Formerly published under the HE seriesFE-554 (Revised

Crane, Laurence M.

Lindell, David

Pankow, Debra

English

NDSU Libraries Institutional Repository

Debra PankowFamily Economics SpecialistLaurence M. CraneFormer Farm Financial Management SpecialistReviewed by:David Lindell, CPA, JDTrusts are flexible and useful tools inestate planning and can be designed in avariety of ways. They can help familiesmeet a variety of estate planning objectives,such as avoiding probate or reducingprobate costs, providing propertymanagement for a surviving spouse orchildren, giving children their inheritanceover a period of time, providing forincapacity (self or others), reducing deathor income taxes, naming a guardian forminor children, or contributing to acharity.FEBRUARY 2000ESTATE PLANNING IN NORTH DAKOTA: THE BASICSPart 4:TrustsWhat is a trust?A trust is a form of property ownership underwhich the benefits of owning property—real orpersonal (tangible or intangible)—are separatedfrom the responsibilities of ownership. Put anotherway, it is an arrangement whereby someone holdslegal title to and manages property for the benefitof someone else.  A trust is an artificial being,generally created by a written document orinstrument.  Although not recommended, a personcan create an oral, non-written trust for personalproperty simply by declaring that the property isbeing held in trust for the benefit of someone.Trusts involving real property or that are createdby will must have written instructions, however.Trusts can be simple or complex. Generally,the more complex the trust and the higher thevalue of the property in the trust, the greater thelegal and other fees involved in setting it up.Trusts require five basic elements—a grantor,a trust instrument, a trustee, property for thetrust to manage, and beneficiaries.  The grantoris the person setting up the trust.  This person issometimes referred to as the settlor or trustor.The trust instrument is a set of instructionsthat specifies the rules of operation of the trust,the powers of the trustee (the person or firmmanaging the trust), and how the beneficiaries willshare the income generated by the trust and theFE-554 (Revised)2principal remaining at the time of ultimatedistribution of the property.  The law allows theperson making the trust to write into it almostany directions, conditions and restrictions desired.The grantor may give the trustee broad andsweeping powers —such as those that might beneeded if the trustee is to manage a farm or otherbusiness —or leave the trustee very little roomfor decision making.  This is one area where carefulthought and planning are a must, since theconsequences of a mistake could be long-term.Generally, trusts can continue for any specifiedperiod of time —such as a lifetime, until a childreaches a specific age or until a spouse remarries.However, there is a rule against trusts continuing“in perpetuity.”The trustee receives the property, investscapital if necessary, collects the income, handlesthe accounting, pays taxes due and reinvests ordistributes income according to the rules laiddown by the trust.  The trustee also holds title tothe trust property but has no personal ownershipor rights in the property. Finally, the trusteeultimately distributes the principal to the remainderbeneficiaries in accordance with the trustinstrument. Clearly, the selection of a trusteeis an important decision.A trustee can be an adult, a bank with trustauthority, a trust company or a combination ofthese. Non-family members and banks and trustcompanies who serve as trustees normally chargea fee for their services. Family members typicallywaive them. Fees vary according to the type andvalue of the property being managed, with atypical annual fee ranging from three-fourths ofone percent to one percent of the value of thetrust property.There is a high degree of “fiduciary” respon-sibility imposed upon a trustee.  The trustee isrequired to carry out the exact instructions ofthe trust agreement with diligence and care.For example, a trustee cannot act beyond theauthority found in the trust or beyond what areasonable and prudent person would do underthe circumstances.Property placed in the trust either at thedeath of the grantor or during the grantor’slifetime is called the “corpus” of the trust or theprincipal. Another asset of the trust is the incomeproduced by the principal.Beneficiaries are the recipients of theincome from the trust property or of the trustproperty itself.  They can be the grantor, thespouse, the children, a charity or any entity theproperty owner desires.  There can be numerousbeneficiaries and they can even succeed oneanother. For example, income from the trust canbe distributed to the grantor’s spouse during thespouse’s life, and upon the spouse’s death theincome or principal can be distributed to thechildren. It is even possible for the same personto play multiple roles, such as that of grantor,trustee and beneficiary.3Types of trustsThere are two general types of trusts: livingtrusts (or inter vivos trusts, meaning “between theliving”) and testamentary trusts. Living trusts areestablished by a grantor during his or her lifetime.Generally, property is transferred into the livingtrust soon thereafter. (A typical problem with theestablishment of living trusts is the grantor’s failureto follow through and transfer property to thetrust—or “fund” the trust). It should be notedthat a few trusts are purposefully left “unfunded,”such as some life insurance trusts.  Testamentarytrusts become effective at the death of the grantorand are usually established by will.Living trustsLiving trusts can be further classified asrevocable or irrevocable. In general, revocabletrusts can be changed or terminated by the grantorat any time. By contrast, an irrevocable living trustgenerally cannot be changed or terminated by thegrantor once it is in force.  At the death of thegrantor, a revocable trust becomes irrevocable.For both revocable and irrevocable livingtrusts, upon the death of the grantor, the trusteecontinues to hold title to the property.  Thus, thereis no need to institute a probate proceeding in thecourt to determine title. For that reason, probatedelays and costs, as well as some of the relatedattorney and executor fees, can be reduced.Another benefit to the living trust is privacy. Sincetrust property transferred by the grantor duringlifetime does not go through probate, the termsof the trust and the trust property are not a matterof public record. On the other hand, a potentialhazard of not going through the probate processis that the probate provisions limiting the timecreditors can file claims against the estate areabsent.The degree to which the grantor retainscontrol over the trust benefits has a significantimpact on how the living trust is operated andwhat the tax consequences are. In general, majortrust benefits can be categorized as (1) the rightto revoke, alter, or amend the trust; (2) the rightto income from the trust; and (3) the right to areturn of any of the principal.By retaining the right to revoke, alter or amendthe trust (a revocable living trust), the grantorcan terminate the trust at any time and regain thetrust property. In such an instance, the propertyremains in the grantor’s gross estate for estate taxpurposes (but it does not become a gift subject togift tax). For income tax purposes, trust income istaxed as if the grantor still owned the property.While the revocable living trust does not createany tax savings for the grantor, it does allow thegrantor to select a manager (trustee), yet stillmaintain control over the property.  This wouldbe important to someone who wants to retirefrom active management or who is concernedabout becoming incapacitated in the future. Unlessadvance planning is done, such as through sometype of trust or durable power of attorney, aconservator would need to be appointed by thecourt to manage the incapacitated person’sproperty.The second type of living trust is theirrevocable living trust, where the grantor cannotrevoke or alter the trust.  The tax consequencesdepend upon what other rights the grantor hasretained. For example, if the grantor has the rightto receive income distributions from the trust,income and expenses will generally be taxed as ifthe grantor still owned the property. Further, thevalue of the trust property will be included in thegrantor’s gross estate for estate tax purposes.4If the grantor retains the right to receive thetrust property at some future date, the results aredifferent.  The amount included in the grantor’sgross estate is the future value of whatever he orshe is entitled to receive from the trust on thatfuture date.If the grantor retains none of these benefits(that is, cannot revoke, alter or amend the trust;has no right to income from the trust; has no rightto the return of any of the principal; and meetscertain other criteria), the transfer is as completeas if by gift. One of the reasons people create anirrevocable living trust is to do just that—givethe property away for good and get it out of theirestate for tax purposes. In such instances, thevalue of the property in the trust is normally notincluded in the grantor’s gross estate for death taxpurposes.  There are several exceptions to this rulerelative to certain transfers made within one orthree years of death, or where certain transfersinvolve a retained interest in the property. Further,the income from the trust usually is taxed to thetrust itself (except to the extent it is distributedto beneficiaries, in which case  the beneficiariespay the income taxes), as are capital gains.However, while death taxes, attorney and executorfees, and relevant probate costs are generallyavoided (at the death of the grantor), the value ofthe property transferred to the trust is subject togift taxes if it exceeds annual exclusions (exceptbetween spouses).Testamentary trustsTestamentary trusts, by their nature, are irrevo-cable.  They generally cannot be altered once theyare in force (unless the trustee has been given ageneral or special power of appointment to alterwho benefits from the trust).  That is, they becomeoperational at the death of the grantor (althougha will that creates one can be changed at any timewhile the grantor is alive).  A grantor who createsa testamentary trust keeps direct control overproperty during his or her lifetime. Upon death,the trust comes into being and property istransferred to be managed and distributed inaccordance with the instructions in the trustinstrument. Because the property goes into thetrust after the death of the owner, it first passesthrough probate.  All related costs are paid at thattime.  The property is also considered part of thegrantor’s gross estate and may be subject tofederal estate taxes. In addition, unlike living trusts,testamentary trusts are subject to some courtsupervision.There are several features associated with atestamentary trust. Management of the propertyis provided by the trustee.  Income usually istaxed to the trust itself (except to the extent it isdistributed to beneficiaries, where the beneficiariespay the income taxes), as are capital gains. Inaddition, the trust property generally is not subjectto estate taxes when distributed to the beneficia-ries (unless some beneficiary held a general powerof appointment over the trust property, or thetrust is a marital deduction trust—defined in thenext section).Testamentary trusts are sometimes used toprovide for property management for survivingminor children should both parents die.  Thetrustee could be the person named as guardian, orit could be another person (or a bank with trustauthority or a trust company). If the guardian andtrustee are not the same person, the additionalsupervision over distribution of the funds needs tobe weighed against the possibility of disagreementsbetween child, guardian and trustee.  Testamentarytrusts are also used to provide  management ofproperty for someone (such as a surviving spouse)through a life interest, with the property ultimatelygoing to someone else (such as the children) uponthe death of the holder of the life interest.5Other trustsThere are numerous trust provisions orspecific trusts that may help individuals and familiesreach their estate planning objectives.  Theseinclude marital trusts (such as qualified terminableinterest property trusts or QTIP trusts, power ofappointment trusts, and estate trusts), nonmaritaltrusts, Medicaid trusts, qualified domestic trusts,and others.To use the marital deduction when calculatingestate taxes, generally the deceased must leaveinterest in property to the surviving spouseabsolutely—that is, with no strings attached(such as those that would limit what the survivingspouse could do with the property). One of severalexceptions to the general rule is a qualifiedterminable interest property trust or QTIP trust.This marital trust can provide, among other things,the  means for a spouse to keep his or her estateout of the hands of a surviving spouse’s subsequentspouse (if there is one).  The surviving spouse getsthe lifetime income from the trust, but the corpusor principal of the trust goes to the grantor’schoice of beneficiaries (when the surviving spousedies).  The property is included in the gross estateof the surviving spouse for federal estate taxpurposes.Another type of trust is the life insurancetrust.  While generally referring to irrevocable orrevocable living trusts, life insurance trusts mayalso be testamentary trusts. Life insurance trustsgenerally are funded as “owners” of life insurancepolicies, but they also may be unfunded, with thetrust named as beneficiary of policies owned byothers.Probably the major advantage for insurancetrusts is the greater flexibility and control possibleover determining how proceeds and income aredistributed.  As with other trusts, the benefits haveto be weighed against the costs of establishingthe trust.A type of nonmarital trust that takes advantageof the unified credit available under federal estatetax laws is the credit-shelter trust. Here’s a typicalexample.  A spouse places up to $675,000 worthof property into the trust at his or her death, withno federal estate tax liability.  Assets having a valueup to the applicable exclusion amount are exemptfrom estate taxes. Reforms in estate laws will allowup to $675,000 in a credit-shelter trust in 2000 and2001. The applicable exclusion amount allowed willincrease each year to amount of $1 million in 2006and thereafter.  The trustee is given the power todistribute trust income (and in some situations,distribute a portion of the trust principal up tospecific restricted amounts) to the surviving spouseand to distribute the trust principal to the couple’schildren upon the death of the surviving spouse.For federal estate tax purposes, the property isnot included in the taxable estate of the survivingspouse.A relatively simple way to put property into a“custodianship” for minor children was createdby the Uniform Transfers to Minors Act.  Theterms of this trust substitute are rigid and maynot provide enough flexibility for some families,however.When the custodianship is established by gift,initial transfers are subject to the gift tax rules,but no further transfer taxes are due when theproperty is distributed to the child or for thechild’s benefit. It can be also be used anytime aminor receives an interest in any property. If theminor dies before the custodianship is terminated,the value of the property in the fund is includedin his or her gross estate. Gifts placed in this typeof arrangement generally are not included in thegrantor’s gross estate for death tax purposes,unless the donor acts as custodian and dies beforethe custodianship is terminated.6The income on the property is taxed to theminor child. However, with the so-called “kiddietax” created by the 1986 Tax Reform Act, many ofthe income-shifting advantages have been removed.For example, if a child is eligible to be claimed as adependent on someone else’s income tax return,he or she must pay taxes on unearned income overa specified amount. Further, for those under 14, netunearned income (generally, investment income inexcess of a certain amount) is taxableat the parent’s marginal tax rate.ReferencesThis publication is based on material developedby Joyce E. Jones, Extension Specialist, Adult Devel-opment and Aging, Kansas State University Coop-erative Extension Service, Manhatten Kansas, 1992.Other sources include:Douglas F. Beech, Sam Brownback, and Martin B. Dickinson,Farm Estate Planning, Cooperative Extension Service,Kansas State University, S-24, January 1985.Richard W. Carkner, Estate Planning for Washington Families,Cooperative Extension Service, Washington StateUniversity, EB 1231, July 1984.Neil E. Harl, Estate Planning: Planning for Tomorrow, Coopera-tive Extension Service, Iowa State University, Pm-993,August 1988.Philip E. Harris, Farm Estate Planning Workshop, CooperativeExtension Service, University of Wisconsin-Madison,July 1989.Ralph E. Hepp and Myron Kelsey, Trust Uses in EstatePlanning, Cooperative Extension Service, Michigan StateUniversity, E–1345, Revised June 1989.Sidney Kess and Bertil Westlin, CCH Estate Planning Guide,1994 Edition, Commerce Clearing House, Inc., July1994.Marguerite T. Smith, “When to Trust Living Trusts,” Money,August 1990.The authors would like to thank the following fortheir review of this publication:Terry W. Knoepfle, J.D., CPA, Assistant Professor, Taxationand Business Law, North Dakota State University.David M. Saxowsky, J.D., Associate Professor, AgriculturalEconomics, North Dakota State University.Kenneth Norman, J.D., Miller, Norman and Associates,Moorhead, Minnesota.7NDSU Extension Service, North Dakota State University of Agriculture and Applied Science, and U.S. Department of Agriculture cooperating.Sharon D. Anderson, Director, Fargo, North Dakota. Distributed in furtherance of the Acts of Congress of May 8 and June 30, 1914. We offer ourprograms and facilities to all persons regardless of race, color, national origin, religion, sex, disability, age, Vietnam era veterans status, or sexualorientation; and are an equal opportunity employer. 1500-5-95, 3M-3-96, 2M-3-99, 3M-2-00This publication will be made available in alternative formats for people with disabilities upon request (701) 231-7881.This publication is not intended toprovide a substitute for legal advice.Nor is it intended to serve as a completeand exhaustive text on estate planning.Rather, it is designed to provide basic,general information about thefundamentals of estate planning so youwill be better prepared to work withprofessional advisers to design andimplement an effective estate plan.Information in this publication is basedon the laws in force on the date ofpublication.

ESTATE PLANNING IN NORTH DAKOTA: THE BASICS Part 4: Trusts

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ESTATE PLANNING IN NORTH DAKOTA: THE BASICS Part 4: Trusts

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