Trusts in general are an exceptionally versatile and flexible estate-planning tool. Forming a Trust in California can accomplish a lot of what a last will and testament in California does, distributing your assets to heirs but without the need for a California probate. In addition, some irrevocable trusts can help reduce estate taxes, ensure Medi-Cal eligibility, or keep assets within the family over several generations.
A spendthrift trust can protect loved ones from their creditors—or from their own profligate spending. You can even use a trust to support a charity that’s dear to your heart while making sure you have a means of support for the rest of your life. The potential uses for trusts are seemingly endless.
In California, a settlor can form a trust for just about any purpose; just as long as the purpose is not illegal and does not otherwise violate the state’s public policy. For these reasons, forming a trust in California is an important priority for many seeking to do California estate planning.
How California Trusts Work
Trusts in California are governed by Division 9 of the California Probate Code and by generally applicable common law principles. All trusts have a basic structure and many key features in common. Every trust involves three indispensable parties: a “settlor” (or “grantor”), one or more beneficiaries, and a trustee. The settlor is the person who forms the trust and transfers the property that will be held within the trust. A beneficiary is someone who enjoys the benefits of the assets held in the trust—whether from the assets themselves or from income derived from those assets. And the trustee is the person who manages the trust—preserving and maintaining trust assets, making distributions to beneficiaries, and acting on behalf of the trust in legal matters.
There can be some overlap among the roles in any given trust. So, for instance, the settlor, beneficiary, and trustee of a living trust may all be the same person, at least for a while. The important thing, though, is that each role is filled.
In most cases, a trust is embodied in a “declaration of trust” or similarly titled document, though California law technically does not require a written instrument evidencing a trust unless the trust involves real estate. Along with identifying the necessary parties, a declaration also sets forth the purpose of the trust and provides the trustee with instructions as to how trust assets will be managed and distributed.
Instructions laid out in a declaration of trust can be general, allowing the trustee wide discretion, or very detailed and explicit. Under California trust law (like the law of most any other jurisdiction) trustees are legally required to honor instructions provided in a trust instrument, and trustees must make a good faith effort to manage the trust in accordance with its stated purpose.
A trustee has what is known as a “fiduciary relationship” to the beneficiaries with regard to the trust. That means that, even though the trustee has the legal right to exercise control over trust assets, he or she must always do so in the best interests of beneficiaries. A trustee needs to make sure trust assets are properly maintained, including, for instance, by seeing that any taxes due for trust assets are timely paid. A trustee charged with making investments must invest prudently. Courts usually won’t second-guess a trustee who makes a good-faith investment that happens to lose money, but trustees can be held liable for losses incurred by a trust as a result of the trustee’s neglect, malfeasance, or other breach of the fiduciary duty.
“Funding” a trust simply means formally transferring assets into the trust to be managed by the trustee. In California, a trust does not legally come into existence until it has some sort of actual property in it. Thus, it is of vital importance that a settlor takes the appropriate measures necessary to transfer assets to the trust. By way of example, if you wanted your home to bypass probate and descend to your children through a living trust, you would need to record a deed transferring legal title to the trust. Just executing a declaration of trust that says the trust is the owner of the real estate is not enough.
Payments of trust assets by the trustee to beneficiaries are known as “distributions.” The level of discretion over distributions afforded to the trustee can vary tremendously depending on the nature and purpose of the trust. Where one trust might set a precise measure and fixed schedule for distributions, another trust might let the trustee use his or her best judgment to make distributions based on beneficiaries’ current needs.
The formal conclusion of a trust is referred to as “termination.” A trust can terminate when it is revoked by a settlor who retained the right to revoke the trust, when the trust’s purpose has been fully accomplished, when the trust runs out of assets, on a predetermined date defined in the declaration, or, in fairly rare cases, when the stated purpose of the trust has become illegal or contrary to public policy.
Forming a Revocable vs. Irrevocable Trust in California
Although trusts come in many different flavors, every trust must fall within one of two categories: revocable or irrevocable. With a revocable trust, the settlor reserves the right to amend or terminate the trust. Conversely, the settlor gives up those rights when creating an irrevocable trust. Settlors of revocable trusts can retain control over trust assets pretty much as if the settlor still personally owned the property. Formation of an irrevocable trust is more permanent—the settlor can sometimes continue benefitting from trust assets as a beneficiary, but the right to control the property ceases except through the instructions stated in advance in the declaration.
The Option to Amend an Irrevocable Trust
Under California law, an irrevocable trust can only be amended or terminated under terms set forth in the declaration of trust, with the consent of the trustee and every beneficiary; or upon court approval under limited circumstances. Beneficiaries can petition for amendment if circumstances have changed to the point that continuing the trust under its current terms is impracticable or would conflict with the stated purpose of the trust.
California also allows for “decanting” of irrevocable trusts in certain scenarios. When a trust is “decanted,” the trustee distributes all trust assets into a newly formed trust more appropriate to the present circumstances. If the original trust affords limited discretion to the trustee, decanting can only be used to change administrative provisions. A trustee with wider discretion can decant a trust to amend some distributive provisions, but not if the new trust would name new beneficiaries or hinder the original trust’s charitable purposes or tax advantages.
Forming Living vs. Testamentary Trusts in California
A second dichotomy among trusts exists between “living” (a/k/a “inter vivos”) and “testamentary” trusts. A trust is a “living trust” if it is formed while the settlor is still alive. A “testamentary trust,” on the other hand, is created via the settlor’s last will and testament and does not come into being until the settlor’s death. A living trust can be revocable or irrevocable, but testamentary trusts, by definition, must be irrevocable because, once the trust is formed, the settlor is no longer around to revoke or amend it.
Revocable living trusts are probably the most popular form of trust. When you hear someone talking about forming a living trust to act as a will substitute, they are almost always talking about a revocable living trust. When used for this purpose, the settlor is often also the trustee and beneficiary, allowing continued control and beneficial use of trust assets for life. Upon the settlor’s death, a successor trustee, usually named in the trust declaration, takes over, and the trust becomes irrevocable. The successor trustee then manages or distributes assets pursuant to instructions previously provided by the settlor. Thus, the living trust serves as a stand-in for a will because the successor trustee is distributing assets that would otherwise have been distributed by an executor.
When using a living trust as a will substitute, it’s also a good idea to execute a “pour-over will,” which bequeaths to the trust any and all assets which were not already transferred. Absent this back-up, assets left out of the trust descend to heirs under California’s intestate succession laws, which usually means they end up with a surviving spouse or children. Importantly, with or without a pour-over will, any assets that have not yet made it into the trust as of the time of death will need to go through probate.
Benefits of Trusts in California
Trusts can serve many, many functions—ranging from relatively simple, general estate-planning goals to complex and precise asset-protection strategies. A single trust can have more than one purpose or can be narrowly defined to accomplish an exact objective. Whatever your financial planning needs, there’s a strong chance that a trust can help in meeting them.
Probate Avoidance: California has a notoriously time-consuming and expensive probate process. Fortunately, though, assets that descend through a trust do not need to pass through probate and can therefore be received by beneficiaries more quickly and with lesser transaction costs. Even if probate is necessary for other assets, wealth in a trust does not count toward the $150,000 limit for California’s streamlined probate. So, for example, transferring a home outside probate via a living trust can facilitate much quicker, cheaper administration of assets that do need to pass through probate.
A secondary benefit of using a trust to avoid probate is that it allows you to keep your financial affairs private. The probate process is public, and a publicly filed will can be reviewed by just about anyone willing to take the time to review the records. Trusts, though, can be kept private. So, if you prefer keeping your estate confidential, a trust may be a wise choice.
Flexibility in Asset Distribution: Wills let you decide where your assets end up, but not much more than that. You can tell beneficiaries how you would like them to use the wealth you leave them in your will, but they don’t have any real legal obligation to honor your wishes. A trust, on the other hand, lets you exercise continuing control over wealth in the trust through the instructions you leave for the trustee. And a trustee does have a legal obligation to honor those instructions.
By way of example, you could transfer one or more rental properties into a living trust during your life and continue to benefit from the regular rental income. Upon death, the property bypasses probate and, per instructions you leave for the successor trustee, is deeded to a second trust created for the purpose of owning the real estate. The trustee continues to rent the property under terms laid out in advance, pays the taxes, and arranges for maintenance. After deducting the administrative expenses, the trustee distributes the profits earned by the real estate to the beneficiaries named in the trust. Thus, by using a trust, you save the time and cost of probate, provide a long-term income stream for loved ones, and avoid the risk that they sell off the property for a short-term windfall and miss out on the long-term profit potential. A will alone could not ensure any of these objectives.
Reduced Estate Taxes: While California does not currently have a state-level inheritance or estate tax, the federal estate tax can be as high as 40% for estates large enough to qualify. However, assets held in certain irrevocable trusts are not counted when calculating taxable estates. And, as a result, a well-planned trust can equate to huge tax savings under the right circumstances. Importantly, for the approach to work the settlor cannot serve as trustee and must give up any “incidents of ownership” over trust assets. That means that, once the trust is in place, you can’t revoke it, amend the instructions to the trustee, or change beneficiaries. It’s a big commitment, but the tax savings can be well worth it.
Asset Protection and Preservation: A creditor who has obtained a money judgment against a debtor has a legal right to attach assets owned by the judgment debtor (subject to statutory exemptions). Assets held in certain trusts, though, are beyond the reach of creditors. There are exceptions for family support obligations and tax claims, but, for the most part, beneficiaries’ creditors cannot attach wealth held in an irrevocable trust until it is actually distributed (i.e., until the asset is no longer in the trust). California law limits creditor attachment to rights the debtor personally holds, so, if a beneficiary does not have any right to control trust property other than by receiving occasional distributions from the trustee, assets held in the trust are safe.
This same principle holds true for divorce and bankruptcy as well. Personally-owned wealth is potentially subject to attachment by a bankruptcy trustee or loss in a property settlement stemming from the owner’s divorce. But if the wealth is instead held in a properly designed trust, and ownership is limited to the right to benefit from the property through trustee distributions, the risk of loss due to the beneficiary’s divorce or bankruptcy is nearly eliminated.
Medi-Cal Planning: Means-tested benefits programs like Medicaid require recipients to satisfy income and wealth tests when qualifying for eligibility. For the Medi-Cal program (California’s version of Medicaid), the resource limit is $2,000, which means that an applicant cannot qualify if he or she owns assets worth more than $2,000 (excluding certain exempt assets like a personal residence or vehicle). By transferring wealth into a properly designed trust, though, an applicant can retain some beneficial interest in property that is otherwise removed from the means-test calculation. Perhaps more importantly, if a trust is set up right, assets transferred to the trust can be preserved for eventual inheritance by heirs, but Medi-Cal penalties for transfers during the “look-back period” are either eliminated or minimized.
Specialized Trust Forms: Scores of specialized forms of trusts can be used in California to accomplish specific financial planning objectives. We can’t list every single form here, but these are a few of the most frequently used trusts in California estate planning.
Spendthrift Trust: Spendthrift trusts are designed to serve the duel purposes of protecting trust assets from creditor claims and preventing squandering of assets by beneficiaries. Spendthrift trusts are particularly useful for settlors who want to provide financial support for loved ones prone to irresponsible spending or who have judgments pending against them.
A spendthrift provision included within the trust’s declaration prohibits beneficiaries from assigning their beneficial interests to any third parties. As a result, creditors cannot attach the interest or assets within the trust because the beneficiary has no effective control over either. Creditors can, however, still attach funds or property after distribution by the trustee to the beneficiary. Like most states, California does not allow “self-settled” spendthrift trusts, so a settlor who transfers property to a trust and then names him or herself as beneficiary won’t receive any additional protection against creditors.
Dynasty Trust (a/k/a “generation skipping trust”): Dynasty trusts facilitate transfer of wealth through multiple generations while minimizing transfer taxes like estate tax, gift tax, and GST tax. By definition, dynasty trusts are long-term and irrevocable. Under California’s version of the Rule against Perpetuities, they can last a little more than 90 years.
The objective of a dynasty trust is to keep assets within a family for several generations, protected against loss to creditors, divorce, bankruptcy, or squandering by earlier generations. A dynasty trust is also useful in keeping core assets unified by avoiding the diffusion that often otherwise occurs as wealth is transferred to each succeeding generation.
Crummey Trust: Crummey trusts take advantage of the annual federal estate tax exclusion to remove wealth from the settlor’s estate, thereby reducing eventual estate tax liability. To work, the trust must be irrevocable, and a cooperative beneficiary must be permitted a limited time to access assets transferred to the trust. As long as the beneficiary does not exercise that right (and instead just enjoys the benefits of the wealth under the terms of the trust), transferred wealth is no longer in the settlor’s estate and can grow without adding any additional estate tax liability.
Qualified Personal Residence Trust (“QPRT”): Another trust designed to reduce estate taxes, a QPRT is formed for the special purpose of holding a settlor’s personal residence and protecting it against judgment creditors. The settlor transfers the home to the irrevocable trust and reserves the right to continue living there, with the remainder interest assigned to the trust’s ultimate beneficiaries (typically the settlor’s children or grandchildren). When properly executed, a QPRT removes the personal residence from the settlor’s eventual estate tax calculation. In California, with its famously high real estate values, QPRTs are a particularly effective means of limiting estate tax liability.
Irrevocable Life Insurance Trust (“ILIT”): Like a QPRT, an ILIT is an irrevocable trust intended to own a very specific asset. But, instead of real estate, an ILIT owns a life insurance policy. Because the trust is irrevocable, the value of the policy is removed from the estate. However, the trust’s declaration can instruct the trustee to use the eventual policy payout for purposes that benefit the estate, such as burial or final medical expenses, administrative costs, creditor claims, or taxes owed on other assets—or to provide a legacy for loved ones. By guarantying a source of liquidity upon the decedent’s death, the ILIT protects other, illiquid assets like real estate or business interests that might otherwise need to be sold for below market value to pay for estate administration.
Special Needs and Medi-Cal Trusts: Trusts are a great tool when securing or maintaining eligibility for Medi-Cal and other means-tested government benefits. A properly planned Medi-Cal trust allows a settlor to meet asset limits for eligibility while still providing for eventual transfer of trust assets to heirs. Under California law, assets held in a compliant trust will not be subject to future recovery claims by Medi-Cal and can therefore pass to the trust’s ultimate beneficiaries instead. Special needs trusts serve a similar function and are commonly used to ensure that a substantial sum received by a recipient of benefits—such as through a legal settlement or inheritance—does not jeopardize continued eligibility.
Trusts are an effective and widely useful financial planning tool that can serve numerous functions. But they also tend to be complex and sophisticated. A seasoned California estate-planning attorney can help you evaluate your current financial situation, develop a strategy for achieving your goals, and decide whether one or more trusts are appropriate for the objectives you want to accomplish.
Steve Gibbs, Esq.