Trust

Investment advisers who serve clients with trust accounts or who advise trustees on investment policy must understand the foundational trust framework, the distinctions among the major trust types, the fiduciary obligations of trustees under the Uniform Prudent Investor Act, and the tax treatment of trust income under IRC Subchapter J — all of which are directly tested on the Series 65 examination in the context of client account types, estate planning, and the legal framework governing investment management.

The Three Essential Parties — Grantor, Trustee, and Beneficiary

Every trust relationship involves three essential parties whose roles and relationships to each other define the legal and economic structure of the arrangement.

The grantor — also called the settlor, trustor, or creator — is the person who establishes the trust by executing the trust document and transferring assets into the trust. The grantor defines the trust’s purpose, identifies the trustee and beneficiaries, specifies the terms under which the trust will be administered, and determines the conditions under which distributions will be made. The grantor’s authority over the trust after its creation depends fundamentally on whether the trust is revocable or irrevocable — in a revocable trust the grantor retains the power to amend, modify, or terminate the trust during their lifetime, while in an irrevocable trust the grantor permanently relinquishes control over the transferred assets and generally cannot modify the trust’s terms after its creation.

The trustee is the individual or institution — the grantor personally, who may serve as trustee of their own revocable trust, or a family member, a bank trust department, a trust company, or a professional fiduciary — who holds legal title to the trust assets and bears the fiduciary responsibility for managing those assets according to the trust document’s terms and applicable law. The trustee’s role is not ownership in any economically beneficial sense — the trustee holds title as a legal mechanism for management and control rather than for personal benefit. The trustee owes the beneficiaries a comprehensive set of fiduciary duties including the duty of loyalty — to act solely in the beneficiaries’ interests without self-dealing — the duty of prudence — to invest and manage the trust assets as a prudent investor would — the duty of impartiality — to balance the competing interests of current income beneficiaries and remainder beneficiaries — and the duty of full disclosure — to keep beneficiaries informed about the trust’s administration and financial condition.

The beneficiary is the person or entity for whose benefit the trust assets are held and managed. Trusts frequently have two categories of beneficiaries with different temporal interests — current beneficiaries who are entitled to receive income or other distributions during the trust’s administration period, and remainder beneficiaries who receive the trust’s remaining assets when the trust terminates at a specified event such as the death of the grantor or the attainment of a specified age by the current beneficiary. The trust document specifies the trustee’s obligations to each category — including mandatory income distributions, discretionary principal distributions, and the conditions under which the trustee may or must make payments.

Revocable Versus Irrevocable Trusts — The Foundational Distinction

The most fundamental classification of any trust is whether it is revocable or irrevocable — a distinction with profound implications for the grantor’s control over the assets, the trust’s tax treatment, and its effectiveness for asset protection and estate planning purposes.

A revocable trust — most commonly established as a revocable living trust or inter vivos trust — is one that the grantor retains the power to amend, modify, or revoke entirely during their lifetime. Because the grantor can reclaim the assets at any time by revoking the trust, the assets are treated as still belonging to the grantor for virtually all legal and tax purposes during the grantor’s lifetime. The Internal Revenue Code under IRC Sections 671 through 677 treats the grantor as the owner of a revocable trust’s assets — all income, gains, deductions, and credits of the trust are reported directly on the grantor’s personal income tax return as if the trust did not exist as a separate entity. During the grantor’s lifetime the revocable trust need not file its own income tax return or obtain a separate employer identification number — under the optional reporting method in Treasury Regulation Section 1.671-4 the trustee may instead furnish the grantor’s own name and Social Security number to every payor of trust income.

The primary benefits of a revocable living trust are probate avoidance and continuity of management. Assets held in a revocable trust at the grantor’s death transfer directly to the named successor beneficiaries without passing through probate — the court-supervised estate administration process that applies to assets held in the grantor’s individual name. This avoidance of probate provides privacy — trust distributions are not part of the public record as probate proceedings are — and efficiency — trust distributions can be made within days or weeks of the grantor’s death rather than the months or years that complex probate proceedings can require. If the grantor becomes incapacitated during their lifetime the named successor trustee — designated in the trust document — can assume management of the trust assets immediately without requiring a court-appointed conservatorship, providing continuity of financial management during incapacity.

The Irrevocable Trust — Relinquished Control and Its Consequences

An irrevocable trust is one in which the grantor permanently relinquishes control over the transferred assets — after the trust is created and funded the grantor generally cannot modify its terms, reclaim the assets, or change the beneficiaries without the consent of the beneficiaries and potentially court approval. This permanent relinquishment of control is the essential characteristic from which all of the irrevocable trust’s distinctive tax and asset protection benefits flow.

Because the grantor no longer owns or controls the assets in an irrevocable trust, those assets are generally excluded from the grantor’s taxable estate for federal estate tax purposes — a powerful estate planning benefit for high-net-worth individuals whose estates exceed the federal estate tax exemption. Assets transferred to an irrevocable trust may also be protected from the grantor’s creditors — because the grantor no longer legally owns the assets, creditors of the grantor generally cannot reach them — subject to applicable fraudulent transfer laws that prevent transfers made with the intent to defraud existing creditors. Unless the grantor has retained a power that makes it a grantor trust, an irrevocable trust is treated as a separate taxable entity — it must obtain its own employer identification number, file its own fiduciary income tax return on Form 1041, and pay its own income taxes on any income it does not distribute to beneficiaries under the compressed income tax rate schedule that the Code prescribes for estates and trusts.

Spendthrift Provisions and the Reach of Creditors

The Uniform Trust Code — the model trust statute promulgated by the Uniform Law Commission in 2000 and since amended, which states adopt with their own variations — allows a grantor to protect a beneficiary’s interest from the beneficiary’s own creditors through a spendthrift provision. The provision is valid only if it restrains both voluntary and involuntary transfer of the beneficiary’s interest, so a clause that merely forbids the beneficiary to assign the interest while leaving creditors free to attach it does not qualify, although a term declaring that the interest is held subject to a spendthrift trust, or words of similar import, is sufficient. While a valid provision applies, the beneficiary cannot transfer the interest, and a creditor or assignee of the beneficiary cannot reach the interest or a distribution by the trustee before the beneficiary receives it.

The protection is not absolute. The Code makes a spendthrift provision unenforceable against a beneficiary’s child, spouse or former spouse who holds a judgment or court order against the beneficiary for support or maintenance, against a judgment creditor who has provided services for the protection of the beneficiary’s interest in the trust, and against a claim of the state or the United States to the extent a statute so provides. Such a claimant may obtain a court order attaching present or future distributions to or for the benefit of the beneficiary.

Claims by the grantor’s own creditors follow separate rules that apply whether or not the trust contains a spendthrift provision. During the grantor’s lifetime the property of a revocable trust is subject to the claims of the grantor’s creditors. Where the grantor of an irrevocable trust is also among its beneficiaries, a creditor of the grantor may reach the maximum amount that can be distributed to or for the grantor’s benefit — so a grantor cannot place assets beyond the reach of their own creditors by transferring them to an irrevocable trust from which the trustee may still pay them.

Living Trusts Versus Testamentary Trusts — The Timing Distinction

Trusts are also classified by when they are created relative to the grantor’s lifetime — as either inter vivos trusts created during the grantor’s lifetime or testamentary trusts that come into existence only upon the grantor’s death.

A living trust — formally called an inter vivos trust from the Latin meaning between the living — is established and funded during the grantor’s lifetime. It becomes operational immediately upon execution and funding — the grantor transfers assets into the trust and the trustee assumes management responsibilities during the grantor’s life. Living trusts may be either revocable or irrevocable as discussed above. The revocable living trust is a widely used estate planning vehicle for middle and upper-income individuals — providing probate avoidance, incapacity planning, and privacy at relatively low cost compared to complex irrevocable trust arrangements.

A testamentary trust is created through a grantor’s last will and testament and comes into existence only upon the grantor’s death — when the will is probated and the assets designated for the trust are transferred from the decedent’s estate into the newly created trust. A testamentary trust is irrevocable by definition — because the grantor is deceased it cannot be modified or revoked. Because the testamentary trust is created through a will it must go through the probate process — unlike a living trust it does not avoid probate and its terms are part of the public probate record. Testamentary trusts are commonly used to manage assets for minor children — where the grantor wants to provide for the children’s financial needs but does not want them to receive outright ownership of assets until they reach a specified age — and for beneficiaries with special needs or financial management challenges who would benefit from ongoing trustee oversight.

When a Revocable Trust Becomes Irrevocable at the Grantor’s Death

While a trust remains revocable, the Uniform Trust Code subjects the rights of the beneficiaries to the control of the grantor and provides that the trustee’s duties are owed exclusively to the grantor — an important qualification of the trustee’s ordinary duties to the beneficiaries. The trustee may therefore follow a direction of the grantor even where it is contrary to the terms of the trust, and the trustee’s duty to inform and report is owed to the grantor rather than to the named beneficiaries.

The grantor’s death ends the power to revoke, and the trust becomes irrevocable. Within sixty days after the trustee acquires knowledge that a formerly revocable trust has become irrevocable, the Code requires the trustee to notify the qualified beneficiaries of the trust’s existence, of the identity of the grantor, of their right to request a copy of the trust instrument and of their right to a trustee’s report. Thereafter the trustee must send the current distributees, at least annually and at the trust’s termination, a report of the trust property, liabilities, receipts and disbursements, including the source and amount of the trustee’s compensation.

The trust’s tax position changes at the same moment. The trust ceases to be treated as owned by the grantor, and a trust that continues after the death must obtain its own taxpayer identification number. Section 645 of the Internal Revenue Code, however, allows the executor and the trustee of a qualified revocable trust — one treated as owned by the decedent under Section 676 because of the decedent’s power to revoke — to elect jointly to have the trust treated and taxed as part of the decedent’s estate rather than as a separate trust. The election must be made by the due date, including extensions, of the estate’s first income tax return, is irrevocable once made, and runs until two years after the date of death where no estate tax return is required, or until six months after the final determination of estate tax liability where one is.

The Uniform Prudent Investor Act — The Investment Standard for Trustees

The Uniform Prudent Investor Act — adopted by most states and the foundational legal standard for trust investment management — establishes the standard of care that trustees must meet when investing and managing trust assets on behalf of beneficiaries. The Act’s prefatory note identifies five fundamental alterations it makes in the former criteria for prudent investing — the standard of prudence is applied to the portfolio as a whole rather than to individual investments, the trade-off between risk and return is the trustee’s central consideration, all categoric restrictions on types of investment are abrogated so that a trustee may invest in any kind of property consistent with the Act’s standards, diversification is integrated into the definition of prudent investing, and the former rule forbidding delegation of investment functions is reversed. The principles that govern trustee investment conduct under the Act follow.

The risk and return trade-off principle requires trustees to make investment decisions considering both risk and expected return — recognising that some risk is appropriate to achieve returns adequate to meet the trust’s purposes. The duty of prudence is evaluated not on an investment-by-investment basis but by looking at the total portfolio — an individual investment that appears risky in isolation may be appropriate as part of a diversified portfolio strategy.

The diversification duty requires trustees to diversify trust investments unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversification — and because the prudent investor rule is a default rule that the terms of a trust may expand, restrict, eliminate or otherwise alter, the trust document may itself relax the duty. The Act recognises Modern Portfolio Theory’s foundational insight that diversification reduces unsystematic risk without sacrificing expected return — making diversification the trustee’s default obligation in the absence of specific trust direction otherwise.

The total return principle recognises that investment return encompasses both income — dividends, interest — and capital appreciation — and the Act lists the expected total return from income and the appreciation of capital among the circumstances a trustee must consider, so that a trustee pursues total return appropriate to the trust’s risk tolerance rather than optimising for income alone at the expense of overall portfolio performance. This total return approach displaced the older prudent man rule, which the Restatement (Second) of Trusts had framed as making only such investments as a prudent man would make of his own property having in view the preservation of the estate and the amount and regularity of the income to be derived.

Impartiality and Delegation Under the Act

The duty of impartiality requires trustees to balance the competing interests of current income beneficiaries — who receive the trust’s income distributions and therefore prefer income-generating investments — and remainder beneficiaries — who receive the trust’s principal when it terminates and therefore prefer capital appreciation strategies. The trustee must manage the portfolio to serve both groups fairly rather than favouring either at the other’s expense.

The delegation authority permits trustees to delegate investment functions to qualified investment advisers — and many bank trust departments and institutional trustees do engage investment advisers to manage the investment portfolio under the trustee’s oversight. When the trustee delegates investment management to an adviser, the trustee must exercise reasonable care, skill and caution in selecting the adviser, in establishing the scope and terms of the delegation consistent with the purposes and terms of the trust, and in periodically reviewing the adviser’s actions to monitor its performance and compliance with those terms — and a trustee who does so is not liable to the beneficiaries or to the trust for the adviser’s decisions or actions.

Inception, Costs and Hindsight Under the Act

The Uniform Prudent Investor Act imposes duties from the first day of a trusteeship. Within a reasonable time after accepting a trusteeship or receiving trust assets, a trustee must review the trust assets and make and implement decisions concerning their retention and disposition, in order to bring the portfolio into compliance with the purposes, terms, distribution requirements and other circumstances of the trust and with the Act. A trustee who receives a concentrated or otherwise unsuitable portfolio from the grantor or from a predecessor trustee therefore cannot simply continue to hold it because someone else selected it — the Act’s commentary describes the requirement to dispose of unsuitable assets within a reasonable time as old law.

The Act also governs what a trustee may spend. In investing and managing trust assets, a trustee may incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the trust and the skills of the trustee. The commentary is blunt that wasting beneficiaries’ money is imprudent and that trustees are obliged to minimise costs in devising and implementing investment strategies, so that a sound allocation implemented through needlessly expensive arrangements can still fall short of the Act.

Finally, the Act fixes the moment at which a trustee’s conduct is judged. Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of the trustee’s decision or action and not by hindsight. A diversified portfolio that was reasonably suited to the trust when it was assembled does not become a breach merely because markets later fell and the trust lost value — the question is whether the decision was prudent when it was made. The Act separately requires a trustee to make a reasonable effort to verify facts relevant to the investment and management of trust assets.

Trust Accounts in the Brokerage and Advisory Context

Investment advisers and broker-dealers frequently manage trust assets through investment advisory agreements or brokerage accounts established in the trust’s name. The account opening process for trust accounts requires documentation of the trust’s existence and terms — typically through a certificate of trust or a copy of the trust document — to verify the trustee’s authority to open the account and the trustee’s investment powers under the trust document.

The trustee — not the beneficiary — is the legal account holder and the party with legal authority to direct investments and execute transactions in the trust account. An investment adviser who receives investment directions from a beneficiary rather than the trustee is not acting on the authority of the legally entitled party — the trustee’s written direction or documented delegation of investment authority to the adviser is required before the adviser can manage trust assets.

Under FINRA Rule 4512 — which requires the member to record each customer’s name and, for a corporation, partnership or other legal entity, the names of any persons authorised to transact business on its behalf — and the know-your-customer obligations applicable to broker-dealers, the account opening documentation for a trust account should identify the trust as the account holder, document the trustee’s authority, and collect the information necessary to satisfy anti-money-laundering customer identification programme requirements under the Bank Secrecy Act and FINRA Rule 3310.

For investment advisers under the Investment Advisers Act of 1940, the fiduciary duty owed to a trust account client runs to the trustee as the legal account holder — but the adviser must understand that the trustee’s own fiduciary duty runs to the beneficiaries, and that the adviser’s recommendations must be consistent with the trustee’s ability to satisfy the trustee’s prudent investor obligations to those beneficiaries.

Certifications of Trust, Co-Trustees and Third Parties Dealing With a Trustee

Under the Uniform Trust Code, instead of furnishing a copy of the instrument to a person other than a beneficiary, the trustee may furnish a certification of trust stating that the trust exists and the date the instrument was executed, the identity of the grantor and of the currently acting trustee, the trustee’s powers, whether the trust is revocable and who holds any power to revoke it, the authority of co-trustees to sign, the trust’s taxpayer identification number and the manner of taking title to trust property. The certification need not contain the trust’s dispositive terms, and the recipient may require only those excerpts of the instrument and its amendments that designate the trustee and confer the power to act in the pending transaction. A recipient who demands the full instrument as well is liable for damages if a court finds the demand was not made in good faith.

The Code protects the firm that relies on the trustee. A person who acts in reliance on a certification of trust without knowledge that its representations are incorrect is not liable to any person for so acting, and may enforce a transaction entered into in good faith against the trust property as if the representations were correct. More generally, a person other than a beneficiary who deals with a trustee in good faith is not required to inquire into the extent of the trustee’s powers or the propriety of their exercise.

Where a trust has several trustees, the Code provides that co-trustees who are unable to reach a unanimous decision may act by majority decision, and that a trustee who does not join in an action of another trustee is generally not liable for it, although each trustee must exercise reasonable care to prevent a co-trustee from committing a serious breach of trust.

Tax Treatment of Trust Income — IRC Subchapter J

The federal income tax treatment of trust income is governed by IRC Sections 641 through 692 — Subchapter J of the Internal Revenue Code — which establishes a comprehensive framework for taxing the income generated by trust assets and allocating that tax liability between the trust itself and its beneficiaries.

The fundamental principle of trust income taxation is the conduit principle — income distributed by the trust to its beneficiaries is generally taxed to the beneficiaries at their individual tax rates rather than to the trust. Income retained by the trust is taxed to the trust at the trust’s own income tax rates — which are severely compressed relative to individual rates. For 2025 a trust’s taxable income above only fifteen thousand six hundred and fifty dollars is taxed at the top thirty-seven percent federal income tax rate — far below the seven hundred and fifty-one thousand six hundred dollar threshold above which the thirty-seven percent rate applies to married individuals filing jointly. This compressed rate structure creates powerful incentives for trust distributions — retained trust income is taxed at the highest rates very quickly, while distributed income allows beneficiaries to utilise their own potentially lower marginal rates.

Grantor trusts — trusts in which the grantor retains specified powers under IRC Sections 671 through 677, including all revocable trusts — are taxed entirely to the grantor rather than as separate entities. The trust’s income, deductions, and credits flow directly to the grantor’s personal return regardless of whether distributions are actually made.

Distributable Net Income, Simple Trusts and the Character of Distributions

Subchapter J sorts trusts that are not grantor trusts into two groups. A trust whose terms require all of its income to be distributed currently, and which makes no charitable payments or set-asides, deducts the income it is required to distribute, and its beneficiaries include that income whether or not it is actually paid to them in the year. The regulations call such a trust a simple trust and every other trust a complex trust, and the status is tested year by year — a trust required to distribute all its income becomes a complex trust in any year in which it actually distributes principal.

Both the trust’s distribution deduction and the amount the beneficiaries must include are capped by distributable net income, which is the trust’s taxable income computed with specified modifications. Tax-exempt interest is added in, while capital gains are generally left out to the extent they are allocated to principal and are not paid, credited or required to be distributed to a beneficiary during the year — so in a trust whose instrument allocates gains to principal, those gains are taxed to the trust itself even in a year when all of its interest and dividends are paid out.

Amounts distributed also keep the tax character they had in the trust’s hands. Unless the trust instrument specifically allocates different classes of income to different beneficiaries, a distribution is treated as consisting of the same proportion of each class of income entering into distributable net income as that class bears to the total. A beneficiary of a trust holding municipal bonds and corporate stock therefore receives a proportionate share of tax-exempt interest that remains tax-exempt, alongside dividends that remain dividends.

Timing Rules and the Net Investment Income Tax for Trusts

A trust must use the calendar year as its taxable year. The only exceptions in the Code are trusts exempt from tax under Section 501(a) and charitable trusts described in Section 4947(a)(1).

Section 663(b) allows the fiduciary to elect to treat any amount properly paid or credited to a beneficiary within the first sixty-five days of a taxable year as paid or credited on the last day of the preceding taxable year. The election is made by the fiduciary for each year to which it is to apply, so a trustee who distributes in January or February may carry that income out to the beneficiaries for the year just ended rather than leaving it to be taxed at the trust’s compressed rates.

Trusts are also subject to the 3.8 percent net investment income tax, but on a base defined differently from the base for individuals. A trust pays the tax on the lesser of its undistributed net investment income or the excess of its adjusted gross income over the dollar amount at which the highest income tax bracket for estates and trusts begins for the year. Because only undistributed net investment income enters the first measure, investment income that the trustee distributes to beneficiaries leaves the trust’s own base. A trust required to distribute all of its income currently also deducts a personal exemption of three hundred dollars, and other trusts one hundred dollars, in place of the deduction for personal exemptions that individuals receive.

Grantor Trust Status Beyond the Revocable Trust

The grantor trust rules reach well beyond revocable trusts. An irrevocable trust is treated as owned by the grantor for income tax purposes where, for example, its income may be distributed to the grantor or the grantor’s spouse without the approval or consent of an adverse party, or where any person holds, in a nonfiduciary capacity and without the approval or consent of a fiduciary, a power to reacquire the trust property by substituting other property of an equivalent value. A trust can therefore be complete for gift and estate tax purposes — its assets outside the grantor’s gross estate — while its income is still taxed to the grantor, as the facts of Revenue Ruling 2023-2 describe.

Revenue Ruling 2004-64 addresses the grantor who pays that income tax. The grantor’s payment of the income tax attributable to the trust’s income is not treated as a gift of the amount of the tax to the trust beneficiaries. If the trust instrument or applicable local law requires the trust to reimburse the grantor for that tax, however, the full value of the trust’s assets is includible in the grantor’s gross estate under Section 2036(a)(1); a provision merely giving the trustee discretion to reimburse does not by itself cause inclusion, whether or not the discretion is exercised.

Grantor trust status for income tax purposes does not bring the basis adjustment at death. Under Revenue Ruling 2023-2, where the grantor funded an irrevocable grantor trust by a completed gift and the trust assets are not included in the grantor’s gross estate, the assets do not receive a basis equal to their fair market value at the grantor’s death under Section 1014, because they were not acquired from or passed from a decedent as Section 1014(b) defines those terms; their basis immediately after the death is the same as immediately before it. Property the grantor transferred to a revocable trust while reserving the right to revoke it is, by contrast, listed in Section 1014(b)(2) as acquired from the decedent.

Examination Relevance and Key Takeaways

The trust is tested on the Series 65 examination in the context of client account types, estate planning, the fiduciary duties of trustees under the Uniform Prudent Investor Act, and the tax treatment of trust income under IRC Subchapter J.

The key points to retain are these.

A trust is a legal arrangement in which the grantor transfers legal title to assets to a trustee who manages them for the benefit of the beneficiaries according to the trust document’s terms. The three essential parties are the grantor — who creates and funds the trust — the trustee — who holds legal title and owes comprehensive fiduciary duties to the beneficiaries — and the beneficiaries — who hold beneficial interest in the trust assets and receive distributions according to the trust’s terms.

The foundational distinction is revocable versus irrevocable. A revocable trust — most commonly a revocable living trust — allows the grantor to amend, modify, or revoke during their lifetime — assets are treated as the grantor’s own for tax purposes under IRC Sections 671 through 677 — income reported on the grantor’s personal return — no separate tax return required where the trustee uses the optional reporting method. Primary benefits are probate avoidance, privacy, and continuity of management during incapacity. An irrevocable trust permanently removes assets from the grantor’s control and estate — assets excluded from the grantor’s taxable estate for federal estate tax purposes — potentially protected from grantor’s creditors — unless it is a grantor trust, treated as a separate taxable entity filing its own Form 1041 under the compressed trust income tax rate schedule that reaches the thirty-seven percent top rate at only fifteen thousand six hundred and fifty dollars of taxable income in 2025.

A living or inter vivos trust is created and funded during the grantor’s lifetime — may be revocable or irrevocable. A testamentary trust is created through a will and comes into existence only upon the grantor’s death — irrevocable by definition — requires probate — commonly used for minor children and beneficiaries needing ongoing management oversight. The Uniform Prudent Investor Act governs trustee investment obligations — requiring risk-return analysis, portfolio diversification, total return investment approach, impartiality between current income and remainder beneficiaries, and permitting delegation of investment management to qualified advisers. Trust income distributed to beneficiaries is taxed to beneficiaries at their individual rates — income retained by the trust is taxed to the trust, under IRC Subchapter J, at the severely compressed trust rate schedule — creating strong incentives for trust distributions to avoid the top rates that apply at very low trust income levels.