It’s also worth noting that the area of trusts can feel complicated because of the legal nature of trusts and the jargon associated with them. In an attempt to simplify the complex, a trust is a triangular relationship between three parties: the grantors, the trustees and the beneficiaries. These three parties can all be the same person, or they can be separate individuals depending on the situation and the nature of the trust:
- The grantor (sometimes called settlor or trustor) of a trust is the person who creates the trust and typically funds it with assets as well.
- The trustee is the person or entity that owns legal title to the trust assets but maintains a fiduciary relationship to the beneficiaries. Read our related article to learn more about the role of the trustee.
- The beneficiaries are those people or entities that benefit from the trust’s assets.
Generally, the variety of types of trusts are named by a particular characteristic that the trust possesses. For example, an inter vivos (during life) trust is simply a trust created during one’s life and may contain other characteristics that lead it to be called by other names as well. Similarly, a trust created upon one’s death can be called a testamentary trust but may have other characteristics as well.
The two most commonly known types of trusts are revocable and irrevocable trusts. As their names suggest, a revocable trust can be changed, altered and amended during the life of the trust grantor, while an irrevocable trust cannot be changed, altered or amended. Other common names for trusts — such as living, joint, marital, charitable, special needs, life insurance, credit shelter, etc. — are generally versions of either a revocable or irrevocable trust that are intended to perform a specific function or accomplish a specific goal. It’s best to consult with your attorney and/or financial advisor if you have questions regarding specific provisions or functions of a trust or if you are planning to create such a trust.
Finally, consider taxation when trust planning since trusts face the subject of taxes. For income tax purposes, trusts are identified as either grantor trusts or nongrantor trusts. Generally, if a trust is identified as a grantor trust, the grantor/creator of the trust is responsible for reporting all income of the trust on their personal tax return. This would include all interest, dividends, rents, capital gains, etc., that the trust generates. Thus, the income resulting from the trust falls into the grantor’s personal tax brackets. Conversely, nongrantor trusts are typically treated as separate tax entities and are given a tax ID or another identification number. Therefore, nongrantor trusts must file their own tax return and report all income of the trust separately from the trust grantor.
However, just because a trust is a nongrantor trust and has income, that does not mean it will owe income taxes. If any portion or all of the income a nongrantor trust generates is disbursed to beneficiaries, the trust will receive a deduction. Thus, income disbursed from a nongrantor trust to a beneficiary will result in the beneficiary paying income tax rather than the trust. However, if income is accumulated within the trust and not distributed, the trust is likely responsible for the income tax liability. Trusts face much smaller income tax brackets and therefore reach the highest marginal rate for income much more quickly than individuals. Therefore, it is generally beneficial for income to be disbursed and income taxes to be paid by the beneficiaries rather than the trust. Ultimately though, the trust’s provisions will dictate how and when income may or shall be distributed and therefore who is responsible for the income taxes. As always, it’s important to consult with your tax advisor or financial professional when handling trust taxes.
While there could never be an exhaustive list of all the types of trusts, trusts can be created to accomplish just about any goal during a person’s life and even after their death. And trusts can be an important part of an overall financial plan.