For people interested in asset protection and wealth management, trusts are an important financial planning tool. Controlling what happens to one’s wealth and assets during and after a lifetime is one of the main benefits of establishing a trust. Further, trusts provide an effective way to minimize taxes and ensure that beneficiaries receive assets according to your wishes.

If you’re considering establishing a trust, keep reading for the answer to “What is a trust?” You’ll also discover different types of trusts, their specific benefits, and the steps required to create one.

What is a trust?

For the uninitiated, a trust is defined as a legal arrangement where one party (referred to as a trustee) holds assets for the benefit of another party (referred to as a beneficiary).

The overall purpose of a trust is essentially to manage wealth, protect assets, and ensure that the trust’s assets are distributed according to the trustor’s wishes.

Trusts have been around for hundreds of years, originating in medieval England during the 12th century. Their primary function was to allow landowners to transfer their property to a trusted individual when they went to war. This individual (referred to as the trustee) would manage the property and take care of dependent family members until the landowner returned.

As one might imagine, conflicts arose when the landowner returned, and the trustee refused to relinquish the property. This led to English courts creating a more formal legal framework to protect the various parties’ interests. These protections have formed the structure of today’s laws regarding trusts, especially as trust law has evolved from agreements solely related to landholding to asset management and wealth protection.

Foundational Components of a Trust

jigsaw puzzles

There are three parties in a trust arrangement, and each party has specific roles and responsibilities.

  1. Grantor (Settlor): The settlor, also called the grantor or the trustor, is an individual or entity who establishes the trust by transferring assets into it. This party also defines the terms of the trust, how it’s structured, and who will benefit.
    The key responsibility of the settlor is funding the trust, meaning that assets (referred to as the trust res) must be transferred into the trust. Virtually any asset can be transferred into a trust, including:

  2. Trustee: The trustee is the individual or entity tasked with managing the trust according to the terms specifically outlined by the settlor. A trustee has a fiduciary duty to act according to the best interests of all beneficiaries, meaning they cannot engage in conflicts of interest and must treat each beneficiary equally.Along the lines of managing the trust assets with care, loyalty, and due diligence, a trustee’s overarching responsibilities include overseeing investments by preserving the principal and growing income (if applicable). Trustees also distribute assets based on the trust’s terms.
  3. Beneficiary: Like trustees, beneficiaries can be either individuals or entities. As the term suggests, beneficiaries are the parties who are designated to receive the benefits of the trust. This could include receiving income, periodic distributions, or ownership of trust property at the termination of the trust.
    Depending on the terms of the trust, a beneficiary may need to meet certain conditions to be eligible to receive benefits. Requirements could include reaching a minimum age, completing a specific milestone, or refraining from an activity. Any requirements established by the grantor must not violate public policy.

Types of Trusts

There are several different types of trusts, each serving different purposes. Some of the more common or well-known types of trusts include the following:

  • Revocable trusts: Also referred to as living trusts, a revocable trust allows the grantor to modify, amend, or even terminate the trust in the span of their respective lifetime. These trusts provide flexibility to the grantor because they can make changes as needed.
  • Irrevocable trusts: An irrevocable trust typically cannot be modified once it’s created, though there are exceptions for conditions like beneficiary consent. While these trusts lack flexibility, they can be superior for asset protection. A testamentary trust is a type of irrevocable trust because it is effective after the grantor’s death.
  • Spendthrift trusts: A spendthrift trust allows the trustee to maintain control over the trust assets and their distribution. Further, the beneficiary cannot sell or transfer their interest in the trust. The effect of this arrangement is to preserve the trust property in cases where the beneficiary is financially irresponsible, or there is a risk of the assets being mismanaged. Spendthrift trusts can be shielded from creditors, though there are some exceptions.
  • Special needs trusts: A special needs trust protects beneficiaries with disabilities, facilitating a more secure financial future while simultaneously allowing for eligibility in public benefits programs like Medicaid or Supplemental Security Income (SSI).
  • Charitable trusts: In situations where a charitable organization is the designated beneficiary, a charitable trust may be established. In addition to supporting a philanthropic cause, there can be tax advantages to a charitable trust.
  • Honorary trusts: Recognized by statute, an honorary trust may have non-human beneficiaries, such as a pet. Honorary trusts can also serve non-traditional purposes, like maintaining a gravesite.
  • Generation-skipping trusts: In a generation-skipping trust, an entire generation of beneficiaries is skipped. For example, a person may name their grandchildren as beneficiaries rather than their children. The purpose of this type of trust is to minimize the estate tax burden since the tax is only assessed once rather than at two inheritance intervals.

How Trusts Work: Creating and Managing a Trust

dart board

After gathering an understanding of the concept of “What is a trust?” the next step is getting a general grasp of the process involved in creating a trust. Each must be executed properly and in a specific order to ensure the trust instrument is valid.

  1. Determine the type of trust based on the settlor’s goals.
  2. Draft the trust agreement, including the trust terms, the trust property, and instructions for trust management and asset distribution.
  3. Fund the trust by transferring assets into it.
  4. Appoint a trustee to carry out the terms of the trust.
  5. Sign and execute the trust to make it legally enforceable.

Distribution of Assets

Assets are to be distributed according to the trust terms. In the case of revocable and testamentary trusts, assets are often distributed after the grantor or testator’s death. This does not necessarily mean that everything is distributed in a lump sum, however. The terms may specify periodic distributions or some other arrangement based on a timetable, milestone, or achievement.

Management of the Trust

The burden of managing the trust falls upon the trustee(s). The trustee invests, manages, and protects the trust assets. This is a fiduciary role in which the trustee must put the needs of beneficiaries above his own. In addition to buying or selling investments, management may also require maintaining the property like real estate, bringing or settling claims, and ensuring that the trust remains financially healthy.

Other responsibilities of trust management include keeping detailed records, reporting to beneficiaries, and being in compliance with applicable tax regulations.

Benefits of Establishing a Trust

There are numerous benefits to establishing a trust, such as providing a structured approach to distributing assets, protecting wealth, and potentially minimizing tax liabilities.

Some of the key benefits of establishing a trust include:

  • Estate planning advantages: One of the primary benefits of establishing a trust is avoiding the probate process, which works to streamline estate distribution and reduce conflict among heirs. Unlike a will, which goes through probate, a trust can result in a faster and more direct transfer of assets.
  • Asset protection: Keeping assets secure from creditors, lawsuits, and fiscally reckless family members or minors is another essential benefit of establishing a trust.
  • Tax benefits: Trusts can also be used to minimize tax liabilities, including income tax. Estate tax savings and reduced tax burdens for capital gains may also be possible, depending on the type and nature of the trust.

Common Misconceptions About Trusts

woman telling secret to her husband

While trusts are powerful financial tools, they are often misunderstood, and myths abound about their benefits and functionality. In understanding what is a trust, three common misconceptions must be addressed:

  1. Trusts are only for the wealthy. One of the most prevalent misconceptions is that trusts are exclusively for wealthy individuals or families. While no question trusts can be extremely beneficial for high-net-worth individuals, trusts are not exclusively for the affluent.
    Trusts can be useful for anyone interested in protecting their assets, ensuring a relatively smooth distribution of property, or providing for minor children or beneficiaries with special needs. This is true even if an individual has a modestly-sized estate.
  2. All trusts are irrevocable. A second common misconception is that all trusts are irrevocable, meaning they cannot be changed once established. In reality, there are two primary types of trusts: revocable and irrevocable. A revocable trust allows the grantor to modify or dissolve the trust during their lifetime, offering flexibility as circumstances change. By contrast, an irrevocable trust cannot be altered once it is created, but it can provide superior asset protection and tax benefits.
  3. Trusts eliminate all taxes. Many people believe trusts are miraculous tax havens that shield them from the hands of Uncle Sam. However, this is not the case. While trusts can offer tax advantages, including reducing estate and income taxes, they do not automatically eliminate all taxes, especially when it comes to taxable earnings generated by the trust.

The Bottom Line

In answering the question, “What is a trust?” trusts serve as versatile financial planning tools offering several benefits, including wealth management, asset protection, and streamlined estate distribution. To learn more about trusts, please contact Blake Harris Law for a consultation.