Various Trust Types and How They Can Be Helpful Planning Tools

Various Trust Types and How They Can Be Helpful Planning Tools

Trusts are entities that exist under state law. The Internal Revenue Code does not define trusts; however, the tax regulations provide a definition of an individual trust as “[a]n agreement created either by a person’s will (testamentary trust) or by an inter vivos (living person) declaration whereby a trustee takes title to property for the purpose of protecting or conserving for the beneficiaries under the ordinary rules applied in chancery or probable courts.”

The other types of trusts are business trusts where title to property is conveyed to the trust’s trustees that are arrangements to operate property to carry on a profit making business. Such trust arrangements are taxed as corporations or partnerships depending upon the facts and circumstances.

Regarding individuals, trusts have a myriad of uses. They can provide asset protection to beneficiaries and, with planning, may provide relief from income taxes, federal estate, or state inheritance taxes. They can be used to maintain continuity in the operation of closely-held business entities, as in voting trusts. They can also be used to provide investment management, creditor protection, or protection of assets in a divorce proceeding related to a beneficiary, or to manage assets for a handicapped child or older beneficiaries. They can also be used to encourage a beneficiary to act in a desired lifestyle or discourage an undesirable lifestyle, such as the use of drugs or alcohol. Certain trusts also eliminate or reduce probate requirements regarding an individual’s estate.

Some of the considerations that must be addressed for not using trusts include assets being insufficient to create a trust, or parents not caring what happens to their assets after their deaths or believing their children will need to spend their inheritance for living expenses.

Trusts have their own set of rules regarding taxation of income. The trust document depends on what type of trust is being created. For example, if the document permits the individual forming the trust the right to substitute assets or change the terms, the income from such a trust is taxed on the individual tax return who formed the trust. A trust document that requires all income to be distributed to the beneficiary is taxed on the beneficiary’s income tax return. This is known as a simple trust. For other trust documents that give the trustee the option of determining the amount of the income to be distributed or not distributed, the undistributed income is taxed on the trust’s income tax return. This is known as a complex trust.

A key issue that must be determined is choosing a state of legal jurisdiction for a trust. This takes into consideration numerous factors. In many instances, an individual’s state of residence might meet all of the objectives of the trust. In some cases, creating a trust in another state may be more beneficial depending upon the particular facts and circumstances.

It should be noted that the Trump administration is proposing changes in the estate and gift tax law. Part of the proposal is to eliminate the estate tax. Many present estate plans provide for the use of trusts in various forms. If these proposals are enacted, it will be essential to revisit the use of trusts.

Harry F. Murphy can be reached at hmurphy@kmco.com or 215.441.4600.

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