The terminology of trusts

Trusts are popular estate planning tools. Essentially, a trust is a written legal agreement that names individuals and entities to certain roles for the management and preservation of assets. These assets, often referred to as trust property, can include everything from financial accounts to real estate holdings. A trust can be used to manage assets during your lifetime and after your death.  

There are various types of trusts to consider, each with its own specific trust terms tailored to your estate planning needs. Understanding these terms is crucial to ensuring your wishes are accurately reflected.

Like most legal documents, trusts use many terms and designations that are unfamiliar to nonlawyers. To help you better understand their mechanics and purpose, we’ve put together a short primer on the language of trusts, including different types of trust instruments and their specific roles in estate planning.

THE MAIN PARTIES OF A TRUST

Grantor: This individual, who may also be called the settlor or trustor, establishes a trust and transfers assets to a trustee. The grantor may create a self-settled trust where they are both the grantor and a beneficiary. A self-settled trust can be used to protect assets, although their effectiveness varies by state.

Trustee: An individual, bank or trust company that holds and administers the trust’s assets and distributes income and principal to the beneficiaries in accordance with the trust’s terms. If there is more than one trustee in a trust, they are called “co-trustees.” A trustee has the fiduciary duty to always act in the best interests of the trust’s beneficiaries. The grantor can also serve as a trustee in certain trusts.

Beneficiary: An individual or entity for whom a trust is created. There can be multiple beneficiaries of a trust. The trust’s terms will define the type and timing of distributions a beneficiary will receive. For example, a beneficiary may receive income and principal distributions during their lifetime, but a remainder beneficiary will not receive a distribution until after the lifetime beneficiary’s death.

TRUST CATEGORIES

There are two main categories of trusts: revocable and irrevocable.

Revocable: A trust, often called a “revocable living trust” or a “living trust,” which can be revoked, modified or amended by the grantor while they are alive. A revocable trust is often considered a substitute for a last will and testament because it can direct how its assets will be distributed after the grantor’s death without opening a probate estate.

Irrevocable: A trust that, once established, cannot be changed. An irrevocable trust can be created during a grantor’s lifetime or at his or her death. Irrevocable trusts are frequently used for advanced estate planning strategies like asset protection, potential tax mitigation and charitable gifts.

Often an estate plan will begin with a revocable trust that evolves into an irrevocable trust after the grantor’s death. Irrevocable trusts are structured for specific purposes like minimizing estate taxes, providing for a disabled family member or establishing a charitable legacy. As a result, the terms of an irrevocable trust are generally more complex than those in a revocable trust intended to avoid probate.

DIFFERENT TYPES OF IRREVOCABLE TRUSTS

Marital Trust

After the death of the first spouse to die, a revocable trust may separate into a marital trust or “A trust” and a credit shelter or “B trust”. Estate plans for married couples implement “A/B trust” arrangements after one spouse dies to minimize federal or state estate taxes by using the unlimited marital deduction to fund the A trust and federal or state estate tax exemptions to fund the B trust.

The unlimited marital deduction allows the tax-free transfer of assets to a martial trust for the sole lifetime benefit of the surviving spouse. Assets remaining in the marital trust after the death of the surviving spouse will be included in the estate of the surviving spouse, and the surviving spouse can name the remainder beneficiaries. However, if the deceased spouse wanted to control who the remainder beneficiaries will be, they could utilize a type of marital trust called a qualified terminable interest property trust, or QTIP trust. A QTIP trust is often used in blended families where the deceased spouse wants the remainder beneficiaries to be the children from a prior marriage. A QTIP trust qualifies for the unlimited marital deduction through an election made on the deceased spouse’s estate tax return. The surviving spouse must receive the QTIP trust’s income and may have access to its principal. The assets remaining in the QTIP trust will be included in the estate of the surviving spouse when they die.    

Credit Shelter Trust

The ‘”B trust ” or credit shelter trust may also be called a family trust or bypass trust. Its purpose is to “shelter” the deceased spouse’s federal or state estate tax exemption and reduce or possibly eliminate estate taxes. The surviving spouse, children and grandchildren may all be lifetime beneficiaries of a credit shelter trust. Because the estate tax exemption was used to fund the credit shelter trust, distributions to remainder beneficiaries are not subject to additional estate taxes.

Special Needs Trust

A special needs trust benefits a disabled individual and allows them to maintain eligibility for needs-based government benefits like Medicaid. Distributions from a special needs trust can supplement, but do not supplant or replace, the government benefits. For example, a special needs trust can pay for dental procedures that are not covered by Medicaid.

There are different types of special needs trusts. If the beneficiary’s assets fund the trust, it is a first party special needs trust. After the beneficiary’s death, assets remaining in the special needs trust must be used to repay the state’s Medicaid program for the services the beneficiary received during their lifetime. This “payback” provision is mandatory under federal law.

The assets of a parent, grandparent, other family member or friend can fund a third-party special needs trust. Third-party special needs trusts are not required to have similar payback provisions and can have remainder beneficiaries.      

Spendthrift Trust

An irrevocable spendthrift trust allows the grantor to leave an individual a sum of money but limits their direct access to the funds. Instead, a trustee would distribute the trust’s income and principal based on guidelines you provide in the trust agreement. Distributions can be for an allowance or for specific expenses, such as college or medical expenses, or to buy a home or start a business. This type of discretionary trust prevents the trust property from being squandered or seized, generally protects the beneficiary from creditor’s claims and can enable long-term financial security.

Irrevocable Life Insurance Trust

An irrevocable life insurance trust can reduce the value of the grantor’s estate and provide liquidity for the trust’s beneficiaries. The trust owns a life insurance policy on the grantor’s life, the trustee pays the premiums and the policy’s proceeds are not included in the grantor’s estate. An ILIT may be used to provide liquidity to the beneficiaries of the grantor’s estate and may be created to pay for anticipated estate taxes.

Crummey Trust

Named for Clifford Crummey, who was the plaintiff in a United States Tax Court case in the 1960s, a Crummey trust offers a means of transferring the grantor’s wealth through gifts that qualify for the annual gift tax exclusion. The gift tax exclusion is the amount that a donor may give to someone without reducing their combined federal gift and estate tax exemption. In 2024, the annual exclusion is $18,000, and in 2025, it will increase to $19,000. The gift must be what’s called a “present interest”, meaning that the recipient has an immediate present rather than a future right to the gift.

Here’s how a Crummey Trust works. The Grantor contributes the annual gift tax exclusion amount to the trust. The trust’s beneficiary receives written notice of the contribution. The notice sets a period (usually 30 to 60 days) in which the beneficiary may choose to withdraw the contribution or have it remain in the trust. The period with the withdrawal option qualifies the contribution as a present interest gift for the gift tax exclusion.

An ILIT is a type of Crummey trust. The trustee of an ILIT uses Crummey notices to advise the beneficiary of the grantor’s contribution to the trust. After the set period expires, the contribution qualifies for the gift tax exclusion, and the Trustee uses the contribution to pay the life insurance policy’s premiums.  

Dynasty Trust

Designed primarily to pass wealth from generation to generation without incurring gift taxes or estate taxes, a dynasty trust’s defining characteristic is its duration. Many trusts will terminate at some point, either by design or legal mechanism, but a dynasty trust can last for generations and in some cases, forever. By preserving trust property over multiple generations, a dynasty trust helps maintain family wealth and provides asset protection against creditors and divorce settlements.

Charitable Trusts

Charitable trusts allow a grantor to establish a charitable legacy and receive a charitable income tax deduction based upon certain provisions of the Internal Revenue Code. There are two general types of charitable trusts, charitable remainder trusts and charitable lead trusts.

As the name implies, a charitable organization is the remainder beneficiary of a charitable remainder trust. The grantor or another named individual receives income payment from the trust for their lifetime or a period of up to 20 years. If the trust is a charitable remainder annuity trust, the income beneficiary’s payments will be an annual fixed annuity amount. If the trust is a charitable remainder unitrust, the income beneficiary’s payments will be a fixed percentage of the trust assets on a specified date (usually December 31).

A charitable lead trust is the opposite of a charitable remainder trust. The charity receives either fixed annuity or fixed percentage payments for the lifetime of an individual or a set period of years. At the end of that term, individuals are the trust’s remainder beneficiaries. 

Depending on your individual needs and financial situation, you can choose a trust structure – or multiple types of trusts – that can help you achieve your estate planning goals. An Edelman Financial Engines planner can work with you and your estate attorney to help you weigh the pros and cons and help determine what type of trust makes sense as part of your overall integrated wealth plan.