What is a Trust?
Most people have heard of trust funds but few people actually understand what a trust fund is, or what a trust actually is.
The general public assumes that a trust is a tool reserved for wealthy individuals that use trusts to pass their wealth down to their heirs.
In fact, most people actually use trusts in their financial affairs but are not aware of it. Financial products such as pension and retirement plans as well as mutual funds are trusts.
So what is a Trust?
A trust is simply a legal agreement between 3 legal persons. It is a fiduciary relationship in which a Trustor gives his right to hold and manage his assets to a Trustee for the Trustee to hold and manage these assets for the benefit of a Beneficiary.
Origins of Trusts
A trust is not a modern invention. Trusts have been in existence for hundreds of years.
Trusts and the laws that governed trusts were first developed in the 12th century in England during the period of the Crusades war between Christians in Western Europe and Muslims in the Middle East. When a Christian landowner left England to go and fight in the war, he would pass the ownership or title of his land in England on to another person to manage this land for him while he was away.
The landowner (Trustor) would entrust his land to this person (Trustee) in his absence for the benefit of the landowner and his family (Beneficiary). And when the landowner would return from the war, the land would be conveyed back to him.
The Trustor would detail exactly how he wanted the Trustee to manage the land for him. And in the event that the Trustor died at war, the Trustor would have also explained how the land should be distributed to or managed for his heirs.
How Trusts are Formed
The laws that govern trusts differ in different jurisdictions. Each jurisdiction has its laws that define the rules and lifespan of a trust.
But the basic process to form a trust is essentially similar everywhere in the world:
– The trust is created by the Trustor who identifies which assets he wants to place in a trust.
– The Trustor identifies who the Trustee will be. The Trustee could be a professional trust company (corporate trustee), an attorney, a family member, or even a friend.
– The Trustor identifies who the Beneficiaries of the trust are. The beneficiaries could be the Trustor himself, a spouse, family members, or anyone else.
In some jurisdictions, the Trustor, the Trustee, and the Beneficiary can all be the same person.
In a Trust agreement drafted by an attorney, the Trustor then outlines which assets are to be transferred to the trust, who the Trustee and Beneficiaries will be, and how the Trustor wants the assets to be managed for and distributed to the Beneficiaries.
The trust agreement will clearly define how the assets are managed and distributed during the life and after death of the Trustor.
Why Trusts are Formed
Trusts are extremely valuable tools for managing personal finances during the life of a person and even after the death of a person.
They can provide huge benefits to anyone at any wealth level. However, depending on the complexity of the trust assets and trust agreement, trusts can be costly to set up and manage. But a simple cost-effective trust can be set up by the average person.
Trusts are formed for 3 main reasons: Estate Planning, Asset Protection, and Tax Planning.
Estate Planning
The popular term “trust fund” is an important tool used in estate planning. The so-called trust fund baby is a beneficiary of the trust.
The common purpose of a trust is for a parent to pass his assets to his child through a trust fund.
The child may not have the knowledge or skills to manage the assets so the assets are placed in a trust and managed by a more knowledgeable trustee for the benefit of the child. The trustee could be an attorney, a trusted family member, or a corporate trustee.
Then, the trust agreement may state that when the parent passes away or the child reaches a certain age, the assets may be transferred to the child.
This is how a parent can perform estate planning using a trust.
A parent or guardian may also set up a trust for an adult dependent who may need special assistance to manage their personal finances. This could be a dependent with a mental disability that may impair their ability to manage their assets. A trustee can manage the assets on behalf of the dependent.
Asset Protection
When a Trustor transfers his assets to a trust, the trust is the legal person or entity that now owns the assets. This means that even if the Trustor is faced with a lawsuit, divorce, or a creditor claim on his assets, those assets are outside of the reach of his claimants.
Those assets that are in the trust technically do not belong to him. The assets belong to the trust. The assets are safe as long as they were placed in the trust before the claim was made by the claimant.
Privacy
Privacy is a key component of asset protection.
Trusts also provide privacy to the Trustor and beneficiaries. The trust that owns the assets is the public holder of the title to the assets. As such, creditors or unscrupulous individuals will not know which assets the Trustor owns to go after these assets.
Even upon the death of a Trustor, his assets may be vulnerable. If the Trustor only writes a will, the terms of a will are generally made public. Therefore, anyone can find out which assets the deceased will be passing on to his heirs.
But if the Trustor had set up a trust, the terms of a trust are not made public. This privacy protects the beneficiaries of the trust.
Tax Planning
Trusts are used for tax planning, especially after the death of the Trustor.
Because a deceased person cannot own assets, there must be a legal process by which his assets are transferred from the deceased person to a living person. This process is called probate. It’s a public process in which a legal court signs off on the disposition or transfer of the assets of the deceased.
Depending on the applicable jurisdiction, probate fees can cost between 1% to 2% of the value of the assets.
If the deceased had set up a trust, the assets do not go through probate as the assets are not owned by the deceased. They are owned by the trust which continues to exist after his death.
With no probate process, the assets do not become part of the public record. No legal court is involved in the disposition or transfer of the assets of the deceased. Everything is taken care of privately as outlined in the trust.
Estate Taxes
If the deceased was a tax resident of a jurisdiction that has an estate tax and is not exempt from paying this estate tax, this tax can be very costly to the heirs of the deceased.
In the U.S., as of 2022, a 40% estate tax is applicable to assets over $12.06 million for an individual and $24.12 million for a married couple.
If the assets of the deceased are in a trust, the estate tax can be avoided entirely. Thus, the heirs of the deceased would receive the assets without having to sell the assets such as a family home or family business in order to pay the estate tax.
In jurisdictions that do not have any estate taxes, this is not important.
Categories of Trusts
There are as many different types of trusts as there are specific needs for trusts. But each trust fits into these 4 general categories:
Revocable Trust
A Revocable Trust is a trust that allows the Trustor to change the terms of the trust or even terminate the trust during his lifetime.
A Trustor may want the option to change the terms if he believes some circumstances of his life may change in the future that may require the terms to be changed.
For example, he may incur unexpected medical bills that require more money to be distributed from the trust than he originally anticipated. He may decide to change certain restrictive terms placed on beneficiaries in the trust if the life circumstances of the beneficiaries change.
Irrevocable Trust
An irrevocable trust is a trust that does not allow the Trustor to change its terms.
Living Trust
A Living Trust or Inter Vivos Trust is a trust that is formed during the life of the Trustor. A living trust can be a revocable or irrevocable trust.
Testamentary Trust
A testamentary trust is a trust that is triggered and formed after the death of the Trustor.
During his lifetime, the Trustor would have already specified how he wants his assets managed or distributed via a trust after his death.
A testamentary trust must be irrevocable.
Examples of Trusts
Each jurisdiction has different types of trusts. These are a few examples of trusts and how the trusts are used:
Blind Trust
A blind trust is a trust in which the designated trustees manage the assets of the trust without the input of the Trustor or beneficiaries. A blind trust is usually formed to establish the independence of the assets from the influence of the Trustor or beneficiaries in order to avoid any conflict of interest.
This is very common when an individual enters a political office. U.S. Presidents normally move their assets into a blind trust when they are elected President and before they take up their new role.
The President has significant influence over economic policies that affect his own assets and wealth. The blind trust is designed to prevent the President from implementing policies and managing his own assets in a manner that is not in the best interests of his constituents.
For example, U.S. President Donald Trump used a trust called Donald J. Trump Revocable Trust when he was elected President in 2016. The trust was originally created on April 7, 2014 and amended on Jan. 17, 2017 to act as a blind trust before he took office. The trustees were the President’s sons Donald J. Trump Jr. and Eric Trump as well as Allen Weisselberg who was the chief financial officer of the Trump Organization.
Business Family Trust
Generally, family trusts are set up by families that own a business that the family would like to keep in the family even after the death of the family founder of this business.
A family trust is set up to own shares in the business.
Shares in the business are transferred to the trust, which has the family members as its beneficiaries. The trustee can be a manager of the business, corporate trustee, an attorney, or family member.
In most jurisdictions, this share transfer is generally accomplished by doing an estate freeze, in which the current shareholders (usually the founders) convert their Common Shares to Preferred Shares in the business. Then, the business sells new Common Shares to the Trust at a nominal par value. The holders of the Preferred Shares receive special privileges such as preferred dividend payments that the founders can use as retirement income.
Like any other shareholder, the trust receives dividends or capital gains from business. The trust then distributes this income to the trust beneficiaries who are family members.
This structure is especially beneficial when the family has children or family members that do not work in the business. The trust effectively owns shares in the business on their behalf. And as trust beneficiaries, they receive income from the business without directly owning any shares or working in the business.
Upon the death of the family business founder, the trust and business continue uninterrupted as the business is still owned by the trust, and the business continues to be managed for the benefit of the rest of the family.
Family Foundation or Charitable Trust
A Family Foundation or Charitable Trust is a trust that is set up to perform charitable activities. It is governed by the laws of its jurisdiction.
Certain assets are transferred to the trust and they are used for charity. The trust can also invest its assets and donate the profits to charity.
Any asset class can be transferred to the trust. There are family foundations that focus on art.
For example, Alice Walton, daughter of Sam Walton who founded WalMart, created the charitable trust Crystal Bridges Museum of American Art in Bentonville, Arkansas in 2011. She donated dozens of paintings from her personal collection to the museum. And the Walton Family Foundation, the family’s main charitable arm, has donated over $1 billion including endowments to the museum.
These donations are tax-deductible. And family members can work in the family foundation or charitable trust and receive salaries. Or family members can work as consultants to the family foundation or charitable trust and receive consulting fees.
As such, a family foundation or charitable trust can be an effective family wealth management and tax planning vehicle.
Mutual Funds
It may come as a surprise to many people that their mutual funds and index funds are trusts. A mutual fund is really a mutual fund trust. It is regulated by the laws of the jurisdiction of residence of the mutual fund.
A mutual fund is an investment vehicle in which money collected from different investors is pooled together to invest in assets such as stocks and bonds.
When you purchase units in a mutual fund, you are entering into a trust agreement with the mutual fund trust company.
– You are the Trustor.
– The mutual fund trust company is the Trustee that holds and manages your assets.
– You are the Beneficiary of the investment proceeds from these assets.
You may have never read the trust agreement but it will detail that the mutual fund trust is a trust in which all holdings and transactions in the units comply with the terms that govern the number of unit holders, the dispersal of ownership of the units, how units are redeemed by unit holders, how profits are distributed to unit holders, how units are traded on the public markets, etc.
In most jurisdictions, profits generated in a trust are taxed at a very high tax rate. In order to avoid paying these high taxes, mutual funds distribute their profits to the unit holders who then pay their taxes at their own individual income levels. However, in many jurisdictions, foreign profits are taxed inside the trust before they are distributed to unit holders.
401(k), 529, RRSP, RESP – Retirement and Savings Plans
Government-regulated retirement and savings plans are also trusts.
The government offers tax benefits to individuals who set up these plans according to the law. These plans are essentially tax shelters that allow holders to defer taxes into the future.
United States
In the United States, a 401(k) plan is a trust. It is a retirement savings and investing plan that some employers may offer. It allows the employee to contribute a portion of his untaxed salary to the plan. And the funds can be invested in assets that the employee chooses. The employee contributor is the Trustor and Beneficiary of the trust. The financial institution that offers the plan is the corporate Trustee.
The assets of the 401(k) plan are held in trust by the corporate trustee who handles contributions, plan investments, and distributions to and from the 401(k) plan.
In the U.S., there is also the 529 plan, which is a tax-advantaged savings plan created to encourage saving for future education costs. 529 plans are sponsored by states, state agencies, or educational institutions.
A 529 plan is a trust. The contributor is the Trustor. The financial institution that offers the plan is the corporate Trustee. The future student is the Beneficiary.
529 Prepaid Tuition Plans allow an individual to purchase credits at participating public in-state colleges and universities for future tuition fees at current prices for the Beneficiary.
529 Education Savings Plans allow an individual to open an investment account to save for future qualified higher education expenses of a Beneficiary at any U.S. college or university.
Canada
In Canada, there is the Registered Retirement Savings Plan (RRSP) trust and Registered Retirement Income Fund (RRIF) trust for retirement planning. The contributor is the Trustor and Beneficiary of the trust. The financial institution that offers the plan is the Trustee.
In Canada, there is also the Registered Education Savings Plan (RESP) trust, which is a special savings account for parents who want to save money for their child’s education after high school. The contributor is the Trustor. The financial institution that offers the plan is the Trustee. The child is the Beneficiary of the trust.
Most government-regulated retirement and savings plans offered in most countries are trusts.
Lifespan of a Trust
Each jurisdiction sets its own laws that govern its trusts and their lifespan. Some examples include:
UNITED STATES
In the state of Nevada, a trust can have a lifespan of 365 years.
In the state of Wyoming, a trust can have a lifespan of 1,000 years.
In the state of Delaware, a trust can have an unlimited lifespan.
CANADA
In the province of Ontario, the assets of a trust are deemed to be disposed of after 21 years. However, this 21-year rule does not automatically dissolve a trust. The trust law deems that the assets are disposed of and the assets are automatically re-acquired immediately thereafter. Thus, the trust incurs a taxable capital gain on its assets on the 21st birthday of the trust as if the assets had been sold. A capital gains tax becomes due and payable to the tax authorities and the after-tax assets remain in the trust. And the trust itself continues indefinitely.
In the province of Prince Edward Island, a trust can exist to the life of the last beneficiary, plus 60 years.
OFFSHORE TRUSTS
In the Bahamas, a trust can have a lifespan of 150 years.
In Jersey, a trust can have an unlimited lifespan.