US Estate Planning: What is a Trust?

Del Sol CPA
Sep 7
4 min read

Updated: Nov 2

I've heard so much about Trusts, and they seem like they're just for the wealthy. But what exactly is a Trust?

What is a Trust?

A trust is a legal entity where a grantor transfers assets to a trustee who manages them for designated beneficiaries. The trustee has fiduciary responsibility to operate solely in the beneficiaries' best interests according to the trust document's terms. Once a trust is created, it is then funded with assets or properties that can be distributed to beneficiaries according to the trust’s guidelines.

Trusts bypass the probate process entirely, allowing assets to transfer directly to beneficiaries without court involvement. This provides privacy since probate proceedings are public record, while trust distributions remain confidential.

While commonly associated with wealthy families managing generational wealth, trusts serve anyone seeking to distribute assets efficiently. They're particularly valuable for managing inheritances for minors or financially irresponsible beneficiaries through structured distributions.

Reasons to Set up A Trust

Transfer wealth to next generation - Trusts provide structured mechanisms for passing assets to children and grandchildren with specific distribution terms and timing.
Keep a family business within the family - Business assets placed in trust can be managed by trustees to maintain family control across generations.
Create a charitable legacy - Charitable trusts allow you to support causes while potentially receiving tax deductions and income streams.
Minimize estate tax and gift tax liability - Irrevocable trusts remove assets from your taxable estate, reducing overall tax burden.
Shield assets from creditors - Because grantors relinquish their ownership of assets in an irrevocable trust, they are protected against creditor claims.
Avoid probate process - Trust assets transfer directly to beneficiaries without court involvement, saving time and costs.

Remember, trusts are not just for high-net-worth individuals or wealthy families. If you have a complex family structure, children from multiple marriages, family members who are in debt or financially irresponsible, or any other circumstances that might increase the complexity of inheritance distribution, a trust can be an extremely valuable asset in your estate planning toolkit.

What are the different types of trusts?

The trust landscape offers numerous structures, each designed to address specific estate planning goals and family circumstances. Understanding the key distinctions between revocable and irrevocable trusts, as well as simple versus complex trust classifications, provides the foundation for selecting the most appropriate vehicle for your wealth transfer objectives.

These categories determine everything from tax treatment to asset protection capabilities, making the choice between them one of the most critical decisions in trust planning.

Simple vs. Complex

Trusts generally fall into two high-level categories; simple and complex. They are distinguished mainly by their distribution mechanics and tax treatment.

Simple Trusts

A simple trust operates under strict IRS guidelines that limit its flexibility but provide clear tax treatment. To qualify as a simple trust, the entity must meet specific criteria that distinguish it from more complex structures:

Income distribution requirement: Must distribute all earned income annually to beneficiaries—no income can be retained within the trust.
Principal restrictions: Cannot distribute any principal assets during the tax year.
Charitable limitations: No distributions to charitable organizations are permitted.
Tax treatment: Reports income to IRS annually and claims deductions for distributed amounts.
Beneficiary taxation: Beneficiaries pay ordinary income tax on distributions received.
Trust taxation: Trust pays capital gains tax on asset appreciation.

This structure works well for grantors seeking to preserve underlying assets while providing regular income streams to beneficiaries. The simplicity comes at the cost of flexibility; trustees have limited discretion in managing distributions or responding to changing beneficiary needs. Simple trusts also do little in the way of limiting estate tax liability.

Complex Trusts

Complex trusts offer significantly more flexibility by meeting different criteria that allow for sophisticated distribution strategies. A trust qualifies as complex if it does any one of the following during the tax year:

Income retention: The trust refrains from distributing all income to beneficiaries, allowing accumulation within the trust
Principal distributions: The trust distributes some or all principal assets to beneficiaries
Charitable giving: The trust makes distributions to qualified charitable organizations

The distribution hierarchy for complex trusts follows a specific order, mandated by tax law:

Ordinary income must be distributed first 
Dividend income follows 
Capital gains distributions come next 
Principal can only be distributed after all income categories are exhausted

Furthermore, distributions should be made in an equitable manner, to be fair and proportional among trust beneficiaries, such that trustees are prevented from favoring certain beneficiaries over others without explicit trust language permitting such discretion.

Key advantages of complex trusts:

Enhanced control: Trustees can respond to changing beneficiary circumstances
Tax planning opportunities: Income can be retained in lower tax years and distributed when beneficial
Multigenerational planning: Better suited for dynasty trusts spanning multiple generations
Charitable integration: Allows combination of family and philanthropic goals
Asset protection: Greater flexibility in protecting assets from creditors

Complex trusts require more sophisticated administration and legal oversight but offer the flexibility necessary for large estates with diverse beneficiary needs and long-term wealth management objectives.

In the upcoming article, we will explore another crucial distinction between types of trusts: whether they are revocable (living) trusts or irrevocable trusts. Each type provides significantly different benefits and limitations. Stay tuned for our blog post!

📚 Article Series: US Estate Planning