Trust

A trust is a legal arrangement in which an individual (the grantor) transfers legal ownership of ASSETS to one party (the trustee) and the legal right to enjoy and benefit from those assets to a second party (the beneficiary). This arrangement is generally designed for the protection of the beneficiary, who is often a minor child or family member incapable of competently managing the assets themselves. However, a trust is sometimes used to split benefits between two classes of beneficiaries, the INCOME beneficiaries (persons who receive the current income arising from the trust assets) and the remaindermen (persons who receive the trust assets upon a future termination of the trust). In other situations the income beneficiary and the remainderman could be the same individual. Trusts are often used to control the transfer of family businesses from one generation to the next. The terms of the trust, the duties of the trustee and the rights of the various beneficiaries are specified in a legal document (the trust instrument). The assets placed into the trust are the trust corpus or trust principal. The role of the trustee is that of a fiduciary who is required to act in the best interest of the trust beneficiaries rather than for his/her own interest. A competent friend, knowledgeable family member, or the professional trust department of a bank usually fills the position of trustee. Professional trustees receive an annual fee to compensate them for services rendered. The purpose of a trust is to protect and conserve its assets for the sole benefit of the trust beneficiaries. Traditionally, unless a trust specified a different standard, a trustee was required to manage trust assets under a “prudent- man” rule whereby cautious INVESTMENTs are required. Most recently, states have adopted laws providing a “prudent-investor” rule, permitting trustees to play the STOCK MARKET prudently, unless the trust itself imposes a more restrictive standard. The trustee is often concerned about a lawsuit for DAMAGES under a “breach of fiduciary duty” claim whereby the beneficiaries assert that the trustee mismanaged the fund investments. The taxation of a trust is a hybrid concept. A trust files a form 1041 with K-1 schedules that report income (if any) to be taxed to the beneficiaries. To the extent that the trust distributes the current year’s income, the income is taxed to the beneficiaries who received the income, resulting in the income being taxed at the beneficiary’s marginal tax rate. To the extent the trust does not distribute current income, the trust pays the tax on the income, and the income is taxed at the trust’s marginal tax rate. The marginal income-tax rates for trusts rise to the maximum level at approximately $9,000 of annual income, compared to the maximum rate for single or married individuals, approximately $290,000 of annual income. Trusts that do not currently distribute income thus pay a high tax burden compared to trusts that do currently distribute income to beneficiaries, if the receiving beneficiaries are not themselves at the maximum marginal rate level. Currently trusts are used in various situations. Many wills are written in such a way that trusts are established upon an individual’s death. For example, a husband might place assets at his death in trust for the lifetime benefits of his wife (the income beneficiary), and at her death the trust would terminate and the assets distributed to his children (the remaindermen). During the surviving spouse’s life, as she receives the income, she reports it to be taxed on her individual return. Another example of a common trust created under a will would be an individual stipulating that assets be placed into a trust for the benefit of a minor child at the decedent’s death. The decedent might name a family member as the trustee. The trust could exist until the minor child reaches a specified age (for example, 30), at which time the trust would terminate and the child would receive the assets outright. Many individuals use trusts set up during the individual’s lifetime to obtain estate-planning and investmentmanagement benefits. For example, an individual could place a valuable building into a trust that ran for the joint lives of the individual and his/her spouse (current income being paid to individual and spouse), with the trust terminating at the death of the survivor and the assets then transferring to a charity. Thus, the individual and spouse are the income beneficiaries and the charity is the remainderman. The individual receives a double benefit in this case: The asset will be managed by the charity, with the income stream being paid to the individual (or spouse) for life; and the individual can take a current tax deduction for the future gift to the charity. The income stream could be set up as an ANNUITY interest (a set annual amount to be paid each year), or it could be set up as a unitrust interest (a set percentage of the assets to be paid each year). If the income stream is an annuity interest, the trust is known as a CRAT (Charitable Remainder Annuity Trust). If the income stream is a unitrust interest, the trust is known as a CRUT (Charitable Remainder Unitrust). The charity deduction would be the fair MARKET VALUE of the building minus the present value of the retained income stream. Another variation on charitable trusts set up during an individual’s lifetime is the Charitable Lead Trust (CLT). In these trusts, the income beneficiary is the charity and the remainderman is usually a family member of the person setting up the trust (for example, a grandchild). In this case, the charitable contribution deduction would be the present value of the income stream to the charity. The trust might last until the remaindermen reached a certain age (for example 30 years old). There are also noncharitable retained-interest trusts that could be set up during an individual’s lifetime to obtain estate-planning benefits. A valuable asset (for example, an apartment complex) could be set up in a trust that ran for a specified period of time (e.g., 15 years). The individual would retain an income interest for the specified years, either an annuity interest or a unitrust interest. At the end of the period of time (15 years in this case), the trust would terminate and ownership would transfer to the beneficiaries specified in the trust document. The individual would owe gift tax on the gift to the beneficiaries, valued at the fair market value of the assets minus the present value of the retained-income interest. If the individual lived longer than the trust term (15 years in this case), the trust assets would not be included in the taxable estate of the individual establishing the trust. If the individual died during the trust term, the fair market value of the assets would be included in his/her taxable estate. A final retained-interest trust that is a popular estateplanning strategy is a Qualified Personal Residence Trust. In this trust, the individual places a personal residence in the trust, which will terminate after a set period of time, upon which the assets will transfer to the beneficiaries specified in the trust document. The current gift tax to be paid on the future transfer to the beneficiaries is calculated as the present value of the fair market value of the residence, with the discount period being the term of the trust. If the individual outlives the term of the trust, it is not included in his/her taxable estate. If the individual dies during the trust term, the fair market value of the residence would be included in his/her taxable estate. Trusts are often used to protect assets and preserve them for the future benefit of other individuals (usually family members). They are also used in estate and financial- planning strategies and in charitable giving endeavors. A common distinction is made between the income beneficiaries (who receive the income during the life of the trust) and the remainder beneficiaries (who receive the assets at trust termination). To the extent that income is currently distributed, the receiving beneficiaries pay tax on the income. To the extent that income is not currently distributed, tax is paid on the income by the trust. Trusts’ marginal rates reach the highest level at a relatively low level of income. If the trustee has discretion over whether to distribute the income or retain it at the trust level, the trust is categorized as a complex trust. If the trustee is required to distribute the income currently, has no charitable organizations as beneficiaries, and does not distribute trust corpus during the year, the trust is categorized as a simple trust. If the trustee can determine, within guidelines established by the trust, the timing of income or corpus distributions and who will receive them (among a specified class of beneficiaries), the trust is known as a sprinkling trust.