisdictions other than Texas, Oklahoma, and California, a trust is irrevocable unless expressly made revocable.

III. How does it work?

At least three parties are involved: Settlor (also known as a Grantor or Trustor), Trustee, and Beneficiary.
One person can act in one or more capacities.
A. Settlor, Grantor, Trustor

• The person who creates a trust.
• Settlor by a written instrument with required formalities creates a trust. May be created during life or by the settlor's Will at death.

B. Trustee

• May be one or several.
• May be individual or a corporate, if the corporate charter authorizes the corporation to exercise trust powers. For example, your friend, family members, or bank or trust company.
• Trustee is held to a very high standard of conduct and is under a fiduciary duty to administer the trust solely in the interest of beneficiaries.
• Administration Rule of Thumb: If fee simple owner can do it, Trust Code expressly authorizes trustee to do it, except to appropriate benefit.
• Exceptions
  • Speculative Investment (too speculative and not within the reasonable prudent person investment standard) and Self-Dealing
  • Self-dealing, where the trustee acts in the same transaction both in its fiduciary capacity and in an individual capacity is sharply limited, and the some transactions are prohibited. For example, the Trustee may not buy or sell trust asset. Trustee may not borrow trust funds or make loans to trust.
• If the trustee improperly manages the trust estate, the trustee may be denied compensation, subject to personal liability, and removed as trustee by a court.
• Because a trustee has onerous duties and liabilities, the law does not impose upon a person the office of trust unless the person accepts.
• Once a person accepts it, the person can be released from liability only with consent of the beneficiaries or by a court order.

C. Beneficiary

• Beneficiaries hold equitable interest, have exclusive claim against property, and have personal claim against the trustee for breach of trust.
• If the trustee wrongfully disposes of the trust property, the beneficiaries can recover the trust property unless it has come into the hands of a bona fide purchaser.

IV. Why are trusts used in estate planning?

• To distribute benefits over a chosen interval or to multiple beneficiaries.
• To protect survivors from others or themselves.
• For income producing property especially, revocable trust is useful in keeping separate and part property that a H or W or Both want not to be commingled with their other assets. Spouses may want to establish trusts to segregate property each brings to the marriage or acquires by inheritance.
• To avoid problems in managing property by minors, those who are disabled, or others without legal capacity to act, avoiding court supervised guardianship of property. Although a custodianship account for securities or other assets is often used for the property management purpose, it is an agency relationship and terminates on the disability or death of the principal. A revocable trust continues during the settlor's incapacity.
• To avoid or minimize transfer taxes (see. Generation Skipping Trust, Marital Deduction Trust, etc.)
• To avoid probate. See. Note from Estate Planning I F95
• To avoid cost, delays, and publicity (a will is a public record)
• Provide a simple mechanism (vs. business entities) for consolidating management property.

V. Specific Concerns

A. Tax on Trust Property or Income? See. Trust Code

If revocable or Grantor trust, trust income is taxable to Settlor even if distributed.
If irrevocable, trust income is taxable to Settlor to the extent Settlor retained interest.
If the income retained in trust, it is taxed at higher rate than individual rate.
If the income is distributed to beneficiaries, it is taxed at the individual rate.
Tax rules for revocable trusts are fairly straightforward in most situations, and for irrevocable trusts are very complex in some applications.

B. How long may a trust last?

Under a private trust all interest must vest, if at all, within lives in being plus 21 years. How long approximately? However long the settlor determines, but no longer than 100+ years (new born today plus 21 years) A charitable trust; however, can be perpetual.

C. Rights of Creditors

With Spendthrift Clause, a settlor may expressly provide that the beneficiary's interest in the income or principal may not be voluntarily or involuntarily transferred before the interest is distributed to the beneficiary. The beneficiary's interest is not transferable, therefore, is not reachable by creditors.
Except:

• To satisfy the beneficiary's child support obligations,
• Creditors who furnish necessaries (medicine, food, shelter)
• Federal Tax Liens
• Settlor as beneficiary

If a trust is revocable, Settlor's creditors can reach the entire trust property even if the settlor does not reserve any beneficial interest. Personal creditor of the TRUSTEE cannot reach the trust property.
Thus it is important to set up a trust by 1st generation, so that creditor of 2nd and 3rd generation as beneficiary or trustee cannot get to it.

VI. Conclusion

Since World War II, there has been an enormous increase of private wealth in the United States. In addition to the recent explosion of wealth creation among high tech generations in the U.S., the wealth created overseas has been brought into the U.S through the foreigners moving to the U.S. as well. They are the foreign executives running U.S. companies or subsidiaries of foreign companies, the wealthy individuals retiring and the younger generations with substantial inheritance working for the employer. With this increase in wealth, a great many more people have needs for property management that are best met through creation of trust.