3. 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.
Trust Basics
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:
| Party | Role |
|---|---|
| Grantor (also called settlor or trustor) | Creates the trust and transfers assets into it |
| Trustee | Manages trust assets; has a fiduciary duty to act in beneficiaries' best interests |
| Beneficiary | Receives the benefits (income, principal, or both) from the trust |
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.
Revocable Trust
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 typically serves as 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 individual accounts)
- Does not provide asset protection from the grantor's creditors (because the grantor retains control)
Irrevocable Trust
An irrevocable trust requires the grantor to permanently give up control of the assets.
- The grantor cannot modify or dissolve the trust once it is established (changes require beneficiary consent)
- 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.
Revocable vs. Irrevocable Trust Comparison
| Feature | Revocable Trust | Irrevocable Trust |
|---|---|---|
| Grantor control | Full control retained | Control permanently relinquished |
| Modification | Can be modified or dissolved | Generally cannot be changed |
| Estate inclusion | Assets included in taxable estate | Assets generally excluded |
| Income tax filing | Grantor's personal return (1040) | Separate return (Form 1041) |
| Probate | Avoids probate | Avoids probate |
| Creditor protection | None (grantor still controls) | Yes (grantor no longer owns) |
| Gift tax | No (not a completed gift) | May trigger gift tax |
Exam Tip: Gotchas
The key tradeoff: revocable trusts offer flexibility (the grantor keeps control) but no estate tax or creditor benefits. Irrevocable trusts remove assets from the estate (tax savings) but the grantor gives up control permanently. The exam tests this tradeoff frequently.
Estates
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.
- 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 exceeds the federal estate tax exemption
- An estate is a separate tax entity and files Form 1041 for income earned during the administration period
- 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.