What Is a Trust | The Motley Fool

Many of the modern financial instruments used today, such as limited liability corporations (LLCs) and stocks, can trace their roots back to 17th-century Holland. However, the modern concept of trusts dates back to the Dark Ages.

Eleventh-century English crusaders entrusted their properties to third parties while leaving history's first "trust fund kids" back home in the shire. Trusts are an extremely useful tool in the financial world, both for protecting existing assets and planning for taxes and death.

A clipboard with living trust and estate planning written on the paperwork it's holding. — Image source: Getty Images.

What is a trust?

A trust is a legal arrangement in which one party, known as the trustor, settlor, or grantor, transfers assets to a third party, known as the trustee, to manage on behalf of beneficiaries. In a way, trusts are a way to own assets without really owning them.

Trusts can be used to protect assets, offset taxes, and shield assets from creditors. They are also heavily associated with estate planning since they can be used to transfer assets to beneficiaries while avoiding estate taxes and complications in probate court.

How trusts are used

A trust structure can be used for a number of things, from funneling money meant for another purpose into complicated structures to obscure identities to the more mundane goal of starting a trust fund to minimize estate taxes on the children of people who have acquired a substantial amount of wealth. Trusts are mainly utilized for the following reasons:

Asset protection and estate planning

Trusts can help shield assets from creditors or legal judgments by transferring them to a trustee. In this case, the assets no longer belong to the original owner or "settlor"; they belong to the trustee. A common trust used for asset protection is an irrevocable trust, which can have major tax advantages for assets when they are wrapped up inside.

In estate planning, trusts enable people to manage and distribute an individual's assets when they die. The first major benefit is that they establish direction on how to distribute an individual's assets without the need for an expensive probate court and a drawn-out legal process. Trusts can also come in handy when attempting to manage and reduce estate taxes.

Tax management

Certain types of trusts, such as irrevocable trusts and charitable remainder trusts, can help significantly reduce estate taxes and distribute income in a tax-efficient manner. Most people are familiar with the idea of eliminating taxes while passing wealth to heirs.

However, different types of trust structures can be embraced for different needs. A charitable remainder trust, for example, can provide the settlor with income during their lifetime while donating the remainder to charity, offering tax deductions via charitable donation exceptions.

Caring for beneficiaries

Trusts are an important tool for managing the assets of people who might be unable to handle their affairs, such as minors or people with disabilities. A special needs trust, for example, allows assets to be held for a beneficiary without excluding them from income derived from Social Security or Medicaid. Trusts for minors can be set up to hold assets until they reach a certain age.

Identity protection

While walking down the streets of Mayfair in London or the Upper West Side of New York City, one might be unaware that many of the apartments are actually owned by LLCs, which are owned by trusts, many in offshore jurisdictions. Instead of John Doe owning an apartment, it can be an LLC owned by a trust, with a law firm as the only name on the paperwork. Trusts are great for shielding the identities of those who want to hold assets without revealing who they are.

Type of trusts

Revocable trusts

Also called "living trusts," revocable trusts are created by a grantor and can be altered, dissolved, or "revoked" at any point in their lifetime. Unlike other types of trusts, grantors will serve as the trustee of the trust, and the main benefit is usually just to avoid the probate court with asset distribution since there are no tax benefits during the grantor's lifetime.

Irrevocable trusts

Unlike revocable trusts, irrevocable trusts cannot be changed or managed during the grantor's lifetime. When assets are transferred into an irrevocable trust, they are no longer owned by the grantor and can help protect assets from creditors and avoid estate taxes when the grantor dies.

Discretionary trusts

Discretionary trusts provide a third party to oversee the distribution of a trust's assets to the beneficiaries. They are usually created to protect beneficiaries from poor financial management or other aspects that might negatively affect an inheritance.

Charitable trusts

Charitable trusts are mainly set up to take advantage of tax laws related to charity by either providing a fixed payment to charity or allowing the grantor or beneficiaries to derive income from the trust while donating the rest to charity.

Special needs trust

A special needs trust helps manage assets for people with disabilities so that they can still receive government aid from programs like Social Security and Medicaid while retaining access to existing assets that otherwise might disqualify them.

Testamentary trusts

Testamentary trusts are usually associated with wills and take effect after a grantor's death. These trusts are indeed subject to probate but allow for more direct asset distribution, which can be useful with minors and complex family situations, such as children from different marriages.

Is it worth it to set up a trust?

Trusts do indeed have downsides, with one of the primary ones being expense. Trusts are not cheap to establish and maintain; below are typical costs associated with establishing a trust:

Typical costs associated with a trust.
Type of Fee	Estimated Cost
Trustee fees	0.5% to 1.5% of assets yearly
Legal fees	$150 to $450 per hour
Accounting fees	$500 to $2,000+ annually
Investment management fees	0.5% to 1.5% of managed assets
Real estate management fees	7% to 10% of rental income
Miscellaneous fees	Varies
Setup fees	$1,200 to $10,000+

Most of the time, trusts are only worth implementing if an individual has complex finances or a considerable amount of wealth. Still, consulting a financial professional on how a trust structure could help might be an eye-opening experience.

Example case: Commodities trader sets up a trust

Let's say a commodities exporter who made money shorting the price of grain has a net worth of $50 million, primarily in commodities investments. Without a trust, the estate would be subject to federal estate taxes (and possibly state taxes, depending on where they reside) when they die.