Trusts and Estates

The exam tests two things at once: which trust type does what, and who the adviser's actual client is once a trust, testamentary trust, or estate is involved. Keep the grantor, trustee, and beneficiary roles straight and most questions resolve quickly.

A trust is a legal arrangement where a grantor (also called settlor or trustor) transfers assets to a trustee to manage for the benefit of beneficiaries. The trustee has a fiduciary duty to manage trust assets according to the trust document and applicable law. Trusts are separate legal entities that can own securities, open brokerage accounts, and be clients of an investment adviser.

The adviser's legal client is the trustee, not the beneficiaries: investment direction for the trust account must come from the trustee, and the beneficiaries cannot instruct the adviser directly. If the adviser is also the trust's trustee, particularly with authority to withdraw trust assets, the adviser has custody of those assets under the SEC's custody rule, which triggers obligations such as a surprise examination.

Investment decisions must align with the trust document's terms and state trust law based on the Uniform Prudent Investor Act (UPIA), which most states have adopted to govern how a trustee invests and manages trust assets. UPIA sets out several specific duties for the trustee:

• Prudent investor standard: the trustee must invest and manage trust assets the way a prudent investor would, weighing each holding by its role in the total trust portfolio and its contribution to the portfolio's risk and return, rather than judging any single investment in isolation
• Duty to diversify: the trustee must diversify trust investments unless the trustee reasonably determines that special circumstances make the trust's purposes better served without diversifying
• Duty of loyalty: the trustee must manage trust assets solely in the interest of the beneficiaries, never for the trustee's own benefit or a third party's
• Duty of impartiality: when a trust has more than one beneficiary, such as a current income beneficiary and a remainder beneficiary, the trustee must act impartially and balance their competing interests rather than favoring one
• Duty on delegation: a trustee may delegate investment functions to an agent, such as an investment adviser, but must select the agent prudently, define the scope and terms of the delegation, and periodically monitor the agent's performance and compliance

What Happens With a Revocable (Living) Trust?

• Grantor can modify, amend, or revoke the trust at any time during their lifetime
• Assets remain in the grantor's taxable estate; there is no estate tax benefit
• Grantor typically is the trustee during their lifetime
• Avoids probate at death; assets pass to beneficiaries without court involvement
• Becomes irrevocable upon the grantor's death

What Happens With an Irrevocable Trust?

• Cannot be changed or revoked once established, with limited exceptions
• Assets are generally removed from the grantor's taxable estate (an estate tax benefit)
• Grantor gives up control of the assets
• May provide asset protection from the grantor's creditors
• The trust is a separate taxpayer and files its own tax return (Form 1041)
• Income the trust retains (does not distribute) is taxed to the trust itself, at compressed tax brackets that reach the top marginal rate at a much lower income level than individual brackets. Income the trust distributes to beneficiaries is taxed on the beneficiary's return instead: the trust issues each beneficiary a Schedule K-1, which the beneficiary uses to report that income on their own personal tax return

Exam Tip: Gotchas

• Removing assets from the grantor's estate is not the same as "no one pays tax." An irrevocable trust shifts who is taxed: the trust itself on income it retains, or the beneficiary on income it distributes. Either way, the income doesn't go untaxed.
• A trust that retains income pays a higher effective rate than an individual with the same taxable income, because trust tax brackets are far more compressed. See Tax Considerations for the full trust-vs-individual bracket comparison.
• Estate-tax removal and continued control trade off against each other. A revocable trust keeps the grantor's ability to change or revoke it, which is exactly why its assets stay in the taxable estate. An irrevocable trust generally removes assets from the taxable estate, which requires the grantor to give up that same ability to change it.

How Is a Testamentary Trust Different From a Living Trust?

• Created through the terms of a will; only takes effect upon the grantor's death
• Goes through probate, unlike a living trust
• Always irrevocable once the grantor dies

What Distinguishes a Charitable Remainder Trust From a Charitable Lead Trust?

• CRT pays income to the grantor or beneficiary for life or a term of years (maximum 20 years), then the remaining assets go to charity. The Internal Revenue Code requires this payout to be at least 5% and no more than 50% of the trust's value each year
• CLT pays income to charity for a specified period, then the remaining assets pass to the grantor's heirs
• The CRT remainder to charity must be at least 10% of the trust's value. There are two CRT structures: a charitable remainder annuity trust (CRAT) pays a fixed dollar amount set when the trust is created, and tests the 10% remainder rule once, against the trust's initial fair market value. A charitable remainder unitrust (CRUT) pays a fixed percentage of trust assets that are revalued every year, and tests the 10% rule separately for each contribution, against that contribution's value on the date it was made

Exam Tip: Gotchas

CRT and CLT are "mirror images." CRT means income to the individual, remainder to charity. CLT means income to charity, remainder to the individual or heirs. The exam tests which beneficiary receives income versus remainder.

Who Is the Adviser's Client When an Estate Is Involved?

• An estate is the legal entity that holds a deceased person's assets during the settlement process
• Managed by an executor (named in the will) or an administrator (appointed by the court if there is no will)
• The executor or administrator has fiduciary duties similar to a trustee
• Estates are temporary; they exist only until assets are distributed to beneficiaries
• The estate is a separate taxpayer and files Form 1041
• Investment objectives are typically capital preservation and liquidity, reflecting a short time horizon
• The adviser must work with the executor or administrator, not the beneficiaries

Exam Tip: Gotchas

• A revocable trust avoids probate but does NOT remove assets from the taxable estate.
• A testamentary trust goes through probate because it is created by the will, which must be probated.
• At the grantor's death, a revocable trust becomes irrevocable.

What Should You Check on Exam Day?

• Revocable trust: avoids probate, stays in the taxable estate, grantor keeps control, becomes irrevocable at death.
• Irrevocable trust: generally removed from the taxable estate, grantor gives up control, files its own return.
• Testamentary trust: created by a will, goes through probate, always irrevocable once funded.
• CRT and CLT are mirror images; identify which beneficiary gets income first and which gets the remainder.
• For a trust, the adviser's legal client is the trustee, not the beneficiaries; if the adviser is also the trustee with withdrawal authority, that role creates custody of the trust's assets.
• For an estate, the adviser's fiduciary contact is the executor or administrator, not the beneficiaries directly.