Testamentary Trust

A testamentary trust is a trust governed by the last will and testament of a grantor and it comes into being after the grantor’s death. Opting for such a trust requires the trustee and beneficiary to take the help of a judicial procedure to get their hands on the inheritance.

The testamentary trust favors tax-efficient inheritance. Moreover, the court’s supervision ensures that the assets are distributed as per the trust agreement.

• A testamentary trust is established to ensure the proper implementation of a grantor's will. The trust comes into existence only after the death of the grantor/ testator.
• The testamentary trustee looks after the beneficiaries' inheritance till they are allowed to take charge of the assets.
• The purpose behind such trusts is to keep the assets in safe hands after the testator's death. It even reduces the estate tax liabilities of the beneficiaries.

A grantor is a person such as a father who creates a will to transfer the assets owned under his name to his spouse and children upon his demise. The testamentary trust is one of the means of transferring the assets to the beneficiaries. As discussed above, such trust comes into being after the grantor’s demise under the court’s watch. The process is referred to as probate.

To understand the trust’s functioning, let's first find out about the four parties involved in it:

1. Grantor/Testator/Trustor/Settlor/Deceased Person: Grantor or trustor is the owner of the assets who decides to grant his/her assets to his/her survivors after the grantor’s death. The assets could be property, wealth, capital gains, life insurance proceeds, valuables, etc.
2. Executor: The executor is the person who is authorized by the probate court to present the grantor’s will in the court to establish a testamentary trust. Normally, the grantor names an executor in the will. In some cases, when a name is not there, the grantor’s survivors approach a lawyer to oversee probate proceedings.
3. Trustee: A testamentary trustee is appointed as the caretaker or manager of the trust until the beneficiary takes over. He/she can be a family member, close relative, friend, or 18+ acquaintance. Such a person relishes some powers, but the state law governs his/her activities.
4. The beneficiary or beneficiaries can be anyone whom the grantor decides to choose as the legal owner of his/her assets after his/her demise. Beneficiaries could be spouse, minor child, adult children, disabled family member, or other dependants. Sometimes, a beneficiary is a charitable trust or non-profit organization.

• In the case of this trust, till the grantor is alive, the asset ownership stays under the grantor’s name. When the grantor dies, it becomes imperative to establish a testamentary trust to allow inheritance and ownership rights to the beneficiaries.
• The inheritance takes place as per the last will of the grantor. The grantor writes a will which guides the terms of inheritance. This legal paper states a grantor’s final decision regarding who will inherit what. Make sure you have two witnesses if you reside in any state other than Louisiana and Colorado.
• After the demise of the grantor, the will is submitted for the probate procedure by the executor. The probate court ensures the credibility of the documents.
• The court then orders to form the testamentary trust and allows the transfer of ownership title to the trust instead of the grantor. The testamentary trustee is also recognized at this stage.
• Thereafter, the testamentary trustee assumes the charge of safeguarding and managing the trust’s assets. When the right time arrives, the trustee entrusts the assets to the authorized beneficiary. This right time is a condition mentioned in the will. The conditions vary as per the wills.
• Some wills suggest inheritance on or after the beneficiary's 18th birthday, basic education or any other criteria. With the trustee's handing over the assets to the beneficiary, the trust automatically ceases to exist.
• This trust is preferred by people who want to put some conditions to inheritance. The conditions ensure that the assets are distributed only when the beneficiaries are fit to handle them. Some wills also allow for a regular income to the trustee.
• There are broadly two types of testamentary trusts based on the number, i.e., separate or family trusts. When classified by the extent of the beneficiary's involvement, the other two types include discretionary and protected trusts.

Mrs A is a single mother and has a son, B. She owns a house, car, factory and fixed deposit. She created a testament for securing her child's future. Mrs A's father, Mr Z, took the responsibility of becoming the testamentary trustee.

She specified in her will that the income from fixed deposits and factory would be used for paying her child's education and living expenses. Also, she mentioned that the inheritance would be handed over to B when he turns 18. After a year, Mrs A passed away in an accident.

For five years, Mr Z took care of the assets. He also paid for the B's education and living expenses from assets income. On B's 18th birthday, Mr Z transferred the assets to him as stated in the will.

If the assets are directly transferred to the beneficiary, who is also a taxpayer, then the income from inheritance becomes taxable. However, by forming a testamentary trust, the trustor can save the beneficiary from such taxes.

Although the government levies certain taxes on the trust, this liability can be reduced significantly if well-planned. Individuals enjoy tax threshold benefits under the stepped marginal tax rate system. Individuals enjoying a low tax rate can take the trust income under their own name to benefit from a low tax rate. Similarly, those under 18 or who do not have a taxable income can do the same.

The beneficiary is also liable to pay capital gains tax on real estate or capital asset inherited from the trustor. But the trust helps in bringing down this liability by utilizing the provisions of the tax laws. Please note that every state has its laws for the taxation of trusts. Therefore, the income exempted in one state can become taxable in another.

While it comes with some advantages, it is exposed to certain limitations too -

• The trust doesn’t allow immediate ownership of the assets to the beneficiary. In fact, the beneficiaries have to undergo probate procedures and get involved with a lawyer to bring the trust into existence.
• The trust is irrevocable that itself pose many disadvantages.
• The conditions stated in the will may become unsuitable over time. In the absence of the trustor, clarifications become impossible.
• Sometimes, the trustee resigns, feeling overwhelmed. The court can intervene to assign a new trustee, but it will be against the trustor’s last wish.
• It is a complicated provision formed and administered by the state laws to ensure proper execution of a trustor's will. The process of probate is time-consuming and expensive in some cases.

While succession planning, a grantor can go for any trust creation. The significant difference between these two trusts is that the testamentary trust comes into existence after the trustor's demise. However, the living trust is formed and is functional while the trustor is still alive.

There is no scope for making changes in the testamentary trust since the trustor is no more, while a revocable living trust allows changes. Unlike a living trust, confidentially suffers due to probate procedures under a testamentary trust. Despite tax benefits, many grantors find the living trust more convenient, flexible and reliable.

This has been a guide to what is Testamentary Trust and its definition. Here we discuss how does it work along with examples, taxation, and its disadvantages. You may find more from the following articles -

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