Flyover 5 - Trusts

We spent the last few lessons talking through the law of intestacy and the law of wills. Now we're going to focus on the third member of the teeny triumvirate: trusts. Let's start with the very basics. What exactly is a trust? Fundamentally, a trust is a legal instrument that allows one party to manage property for the benefit of another.

The trust accomplishes this by splitting ownership of assets between two people or groups of people. One party, the trustee, has legal title and the responsibility to control the property. The trustee makes investment decisions, keeps the books, and safeguards the trust assets. The other party, the beneficiary, receives all the benefits flowing from the property.

Now, trusts are incredibly useful because they can be easily customized. The person creating the trust can leave extremely specific directions for the trustee, or they can vest the trustee with an enormous amount of discretion so that the trustee can respond to changing circumstances. Let's look at an example of a trust.

Imagine that Alexander Hamilton has a son, Philip, who isn't very trustworthy. If Hamilton leaves Philip money in his will, Philip will instantly waste his inheritance on fancy muskets and velvet frocks. What should Hamilton do? Well, instead of passing his money through a will, Hamilton could put his wealth in a trust and instruct the trustee to only pay Philip $1,000 each month. The trustee would take Hamilton's money, manage the assets, and make investment decisions. Philip would still benefit from Hamilton's fortune, but he couldn't spend all the money at once.

5 Requirements for a Trust

Now, if Hamilton wants to make a trust, what exactly does he need to do? How do you create a trust? Well, there are five basic requirements for making a trust: (1) parties, (2) property, (3) intent, (4) capacity, and (5) a legal purpose. Let's quickly walk through these.

1. Parties

The first thing that every trust needs are three parties: a settlor, a beneficiary, and a trustee. A settlor is just the person who creates the trust. That's never an issue on the bar exam. Additionally, every trust needs at least one beneficiary. Most of the trusts that appear on the MEE actually have more than one beneficiary.

The trust you'll see on the exam generally looks something like this: Hamilton puts $10 million in a valid trust. He directs the trustee to pay income from the trust to his wife, Eliza. Then, upon her death, the trust should distribute the remaining principal to Hamilton's children. In this example, Hamilton's wife is what's known as the income beneficiary. That means that any income generated by the trustee should go to her. Hamilton's children are the remaindermen. They get any remaining trust assets when the income beneficiary dies.

Let's talk about some actual MEE problems that implicate beneficiaries. Occasionally, the bar examiners will throw something like this at you: Hamilton puts 10 million in trust and authorizes the trustee to pay income to Hamilton's friends for 20 years. Is this a valid trust? It's not. Why? Because we don't have the right kind of beneficiaries.

A trustee can leave money to a named individual or a defined class of people. You can give stuff to my children or members of my graduating class, but friends is not a defined class. Who counts as a friend? Facebook friends? The contacts in your phone? There's no way for the trustee to know who to pay. As a result, this trust provision fails.

Let's just review. Our black-letter law here is that every trust needs a beneficiary, and those beneficiaries can't be indefinite. You cannot leave a trust to my revolutionary abolitionist comrades or my fellow law school gunners. Those are too indefinite.

Finally, every trust needs at least one trustee. Usually, the settlor appoints a trustee in the trust documents, but what happens if the trust document doesn't name a trustee, or if the named trustee has died or refuses the job? That's actually okay. A court can appoint a trustee to run the trust. The black-letter law here is that no trust fails for want of a trustee.

One final point on the parties to a trust. The same person may be settlor, trustee, and a beneficiary. Hamilton could name himself trustee over a trust with $10,000 in assets to pay for powdered wigs for himself and Jefferson. Hamilton is the settlor, he's the trustee, and he's one of the beneficiaries. That's totally fine. The thing that's not okay is if the same person is the controlling trustee and the sole beneficiary. In that case, the person has not split legal title to the property in any meaningful way, and therefore, no trust is created. Let's move on to the other requirements.

2. Property

In addition to the three parties, trusts need to be funded with property. The black-letter rule is that the property needs to be in existence and ascertainable. Ascertainable just means that the trust property must be clearly defined. The trustee must know exactly what assets they're responsible for managing. The inexistence requirement is pretty self-explanatory too. The trust can only be funded with a recognized property interest.

Let's do a quick hypothetical. Which of the following things could you put in a trust: a stock certificate, a lottery ticket, the rights to your first novel which you've written, next year's stock trading profits? Well, the stocks, lottery tickets, and intellectual property rights can all fund a trust. They exist. However, you can't fund a trust with next year's stock trading profits. A mere expectancy of profits is not a recognized kind of property.

3. Intent

All right, after rounding up some property, the settlor must also intend to make a trust. This is rarely an issue with professionally drafted documents. Lawyers will put the word "trust" in capital letters somewhere at the top of the page. Hamilton's lawyers, for instance, might label his documents as "The Hamilton Family Trust."

Now, when lay people make their own documents, things can get more confusing. They often don't use the word "trust." Does that invalidate the document? Not necessarily. There are no magic words that are needed to create a trust.

Here's the test: did the purported settlor intend to split title to the property and impose enforceable obligations on one party? For example, assume that Hamilton wrote a document that said, "I'm holding the money in my bank account for Washington to use to purchase guns and ships." This looks like a valid trust. Although Hamilton hasn't used the word "trust," he's holding or managing a defined set of assets for the benefit of another person.

In contrast, a document that says, "I give $10,000 to Jefferson, and I hope he uses the money to aid the war effort" probably isn't a trust. The word "hope" indicates that Jefferson doesn't have enforceable obligations. He's not a trustee. Hamilton has suggested a purpose, but it's not mandatory. Jefferson can use the money for whatever he wants.

4. Capacity

Settlors also need to have capacity in order to make a trust. We talked about capacity in the section on wills, so we don't need to cover that ground again. Just know that all of the doctrines we discussed, capacity, insane delusion, undue influence, and fraud, can be imported into trust disputes.

5. Legal Purpose

Now, moving on, all trusts need to have a legal purpose. That means the courts will invalidate any trust provision that encourages illegal activity or undermines public policy. Hamilton could not give money to a trustee with the instruction to pay $10,000 to the person who killed Aaron Burr. The trust would fail because it promotes illegal activity. In this case, the trust would give the money back to Hamilton.

Similarly, Hamilton could not create a trust that gives Angelica Schuyler $10,000 if she leaves her husband. Trusts can't be used to break apart families or impose unreasonable restraints on marriage. That kind of thing violates public policy.

In addition to our five main trust requirements, parties, property, intent, capacity, and legal purpose, two additional doctrines can sometimes sabotage trust creation. First, trusts that hold real estate are subject to the statute of frauds. They must be in writing. And second, trusts are subject to the rule against perpetuities in many states.

The rule against perpetuities, as you know from property, is a swamp. It's difficult and confusing. We won't go over it here, but if you see a trust that threatens to give property to a settlor's grandkids' grandkids, you should at least mention that the RAP does apply to trusts.

Let's do one review problem before moving on. Here's a clause from Marilyn Monroe's actual will. It reads, "I give and bequeath all my personal effects and clothing to Lee Strasberg, it being my desire that he distribute these in his sole discretion among my friends, colleagues, and those to whom I am devoted."

Does this clause create a valid trust? What do you think? The answer no. First, it doesn't appear that Marilyn intended to create a trust. There's little evidence that she wanted to split the title to her property and impose enforceable obligations on a trustee. The words "it being my desire" look more like a suggestion than a mandatory duty.

Second, Marilyn has not left her property to a defined class of beneficiaries. It's impossible to define who counts as her friends or colleagues or those to whom she is devoted. This is not a trust but rather an outright gift to Lee Strasberg.

Revocable Trusts

All right, that's a good outline of everything you need to know about creating trusts, but what about amending or revoking a trust? Let's talk about how that works. In most trusts, the settlor retains for themselves the power to terminate the instrument. These are known as revocable trusts.

On a few recent bar exams, the testers have asked whether the power to revoke includes the ability to modify the trust instrument. The answer is yes. If a settlor has the power to terminate, they can also amend the instrument.

Now, to modify or cancel a revocable trust, the settlor need only follow the procedures laid out in the trust document. Usually, trust instruments require the settlor to put changes in writing and then deliver the amendments to the trustee. Now, if the document does not provide guidance, the trust can still be revoked by any act that provides clear and convincing evidence of the settlor's intent. The bottom line, the thing you need to remember, is that changing a revocable trust is pretty easy.

Irrevocable Trusts

But not all trusts are revocable. Occasionally, and most often for tax reasons, a settlor will create an irrevocable trust. Settlors lose an enormous amount of control over the trust property when they give up the right to unilaterally end or change the trust. At that point, the trustee is really in charge. Nevertheless, even irrevocable trusts can be terminated or amended in a very limited number of circumstances.

First, if the settlor is still alive, a court will authorize revocation or modification if the settlor and all the beneficiaries agree to a change. For example, imagine that Hamilton makes an irrevocable trust to pay Eliza $1,000 each month for the rest of her life. If Hamilton and Eliza agree to end the trust, most courts will allow them to split the money however they choose.

Things get much more complicated once the settlor died. What should courts do when the beneficiaries petition to modify or terminate a trust and the settler is not around to give consent? If the settlor has died, a court will revoke a trust if all the beneficiaries assent and the change will not frustrate a material purpose of the trust.

Determining what counts as a material purpose can be tricky. Imagine that Hamilton creates a trust intended to finance Eliza's education. Then, upon Eliza's death, the trustee is to divide the remaining assets among Adams and Jefferson. If Hamilton dies, can Eliza, Adams, and Jefferson convince a court to terminate the trust and split the trust property between them? What do you think? Probably not. Hamilton intended the trustee to finance Eliza's education. If the trust is terminated, Eliza could spend the money on anything, not just books and tuition.

Let's do one more example. What if Hamilton set up a trust to provide Eliza with $2,000 every month during her lifetime? Would early termination frustrate the material purpose of this trust? Courts are actually split on this one. Most courts hold that providing Eliza with a steady income is a material purpose, and as a result, they would refuse to revoke the trust. Other courts argue that the purpose is only for the trust to help Eliza. These courts would end the trust.

Let's talk about one more doctrine before we end the lesson. Courts can also terminate or amend a trust under the changed circumstances rule. A court can modify a trust if (1) circumstances exist that were not anticipated by the settlor, and (2) the modification would further the settlor's purposes.

Let's imagine that Hamilton sets up a well-funded trust to benefit Eliza for her life. What if the stock market crashes after Hamilton dies and the assets of the trust aren't enough to cover the expenses of trust administration? Could Eliza petition a court to end the trust early and take the remaining assets as a lump sum? Probably yes.

First, Hamilton could not have anticipated that market conditions would ruin the trust. Second, allowing Eliza to take some money before the administrative fees gobble up the remainder does advance Hamilton's purpose of taking care of Eliza.

That's great work, and that's it for now.