Post the Law #6: Trusts

There was a recent comment asking whether I could go over trusts, so here I am ready to talk about trusts. We are not talking about trusting people, we are talking about a mode of transferring property from one person to another. Don’t worry about being lost; I’ll try to give the general, basic understanding of what trusts are and why people use them. I added a few funny legal cartoons from Stu's Views to liven this long winded discussion.

Everyone acquires property (money or physical possessions) during their lifetime. What we do with that property is entirely up to us. Any property you own when you die is magically transformed into something called your “estate”. An estate is any property you own including land, stocks, furniture, vehicles, pencils, paper, and even the moldy cheese in your refrigerator. What to do with this “estate” is what most of property law involves. This would include wills, trusts, and intestacy law. These combine to form what is commonly called estate planning. Another way of putting it is that estate planning asks the question, “What do I do with my property?” For now I won’t go over wills or intestacy law as I might save that for another post sometime. For now let’s deal with trusts and how they fit into estate planning.

The definition of a trust is an arrangement whereby a trustee manages property as a fiduciary for one or more beneficiaries. I know that is a lot in one sentence with some technical terms, so we will break it down in a series of steps:

First, you need a person who has property. The property owner plans on giving his property away to someone.

Second, you need a beneficiary, which is a person who is going to benefit from the owner’s gift of his property.

We will stop here for a moment and identify what the beginnings of this trust looks like right now. Two people, one has something and he gives it to another. That is a gift. This happens every Christmas, birthday and anniversary. It doesn’t matter if the gift is elaborate or casual, it is still a gift. Now we are going to add some elements to this gift that will make it a trust instead of a gift.

Third, the owner of the property wants to add some qualifiers (“strings attached”) to his gift so he writes out his conditions in something called a trust agreement.

Fourth, the owner of the property (known as the settlor) gives his property to a trustee (named in the trust agreement) to hold on to the property until the conditions are met.

Fifth, the trustee is bound by a fiduciary duty (a loyal or faithful duty) to manage the property for the trust beneficiary until the conditions have been met.

Sixth, once the conditions of the settlor have been met, the trustee dispenses the property from the trust to the beneficiary.

That’s it. That is a trust. Most people associate trusts with money in bank accounts. That is one way to manage a trust, but do not constrain yourself with the idea that money in a bank is the only type of trust. There are as many different trusts as there are flavors of jelly beans. I’ll only go over a few types in this post.

I think an example would be fitting to illustrate a trust in a real world setting. Adam has $100,000 and a collector’s edition Darth Vader lightsaber. Adam is getting old and wants to make sure the right people get his things. Billy is Adam’s only son and would be the only heir to Adam’s property if he died today. Billy has made it clear that if got any money he would invest it all into a new store that would reignite the desire to have eight-track tapes. Billy has also said that he thinks the lightsaber is stupid and he would throw it away if it ever became his. Adam realizes that Billy has no financial sense and would squander his inheritance. So to prevent it, Adam decides to transfer his property to Billy in a trust rather than through a will or by intestacy. Adam selects his youngest sister, Cindy, to be the trustee of Billy’s trust. The terms of the trust say….

1) Billy gets $1,000 a month or $2,000 a month if he has a job.
2) The trust will pay tuition if Billy goes to a university.
3) The trust will pay for a wedding.
4) Billy gets the lightsaber if he watches all six Star Wars movies in 24 hours.

5) The terms of the trust can be changed only if both the trustee and the beneficiary agree.

There might be some additional things in the trust like who would be trustee if Cindy can’t do it anymore, or what happens to the trust if Billy dies, or maybe a specific date that Billy does get everything immediately (like 25 years from now).

The benefits of a trust are clear in this case. Adam is giving his money away on his terms. Billy is prevented from squandering the whole inheritance at once.

There are additional benefits of trusts that are not immediately clear in this example. Creditors can be thwarted by a trust. If Billy has debts he can’t pay and the creditors come after him, they might see this trust account as easy pickings. Depending on how the payments of the trust are set up, the creditors might reach the funds. If the trustee is required to give Billy the money per month, then the creditors can get an order to garnish the trust wages (not force the trust open, just take the monthly payment) until the debt is paid off. If the trustee has the option to disperse the funds depending on the beneficiary’s status, then the creditors would not be allowed to garnish the wages at all because the trustee is controlling the flow of money, not a set timetable.

A famous benefit of trusts over wills or intestacy is taxes. Apparently no one likes paying taxes, especially paying more taxes just because you die or you lost a family member. It is true that trusts (so long as they are not established to blatantly avoid inheritance taxes-ex. creation of a trust on your death bed) avoid the dreaded inheritance taxes. However, it should be noted that the current inheritance tax only kicks in if the estate in question is over $3 million. Establishing a trust to prevent taxes on your estate of $200,000 is unnecessary because you fall below the line. Additionally the inheritance tax is only law through this year (2010) unless Congress passes an extension (which it always seems to do). It should be noted that Congress tends to move the line to a higher limit rather than a smaller one; the next line might be at $3.2 million rather than $3 million. Bottom line is if you need a trust to avoid inheritance taxes, you are doing pretty well. You probably have enough money lying around to hire a poor property or tax lawyer to check into your estate and see if it is too large to avoid an inheritance tax.

I think the most important reason to use a trust over wills or intestacy is privacy. A trust is a private agreement between (or among) parties. Wills and intestate succession go through the court system and those are public documents. In class we looked at many famous people’s wills and analyzed “what were they thinking” or a better question is “what were their high paid lawyers thinking?” A good example of the public nature of wills is found in the movie Who Framed Roger Rabbit where the detective sends his girlfriend to the probate court to check for Acme’s will. When Acme’s will is found and probated, it is a public document free for anyone to look at. Had Acme used a trust to distribute his property, the terms of the trust would be private. This aspect of a trust is important for some people who want to pass things on without anyone knowing they had it or who is getting it. Maybe you want to transfer a famous painting or an extremely valuable artifact and don’t want treasure hunters to know who has it. A trust is a good way to keep things private.

I want to spend a minute talking about the trustee and why he has such a big role in trusts. When the settlor puts his property in a trust he is giving legal title (power to buy, sell, trade, etc.) to the trustee and he is giving equitable title (benefits of ownership) to the beneficiary. In effect it allows the trustee to manage the property in the trust. Management of trust property could be investing it, putting it in a bank account, exchanging for different property, etc. An important note, however, is the fiduciary duty of a trustee. The trustee is under a fiduciary obligation not to misuse the property in the trust. If the trustee makes changes to the trust property he must do it to ultimately benefit the beneficiaries. The courts have suggested that investing in the stock market, buying real estate, or even investing in new companies are ok for a trustee to do. However, you can’t gamble the money in casinos or be completely stupid in investing (ex. investing in a company that promises to grow trees that grow money as fruit would be considered a breach of the fiduciary duty).

I have one last thing I want to say before I finally post this massive thing that I have been working on for weeks. The three people involved in trusts (settlor, trustee, and beneficiary) can be the same person. Yes, this changes the whole game of trusts. In class when we were learning about trusts this was one of the first things they taught us, otherwise some of the cases would not make sense when we read them. However I think if we are going over the basics of trust, you don’t throw in a big wrinkle like this until the end. Having people with multiple responsibilities in trusts is a common tactic and allows people greater freedom in deciding how to construct their trust. Some common examples of such multiple responsibility trusts are: parents who give money to their children in trust with the parents as trustees (education trusts), older folks who put money in trust to themselves as beneficiaries but put their children or a bank as trustee to manage the money for them, people who put money in trust for themselves with themselves as trustee. Yes, these kinds of trusts are common and used every day.

In conclusion of this long, long, long post about trusts I hope you know more about trusts than you did when you started. I don’t expect anyone to be an expert. I don’t claim to know it all myself. However, if you have a question about trusts, let me know. If I said something that might be confusing, ask, it might simply be an error on my part. Hopefully you learned something, it was quite enjoyable (yet frustrating because I couldn’t always explain things correctly).

Until next time.