Trust Under Agreement: What Is It?
A trust under agreement is a practical, estate-planning tool. While varying in complexities and terms, a trust under agreement is a type of trust created by an agreement (contract) between the Grantor of the trust and a Trustee. A trust under agreement is used when one who wishes to create a trust does not want to use the formalities of creating a trust under a Will (testamentary trust).
Also, a trust under agreement can be used as a separate agreement (contract) during life time of a Testator, instead of a testamentary trust. A testamentary trust, however , is created by the instructions in a Will.
To start a trust under agreement (inter vivos trust), the Grantor simply completes a privately written document where he (or she) declares that he (or she) would hold and donate some (or all) of his (or her) property to a Trustee, for the benefit of certain beneficiaries of the trust.
The Grantor of the trust under agreement can choose exactly what property he wants to donate. And, the Grantor can provide the exact instructions as to how the property held in the trust will be used to benefit the beneficiaries.
Establishing a Trust Under Agreement
For the establishment of a trust under agreement, there are five essential steps to be observed:
- A declaration must be made in writing in a document entitled "Trust Agreement" or "Declaration of Trust," wherein the trustor provides for the substitution or storage of both legal and beneficial title to the property to someone or some persons, other than the trustor, within the state, for some definite period of time or particular purpose. Generally, in the case of real property, the declaration or trust agreement must be signed by the person(s) making the conveyance.
- The declaration must include an expression of intent to hold title as a trustee or trustees for the beneficiaries and not as the undisclosed agent for the beneficiaries. The declaration must be clear that the transferor desires the property to be taken in trust for the benefit of others, and to vest in the trustee or trustees the duties, powers and privileges to deal with the property in such a manner as to serve the interest of the beneficiaries. The trustor is termed "the settlor."
- The beneficiaries of the trust must be specifically designated by name or necessarily ascertainable. It is immaterial whether the beneficiaries are designated in the trust indenture or identified through their membership in a class. The courts, however, look with favor on a trust agreement where the settlor has clearly identified the beneficiaries.
- There must be a competent trustee or trustees. This is always a question of law. A trustee must be a natural person, of sound mind and 18 years of age or older. A corporate trustee may be a bank or any other corporation having power to take trust property under the laws of the state. An individual may act as a trustee for his own benefit under the trust agreement. An agent may be named trustee, although it is better that he be properly authorized by the principal to accept the appointment.
- The trust under agreement must be funded. The property held in the trust is referred to as the "res." The res must be real property, which is conveyed at the time of the execution of the trust agreement, or merely a declaration of trust if the trustor is the owner of legal title. To land, the res may consist of a lien under agreement, or a pledge, or merely an interest in personal property.
Trusts Under Agreement: Types
There are two main types of trusts under agreement: revocable trusts and irrevocable trusts. Generally, irrevocable trusts provide greater asset protection for the trustor, the trustors spouse, and beneficiaries than revocable trusts. However, a revocable trust can offer other benefits that ought to be considered in determining whether a trust will be effective for an estate. Because most trusts are created as revocable trusts, many persons become confused over the concepts of revocable and irrevocable trusts.
A revocable trust is one the terms of which can be changed during the trustor’s life by someone named in the trust agreement or by operation of law. The trustor, himself, or a person other than a creditor, may revoke the trust.
An irrevocable trust is one under the terms of which the trustor is precluded from having ownership of, or power to amend, the trust or the rights of control afforded the trustee without the consent or agreement of the beneficiaries or some other competent party. It is important to keep in mind that a competent court may have the power to change the trust terms. A court’s requirements for changing an irrevocable trust are generally very strict and difficult to meet. One such requirement is that the modification of the trust not be injurious to the beneficiaries. In those situations where a competent court can modify or terminate an otherwise irrevocable trust, a trustor’s creditors are not likely to be prejudiced.
The main reason for creating an irrevocable trust is to remove assets from the beneficiary’s gross estate for estate tax purposes. An irrevocable trust will normally afford greater asset protection for beneficiaries, especially if they are concerned about their own possible incapacity or that of their spouses.
On the other hand, the advantages of revocable trusts over irrevocable trusts are that the terms of revocable trusts change more easily than those of irrevocable trusts; that property can be added to the revocable trust as an estate planning strategy; and, that the trustor is not relinquishing effective control of property placed in a revocable trust. Revocable trusts can also be revoked or terminated at any time during the trustor’s life without the need for court involvement. They can also be used for disposing of property for the trustor’s personal benefit. Revocable trusts can benefit a spouse to whom property passes free from claims of spouses creditors, to diminish or eliminate state inheritance taxes, and to avoid state inheritance taxes on property passing to distant relatives. Revocable trusts with a spendthrift clause provide additional asset protection.
While revocable trusts are undoubtedly the most common type of trust established, it is fair to say that irrevocable trusts are the more effective type of trust available for multiple estate planning purposes. The choice between revocable and irrevocable trusts depend upon, largely, a matter of timing. A revocable trust can free a real estate or other property from probate, prior to death. However, an irrevocable trust is oftentimes a better long-term estate planning option that needs to be given sufficient foresight and consideration.
Benefits of Trusts Under Agreement
Trusts under agreement carry certain advantages. A trust under agreement allows for the structuring of future distributions of income and principal, which can provide for a preferred methodology of distribution. Additionally, a member can have the right to sit back and receive distributions, but also to have some control over distributions. For example, a member could have a mandatory distribution right in the future, but an override if certain circumstances dictate otherwise. However, further implementation of this concept will be discussed when planning the terms of the initial trust and put into effect via the operating agreement and/or other governing documents.
Certain provisions, similar to those found in a living trust, can be drafted to allow for the grantor to act as the trustee or a co-trustee and enjoy the same level of control over the assets held by the trust without triggering inclusion of the trust assets for estate tax purposes.
A trust under agreement also serves as a valid estate planning tool. The trust can own the active business or assets, thereby decreasing the value of the grantor’s taxable estate. This is particularly beneficial if the trust is revocable and the grantor and the grantor’s living spouse are the sole beneficiaries of the trust. Additionally, a properly structured trust can ensure subsequent generations are the long-term beneficiaries of the grantor’s efforts.
One of the sticking points of a trust under agreement is what happens if the grantor or a member wants to obtain a loan from the trust. The IRS rules in this regard require a portion of the income earned by the trust to be distributable to the member [under the terms of the operating agreement and/or other governing document] for the member’s use in making loan payments. It is important to note, a properly structured loan between the trust and the member can be forgiven after a certain period of time.
Myths Around Trusts Under Agreement
One of the most common misconceptions about Trusts Under Agreement is that they are costly. While there are certainly upfront fees associated with establishing the agreement, the overall cost is generally much lower than other estate planning strategies. Trust under agreement do not have to go to probate court – which almost always incurs attorney’s fees and court costs. Additionally, establishing the agreement will prevent the costs of probate court litigation if a decedent has issues in their estate. In other words, your initial investment in establishing the agreement is protecting your heirs from having to pay 10% or more of your estate’s worth if you were to die without a will.
Another misconception is that trusts under agreement are not necessary for lower-net worth individuals . This could not be farther from the truth: The most common estate planning mistake for lower-net worth families is not to have any plan at all. Very few families have enough money to pay outright for long term private care in the event they experience a serious illness. If they do not have an agreement established at this time, not only will they be required to pay out-of-pocket, but upon their death, the remaining value of the account could be used to pay the facility.
Larger net worth individuals may also think that a trust under agreement is unnecessary because they already have a will and trust in place. While these documents can be very effective at passing on valuable assets to family members, they do not protect against state estate recovery. Because the Trust Under Agreement is a type of an irrevocable trust, the assets held within it would not be subject to state estate recovery.
Legal Statutes Governing Trusts Under Agreement
When creating a trust under agreement, there are some legal considerations to keep in mind. Most significantly, you need to ensure that the trust complies with state law. For instance, while most states recognize the validity of oral trusts, an oral, or unwritten, trust will not be recognized under all circumstances. Often, there are certain provisions in a trust that simply cannot be upheld if the trust is not in writing. An attorney can help you determine whether certain provisions in your trust are valid and whether your trust is valid as a whole.
The documentation of the trust is extremely important, especially when it comes to funding the trust. If the trust is funded inappropriately, it may invalidate the trust. Accordingly, anything of value that you would like to include in the trust needs to be documented and transferred properly. If you are unsure how to document or transfer property to your trust, make sure you consult with an attorney for assistance.
Again, having an attorney help you with the establishment of the trust is extremely important. A lot can go wrong if the trust is not created properly. You may not want to establish the trust solely by using information you found online. While online information can be helpful, you may not know how certain information applies to your specific situation or whether it is accurate. Working with an attorney who knows the ins and outs of trusts can help ensure that the trust is valid.
Administering a Trust Under Agreement
Once a trust under agreement is established, it becomes the duty of the trustee to manage the trust in accordance with the terms of the governing document. Given that an irrevocable trust cannot be amended, the drafting process for these trusts requires careful consideration as to how the trust will function and how it will be managed. As such, one of the most important aspects of creating an irrevocable trust is deciding the identity of the trustee and constructing an administrative scheme that accommodates for multiple contingencies that could arise over the life of the trust.
Typically, in the creation of an irrevocable trust, the trust will designate a single trustee (or in some cases two trustees) to oversee the management of the trust. In such a case, the duties of the trustee are easily defined. The trustee must manage the investments of the trust and make appropriate distributions of income and principal to the trust beneficiaries pursuant to the terms of the trust. If the trustee feels that investment management is outside of his or her expertise, or wishes to delegate this responsibility to someone else, he or she can appoint an outside investment advisor to oversee the management of the assets.
In situations where there is a designated co-trustee, or where more than two trustees are appointed, the duties of the individual trustees can become confusing unless carefully delineated in the governing document. For example, in one scenario, the first named trustees may be husband and wife, with their child serving as a successor trustee. In the event of the death of both parents, the practice has been to have the child serve as trustee. However , the child may not feel comfortable serving as trustee at such a young age.
Alternatively, in some cases the governing document contemplates the child as a co-trustee, but the child has no expertise in trust administration, so the other co-trustee (or co-trustees) will have to serve as a mentor to the child to ensure that the terms of the trust are being met. An alternative would be to have the child serve as a co-trustee, but give the other co-trustee sole authority over trust administration and distribution decisions.
Another aspect of the proper management of a trust under agreement involves compliance with state and federal income, estate and inheritance tax laws. In general, amendments to the Internal Revenue Code require that to the extent that a third party, such as a trustee, has the ability to invade the principal of a trust for purposes other than tax, the trust will be treated as a grantor trust, which could lead to adverse tax consequences for both the grantor and the beneficiary of the trust and in some cases cause the trust to be included in the taxable estate of the beneficiary.
Typically, fiduciary income tax returns must be filed each year for the trust, unless an exception applies. In order to avoid penalties and late fees, any fiduciary income tax return for a trust should be filed in accordance with the deadlines prescribed by law and any requests for extensions of time to file should be timely submitted. For large, closely held business interests held by the trust, compliance with the book-up requirements of the Internal Revenue Code, where applicable, is key to ensuring that the value of such closely held business interests are not subject to disclosure and valuation claims by government agencies.
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