Accounting for a Trust

A trust is created by the conveyance of assets to a fiduciary (or trustee) who manages the assets and ultimately disposes of them to one or more beneficiaries. The trustee may be an individual or an organization such as a bank or other financial institution. Over the years, trust funds have become quite popular in this country for a number of reasons.

Often they are estab­lished to reduce the size of a person’s taxable estate and, thus, the amount of estate taxes that must eventually be paid. As one financial adviser has stated, “Who needs to establish a trust? You do, and so does your spouse. There may be several good reasons, but start with this- If you don’t set up trusts, your heirs may pay hundreds of thousands of dollars in unnecessary estate taxes.”

Estate taxes are not the only reason for establishing a trust. People form trust funds to pro­tect assets and ensure that the eventual use of these assets is as intended. Trusts can also result from the provisions of a will, specified by the decedent as a means of guiding the distribution of estate property. In legal terms, an inter vivos trust is one started by a living individual, whereas a testamentary trust is created by a will.

Frequently, the trustor or settlor or grantor (the person who funds the trust) will believe that a chosen trustee is simply better suited to manage complicated investments than is the beneficiary. A young child, for example, is not capable of directing the use of a large sum of money. The trustor may have the same opinion of an individual who possesses little business expertise. Likewise, the creation of a trust for the benefit of a person with a mental or severe physical handicap might be considered a wise decision.

During recent years, one specific type of trust, a revocable living trust, has become espe­cially popular and controversial. The trustor usually manages the fund and receives most, if not all, of the income until death. After that time, future income and possibly principal payments are made to one or more previously named beneficiaries. Because the trust is revocable, the trustor can change these beneficiaries or other terms of the trust at any time.

Revocable living trusts offer several significant advantages that appeal to certain individu­als. First, this type of trust avoids the delay and expense of probate. At the trustor’s death, the trust continues and makes future payments as defined in the trust agreement.

In some states, this advantage can be quite important, but in others the cost of establishing the trust may be more expensive than the potential probate costs. The taxable income of the revocable living trust is included in the grantor’s individual income tax return while that person remains alive. It is not taxed within a fiduciary income tax return.

Second, conveyance of assets through a trust can be made without publicity whereas a will is a public document. Thus, anyone who values privacy may want to consider the revocable liv­ing trust. The entertainer Bing Crosby, for example, set up such a trust so that no outsider would know how his estate was distributed.

Although the number of other types of trusts is quite large, several of the more common include these:

i. Credit Shelter Trust (Also Known as a Bypass Trust or Family Trust):

This trust is designed for couples. Each spouse agrees to transfer at death an amount of up to the tax-free exclusion ($2.0 million in 2007 and 2008) to a trust fund for the benefit of the other. Thus, the income that these funds generate goes to the surviving spouse, but at the time of this second indi­vidual’s subsequent death, the principal is conveyed to a different beneficiary.

ii. Qualified Terminable Interest Property Trust (Known as a QTIP Trust):

Individuals frequently create a QTIP trust to serve as a credit shelter trust. They convey property to the trust and specify that the income, and possibly a portion of the principal, be paid to the surviving spouse (or other beneficiary). At a specified time, the trust conveys the remainder to a des­ignated party. Such trusts are popular because they provide the spouse a steady income but the trustee can guard the principal and then convey it at a later date to the individual’s chil­dren or other designated parties.

iii. Charitable Remainder Trust:

All income is paid to one or more beneficiaries identified by the trustor. After a period of time (or at the death of the beneficiaries), the principal is given to a stated charity. Thus, the trustor is guaranteeing a steady income to the intended parties while still making a gift to a charitable organization. These trusts are especially popular if a taxpayer holds property that has appreciated greatly (such as real estate or stocks) that is to be liquidated. By conveying it to the trust prior to liquidation, the sale is viewed as that of the charity and is, hence, nontaxable.

Thus, tax on the gain is avoided and significantly more money remains available to generate future income for the beneficiaries (possibly the original donor). “This trust lets you leave assets to your favored charity, get a tax break, but retain income for life.”

iv. Charitable Lead Trust:

This trust is the reverse of a charitable remainder trust. Income from the trust fund goes to benefit a charity for a specified time with the remaining principal then going to a different beneficiary. For example, a charity might receive the income from trust assets until the donor’s children reach their 21st birthdays.

v. Grantor Retained Annuity Trusts (Known as GRATs):

The trustor maintains the right to collect fixed payments from the trust fund while giving the principal to a beneficiary after a stated time or at the trustor’s death. For example, the trustor might retain the right to receive an amount equal to 7 percent of the initial investment annually with any remaining balance of the trust fund to go to his or her children at death. Because the beneficiary will not receive the residual amount for years, a current value is computed for gift tax purposes.

Depending on- (1) the length of time before final distribution to the beneficiary, (2) the assumed rate of income, and (3) the amounts to be distributed periodically to the trustor, this value is often quite small so that the gift tax is reduced or eliminated entirely.

vi. Minor’s Section 2503(c) Trust:

Established for a minor, this trust fund usually is designed to receive a tax-free gift of up to $12,000 each year ($24,000 if the transfer is made by a cou­ple). Over a period of time, especially if enough beneficiaries are available, this trust can remove a significant amount of assets from a person’s estate. The change in the gift tax laws and the gradual repeal of the estate tax will significantly impact this type of trust.

vii. Spendthrift Trust:

This trust is established so that the beneficiary cannot transfer or assign any unreceived payments. The purpose of such trusts is to prevent the beneficiary from squan­dering the assets the trust fund is holding or the beneficiary’s creditors from reaching the assets. This type of trust is particularly useful to protect irresponsible beneficiaries, for exam­ple, children and beneficiaries whose former spouses maintain legal actions against them.

viii. Irrevocable Life Insurance Trust:

With this trust, the donor contributes money to buy life insurance on the donor. If a couple is creating the trust, usually the life insurance policy is designed to pay the proceeds only after the second spouse dies. The proceeds are not part of the estate and the beneficiary can use the cash to pay estate and inheritance taxes.

ix. Qualified Personal Resident Trust (QPRT):

The donor gives his or her home to the trust but retains the right to live in the house for a period of time rent free. This removes what is often an individual’s most valuable asset from the estate. This type of trust has characteris­tics similar to a GRAT.

The term of the trust can be as short or as long as desired. The longer the term the lower the value of the gift. If the grantor dies before the term of the trust expires, however, the property will revert back to the estate of the deceased and be subject to estate taxes at its current value. Therefore, a term should be picked that the grantor believes he or she will outlive for the benefits of the QPRT to be effective.

As these examples indicate, many trust funds generate income for one or more beneficia­ries (known as life tenants if the income is to be conveyed until the person dies). At death or the end of a specified period, the remaining principal is transferred to a different beneficiary (a remainder man).

Therefore, as with estates, differentiating between principal and income is ulti­mately important in accounting for trust funds. This distinction is especially significant because trusts frequently exist for decades and can control and generate enormous amounts of assets.

The reporting function is also important because of the trustee’s legal responsibilities. This fiduciary is charged with the wise use of all funds and may be sued by the beneficiaries if actions are considered to be unnecessarily risky or in contradiction to the terms of the trust arrangement. To avoid potential legal problems, the trustee is normally called on to exercise reasonable and prudent care in managing the assets of the fund.

Record-Keeping for a Trust Fund:

Trust accounting is quite similar to the procedures demonstrated previously for an estate. However, because many different types of trusts can be created and an extended time period might be involved, the accounting process may become more complex than that for an estate. As an example, an apartment house or a significant portion of a business could be placed in a trust for 20 years or longer.

Thus, the possible range of transactions to be recorded becomes quite broad. In such cases, the fiduciary often establishes two separate sets of accounts, one for principal and one for income. As an alternative, the fiduciary could utilize a single set of records with the individual accounts identified as to income or principal.

In the same manner as an estate, the trust agreement should specify the distinction between transactions to be recorded as income and those to be recorded as principal. If the agreement is silent or if a transaction that is not covered by the agreement is incurred, state laws apply to delineate the accounting. Generally accepted accounting principles usually are not considered appropriate. For example, trusts utilize the cash method rather than accrual accounting in recording most transactions.

Although a definitive set of rules is not possible, the following list indicates the typical division of principal and income transactions:

Adjustments to the Trust’s Principal:

Investment costs and commissions.

Income taxes on gains added to the principal.

Costs of preparing property for rent or sale.

Extraordinary repairs (improvements).

Adjustments to the Trust’s Income:

Rent expense.

Lease cancellation fees.

Interest expense.

Insurance expense.

Income taxes on trust income.

Property taxes.

Trustee fees and the cost of periodic reporting must be allocated between trust income and prin­cipal. This allocation is often based on the value of assets within each (principal/income) category.

Accounting for the Activities of a Trust:

An inter vivos trust reports on an annual basis (or perhaps more frequently) to all income and principal beneficiaries. However, testamentary trusts come under the jurisdiction of the courts so that additional reporting regularly becomes necessary. Normally, a statement resembling the charge and discharge statement of an estate is adequate for these purposes. Two accounts, Trust Principal and Trust Income, monitor changes that occur. For a testamentary trust, the opening principal balance is the fair value used by the executor for estate tax purposes.

To illustrate, assume that the following events occur in connection with the creation of a char­itable remainder trust. The will of Samuel Statler created a trust with the income earned each year to go to his niece for 10 years and the principal then conveyed to a local university (the charity).

1. Cash of $80,000 and stocks (that originally cost $39,000 but are now worth $47,000) are transferred from the estate to the First National Bank of Michigan because this organiza­tion has agreed to serve as trustee for these funds.

2. The trustee invested cash of $76,000 in bonds paying 11 percent annual cash interest.

3. Dividends of $6,000 on the stocks are collected, and interest of $7,000 is received on the bonds. No receivables had been included in the estate for these amounts.

4. At the end of the year, an additional $3,000 in interest is due on the bonds.

5. As trustee, the bank charges $2,000 for services rendered for the year. Statler’s will pro­vided that such fees should be allocated equally between principal and income.

6. The niece is paid the appropriate amount of money from the trust fund.

As the trustee, the bank should record these transactions as follows: