Trusts can be a useful tool for structured estate planning that aligns with your goals. Understanding the fundamentals of how a trust works and what advantages a trust may provide will help you make informed decisions about your estate plan.

Definition of Trust Elements

Trust: A trust is a legal arrangement in which a person transfers assets to a trustee, to be held and used for the benefit of one or more beneficiaries.

Trust Document: Typically, a trust is governed by a trust agreement in the case of an “inter vivos trust” or by a will in the case of a “testamentary trust.” Inter vivos trusts are created during the lifetime of the grantor, while testamentary trusts are not established until the testator (author of the will) passes away. In either case, the governing document will set forth essential instructions to the trustee regarding the use of trust assets for the beneficiaries. It may also include provisions governing the selection of successor trustees and the ultimate termination of the trust.

Grantor (a.k.a. Settlor): In the case of an inter vivos trust, the person creating the trust is typically referred to as the “grantor” or “settlor.” In the case of a testamentary trust, the person creating the trust is the “testator.” Typically, it is the grantor or the testator whose assets are used to fund the trust.

Trustee: Each trust has one or more trustees. A trustee can be an individual or a corporate entity with trust powers (such as a bank or trust company, or occasionally a charitable institution such as a university). In some cases, the grantor and the initial trustee are the same person. This is often the case with a “revocable trust” or “living trust.” With many other trusts, the grantor and the initial trustee are not the same individual. Among other things, trustees are responsible for holding title to the trust’s assets, investing them in an appropriate manner, and using them for the beneficiaries as provided in the governing document.

Beneficiary(ies): Each trust has one or more beneficiaries who are eligible to receive distributions or otherwise benefit from the trust. Typically, the beneficiaries are individuals, but charitable organizations can also be beneficiaries of a trust. In many cases, the trustees and the beneficiaries are different, but in some situations, one or more of the beneficiaries may also act as trustee(s).

Advantages of Trusts

Providing a Structure for Estate Planning

• Trusts are an essential component of many estate plans. They offer the grantor the opportunity to establish a customized plan for distributing the income and principal of the trust among the grantor’s chosen beneficiaries in the manner and timeframe selected by the grantor.

• Trusts can also play a pivotal role in providing for minors or those otherwise unable to manage assets on their own. In the case of a minor, the trustee can use the trust assets for the minor’s benefit until the minor reaches an age that the grantor deems appropriate for the trust to terminate. At that point, the trustee will distribute the assets to the beneficiary. In the case of an adult with disabilities, the trustee can use the trust assets for that person’s benefit for life.

• In the case of a revocable trust, if the grantor/trustee becomes incapacitated, the successor trustee can typically step in to administer the trust in the grantor’s place. In this scenario, a trust may serve as a better vehicle for asset management than a durable power of attorney. The role and responsibilities of a trustee are generally better defined under state law than those of an agent acting under a durable power of attorney. In addition, financial institutions typically have an easier time dealing with trustees than an agent under a durable power of attorney.

Allowing for Customization

• Within some limits, the document governing a trust can be customized to address the grantor’s specific goals and the needs and circumstances of the beneficiaries.

• Some trusts include incentives designed to encourage certain behaviors or achievements. Others give the trustee broad discretion to make distributions to the beneficiaries under certain conditions.

• As long as the terms of the trust do not violate public policy and adhere to applicable laws, trusts afford those who create them an abundance of flexibility regarding how, when, and to whom assets are distributed.

Avoiding Probate and Preserving Privacy

• Generally, assets held in an inter vivos trust are not subject to probate at the death of the grantor. Probate is the process of settling a person’s estate through a court proceeding and distributing assets to the beneficiaries of the estate. Because probate filings are usually available to the public, avoiding probate can preserve privacy for the beneficiaries.

• Using a testamentary trust (one governed by a will) typically does not avoid probate. In these cases, the testator’s estate may be subject to probate at his or her death before the assets of the estate are turned over to the trustee. In most states, however, once the estate is closed and the trust is funded there would be no ongoing supervision by the probate court.

• The privacy associated with avoiding probate can be especially important for high-profile individuals or those who value keeping their finances undisclosed to outside parties.

Facilitating Tax Planning

• Trusts serve a variety of purposes when it comes to planning for tax reduction.

• From a traditional estate planning standpoint, trusts can be used to reduce and defer the impact of transfer taxes like the estate, gift, and generation-skipping transfer taxes. For example, a married couple can typically defer the payment of estate taxes until both spouses have passed away.

• In some cases, trusts can also be used to minimize income and capital gains taxes.

Protecting Assets

• In most cases, the assets of an irrevocable trust established by someone other than the beneficiary will be protected from the claims of the beneficiary’s creditors. This can be an important factor in designing a trust for the benefit of someone who might have more potential exposure to creditors, such as medical professionals or others in fields with heightened malpractice concerns, business owners who may have potential liability on loan guarantees, or a beneficiary with irresponsible spending habits.

• Similarly, and with certain exceptions, assets held in an irrevocable trust may also be protected from legal claims by a beneficiary’s spouse in the event of a divorce.

• In the case of a revocable trust, because of the grantor’s retained right to revoke or terminate the trust, assets held in the trust are generally not protected from the claims of the grantor’s creditors.

Structuring a Trust to Align with Your Goals

It is crucial to consider your goals and intended outcomes when drafting your trust. Different trusts have certain advantages and disadvantages depending on how the trust is structured and what provisions are included in the trust document. Below are a few common ways trusts can be customized to fit individual needs.

Revocable or Living Trusts

• Revocable trusts, also known as living trusts, offer grantors flexibility for changing goals or dynamic life circumstances while still avoiding probate. They allow the grantor to make changes or, as the name implies, revoke or terminate the trust during the grantor’s life as desired.

• Assets in a revocable trust are generally not subject to probate at the grantor’s death, but they are included in the grantor’s estate for estate tax purposes.

Irrevocable Trusts

• Most revocable trusts become irrevocable when the person having the power to revoke (usually the grantor) dies.

• It is, however, possible to create a trust that is irrevocable during the grantor’s lifetime. Such trusts can serve a variety of purposes, such as making a lifetime gift that benefits certain family members or other individuals, taking advantage of certain tax benefits, holding life insurance outside the insured’s taxable estate, or benefitting charity.

• As the name suggests, an irrevocable trust is generally irrevocable and unamendable except in specific circumstances. Accordingly, careful consideration is recommended for those interested in creating an irrevocable trust.

Grantor Trusts

• The term “grantor trust” is broadly used to describe a trust for which the grantor is treated as the “owner” of all income tax attributes. As a result, the grantor is generally responsible for paying all income taxes and capital gains taxes associated with the trust’s investments. In contrast, the tax responsibility associated with a “non-grantor trust” is typically borne by either the trust or its beneficiaries rather than the grantor.

• Revocable trusts are usually treated as grantor trusts for income tax purposes. An irrevocable trust may also be a grantor trust, depending on how it is structured and what, if any, rights the grantor has retained.

• While it may not seem appealing to be taxed on the income of a trust, in the right conditions, a grantor trust can provide meaningful benefits in the effort to transfer wealth to the next generation. When the grantor, rather than the trust, pays a tax liability, it provides a benefit to the beneficiaries without involving a taxable gift.

Distribution Provisions

• In designing a trust, a grantor can prescribe the conditions under which distributions will be made to the beneficiaries. Such conditions can apply separately to the net income generated by the trust and the principal of the trust.

• In some cases, the grantor will require that all net income be distributed to one or more beneficiaries, while in others the grantor may empower the trustee to exercise discretion in deciding when to distribute net income, if at all. A common standard is to allow the trustee to distribute income as the trustee deems necessary for a beneficiary’s “health, education, maintenance, and support.” The grantor may provide that any undistributed income be added to the principal of the trust.

• A trust document may also permit the trustee to distribute some of the principal of the trust to meet a beneficiary’s needs. These provisions typically provide the trustee with a certain amount of discretion in determining whether to do so and may follow the same standard of the beneficiary’s “health, education, maintenance, and support.”

• A trust for the benefit of the grantor’s child might direct the trustee to terminate the trust and distribute all remaining principal when the beneficiary reaches a certain age. For example, a full distribution could be made at age 40 and partial distributions could possibly be made at earlier ages like 30 and 35.

• A trust might empower a beneficiary to withdraw a certain dollar amount or percentage of the principal balance each year.

Charitable Trusts

• Several types of irrevocable trusts can be established to benefit charity. Some trusts are set up exclusively for charitable beneficiaries, while others can have a mixture of beneficiaries, including individuals and charitable organizations.

• A trust that is established exclusively for the benefit of charitable organizations is often classified as a private foundation. Private foundations enjoy certain tax benefits, such as avoiding most of the tax that would otherwise be imposed on earned income and realized capital gains. In addition, within certain limitations, people who donate to a private foundation can generally claim an income tax deduction for the value of their donation.

• A trust that is established for the benefit of charitable organizations and individuals is often referred to as a “split-interest” trust. One common example of a split-interest trust is a charitable remainder trust (CRT). Typically, a CRT will make regular payments to one or more individuals for a set period, at the end of which, the remaining assets in the trust will be distributed to one or more charitable organizations. Another common example is the charitable lead trust (CLT), in which regular payments are first made to the charitable organization(s) for some time. At the end of that payment period, the assets remaining in the CLT will be distributed to one or more individuals.

• Charitable trusts can generate a positive philanthropic impact long after the grantor is gone. Because of the technical nature of these trusts, it is important to understand the consequences and benefits of these estate planning tools before implementing one of them.

• Donor-advised funds (DAFs) are not trusts, but they can serve as an alternative vehicle for pursuing charitable goals. Donor-advised funds are accounts held at a DAF-sponsoring organization. Donors contribute assets to the account and are generally eligible for a corresponding tax deduction (assuming they itemize their deductions). Assets in the fund can typically be invested for potential growth tax-free before they are distributed to qualified charities of the donor’s choosing.

Navigate Trust Options for Your Estate Plan

Trusts are a versatile tool that can supplement a comprehensive estate plan. Choosing the appropriate approach requires an understanding of your goals in collaboration with experienced advisors who can guide you in attaining them. Contact the Commerce Trust team today if you are interested in learning more about our private wealth management services and how to best incorporate a trust to solidify your financial legacy.

The opinions and other information in the commentary are provided as of April 12, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience.

This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such. 

Commerce Trust does not provide tax advice to customers unless engaged to do so. Commerce Trust does not provide legal advice to its customers. Consult an attorney for legal advice, including drafting and execution of estate planning documents.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Commerce Trust is a division of Commerce Bank.

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