Testamentary Trusts – Trusts When You Can’t Be There

More trusts?  Yes, but only a little bit more.  So far, we’ve discussed only trusts that can be established during the grantor’s lifetime.  This entry concerns trusts that only come into existence once the grantor is deceased.

A testamentary trust is a trust created by a person’s will.  No will, no testamentary trust.  The person creating it is the testator, not the grantor.  A grantor sets up a trust during his or her lifetime.  Here, where the trust is established after death, it is established by a person who executed a will – a testator.  To do, the testator’s intent to set up the trust must be clear in the testator’s will.  This is important –  if the intent to create a trust or to grant powers to a trustee in the will is not clear, then there will be no trust.

Testamentary trusts can be used for tax purposes, or they can be used for other purposes, such as making a gift to someone under a will who is under some legal incapacity, e.g.: the person is still a minor.

There is another type of testamentary trust that testators often establish – spendthrift trusts.  Spendthrift trusts are used to protect a beneficiary from losing his interest to creditors.  (One reason why a grantor cannot create one for himself, though, in the case of a testamentary trust, we are at a loss to find an example where a testator would benefit from such a trust).  A spendthrift trust expressly prevents voluntary or involuntary transfers from the trust or may subject the possession of an interest in the trust to certain conditions.  The crux of a spendthrift trust is that a creditor of the beneficiary may not reach any principal or income of the trust while that principal or income is still in the possession of the trustee, despite any beneficial use or enjoyment the beneficiary may have.  (Note, however, that there are some exceptions to the protection of a spendthrift trust that stem from public policy concerns, e.g.: child support).

With testamentary trusts, testators often give careful consideration to the objects of their bounty.  As with other trusts that they establish while they are alive, however, they must consider something equally or even more important – the trustee and her powers.  Decisions include when the trustee can accumulate – rather than distribute – income; when the trustee can invade the trust corpus to satisfy obligations; and what discretion the trustee has to allocate income from the trust and the property in the trust.  These are for another entry, but something to keep in mind at all times.

Trustees may be required at least once every twelve months to give to any beneficiary of the trust an accounting showing all receipts, disbursements, and other transactions along with the source and nature of each, as well as the inventory, cash, and liabilities.  For this trouble, the trustee is entitled to reasonable compensation for carrying out his duties as trustee and in some cases, reimbursement for expenses.  A trustee may be removed forcibly from his position for cause and for the protection of the trust, among other reasons, and a successor trustee may be appointed according to the terms of the trust, or if not so specified there, then by a court.

The testator must also give thought to a power of appointment.  A power of appointment is a complement to many of the other powers in a trust and dovetails with the considerations a testator makes when drafting a will and setting up rules about who receives trust income and who preserves the property in the trust.  Freely interpreted, a power of appointment is the ability to decide who will receive the body of the trust once the income interest has come to an end.  Sometimes, this power is vested in the trustee; in other cases, the beneficiary holds this power.  However, the same considerations that govern who will be chosen as a trustee are often advisedly the same considerations employed in granting a power of appointment.  A power of appointment can be special (with restrictions) or general (no restrictions).

And finally, a brief note about the tax aspects.  Testamentary trusts, like other trusts, are separate entities for the purpose of reporting and paying taxes.  And generally speaking, like other trusts, the trust may deduct some distributions of income to beneficiaries from its taxable income, and the beneficiaries must include in their own gross income any distributed income.  Other aspects of the tax treatment of trusts depend on whether the trust is simple (distributes all current income) or complex (accumulates income), but that is for another entry.