Trusts and Wills

With an understanding of how beneficiary designations and ownership types transfer assets, let's look at the two primary legal structures for directing asset distribution at death: wills and trusts.

Wills

• Legal document directing the distribution of assets after death
• Must go through probate: a court-supervised process that validates the will and oversees distribution
• Becomes a public record once filed with the probate court
• Can be contested by heirs or parties who believe the will is invalid
• An executor (also called a personal representative) carries out the will's instructions
• Only governs assets that don't have a beneficiary designation or survivorship feature

Intestate succession: If a person dies without a valid will (intestate), state law determines how assets are distributed, typically to the surviving spouse, then children, then other relatives.

Exam Tip: Gotchas

• A will does NOT control assets with beneficiary designations (IRAs, 401(k)s, life insurance, POD/TOD accounts) or assets held as JTWROS. Those transfer outside the will. The will only controls assets that are part of the probate estate.

Trusts: Overview

A trust is a legal arrangement where a grantor transfers assets to a trustee, who manages them for the benefit of beneficiaries. Trusts offer more flexibility, privacy, and control than wills.

Three key roles in every trust:

• Grantor (also called settlor or trustor): Creates the trust and transfers assets into it
• Trustee: Manages the trust assets according to the trust's terms
• Beneficiary: Receives income or principal from the trust

Revocable (Living) Trust

• Grantor retains control and can modify or revoke the trust at any time during their lifetime
• Avoids probate: assets in the trust transfer to beneficiaries without court involvement
• Assets are still included in the grantor's taxable estate (because the grantor retains control)
• Provides incapacity planning: the successor trustee can manage assets if the grantor becomes incapacitated
• Becomes irrevocable at the grantor's death
• Does NOT provide creditor protection during the grantor's lifetime

Irrevocable Trust

• Grantor gives up control and ownership of the assets once transferred to the trust (retaining certain powers, like an interest in trust income, can pull the assets back into the taxable estate even though the trust is still called "irrevocable")
• Assets are generally excluded from the grantor's taxable estate (significant estate tax benefit) as long as the grantor doesn't retain prohibited powers, such as continued enjoyment, income, or control over the assets
• May provide asset protection from creditors, depending on the trust's terms and state law (since the grantor no longer owns the assets)
• Cannot be easily modified once established (requires consent of beneficiaries or court approval in most cases)
• Useful for high-net-worth clients looking to reduce estate tax exposure

Exam Tip: Gotchas

• A revocable trust avoids probate but does NOT reduce estate taxes. A properly structured irrevocable trust does both. If you see "avoids probate AND reduces estate taxes," the answer is irrevocable trust.

Testamentary Trust

• Created by a will: does not exist until the grantor dies
• Subject to probate (because it's part of the will)
• Often used to manage assets for minor children or beneficiaries who need oversight
• Becomes irrevocable once established (after the grantor's death)

Exam Tip: Gotchas

• A testamentary trust goes through probate because it is created by a will. Unlike a revocable living trust, it does not avoid the probate process.

Bypass (Credit Shelter) Trust

• Also called a family trust or B trust
• Used to maximize use of both spouses' estate tax exemptions
• Funded at the first spouse's death up to the federal estate tax exemption amount
• Assets in the bypass trust are not included in the surviving spouse's taxable estate
• The surviving spouse can receive income from the trust but does not own the assets
• Prevents "wasting" the first spouse's exemption
• An alternative, portability, lets the deceased spouse's estate (the executor, by timely filing an estate tax return) transfer the deceased spouse's unused exemption to the surviving spouse without a bypass trust; a bypass trust still has the advantage of keeping later appreciation on those assets out of the survivor's taxable estate

Think of it this way: Without a bypass trust or a portability election, when the first spouse dies everything passes to the surviving spouse tax-free under the unlimited marital deduction (assuming a U.S.-citizen surviving spouse; a noncitizen spouse generally needs a qualified domestic trust to get the same result). But now the surviving spouse owns it all, and only their own exemption shelters assets at their death, wasting the first spouse's exemption. A bypass trust locks the first spouse's exemption in place automatically; a portability election achieves the same basic result without needing a trust, though it doesn't shelter later appreciation the way a bypass trust does.

How it works:

1. First spouse dies; assets up to the exemption amount go into the bypass trust
2. Surviving spouse receives income from the trust during their lifetime
3. At the surviving spouse's death, bypass trust assets pass to heirs (children) without being taxed in the surviving spouse's estate
4. Result: Both spouses' exemptions are fully utilized

Charitable Remainder Trust (CRT)

• Provides income to the grantor or other beneficiaries for life or a specified term
• At the end of the term, the remainder goes to a qualified charity
• Grantor receives a current income tax deduction based on the present value of the charitable remainder
• If the trust sells the appreciated assets, it avoids immediate recognition of the gain; the gain is not eliminated, and later income payments to the beneficiary can carry out that accumulated capital gain over time

Charitable Lead Trust (CLT)

• Opposite of a CRT: income goes to charity first
• Charity receives income for a specified term or period
• At the end of the term, the remainder goes to non-charitable beneficiaries (typically family members)
• Reduces gift and estate tax on the transfer to family members
• The noncharitable remainder is a taxable gift valued at the trust's creation; if trust assets outperform the IRS's assumed rate, the excess growth above that valuation can pass to heirs free of additional gift or estate tax (not income-tax-free)

Exam Tip: Gotchas

• CRT = income to the grantor or another noncharitable beneficiary, remainder to charity. CLT = income to charity, remainder to family. They are mirror images. The name tells you where the charity "leads" or gets the "remainder."

What Should You Check on Exam Day?

• A will controls only the probate estate; assets with beneficiary designations or survivorship transfer outside it
• A revocable (living) trust avoids probate but stays in the taxable estate; an irrevocable trust avoids probate AND generally removes assets from the taxable estate, unless the grantor retained prohibited powers
• A testamentary trust is created by a will, so it still goes through probate, unlike a living trust
• A bypass trust preserves the first spouse's exemption without relying on portability, and also keeps later appreciation out of the survivor's estate; portability (elected by the deceased spouse's executor) is the alternative way to transfer a deceased spouse's unused exemption to the survivor
• CRT pays income to the grantor or another noncharitable beneficiary first with the remainder to charity; CLT pays income to charity first with the remainder to family; a CRT defers rather than eliminates capital gains recognition on appreciated assets it sells