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Essentials of Trust Agreements in New Jersey

Basic Concept of a Trust

In general, a trust is an arrangement whereby one person agrees to hold property for the benefit of another. All trusts must have the same basic components:

A Grantor. The person who creates the trust. The grantor may also be called the "donor," or the "settlor," or the "trustor." All these terms are used interchangeably.

A Trustee. A person or entity must agree to hold money and/or property for the benefit of someone else. There may be more than one trustee and the trustee does not need to be a person. It may be a corporation with trust powers, such as a bank.

A Principal. Something, money and/or property, must be held by the trustee for the benefit of someone else. Also, it may be called the "corpus" of the trust or “res".

A Beneficiary. The person who benefits from the trust. There may be more than one beneficiary.

Classification of Trust

All trusts do not contain the same property, nor do they have the same purpose, nor are they all created in the same manner. These differences distinguish one type of trust from another.

Living vs. Testamentary Trusts. Ask whether the trust becomes effective during the Grantor’s lifetime or only after the Grantor’s death.

A living trust is a trust that becomes effective during the Grantor’s lifetime. Also called and “inter-vivos trust," Latin for during life, most living trusts are generally created by a written instrument.

If the trust is created through a Last Will and Testament, it is called a testamentary trust. This trust only becomes effective after the Grantor’s death because the Last Will and Testament does not become effective until the Grantor’s death.

Revocable vs. Irrevocable Trusts. If the grantor reserves the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is a revocable trust. If the grantor gives up the right to revoke the trust after it becomes effective, including the right to change any of the terms or provisions of the trust, then the trust is an irrevocable trust. Please note that testamentary trust are always revocable. Only living trusts can be either revocable or irrevocable.

The Grantor of a revocable trust can still has control over the property put into the trust. Also, the Grantor can change the terms and conditions. The Grantor retains all incidents of ownership, thus the Grantor is treated as the owner for property tax purposes.

The Grantor of an irrevocable trust is giving up all rights to the property put into the trust. The Grantor has no right to amend, revoke, terminate or change the conditions of the trust. The Beneficiary, not the Grantor, is treated as the owner of the property for tax purposes. A person may use an irrevocable trust to protect their assets from creditors, to become eligible for Medicaid, and to avoid estate taxes.

Types of Trusts

Credit Shelter Trusts

A Credit Shelter Trust is a type of trust that is used by married couples with large estates in order to avoid federal estate taxes upon the death of the first spouse. This type of trust is structured so that, upon the death of the first spouse, the maximum amount of property sheltered from the estate tax is transferred to this trust. The trust is designed so that the assets in this trust will not be subject to estate tax in the surviving spouse's estate upon his or her subsequent death. As a result, the assets placed in this trust upon the death of the first spouse will not be subject to estate taxes in either spouse's estate and will be transferred to other beneficiaries (normally the children) free of any estate taxes.

Even though the assets in a Credit Shelter Trust will not be taxed in the estate of the surviving spouse, the trust is designed in such a way that the surviving spouse can enjoy the benefits of the assets placed in this trust.

Pros

  • Not subject to Estate taxes.
  • The Grantor has the ability to change the cost basis of certain assets.

Cons

  • High legal fees.
  • Transferring property into the trust is cumbersome.
  • A Grantor may need to designate a co-trustee.

Charitable Trusts

A Charitable Trust is a type of trust that has one or more charitable beneficiaries. If properly established under tax laws, a charitable trust will entitle a grantor to deduct a portion of the amount contributed to the charitable trust as a current charitable income tax deduction. There are other tax benefits as well, depending upon the type of charitable trust established.

For example, the amount passing to charity under a charitable remainder trust qualifies for a charitable estate tax deduction upon the death of the grantor. There are four types of charitable trusts; i.e., the charitable lead annuity trust (CLAT), the charitable lead unitrust (CLUT), the charitable remainder annuity trust (CRAT), and the charitable remainder unitrust (CRUT). In charitable lead trusts, one or more charities are paid a certain amount each year for a fixed number of years, with the remainder passing to non-charitable beneficiaries. In charitable remainder trusts, one or more non-charitable beneficiaries are paid a certain amount each year for a fixed number of years or for life, with the remainder passing to one or more charities.

Pro

  • A Grantor may reduce their taxable income.
  • There may be double capital gain benefits.

Con

  • Once the property is within the trust, the Grantor cannot benefit from the principal.

Crummey Trusts

A Crummey Trust is a life insurance trust with certain provisions that allow gifts to the trust to qualify for the annual gift tax exclusion.

Initially, the IRS ruled that gifts of money to a Life Insurance Trust, which were used to pay premiums on life insurance policies held in the trust, did not qualify for the annual gift tax exclusion because the beneficiaries did not have a present interest in those gifts. The only interest they had was a future interest; i.e., when the insured died and the death proceeds were paid into the trust. Under the gift tax rules, the annual gift tax exclusion only applies to gifts of a present interest.

In order to get around this problem, a Mr. D. Clifford Crummey created a life insurance trust that prohibited the trustee from using any money gifted to the trust for at least 30 to 60 days after the gift was made. During that 30 to 60 day period, the beneficiaries were given the right to withdraw the money if they wished. If they didn't withdraw the money during the 30 to 60 day period, their withdrawal rights terminated and the money could then be used to pay the premiums that were due. Of course, the grantor never intended to have any of the money withdrawn from the trust during that 30 to 60 day period. That right was given to them solely to qualify the gift for the annual gift tax exclusion.

The IRS challenged these provisions in court, claiming that the right to withdraw the money was a sham because everyone knew that the money was needed for payment of the insurance premiums. Nonetheless, the IRS lost. The court stated that whether the beneficiaries actually withdrew the money or not, they had the right to do so - and that right is all that's needed to give the beneficiaries a present interest in the gift.

Pros

  • The trust offers grantors a higher amount of control than any other irrevocable trust.
  • The trust is an investment option that falls outside those permitted in Section 529.

Cons

  • The principal is available for withdrawal for a short period of time and there is a potential risk that the beneficiary will withdraw the principal.
  • The trust is treated as a minor’s asset for financial aid purposes.

Dynasty Trust.

A dynasty trust is a trust designed to avoid or minimize estate taxes being applied to great family wealth with each transfer to subsequent generation. By holding assets in the trust and making well-defined distributions to each generation, the entire wealth of the trust is not subject to estate taxes with the passage of each generation.

The assets that are put into the trust are subject to federal gift/estate tax just once, when the Grantor transfers the assets to the trust. They are not taxed again, though multiple generations benefit from them.

A Grantor may use a dynasty trust when the Grantor’s assets are greater than the Federal Estate exemption amounts. Currently an individual’s exemption is $5.25 million and a married couple is $10.5 million. Additionally, as income tax needs to be paid on trust assets, non-income producing assets are better suited for the trust. These trust are generally used for families with great wealth.

When using a dynasty trust, Federal Estate/Gift Taxes only occurs once. Without this, trust assets left to your children would be taxed. Then when these assets were left to their children it would be taxed again.

Additionally, the Grantor has great control over the Dynasty Trust. The Grantor decides who his or her beneficiaries are and what rights they get. The Grantor will appoint a Trustee (Bank or Trust Company) to manage the money and spend it on beneficiaries’ needs according to the terms the Grantor set forth in the Trust. The Grantor can give power to the beneficiaries to give away some trust assets or leave them to others at their own deaths.

This is an irrevocable trust and descendants cannot alter the terms of the trust when circumstances change.

Pros

  • The Trust assets are only subject to Federal Estate/Gift Taxes once.
  • Ensure that succeeding generation of the Grantor’s family pay as little tax as possible.
  • Grantor has control of money long after death.

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