Living trusts, otherwise known as inter vivos trusts, are created during the lifetime of the person who created the trust, who is otherwise known as the grantor, trustor, or settlor (hereinafter, “Grantor”). A Revocable Living Trust (“RLT”) can be established for a specified period of time, upon the occurrence (or nonoccurrence) of a specified event, or until the death of the Grantor. The three essential parties to an RLT are the Grantor, Trustee, and Beneficiary.
The Trustee manages the trust assets for the benefit of the Beneficiary. The Grantor of an RLT retains the absolute right, during his lifetime, to alter the terms of the trust, amend the trust in whole or in part, and revoke the trust in its entirety. A revocable trust morphs into an irrevocable trust when the Grantor dies, or when the Grantor surrenders title to the property held in the trust during his lifetime and relinquishes the right to alter, amend, revoke, or terminate the trust.
In order to create a legally enforceable RLT, the Grantor must transfer the property to the Trustee, who will hold legal title, manage the property, and distribute the income derived from the trust to the Beneficiary. There are two categories of beneficiaries. The income Beneficiary is entitled to receive the income derived from the trust assets for life, fixed period of years, or upon the occurrence (or nonoccurrence) of an event. The principal (or remainder) Beneficiary is entitled to the trust assets (e.g., condominium). In an RLT, the same person can be the Grantor, Trustee, and Beneficiary (both principal and income).
Utility of an RLT
An RLT is utilized for a number of reasons, chief among them is the avoidance of probate. There are other valid reasons for utilizing an RLT. If the Grantor wants a third party to manage any of his properties or he wants to ensure that his business interest or personal assets will continue to be managed and income will continue to be derived from his assets even when he becomes disabled or dies, an RLT provides an efficient mechanism to accomplish those objectives. However, one of the biggest incentives for establishing an RLT is the administrative burden that may ensue upon the Grantor’s death if the Grantor does not have an RLT.
The administrative burden may come about in several forms. For starters, even if the Grantor has a Will, he may still not have a lot of control in passing his estate to the Beneficiary of his choice if he does not have an RLT. Additionally, Wills, by law, have to be filed with the court (“probate”), which results in the contents of the Will becoming public record. This means that not only will there be additional costs and time accrued before the assets are passed to the Beneficiary, but anyone in the public domain can potentially challenge the contents of the Will. A carefully drafted RLT can prevent the additional costs and time by avoiding probate and lessen the likelihood of a challenge of the trust instrument.
Funding is an essential step for an RLT to be legally enforceable. Even though some states permit a nominal amount to meet the funding requirement, it is essential for assets that include real property, securities, and accounts holding liquid assets to be transferred to and held by the RLT in order to avoid probate. However, title to retirement assets or annuities are not recommended to be held by the RLT since it may result in the recognition of income tax by the Grantor. Personal property, especially valuable assets such as paintings and jewelry, should be assigned to the RLT.
Retirement assets, annuities, life insurance, and other assets that have beneficiary designations should name the RLT as a designated (or contingent) beneficiary since it is desired for those assets to end up in the trust upon the Grantor’s death. In other words, the trust instrument will govern how and when the distribution will be made to the Beneficiary. Thus, if the assets end up in the trust as opposed to being transferred directly to the Beneficiary, the transfer can prevent the assets from being squandered or from being required to satisfy debts, judgments, or divorces. Since the assets will be held in the trust’s name under that scenario and not in the Beneficiary’s name, the exposure of these assets to creditors will be less likely.
Choosing the Trustee
Most jurisdictions, including California, have adopted the Uniform Probate Code (“UPC”), which includes the baseline and the more heightened standards for duties imposed on Trustees. The Prudent Investor Rule, which is the baseline rule, states that a trustee will be liable to a beneficiary for losses if she does not exercise the same care and skill that a person of ordinary prudence would exercise in dealing with her own property. The more heightened standard under the UPC states that if a person possesses greater skill than that of ordinary prudence (e.g., investment management), she is under a duty to exercise such skill.
The Trustee will be required to periodically analyze the trust, interpret its provisions, and make difficult decisions. Thus, the Trustee must possess some basic legal, financial, and accounting knowledge in order to make the best decisions in the Beneficiary’s interest. Hence, the standards imposed by the UPC are meant to protect the Beneficiary as well as give guidance to the Trustee on what is expected of her in managing a trust.
An issue that may arise in the selection of a trustee is whether someone who has close ties to the Grantor should be selected as the Trustee. The advantage for picking such an individual is that she may have direct knowledge of the family dynamics. The disadvantages, however, tend to outweigh the advantages for several key reasons as discussed below.
The issues that may arise in picking someone close to the Grantor as a trustee is whether she will be faced with a conflict especially if she is also a beneficiary; whether she will be biased towards one family member over another; and whether she will possess the requisite legal, business, and accounting knowledge to make informed decisions even when she is relying on advice from experts, since identifying whether such advice is accurate is also a critical factor in the decision making process.
What Not to Expect from a RLT
A common misconception is that an RLT is an asset protection tool. It is not. The Grantor of an RLT has the ultimate right to amend and revoke the RLT. For income tax purposes, all income derived from the RLT is taxed at the Grantor’s personal income tax return. As a general rule, asset protection is afforded in circumstances where the nexus between the original owner of the asset and the current owner is de minims. In the case of an RLT, the trust is merely an extension of the Grantor since the Grantor has the absolute right to deal with those assets in any which way he pleases.
Revocable to Irrevocable
During the lifetime of the Grantor, the trust may become irrevocable if he surrenders the right to alter or revoke the trust. The trust may also become irrevocable during incapacity because the Grantor would generally lack the power to revoke the trust in the event of incapacity. As a result, immediate gift tax implications may be triggered. However, if the Grantor retains a life income interest in the trust’s assets and reserves a testamentary power of appointment over the remainder interest, the gift tax consequence may be avoided because a person is always presumed to regain competency at any point prior to his death.
At the time of the Grantor’s death, the trust will become irrevocable, since the Grantor will no longer be alive to amend or revoke the trust. The assets may pass to the Beneficiary outright or they may remain in the trust for future generations. When the assets remain in the trust, there may be notable advantages from an asset protection standpoint.
If the assets do not pass outright to the Beneficiary, the trust will hold title to the assets. Unlike an RLT where the assets are deemed to be an extension of the Grantor, the assets held for the benefit of the so-called “Trust Fund Baby” will not be considered an extension of the Beneficiary. Thus, the assets themselves (but not the income that may be distributed to the Beneficiary that is generated from the underlying asset) will generally be out of a creditor’s reach.
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