A trust is an agreement for one party to care for the assets of another party for the benefit of a third party. In essence, it is a business agreement. The person creating or the original owner of the assets is referred to as the Grantor. The party that will take care of the assets is known as the Trustee. The third party to receive the benefits is referred to as the Beneficiary.
The most common assets transferred to the care of the trustee are cash and real estate. The trustee holds control over the assets and in accordance with the agreement transfers the assets to the beneficiary based on the terms designated in the agreement. The agreement is commonly referred to as the Trust Document.
We have all heard the crazy stories of trusts being set up to take care of pets or some other off the wall goal. The reality is that most are established to take care of individuals that cannot or will not be able to make good decisions. These could be due to age – minors or elderly, mental capacity or to protect the assets from outside creditors. All of these are legitimate justifications for the creation of a trust. There are some scenarios where the trust is established to benefit an organization, but that is for another article in the future.
To create a trust, first the grantor must decide if (s)he would like to change the terms of the trust document in the future (create a living trust). This is critical to understand, if the grantor retains the right to make changes, in effect he has not given absolute permission for a formal entity to exist. In effect, he can revoke the rights or terms and conditions to the agreement. This is referred to as an Revocable Trust. This is very common and there are thousands of these types of trusts out there. Since the grantor retains the right to make changes, no new legal entity exists. Therefore, the trust is merely a shadow of something that may or may not exist in the future. This type of situation has no existence in the eyes of the Internal Revenue Service and therefore is not taxed nor does it require its own Federal Identification Number (FEIN).
Many of these revocable trusts have a trigger in them causing the trust to become permanent. The most common trigger is the death of the grantor. Others include permanent disability or lack of capacity on the grantor to make decisions. Once the trigger is engaged, the trust goes into action. It then becomes unchangeable or permanent in nature and is called an Irrevocable Trust. This automatically creates a new entity and this entity no differently than when a baby is born, must get an identification number from the IRS. This new entity files an annual tax return Form 1041 (notice that an individual is Form 1040) and must conduct itself in accordance with the procedures as outlined by the IRS. See Resources for more information on trusts from the IRS.
In some situations, the Trust must become an entity in the state where it conducts business. In many situations a minimum of registering the name of the trust is required in the state where the trust operates.
The trustee now takes over and controls the assets and is paid from the trust for caring and distributing the assets in accordance with the terms and conditions in the agreement (Trust Document).
There are hundreds of different types of Trusts and they are taxed in accordance with the Code. If you have any questions please contact me via the comment section below and I’ll get back to you as soon as possible. Knowledge is Power.
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Other articles related to trusts and will help the reader to better understand this legal entity format include:
What is a Contract? – to fully grasp the concept of a trust, the reader should understand the terminology used in contracts. This article introduces the reader to these terms and describes their use and how the courts interpret their meaning.
Form 1041 – Income Tax Return for Estates – the most commonly recognized trust by the IRS is the Estate. The IRS requires the trustee to file Form 1041 and this article introduces the reader to this form as it relates to estates.