Trusts can be an effective way to reduce taxes, shelter assets from creditors, and/or prevent assets from going through the probate process.
Last posted by Jaclyn McClellan, CFA | The Motley Fool
Trusts are estate-planning tools, and like other estate-planning structures (like foundations or life insurance), a trust’s structure will determine how assets are controlled, whether they’re protected from future creditors’ claims, and how they’re taxed.
A trust is created by a “settlor” (or grantor) who transfers assets to a trustee. The trustee must then hold and manage the assets for the benefit of the beneficiaries.
Pretty wordy, right? Let’s use an example. If I wanted to create a trust (I would be the settlor) to hold assets for my children (beneficiaries), then I would hire a third party (trustee) to do that. Why would I do that, you ask? Well, the beneficiaries in this situation aren’t the legal owners of the trust; they’re the beneficial owners. That means they will eventually benefit from the trust’s assets, but the assets are not “theirs.” It’s possible for the settlor of a trust to also be one of the beneficiaries, but we’ll get to that in a little bit.
The main benefit of a trust is the ability to avoid probate. Probate is a process in which a will is “proved” in a court of law. Essentially, the deceased person’s will is analyzed by the court system to ensure its validity, and then the estate is distributed to heirs, beneficiaries, creditors, etc. according to the will Probate is notoriously lengthy and expensive, so a trust can save the settlor’s heirs a lot of time, money, and peace of mind.
Further, while wills are a matter of public record, trusts are not, which means people can’t learn everything about them by simply requesting a copy from the courts. There are some circumstances that would allow a trust to become public record (if a beneficiary contests the estate, for example), but they are generally shielded from the public. Not all countries recognize foreign trusts; it depends on each country’s legal system structure.
Revocable versus irrevocable trust
There are many different categories of trusts, but two particular types are important to understand: revocable and irrevocable. In a revocable trust arrangement, or “living trust,” the settlor retains the right to rescind the trust and regain control of the trust assets. In many jurisdictions, in these circumstances, the settlor is the legal owner of the trust assets for tax purposes. Being responsible for tax purposes means the settlor is responsible for the tax payments and reporting on the trust’s investment returns. Additionally, the fact that the trust is revocable and the settlor can reclaim control makes the trust vulnerable to creditors. In our example (in which I am the settlor), creating a revocable trust would allow me to earn income from trust assets but feel comforted knowing that the trust will transfer to my beneficiaries after my death or that I can tell the trustee to continue to manage the assets for my beneficiaries.
Like wills, revocable trusts can distribute assets after your death. Unlike wills, revocable trusts can manage assets during your lifetime.
With an irrevocable trust, on the other hand, the settlor can’t alter or revoke the trust relationship. The trustee is responsible for the tax payments and reporting tax information for trust assets. In this case, the trustee is the owner of the trust. Generally, an irrevocable trust structure offers greater asset protection from a settlor’s creditors.
Fixed versus discretionary trusts
After it is determined whether the trust is revocable or irrevocable, the next distinction to make is fixed or discretionary. The assets in a fixed trust are distributed at certain times or in certain amounts. The terms of the distributions of a fixed trust are specified in the trust documentation.
On the other hand, if the trust documentation states that the trustee should determine how much to distribute based on the beneficiaries’ general welfare, and at the sole discretion of the trustee, then the trust is called a discretionary trust. The settlor can make his or her wishes known in the trust documentation so the trustee has an idea of what the settlor wants, but the trustee is not bound by these wishes. Just as irrevocable trusts can shelter the settlor’s assets from creditors, a discretionary trust can protect assets from claims against the beneficiaries.
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