People who have accumulated assets tend to be people with drive and an interest in influencing their personal fate and well-being. These same people may want to have a voice, if not control, over what happens with their assets both during their lifetime, as well as thereafter. This is where trusts come in.
On a psychological level, trusts offer the space to express one’s voice and wishes regarding one’s assets. There are three key reasons, common in most tax jurisdictions, why people set up trusts:
- When you want to have a say in what happens with your assets (who receives what and when) upon your death. This would be for the next generation and in some jurisdictions, for many generations after. Setting up a trust is thus part of your inheritance planning. This type of trust is often referred to as personal trust or family trust (1).
- When you want to add confidentiality to your assets during your lifetime, you might then set up a trust for privacy reasons:
- When you want to protect assets during your life time from potential liabilities and/or creditors. Setting up a trust is thus a part of your business planning. Tax reasons, using legitimate tax codes and regulations, can be a fourth key reason people might set up a trust but as tax issues differ from country to country, I prefer to address this potential benefit separately. Lastly, charity is a fifth reason, which will be briefly covered as well. To immediately clear up any misunderstandings, one goal a trust will not accomplish is the avoidance of tax.
Trusts have been around since Roman times (2). In those early days, a trust addressed what would happen with property once a person died (testamentary trust). Apparently (3), it was in the 12th and 13th centuries, at the time of the Crusades, that trust law developed further in English common law, addressing the transfer of property while alive (intervivos trust).
The story (4) is that nobility landowner) who went to fight in the Crusades left their property in the hands of friends or family to look after during their absence, only to find out, on return, that they could not claim their assets back anymore… The trust instrument offered a legal way to have a third party temporarily control the assets, with the ownership never fully being relinquished (except of course in the event of the death of the individual).
Countries that developed their legal system on the English model, common law, all recognize the legal concept of trust, among them the US, Australia, Canada and New Zealand (5). A number of Universities are set up as trusts, such as the John Hopkins University in the US (founded in 1867) (6). Trusts are also used for business purposes (corporate trust); one of the more well-known being the Rockefeller trust (7).
Some well-known existing charities, the Red Cross and the American Cancer Society (8) among others, are set up as trusts. Trusts can also be used to leave money to a charity.
Lastly, in the UK many life insurance policies are written in trust (9) and most pension schemes and unit trust investment schemes are structured as trusts (10).
For this article the main focus is on trusts for personal use. STEP, the Society of Trust and Estate Practitioners, is a worldwide professional association with 20,000 members in 95 countries (11). According to STEP (12,) trusts for personal use are particularly relevant for family planning- to arrange one’s family financial affairs, and specifically how to transfer assets from one generation to another. STEP quotes a huge increase in the popularity of trusts in many countries, for example: in 2003 3.6 million domestic trusts were filed in the US. Since January 2014 trusts have also been available in the Czech Republic (13).
What is a trust?
What then is a trust? It is a private legal arrangement involving three or four parties, where the ownership of someone’s assets is transferred to a second party (entity) to look after for the benefit of a third person (or group) (14).
Party one: the person who sets up the trust, the original owner of the assets. This person is called the settler or grantor.
Party two: the entity which hold the assets to look after for the benefit of a third person or group. This entity is called a trust. The people who manage the trust are referred to as trustees.
Party three: the people who will eventually benefit, the third party. They are called beneficiaries.
Note 1: assets can mean financial assets as well as real assets (house, land, gold etc.)
Note 2: a fourth party can be involved as well, the protector (15). It is his role to keep an eye on the trustees and make sure they are managing the trust in accordance with the trust deed and the wishes of the settlor(s). They may also have input on decisions such as choosing investment managers or distributions.
Revocable and Irrevocable
Can the person who set up the trust, later change his mind and undo the trust? There are two possibilities leading to two very different consequences (16).
1) One option is a trust where the settler cannot undo the trust. He has separated himself forever from the assets. In this case, he set up an irrevocable trust. Clearly the irrevocable trust has far-reaching consequences. The benefits have to do with asset protection and tax benefits. Once legally separated from the asset, this asset is “safe” (or so one hopes…) e.g. from creditors (asset protection). The tax benefits tend to be estate tax benefits.
For example, in the US the irrevocable trust often is the desired option when one wants to make full use of the estate tax free sum available to each of the spouses (17).
2) The other option is where the settler can indeed liquidate the trust, undo it or change details in it (such as beneficiaries) (18). In this case, he sets up a revocable trust. The revocable trust is sometimes referred to as a solution with “strings attached” (19): the settler, during his life time, can still make changes or undo the trust altogether.
Trust as a will substitute
A will or testament is a legal declaration which provides for the distribution of one’s assets at death (20). Like a trust, it allows for someone to have a voice in what happens to one’s assets on death. A trust can be part of a will as well as replacing a will.
The latter is especially a financial planning consideration in the US. In the US, trusts are referred to as “will substitutes” (21). The possible benefit being that, where will substitutes are in place, probate can be avoided (22).
Probate is a legal process whereby a will is approved in court. It is a public process. The fact that it is a public process is one reason why people (especially people in the eye of public attention), may want to avoid probate and so are keen to have their assets organized in “will substitutes”, a trust being one of them (23).
The personal trust and special clauses
Settlers who have concerns about making assets available to beneficiaries because of the age of the beneficiary and/or their mental capacity to handle financial responsibilities, can add special clauses to the trust deed for trustees to guide and/or control what assets and amounts become available to the beneficiary and at what age (24). It is also possible to add “spend thrift clauses” (25). “Spend thrift” (a person who spends money in a careless or wasteful way) (26) can be another concern of the settler.
Trustees are extremely important when it comes to trusts; they are at the centre of its success and desired results. In most jurisdictions, trustees are in fact the owner of the trust’s assets (27), albeit in a fiduciary capacity to execute the trust deed and represent the beneficiaries’ interests. No surprise then that the performance of the trustees (or lack of) is the subject of plenty of litigation (28).
Trusts and tax
With millions of trusts existing in numerous countries and with so many different possibilities as to how the trust is organized (revocable-irrevocable being one of these possibilities), it is impossible to summarize tax implications.
Perhaps it is best to take the view- when it comes to income and capital gains tax- to see trusts as “tax neutral” (29), a term used by STEP in the UK context. When it comes to estate tax, there are clearly benefits in some tax jurisdictions. In addition, in many tax jurisdictions there are tax benefits to do with charitable trusts. Trusts are not the domain of “tax havens”. To the contrary, as reported earlier, trusts are increasing in popularity, and this is “on shore”: in the US, the EU and the UK among other places.
The settlers of trusts may have many wishes but in order for these to be executed, these need to be within the law of the country (ies) where the execution takes place. The most clear and straightforward example where a trust meets its limitations is, where the “wish” would be to disinherit one’s spouse. This is illegal in pretty much all countries in the world and a trust cannot override this. Less clear is when it comes to confidentiality and protection goals. Suffice to say that for successful execution, settlers need to be well informed about the laws in countries where the “letter of wishes” will be executed and in addition, understand that laws can change over time. As such, letters of wishes should be kept current and up to date. The litigation related to trusts is substantial and proof that trusts, when they start to challenge their limitations, can run into serious trouble!
Trusts and foundations
A similar concept to a trust is that of a foundation. Originally, foundations were more of a civil law concept (used e.g. in the EU, Liechtenstein and Switzerland), but these days foundations can also be found in common law countries such as the US and the UK (30). Key differences between a foundation and a trust are (31):
- Foundations are a legal entity themselves; trusts are a private arrangement, and do not have a legal entity.
- The founder of a foundation may maintain control of the foundation through a written mandate. Once the trust has been “settled”, the settler no longer has any rights in respect of the trust. Although he can revoke the trust in case of a revocable trust.
Trusts, foundations and charity
A lot of good work is done through trusts and foundations by well-known people, using their voice for a good purpose, whether it is finding solutions for diseases, poverty alleviation or improve education. I already mentioned the Red Cross and the Cancer Society who are organized as trusts. The world’s largest foundation is the Bill and Belinda Gates’ Foundation (USD 48 billion) (33). An example of a smaller foundation is that of the Roger Federer Foundation (CHF 14.5 million) (34), set up in Switzerland. There are thousands of such vehicles of varying sizes where the founder is less well known. Tax breaks do come along for charitable trusts, depending how they are structured and depending on the tax jurisdiction where they are set up.
The running of trusts, done by trustees, is a professional service and a business in itself. This is where trust companies come into the picture. A trust company is a corporation which performs the fiduciary responsibilities of trusts, as executed by the trustees (35).
The trustees will look after the assets (often using other professional services), keep records, prepare court accountings, and pay bills (depending on the nature of the trust) medical expenses, charitable gifts, inheritances or other distributions of income and principal (36). Trustees do not need to be professionals”; they can be family members or friends. Lastly, depending on the type of trust, the settler can also be one of the trustees.
Trusts and portfolio management
It is the responsibility of the trustees to make sure that the assets in the trust are looked after well, whether these are real assets (such as land or property) or financial assets. When it comes to financial assets, often the trustees will not take on the management of these assets themselves but appoint a professional portfolio manager to do so.
The portfolio manager needs to meet the (often stringent) criteria set by the trustees. As the ultimate fruit of the portfolio management is with the beneficiaries, contact with the beneficiaries may well be part of the management process as well.
There are a large number of portfolio management companies in financial centres in Europe. Just in Switzerland, there are 2600 (37). Many of them are specifically tuned towards managing financial assets in trusts.
Trusts and costs
Trusts come with a price tag. Even for the most simple of trusts, setting up costs quickly add up to a couple of thousand Euros/USD, as is true for running costs (p.a.). Costs involved with a more complex trust will be considerably higher. So, the benefits need to outweigh these costs. When a portfolio manager becomes involved to manage the financial assets of the trusts, these services will come, of course, with a fee as well.
Trusts and its pitfalls
Trusts come with pitfalls. So, anyone who is considering setting up a trust needs to make sure they are fully informed about what is involved and should also seek professional help. Here are areas of concern to be aware of where things can go wrong:
- Misunderstanding of what trusts can accomplish and what they cannot; Example: expecting tax benefits, where there are none.
- Ill-chosen trustees; Example: selecting trustees who are not professional or worse, prone to fraudulent actions.
- In case of irrevocable trusts: no chance to change one’s mind later;
Example: having separated from one’s assets when times were good, and not being able to reverse the decision when times are not good and the asset is needed.
- Can create negative effects on beneficiaries; Example: leaving large sums of money to children (or grandchildren) which negates any incentive for these (grand) children to make their own mark in the world and gain self-respect.
Trusts are legal arrangements which have been around for centuries and are increasing in popularity. There are a range of benefits as well as plenty of pitfalls. It is imperative that anyone considering setting up a trust should gain a detailed understanding of how trusts work, and be aware of their benefits, as well as the downsides. The selection of a sound professional trust company or absolutely reliable trustees is essential. Trusts come with costs, so benefits and costs need to be carefully weighed. The management of the financial assets can be done by a professional portfolio management company, ideally one which works closely with trust companies and understands the complexities and variances of trust vehicles.
(1), (9), (10), (11), (12), (27), (29), (30): STEP, Trusts explained by Step 2011, www.step.org
(2), (3), (4), (5), (14), (29): Trust Law, Wikipedia, 3 Jan 2016 www.wikipedia.com
(7)Trust (Business), Wikipedia 16 Jan 2016 www.wikipedia.com
(8) Britain’s top 1000 charities, Simon Rogers, 24 April 2013, www.guardian.com
(13) Trust by Havel Holasek Partners, www.havelholasek.cz 16 Jan 2016
(15) Protector (Trust) Wikipedia, 3 Feb 2016
(16) Revocable vs Irrevocable Trusts by N. Brian Caverly and Jordan S. Simon, in “Estate Planning for Dummies” 27 Jan 2016
(17) Wikipedia Bypass Trust
(18), (19) Understanding the basics of Revocable Trusts by Kaiser Law Firm, www.kaiserlawfirm.com
(20) Willl, Wikipedia, 2 Feb 2016
(21), (22), (23), College for Financial Planning, CFP Education module Estate Planning, 2003
(24)(25) Trust clauses and Spendthrift clauses, Wikipedia 2 Feb 2016
(26) Merriam Webster, www.merriam-webster.com\
(28) Trustee Investment Risk Management, by Ray Scott
(30), (31): Foundation vs Trust Purposes, www.rhoneservices.com, Feb 2011
(34), (35): Trust Company Wikipedia, 3 Feb 2016
(38) Image of painting by Karl Friedrich Lessing “The Returning Crusader”, 1835
(39) Image from www.trustess.jhu.edu