Since the Middle Ages, people with assets have used the concept of a “trust” to pass real estate and personal property to the next generation. In the past decade and a half, the concept of a “Living Trust” has become the de facto standard of estate planning tools.
But the question persists in many people’s minds: What exactly does a Living Trust do?
It is helpful to think of a Living Trust as a container, such as a glass, that one person passes to another. Everything inside of the glass (liquids, ice cubes, etc.) will be successfully passed to the other person. Everything that is outside of the glass will not be passed on to them.
Funding is the process of adding the “water” and “ice cubes” are added to the glass through a process called “funding”.
See our article, I’ve Got My Living Trust, Now What Do I Do?
How Does it Work?
A trust is created by a person called a Settlor (sometimes referred to as a Trustor, or a Grantor). Often a husband and wife will jointly settle (create) a Living Trust, which is commonly known as an A-B Trust. After the trust instrument has been created, the Settlor’s assets are placed into the Living Trust, to be held for the benefit of certain designated person(s) [also known as the beneficiary(ies)].
During the Settlor’s lifetime, the Living Trust is completely revocable. This means that the person who created the trust can alter, amend, or revoke the trust during his or her lifetime.
Upon the death of the Settlor (in the case of a single-person Living Trust), or upon the first death of a spouse (in an A-B Trust), the trust becomes irrevocable. This means the trust can no longer be altered, amended, or revoked without court permission.
In the case of an A-B Trust, upon the death of the first spouse to die, the trust splits in to two (2) separate and distinct trusts.
The first Trust (Trust A) is known as the Survivor’s Trust (also known as the Marital Trust). This trust remains revocable during the Surviving Spouse’s lifetime. In addition, the Surviving Spouse has unlimited use of Trust A’s principal and income during their life, and is free to add or remove beneficiaries of Trust A.
In contrast, the Bypass Trust (Trust B, also known as the Credit Shelter Trust), becomes irrevocable upon the death of the first spouse to die. The Surviving Spouse is entitled to income from Trust B, and may invade the principal only for specified purposes, such as for their health, maintenance or welfare.
Upon the death of the second spouse, Trust B is distributed outright to its stated beneficiaries. If drafting is done properly, Trust B should distribute without being subject to Estate Taxes. At this time, Trust A can either be folded into Trust B and distributed according to the terms of Trust B, or it can be distributed to the beneficiaries that the Surviving Spouse has chosen during their lifetime.
The process of dividing the Living Trust into Trust A and Trust B is commonly referred to as the Trust Settlement process. It is important to note a few things. First, when one spouse dies, and a Living Trust is in place, there is still work that needs to be done. While the assets in the Living Trust do not have to be probated, the trust administration process is very important. Simply ignoring this process until the Surviving Spouse dies can have disastrous results for the beneficiaries.
Most importantly, failing to properly divide the Living Trust upon the death of the first spouse can cause you to lose the Estate Tax exemptions that you might otherwise be entitled to. See How A Living Trust Can Help You Disinherit Uncle Sam. It is important not to forget that while a Living Trust has its benefits, it is important to use it in the manner it was designed.
The Living Trust is the cornerstone of a comprehensive Estate Plan. It provides greater flexibility than a simple Will, and helps streamline the Estate Administration process, while keeping costs to a minimum.
We invite you to contact us to discuss your Estate Planning needs in greater detail.
For further discussion of the Living Trust concept, you can go to the following articles that we have written on this important subject:
How a Living Trust Can Help You Disinherit Uncle Sam