What is a Trust?

A trust is just a made-up legal entity that owns property for the benefit of a particular person or group of people. A trust needs to have property, a set of rules, a property manager, and beneficiaries.

A trust has a unique ownership arrangement.

If someone owns and kind of property – house, bank account, stock - they can do whatever they want with it. Whatever they do, they reap the rewards and suffer the misfortune. They pay the associated taxes.

But what if instead of one person in charge of everything, responsibilities were divided? What if different people had different roles for the same property?  

A trust separates property ownership into three categories: 1) the creator, called the settlor, donates the property and sets the trust rules, 2) the trustee manages the trust property according to trust instructions, and 3) the beneficiaries get the windfall, be it income or appreciated property.

A settlor creates a trust for a reason

If a person decides to donate property to a trust, they have some greater goal in mind. Why would anyone take property they own outright and essentially give it to someone else - in this case a trust?

The reasons usually relate to estate planning. It might be to avoid the court probate process upon death, to minimize or delay taxes, to exert control from beyond the grave, or to manage distributions over time.

Depending on the situation, a settlor can retain certain rights so that they get the benefits from the property even though they don’t own it as they did before the transfer. Additionally, one person can take on multiple roles, i.e. a trustee can also be a beneficiary.

A trustee does all the work but gets none of the benefit.

A trustee is the owner of whatever property is in the trust. But the trustee is not the owner in his or her individual capacity. They have been named the owner in the position of trustee for the trust.  

Since they are the owner on behalf of the trust, they can’t just do what they want. For example, spend it on themselves. They have to follow the trust instructions. And this means the trustee can be anyone, since no matter who the trustee is, they follow the instructions of the trust. Replacing a trustee shouldn’t change anything.  

Since the trustee isn’t working for his or her own benefit, they can get paid for their work from the trust assets. They can also hire people to assist them and pay those costs with trust assets.

Beneficiaries do none of the work but get all of the benefit.

Beneficiaries do not manage or control property that is in a trust that benefits them. But they have some oversight. They have a right to know what the trustee is doing. If they feel the trustee is acting inappropriately, such as not following the trust instructions, they can sue to correct things or have the trustee replaced.

Beneficiaries can receive income from a trust on a regular basis or maybe a percentage of the trust value every year. They can get cash or property. Once the trust distributes property to a beneficiary, it’s out of the trust and owned by the beneficiary.

Generally, any income distributed to a beneficiary is taxed as income to that beneficiary. The trust will provide tax documents each year just like an employer would.

Trusts can get complicated

When ownership is split between three parties, many things that might have been simple become more complicated. Since ownership means all of the responsibility and all of the reward, separating ownership means separating responsibility and reward.

This is especially important when it comes to taxes. How does splitting ownership affect who pays what taxes? There are pages and pages of IRS regulations on this issue.

A trust can be revocable or irrevocable. Trusts have different options when involving a married couple. Trusts can offer some protection from creditors. A trust is a private matter but can involve the courts when necessary.

Creating and administering a trust correctly is not an easy task. It involves different people in different roles and often significant amounts of money. The more thought that goes into creating the trust, the more likely it will proceed smoothly