Wealth transfer made easy: Everything you need to know about Trusts

Picture of Yogesh Prasad, CFA, CAIA

Yogesh Prasad, CFA, CAIA

CEO & Founder of Confluent Asset Management

When thinking about the dissemination of wealth to ensure your family’s financial future, one can find few more powerful tools than trusts. They offer much more than a vehicle to save on taxes and are an effective way to keep your assets safe, retaining control over your wealth distribution and giving one’s family enduring peace of mind.

In this newsletter, we are going to guide you through what trusts are, how they work, and the distinct types available. Let’s find out why trust is so important for people who want to keep and manage their wealth well.

What is a Trust?

At its base, a trust is a legal arrangement with the purpose of transferring and carrying on assets following the wishes of the settlor or grantor. Sometimes assets transferred to a trust are described as capital, corpus, or principal. Once an owner transfers any form of property or assets into the trust, a trustee-a person or establishment appointed to conduct assets on their behalf-is subsequently entrusted with this work for the use of trust’s beneficiaries.

The beauty of this setup is that the beneficiaries have beneficial ownership; they own the rights to the benefits of the assets in trust, such as income derived from the assets or usage of the property, without them owning the assets per se. The title to the assets is with the trustee while he discharges his duties according to the trust document-a legally binding agreement that clearly articulates the aim of the trust, its rules, and terms.

Types of Trusts: Revocable v.s. irrevocable

Trusts are not one-size-fits-all. They can be structured in several ways to meet specific goals, but two primary categories are:

Revocable Trusts

A revocable trust is the kind of trust that can be controlled by the settlor. Thus, a settlor can make an amendment or completely dissolve the trust. Since the settlor still retains control, he is considered the owner for the taxation of the trust assets. As such, he has to report and pay taxes for the trust income. However, there is a catch: since the settlor maintains control, the trust assets remain at risk from creditors or lawsuits against the settlor.

Irrevocable Trusts

In an irrevocable trust, the settlor gives up control and ownership of the trust property. Once the property is transferred, the settlor cannot revoke or change the trust. This type of structure offers greater asset protection. For since the assets no longer belong to the settlor, they often are protected against creditors-if, that is, the settlor was not insolvent at the time the trust was created and there were no pre-existing claims by creditors. For tax purposes, the trustee usually reports and pays taxes for the trust on its behalf.

Fixed vs. Discretionary Trusts

Trusts can also be classified according to how distributions are provided to beneficiaries:

Fixed Trusts

In a fixed trust, the trust document states exactly how and when beneficiaries are to receive distributions. Whether it is a regular amount at set intervals or a lump sum at a certain age, the terms are preordained.

Discretionary Trusts

On the other hand, discretionary trusts provide the trustee with discretion. The trustee determines whether, when, and how distributions are to be made, usually based on such factors as a beneficiary’s financial needs or best interests. One immediate advantage of this flexibility is that the creditors of the beneficiaries cannot reach the trust’s assets easily because the beneficiaries have no legal right to demand income or principal.

Source: Research paper on Wealth Transfer Strategies by CFA Institute

Why Trusts matter for wealthy families

Trusts aren’t just about taxes. They’re about control, protection, and legacy. They let you do the following:

  • Protect Your Assets: Safeguard assets against potential claims of creditors or lawsuits.
  • Preserve Your Legacy: Ensure your wealth is used the way you want even after you’re gone.
  • Provide for Future Generations: Provide for loved ones, especially those who may not be financially savvy.
  • Minimize Taxes: With proper planning, trusts can minimize estate taxes along with offering other tax benefits.
  • Maintain Privacy: Unlike wills, trusts do not generally undergo public probate. Therefore, all of your financial affairs will remain private.

Why a Trust?

Trusts achieve many vital goals, thereby becoming indispensable to estate and wealth planning. A close look into its major objectives:

1. Maintaining control

  • This will be the major reason most people go for the trust structure: so that the provision of beneficiaries can be certain but not necessarily letting them have the asset’s complete control.
  • The trusts will further enable you to describe when and exactly how the beneficiaries could get their hands on the resources. For example,
  • Spending of Funds for specific needs of subsistence, health care, and education.
  • Providing for beneficiaries who are not prepared for, or even capable of, handling significant wealth, be it minors, those with disabilities, or individuals who simply cannot show financial restraint.
  • By identifying the “what” and “when” of the trust document, you are ensuring a degree of control over your assets beyond the grave.

2. Protecting your assets

This is particularly what makes asset protection a cornerstone benefit of trusts in cases of individuals with high-net worth or multi-complexity families.

  • Protection from Creditors: Irrevocable trust assets cannot be typically touched by the creditors of the settlor. In fact, discretionary trusts extend further the advantage of protection from creditors of beneficiaries since the latter do not have any legal right against those trust assets until it is distributed to them.
  • Family Business Protection: In community property states, most assets acquired during marriage are considered jointly owned. This can create a potential dilution of family businesses in the case of divorce or death. A trust can protect business ownership by keeping it out of the marital property pool.
  • Avoidance of Probate: Trusts are also instrumental in preventing the lengthy, costly, and public process of probate. By preventing your assets from going through probate, it provides the more efficient, private, and non-redundant means of legal disposal.

3. Effectively managing taxes

Tax efficiency is often an immediate priority for the high-net-worth family. There, trusts may come into great use in keeping at bay some possible or imminent tax burdens.

  • Income Tax Optimization: High-income individuals often face steep progressive tax rates. By transferring assets to a trust, the income generated may be taxed at a lower rate, depending on the trust structure.
  • Beneficiary Tax Strategy: In a discretionary trust, trustees can align distributions with a beneficiary’s tax situation, optimizing when and how income is received to minimize tax liabilities.
  • Jurisdictional Tax Planning: Trusts can also be set up in jurisdictions that provide favorable tax laws for better tax efficiency.

Trust duration and generational planning

Trusts can be established to exist for a period, or in some jurisdictions, they can exist in perpetuity. This affords great latitude to extend the benefits of a trust across many generations while strategically minimizing taxes.

Rule against perpetuities and dynasty trusts

Historically, the rule against perpetuities limited the length of trusts; they had to end within 21 years following the death of the last living person in a defined group alive on the date that the trust was created. However, most states in the United States and common law jurisdictions around the world have abolished it, enabling many trusts to exist for even longer periods and even in perpetuity.

Dynasty Trusts: These perpetual trusts are designed to benefit multiple generations, creating what is often referred to as a “family dynasty.” When properly designed, dynasty trusts enable assets to grow and be transferred across generations with minimal or no wealth transfer taxation.

Generation-skipping strategies and taxation

The high net worth individuals with goals of transferring wealth beyond their immediate heirs utilize generation-skipping strategies to reduce the tax impact on family wealth.

Double Taxation Beaters Transfers to the second generation–that is, children–generally incur taxes, as do transfers to the third generation–the grandchildren, for example. The owners of an estate can redirect assets that surpass what their immediate heirs might need toward a multi-generational trust and in turn bypass one level of taxation.

In other countries, however, such as the United States, there is a disincentive-the generation-skipping transfer tax-applied when direct transfers to grandchildren or subsequent generations are made. This is imposed in addition to all other transfer taxes, ensuring that skipped generations bear a comparable net burden of tax as if the transfers had been made sequentially.

Options to reduce GSTT

Notwithstanding the GSTT, some opportunities can be exploited to effect transfers more efficiently:

GSTT Exemptions: The United States had an ample exemption of $12.96 million in 2023 that can be leveraged for assets held in a dynasty trust. With appropriate planning, this exemption has the potential to shelter substantial amounts of wealth from transfer taxes for several successive generations.

Non-U.S. Persons: Non-U.S. individuals are not subject to GSTT. This creates an interesting opportunity for foreign families creating dynasty trusts in the U.S. jurisdictions, whereby they can avoid all U.S. transfer taxes on their assets.

Maximizing Trust benefits for generational wealth

The length and design of the trust create unique and unrivaled opportunities for long-term wealth protection and intergenerational planning. With dynasty trusts and generation-skipping techniques, families can achieve the following:

  • Protect fortune from being wastefully taxed.
  • Ensure the financial stability of future generations.
  • Achieve their legacy-building goals while maximizing tax efficiencies.

 

These advanced strategies highlight the importance of personalized trust planning, tailored to your unique family and financial circumstances. Stay tuned for our next segment, where we’ll explore the nuances of trust governance and the trustee’s critical role in executing your vision.

Gifts to trusts

When moving assets to a consider, careful attention is needed to make sure the switch aligns with prison and tax requirements.

Irrevocable inter vivos Trusts:

To qualify as a completed present for switch tax functions, the grantor should switch assets to an irrevocable inter vivos trust—one mounted and funded at some point of the grantor’s lifetime. This structure contrasts with testamentary trusts, which can be created posthumously through a will or estate plan.

If a belief isn’t irrevocable, many jurisdictions will now not recognize the switch as finished, meaning the property can also remain a challenge to the grantor’s property and tax liabilities.

Taxation of Trusts

Tax remedy varies extensively throughout jurisdictions, making it vital to consult neighborhood tax experts while establishing or managing a trust.

General Taxation Rules:

In many jurisdictions, trusts are taxed at the identical costs as individuals. However, trusts regularly reach the best profits tax bracket at an awful lot lower profits tiers than people, probably resulting in better tax liabilities.

Source: CFA Institute

Intentionally Defective Grantor Trusts (IDGTs):

In the USA, an irrevocable agreement can be based as an IDGT. This specific setup allows the grantor to:

  • Remove the proficient property, future returns, and paid taxes from their taxable estate.
  • Leverage this structure to correctly switch wealth throughout generations.

 

For individuals in search of extra favorable tax treatments, offshore trusts might also provide an opportunity solution. Offshore trusts are hooked up in overseas jurisdictions, often chosen for their tax benefits, confidentiality, and sturdy asset protection.

Non-Trust Jurisdictions

In civil law jurisdictions, trusts are not commonly accepted. Nevertheless, several mechanisms and adaptations enable individuals in these territories to achieve comparable results:

  • The Hague Trust Convention: A few civil law countries, like Switzerland and Germany, have enacted trust laws or are signatories to this convention, which provides that trusts created in member states are legally recognized.
  • Avoiding Forced Inheritance Rules: Trusts are also used to avoid the application of forced heirship provisions in civil law jurisdictions, which provide for the distribution of a certain portion of an estate to specific heirs.

Hybrid structures

Some of the civil law trust equivalents are as follows:

  • Stiftungs (Foundations): These are established for personal, non-commercial purposes.
  • Anstalts (Establishments): A hybrid between a company and a foundation.

 

While these structures offer solutions in civil law systems, their tax treatment is often uncertain in common law jurisdictions, and many founders convert such entities into trust structures for beneficiaries residing in those regions.

Investment of Trusts

  • Trustees have a very important role in ensuring that the assets of the trust are invested appropriately to meet the objectives of the trust. This responsibility flows from the prudent investor rule, which is the legal framework for trustees in the United States and most common law jurisdictions.

 

  • The prudent investor rule, embracing aspects of modern portfolio theory, imposes various obligations on a trustee in managing the investments of the trust in view of the circumstances of the trust. Before making any investment decision, the trustee must take into consideration, among other things, the purposes of the trust, requirements relating to distribution, and the beneficiaries’ financial needs.

Key considerations under the prudent investor rule

When choosing investments for a trust, trustees must balance several factors that affect the overall strategy and results of the decision:

  • Economic Conditions: Trustees must analyze the current and future state of the economy, including trends in market performance, interest rates, and global economic factors.
  • Inflation or Deflation Impact: Considering how changes in the purchasing power of money may affect the ability of the trust to meet its goals is crucial.
  • Tax Implications: Trustees are supposed to consider how investment decisions or strategies will impact the tax payable by the trust and the tax liabilities of the beneficiaries.
  • Portfolio Role: Every investment should be assessed in respect of its contribution to the diversification and balance of the overall portfolio of the trust.
  • Expected Returns: An investment’s potential for income generation and appreciation, together with the risk of depreciation, is evaluated to enable the trustee to maximize total returns.
  • Beneficiaries’ Resources: Trustees should take into consideration the financial resources that beneficiaries have outside the trust and make investment decisions accordingly.
  • Liquidity Needs: Investments shall be made in accordance with the needs of the trust for available funds, regular income distributions, and capital preservation or growth.
  • Special Value Assets – Some assets may serve a unique purpose for the beneficiaries or the underlying goals of the trust, such as sentimental value, the handling of which shall be considered along with the investment decisions.

Trustees' legal responsibilities

Trustees have a fiduciary responsibility and hence are required to act in the best interest of the beneficiaries and also follow the prudent investor rule. Failure to do so may expose them to liability. To minimize this liability, and to show the application of the rule, a trustee should do the following as a best practice:

  • Record Decision-Making: The trustee must keep detailed minutes of what was considered, analyzed, and rationalized for every investment decision.
  • Seek Professional Advice: Where necessary, trustees may engage the services of an investment adviser or portfolio manager to facilitate complex financial strategies and maintain fiduciary obligations.

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