A trust is an arrangement where the creator of the trust, or settlor, identifies a trustee to manage the assets of the trust for the benefit of one or more people known as the beneficiary or beneficiaries. A trust can be established after death pursuant to a will (known as a testamentary trust) or during one’s life, known as a living trust.
Trusts are established for a variety of reasons. An individual may want to avoid lengthy probate proceedings, a parent may want to care for a child who is a minor or developmentally disabled. A parent might even be concerned with the financial maturity of a child and protect him or her from spending the assets too rapidly.
One important distinction in trust law is the difference between the revocable and irrevocable trust. As the names suggest, the primary distinction between these trusts is that the revocable trust can be terminated upon a certain condition or by the settlor at will where the irrevocable trust cannot. However, there are other important distinctions between the two trust types.
Who owns the trust?
If a settlor sets up a revocable trust, then he or she still owns the assets in the trust because he or she can revoke the trust at any time. However, if the settlor creates an irrevocable trust, then the beneficiary owns the assets because the trust cannot be terminated.
Whether the assets are subject to the settlor’s estate taxes.
Revocable trust assets are still subject to the settlor’s estate taxes upon death because they are still “owned” by the settlor at the time of death. However, because the beneficiary owns the assets of an irrevocable trust, then the settlor can avoid subjecting those assets to estate taxes upon his or her death. Likewise, taxes are treated different for the trust types for the purposes of income tax. The revocable trust income is reported on the settlor’s 1040 whereas the income from an irrevocable trust is reported on a schedule K-1 to either the settlor or its beneficiaries. However, trust law income tax treatment may vary depending on circumstances so a tax professional should be consulted to determine what is appropriate.
Whether creditors can access those assets.
The creditors of the settlor may access the assets of a revocable trust because the settlor can terminate the trust at will and recoup those assets. However, if the settlor creates an irrevocable trust, then the settlor’s creditors can no longer access those assets. The trust may also protect against Medicaid restrictions and protect the assets in a divorce. However, because it violates public policy to allow an individual to shield his or her own assets from creditors by establishing a trust, the settlor cannot establish a an irrevocable trust for the benefit of him or her to avoid creditor attacks.
Who is the trustee?
The settlor or the family member may serve as the trustee with a revocable trust because the settlor still owns the assets of the trust. However, with an irrevocable trust, to protect the assets of the trust, the settlor should identify an independent person to serve in that fiduciary capacity.
Whether the document can be amended or modified.
The settlor can amend the plan terms or modify a revocable trust at anytime, however, an irrevocable trust instrument cannot be modified. Therefore, experienced legal counsel is advisable before an irrevocable trust is established.
Trust law involves complex case-law with a lengthy history. Those that establish trusts should contact an attorney with a practice dedicated to advising clients on trusts to avoid potential issues for their expected beneficiaries. If you wish to establish a trust and need assistance determining which type of trust is best for your circumstances, please contact us for a consultation.