Trusts and Estates

Trusts and estates are commonly tested institutional client types. This section covers how they are structured, who controls them, and how they are taxed.

What Is a Trust, and Who Are Its Three Parties?

A trust is a legal arrangement where one party (the trustee) holds and manages assets for the benefit of another party (the beneficiaries).

Three key parties:

The trustee's fiduciary duty is a legal obligation to manage the trust prudently, avoid conflicts of interest, and act solely for the benefit of the beneficiaries.

Think of it this way: The grantor is the person who "grants" money to the trust. The trustee is the one who manages it. The beneficiary is the one who benefits. These three roles can overlap (the grantor can also be the trustee), but they serve distinct legal functions.

How Does a Revocable Trust Work?

A revocable trust (also called a living trust) allows the grantor to maintain control.

• The grantor can modify, amend, or dissolve the trust at any time
• Assets remain part of the grantor's taxable estate for estate tax purposes
• The grantor is typically the trustee during their lifetime
• Income earned by trust assets is reported on the grantor's personal tax return (Form 1040); the trust is treated as a "grantor trust" and does not file a separate return
• Assets in a revocable trust avoid probate at death (unlike a standard individual account without a TOD/POD designation)
• Does not provide asset protection from the grantor's creditors (because the grantor retains control)

How Does an Irrevocable Trust Differ?

An irrevocable trust requires the grantor to permanently give up control of the assets.

• The grantor generally cannot unilaterally modify or dissolve the trust once it is established; any change depends on the trust's terms and governing state law, and may involve the trustee, a trust protector, the beneficiaries, or a court
• Assets are generally removed from the grantor's taxable estate, potentially reducing estate taxes
• The trust is a separate tax entity: it must obtain its own Employer Identification Number (EIN) and file Form 1041 (U.S. Income Tax Return for Estates and Trusts)
• Trust tax rates tend to reach the highest bracket at relatively low income levels, which is an important planning consideration
• Can provide asset protection from creditors because the grantor no longer owns the assets
• Transferring assets into an irrevocable trust is considered a completed gift and may trigger gift tax

Exam Tip: Gotchas

• Trust tax brackets are compressed. Irrevocable trusts hit the highest federal income tax rate at much lower income levels than individuals. This makes distributing income to beneficiaries (who may be in lower brackets) an important tax planning strategy.
• Irrevocable does not always mean zero flexibility. Some irrevocable trusts include provisions allowing a trust protector or the beneficiaries to make limited modifications.

How Do Revocable and Irrevocable Trusts Compare Side by Side?

Exam Tip: Gotchas

The key tradeoff: revocable trusts offer flexibility (the grantor keeps control) but no estate tax or creditor benefits. Irrevocable trusts generally remove assets from the estate (potential tax savings) and may offer creditor protection, but the grantor gives up control permanently. The exam tests this tradeoff frequently.

What Is an Estate, and How Is It Administered?

An estate is the total collection of assets owned by a deceased person.

• Managed by an executor (if named in a will) or a personal representative (if appointed by the court)
• An estate account is temporary: it exists only until all assets have been distributed to heirs and all debts and taxes have been paid
• The executor has a fiduciary duty to manage estate assets prudently during the administration period
• The estate may need to open an investment account for a short period to hold assets, pay debts, or generate income while distribution is pending

Testamentary vs. Inter Vivos (Living) Trusts:

• A testamentary trust is created by a will and takes effect only after the grantor's death. It must go through probate before assets are transferred. During probate, the grantor's creditors may file claims against the estate; once probate closes and the trust is funded, the remaining assets may gain creditor protection (the trust is irrevocable at that point), depending on the trust's terms and applicable law.
• An inter vivos trust (living trust) is created during the grantor's lifetime. It can be either revocable or irrevocable.

Estate Taxes:

• The estate must file Form 706 (United States Estate Tax Return) if the gross estate plus adjusted taxable gifts exceeds the federal estate tax exemption; an estate may also file it to elect portability of the deceased spouse's unused exemption, even if not otherwise required
• An estate is a separate tax entity and must file Form 1041 if it has $600 or more of gross income during the administration period (or has a nonresident-alien beneficiary)
• The estate tax return (Form 706) is due 9 months after the date of death (a 6-month extension is available)

Note: Estate accounts are not long-term investment accounts. They are transitional, and the investment strategy should reflect a short time horizon and focus on capital preservation and liquidity.

Exam Tip: Gotchas

• Estate accounts are temporary, not long-term. The exam may describe an estate scenario and ask about investment strategy. The answer focuses on capital preservation and liquidity, not growth.
• Executor vs. personal representative: If the deceased left a will, the person managing the estate is an executor. If appointed by the court (no will), they are a personal representative. Both have fiduciary duties.

What Should You Check on Exam Day?

• A trust has three parties: grantor (creates and funds it), trustee (manages it under a fiduciary duty), and beneficiary (receives the benefit).
• Revocable trust: grantor keeps control, assets stay in the taxable estate, income reported on the grantor's Form 1040, avoids probate, no creditor protection.
• Irrevocable trust: grantor gives up control, assets generally leave the taxable estate, files its own Form 1041 under its own EIN, may gain creditor protection, and funding it can trigger gift tax.
• Both revocable and irrevocable trusts avoid probate; standard individual accounts without a TOD/POD designation and testamentary trusts go through it.
• Trust income tax brackets are compressed, reaching the top rate at low income levels.
• An estate is managed by an executor (named in a will) or a personal representative (court-appointed); the account is temporary, favoring capital preservation and liquidity.
• The estate files Form 706 (if the gross estate plus adjusted taxable gifts exceeds the exemption, or to elect portability) due 9 months after death, with a 6-month extension available, and Form 1041 if it has $600 or more of gross income during administration.
• A testamentary trust is created by a will and takes effect at death (goes through probate); an inter vivos (living) trust is created during life and can be revocable or irrevocable.