How Trusts Work

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, it's 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.

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.

Trusts can be structured to achieve different outcomes, and some of the more popular strategies have their own names. What makes it a bit more difficult to sort out is that many trusts combine strategies. For example, an A-B trust includes an A, or marital, trust and a B, or bypass, trust. Here's a quick overview to help you make some sense of popular trust strategies:

A-B trust – This is set up by the grantor to pass assets to his or her spouse first, then to other beneficiaries upon the surviving spouse's death. In other words, if I die, all assets pass to my spouse. If my spouse dies, all assets pass to a new trust, then to our kids or some other beneficiary I name.

Marital trust – The A strategy in an A-B trust might be a marital trust or QTIP trust, which stands for qualified terminable interest property. These trusts are set up for the benefit of a surviving spouse upon the death of a grantor.

Bypass trust – The B in the A-B trust, this is the secondary trust that is created upon the death of the surviving spouse for the benefit of a secondary beneficiaries [source: American Bar Association].

Domestic asset protection trust – This is for the less happily married (or at least more cautiously married) folks who want to shield assets from creditors — including an ex- or soon-to-be-ex-spouse. It's an irrevocable trust, allowed in less than a quarter of U.S. states, that lets the grantor be a beneficiary. Call it the phantom prenup; it can protect young people with significant assets to lose [source: Pagliarini]. A young entrepreneur starting her own business, for example, might have a perfectly happy marriage. But if she transfers the ownership of her company into a trust before getting married, she keeps ownership of the company and its assets from being contested in a potential future divorce [source: Landers].

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 distributions from the trust over a period of time. At the end of that period, the remainder goes to the charity.

Charitable lead trust – This is similar to the charitable remainder trust, but the charity is the beneficiary of the trust first for a period of time. At the end of that period, the remainder goes to beneficiaries, such as children or grandchildren, named by the trustee [source: Fidelity Charitable].

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.