An Introduction to Trusts

Part 1 - What Is a Trust, and How Do They Work?

Andrew J. Willms and Maureen O’Leary Guth

Trusts often are a core component of a family’s wealth management and transfer planning, but too often family members are uneducated about what trusts are, how they operate, and the benefits they provide. This series of articles will shine light on those questions and more. 

The Basics

At its core, a trust is a legal relationship concerning the ownership, management and enjoyment of property that is held in the name of the trust. The person who establishes a trust and transfers property to it is referred to as the grantor or the settlor. A person can be a beneficiary of a trust that he or she creates, though that choice can have important legal and tax consequences (a topic for another day).

The trustee holds and manages that property for the benefit of one or more persons or charities (the beneficiaries) subject to duties imposed on the trustee by law and the terms of the trust agreement. The trustee has legal authority over the trust property but must always adhere to the terms of the trust and act in the best interests of the beneficiaries. 

Types of Trusts

The grantor may establish a trust during life (a living trust) or arrange for a trust to be established at death (a testamentary trust). In most cases living trusts are preferable because they take effect while the grantor is living, assets placed in them are not subject to probate, and they can reduce (and in some cases eliminate) death taxes that would otherwise consume a large share of an inheritance. 

Trusts can be revocable or irrevocable. A revocable trust can be amended by the person who created it. An irrevocable trust cannot be amended by the grantor, although the grantor can give a trust protector the power to change the trust agreement if the change advances the interests of the beneficiaries. Generally speaking, an independent individual is named as the Trust Protector.

A significant benefit of an irrevocable trust is that it can be written so that it is difficult if not impossible for a creditor to seize a beneficiary’s interest in the trust, depending on the law of the state that governs the trust.

Why Create Trusts?

Of particular importance for a family with substantial assets, trusts can serve several purposes at once:

• Protections for beneficiaries. A trust can limit a beneficiary’s access to assets and, under applicable law, may offer protection against poor decisions, undue influence, and (depending on the law of the governing jurisdiction) preserve beneficial interests in the case of a divorce. 
• Provide for multiple generations. Trusts can specify how the interests of current and future beneficiaries evolve over time while giving a trustee authority to respond to changes in circumstances and unexpected developments.
• Transfer tax planning. Properly structured transfers may maximize transfer tax exemptions and shelter the growth in trust assets from death taxes for decades. 
• Continuity of asset management. A trustee can adapt investments as beneficiaries and circumstances change, without dividing or distributing everything at once. The trustee can also arrange for expert management of the trust’s investments.

Next month, we will look more closely at the trustee: what decisions does a trustee make, and what duties come with the authority to make them? In the interim, please reach out if you have any questions or would like to discuss this article.