What Is a Trust?

A trust is a legal arrangement that separates legal ownership (held by the trustee) from beneficial ownership (held by the beneficiary). This separation creates a powerful estate planning tool that allows property to be managed, protected, and transferred according to the grantor's wishes while providing flexibility that wills cannot match.

At its core, a trust is a fiduciary relationship in which one party (the trustee) holds legal title to property for the benefit of another party (the beneficiary). The trust document serves as the governing instrument, establishing the rules for how trust property will be managed and distributed.

The Three Parties to a Trust

Every trust involves three essential parties, though one person may serve in multiple roles:

1. Grantor (Settlor/Trustor)

The grantor is the person who creates the trust and transfers property into it. Alternative terms include:

• Settlor (common in legal documents)
• Trustor (used in some states)
• Donor (when referring to gift aspects)

The grantor establishes the trust terms, determines who will benefit from the trust, and initially funds the trust with assets. In a revocable trust, the grantor typically retains significant control; in an irrevocable trust, the grantor generally relinquishes control upon creation.

2. Trustee

The trustee holds legal title to trust assets and has a fiduciary duty to manage the property for the beneficiaries' benefit. Key trustee responsibilities include:

• Investment management: Prudently investing trust assets according to the trust document and state law
• Record-keeping: Maintaining accurate accounts of all trust transactions
• Tax compliance: Filing trust tax returns and paying applicable taxes
• Distributions: Making distributions to beneficiaries according to trust terms
• Duty of loyalty: Acting solely in the beneficiaries' best interests

Types of Trustees:

The grantor may serve as trustee of their own revocable trust during lifetime, with a successor trustee named to take over at death or incapacity.

3. Beneficiary

Beneficiaries are the individuals or entities entitled to benefit from trust property. Trusts may have:

• Income beneficiaries: Entitled to trust income during their lifetime
• Remainder beneficiaries: Receive trust principal after the income interest ends
• Current beneficiaries: Presently receiving distributions
• Contingent beneficiaries: Receive benefits only if certain conditions are met

Example: A trust provides that income goes to the surviving spouse for life (income beneficiary), with the remaining principal passing to the children at the spouse's death (remainder beneficiaries).

Why Use Trusts? The Five Primary Purposes

1. Asset Management

Trusts provide professional management for those who cannot or prefer not to manage assets themselves:

• Minor children: Cannot legally own property; trustee manages until specified age
• Spendthrift beneficiaries: Those who may mismanage assets receive controlled distributions
• Incapacitated individuals: Trustee manages without court-supervised guardianship
• Elderly grantors: Successor trustee takes over if grantor becomes incapacitated

2. Creditor Protection

Properly structured trusts can shield assets from creditors:

• Spendthrift clause: Prevents beneficiaries from pledging their interest as collateral and protects against creditors of beneficiaries
• Irrevocable trusts: Assets in irrevocable trusts may be protected from the grantor's creditors (with limitations)
• Domestic Asset Protection Trusts (DAPTs): Available in approximately 20 states, these self-settled trusts may protect grantor's assets from future creditors

Important: Fraudulent conveyance laws apply. Transfers made to avoid existing creditors can be reversed.

3. Split Interests in Property

Trusts allow property interests to be divided among multiple beneficiaries:

• One person receives income, another receives principal
• Different beneficiaries can have interests at different times
• Control over ultimate disposition remains with the grantor's plan
• Useful for blended families, charitable planning, and generation-skipping

4. Tax Avoidance and Reduction

Trusts serve several tax planning functions:

• Transfer appreciation: Moving appreciating assets out of the estate freezes the estate tax value
• Reduce gross estate: Irrevocable trusts remove assets from the taxable estate
• Generation-skipping: Properly structured trusts can benefit multiple generations while paying transfer tax only once
• Income splitting: Trusts can distribute income to beneficiaries in lower tax brackets
• Charitable planning: Charitable trusts provide income, gift, and estate tax benefits

5. Probate Avoidance

Trust assets pass outside probate, providing:

• Privacy: Trust administration is private; probate is public record
• Speed: No court delays; distributions can occur immediately
• Cost savings: Avoids probate fees and attorney costs
• Multi-state property: One trust administration regardless of property locations

Revocable vs. Irrevocable Trusts: The Fundamental Distinction

The most critical distinction in trust planning is whether the trust is revocable or irrevocable. This determination affects control, taxation, and asset protection.

Revocable Trusts

A revocable trust (also called a "living trust") can be amended, modified, or completely revoked by the grantor during their lifetime:

• Grantor retains full control over trust assets
• Trust is transparent for income tax purposes (grantor reports income on personal return)
• Assets are included in grantor's gross estate for estate tax
• No creditor protection (assets are reachable by grantor's creditors)
• Becomes irrevocable upon the grantor's death

Irrevocable Trusts

An irrevocable trust generally cannot be modified or revoked once created (with limited exceptions):

• Grantor gives up control over trust assets
• May be a separate taxpayer for income tax purposes (complex trust)
• Assets may be excluded from grantor's gross estate
• Potential creditor protection for both grantor and beneficiaries
• Gift tax may apply when assets are transferred to the trust

Comparison Table: Revocable vs. Irrevocable Trusts

Inter Vivos vs. Testamentary Trusts

Trusts are also classified by when they are created:

Inter Vivos (Living) Trusts

Created and funded during the grantor's lifetime:

• Can be revocable or irrevocable
• Takes effect immediately upon creation and funding
• Provides management during grantor's lifetime
• Avoids probate at death
• Most revocable living trusts are inter vivos trusts

Testamentary Trusts

Created by the terms of a will and funded at the testator's death:

• Not in existence until the will is probated
• Always irrevocable (testator is deceased)
• Subject to probate before taking effect
• Court supervision may be required
• Useful for minor children or spendthrift beneficiaries

Comparison Table: Inter Vivos vs. Testamentary Trusts

Key Trust Terms for CFP Candidates

Understanding these terms is essential for the CFP exam:

• Corpus (Principal): The trust property or assets
• Trust instrument: The legal document creating the trust
• Fiduciary duty: The trustee's legal obligation to act in beneficiaries' best interests
• Distribution standard: The criteria for when and how distributions are made (e.g., HEMS - health, education, maintenance, support)
• Pour-over will: A will that transfers assets to an existing trust at death
• Funded vs. unfunded trust: Whether assets have been transferred to the trust
• Decanting: Moving assets from one trust to another with different terms
• Trust protector: A third party with limited powers to modify trust terms