April 14, 2014

Trust Basics

In Tax Planning

Introduction to Trust Basics

We find it beneficial to occasionally review the basics of trusts so our broader discussion of planning is more helpful.  There are numerous types of trusts, however all trusts share a common structure and generally share similar treatment by the law.


The concept of trusts go back to ancient Roman law, but personal trust law as we know it was developed and expanded upon in England during the 12th and 13th centuries.  Land ownership in England was based on the feudal system and it became customary for a landowner to convey his property to a caretaker to maintain the property during the owner’s absence.  Upon the owner returning, however, the caretaker at times would refuse to convey the property back to the rightful owner, wanting to keep the land for himself.  The courts in England began consistently finding for the original land owner, each case establishing foundational case law against the caretaker.  From these land dispute cases, the principle of equity was born as well as the concept of “use of land”, hence establishing the idea of trust.


A trust is a legal entity that holds assets for the benefit of another.  This entity has three basic parties involved:

  1. Grantor/Trustor/Settlor: The person who creates and funds the trust with whatever asset he chooses.
  2. Trustee:  The person who holds legal title to trust assets, administers the trust, and has a duty to act in the best interest of the beneficiary.
  3. Beneficiary: The person who receives benefits from the trust, such as income or the right to certain assets.

A trust is created through execution of a written agreement, which lays out the names of the beneficiary and trustee, the trustee’s duties, details about the beneficiary’s benefits, and when the trust will end, among other things. Many people discuss setting up trusts to save on taxes or pass property and money to the next generation.


An important consideration is the location, or situs, of the trust itself.   The state where a trust is established can make a big difference in how much estate and income tax liability is incurred.   State laws, not federal laws govern trusts. While there are many similarities in states’ trust laws across the country, you should be aware of some important differences.

One primary difference in state laws is the presence of a state income tax.  Setting up a trust in California for example, where state income and capital gains are taxed, is much different than setting up a trust in Nevada, where neither income nor gains are taxed.  Careful forethought and planning should be taken to establish a trust in a state that is appropriate for your situation.

State laws can also differ in how long a trust may last.   Historically trusts were governed by the rule against perpetuities. The law we inherited from Medieval England frowns upon what was called “dead hand control”; they wanted trusts to end after a certain period of time and didn’t want perpetual trusts.  However, some jurisdictions such as Alaska and Delaware now allow, given the right circumstances and planning, for trusts to run much longer, even into perpetuity.  Allowing property to remain in trust sheltered from transfer taxes for the benefit of descendants over potentially hundreds of years (called dynasty trusts), can provide the ability to create vast amounts of wealth, protect assets from creditors, and save on taxes.

One additional difference among state trust laws is the ability to set up a directed trust.  In many states, the law requires the trustee to manage everything having to do with the trust and the assets it holds.  This encompasses the administration of the trust, paying taxes, and properly investing and managing the assets. Sometimes a trustee has the requisite combination of expertise and education to do the job alone. However, sometimes a division of duties with a third party, such as an investment advisor or board member of a family business, may be needed. These are called directed trusts and not all states allow this arrangement.  Delaware, Alaska, and Nevada are examples of states that do allow them.  If a directed trust is ideal for your situation, consider the appropriate jurisdictions prior to establishing your trust.


The taxation of trusts is an issue much deeper than the scope of this article; however, we can briefly touch on some high level characteristics of trust taxation.   Here are a few basic concepts:

  • Generally, taxation of trusts is determined in the same manner as an individual with some modifications.
  • Trusts receive a deduction for taxable income distributed to beneficiaries.
  • The beneficiaries report and pay tax on the distributions of taxable income to them.
  • What is left represents taxable income retained by the trust, on which the trust must pay taxes.
  • All taxable income will be taxed at its final situs (location).

One primary difference between the taxation of a trust and the taxation of an individual is the compressed tax brackets.   It only takes a trust $12,150 of income to reach the top income tax bracket of 39.6%, whereas it takes a married couple filing jointly $457,600 of ordinary income to reach the same top income tax bracket.  This explains why many trusts, especially testamentary trusts (formed through a Will at death), provide for the mandatory distribution of all income to beneficiaries where the tax treatment will likely be more favorable.


Above are just some of the issues that need to be thought through when considering the use of trusts in your planning.  Trusts can be a powerful tool in obtaining control, creditor protection, and reduction in tax liability. Understanding some of the basic concepts will go a long way in helping you understand trust planning discussions with your team of advisors.

IRS Circular 230 Notice: To insure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication (including attachments) is not intended or written to be used and cannot be used for (1) avoiding penalties imposed under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein unless the communication contains explicit language that it is a tax opinion in compliance with Circular 230 requirements.

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