A trust is an arrangement in which an individual or entity controls property or funds on behalf of someone else without actually owning them. This can be done for tax purposes or to ensure the depositor's wishes are carried out. For example, a deceased grandparent can give a gift to a favorite grandchild when the grandchild turns 18. This can be done by placing $10,000 into a trust, which is managed by a third individual with the age stipulation included in the agreement. (To learn more about these trusts, see Pick The Perfect Trust and Establishing A Revocable Living Trust.)
Trusts can be used in this way to reduce taxes when transferring property or funds. In an estate transfer to a surviving spouse, there are unlimited deductions, so taxes are not an issue. However, if the second spouse dies several years later and the combined estate that is transfered to the children turns out to be larger than the current exemption level, then a trust can help reduce federal estate taxes. By placing the first spouse's estate into a trust in which the manager is the second spouse, the estate of the first spouse is never actually transferred. Because there is no transfer, the second spouse's estate is separate from the trust when given to the children after death. If both the trust and the estate are under the exemption level, then there are federal tax savings.
For example, let's assume Joe and Beth are married and each holds an estate value of $3 million. Let's also assume the estate transfer exemption amount is $3.5 million where they live. Without a trust, if Joe dies and transfers his estate to his wife, then Beth is left with an estate worth $6 million. If Beth dies, the $6 million transfer will exceed the exemption level and taxes will be levied. If, on the other hand, Joe places his estate into a trust for his children, the trust would be independent of Beth's estate. As such, Beth could live off the funds in the trust until she died, then transfer her $3 million estate and the $3 million trust to the children, thus eliminating the tax burden. (For more on estate planning, check out Six Estate Planning Must-Haves and The Importance Of Estate And Contingency Planning.)