Trusts are a means by which a grantor (or settlor) can transfer assets to beneficiaries outside of the probate process. The trustee holds the assets and manages them in the best interests of the beneficiaries according to the constraints of the trust documents.
In a revocable trust, the settlor can rescind the trust and resume ownership of the assets. The settlor is considered the legal owner of the assets for tax and reporting purposes, and creditors, divorcing spouses, et cetera can make claims against the trust assets.
In an irrevocable trust, the settlor relinquishes ownership and control. The trustee is considered the owner of the assets for tax purposes and is responsible for reporting and paying taxes on income generated by the trust. The irrevocable trust protects the trust assets from claims against the settlor.
The trustee may be responsible for distributing assets to the beneficiaries. In a fixed trust, the pattern of distributions to the beneficiaries is predetermined by the settlor and incorporated into the trust documents.
With a discretionary trust, the trustee determines how the assets are to be distributed. The primary concern is that the assets are distributed to produce the greatest benefit to the beneficiary or beneficiaries. The settlor can convey her general wishes through the trust documentation or separately through a letter of wishes. Beneficiaries have no legal right to either the income or the assets of the discretionary trust. Thus, the trust assets are protected from claims against the beneficiaries.
A spendthrift trust is used to transfer assets to a beneficiary who is too young or is otherwise unable to manage the assets. It provides a means for the settlor to transfer assets outside the probate process while maintaining some control over the distribution of the assets.
In some countries, trusts are recognized as legally transferring the ownership of assets but not for tax purposes. If that is the case, the settlor remains responsible for taxes on income generated by the trust.
Trusts are recognized by, and are thus most prevalent in, common law countries but can be found in (i.e., are recognized by) some civil law countries. Foundations, on the other hand, are most prevalent in civil law countries but can also be found in common law countries.
A foundation is a legal entity available in some jurisdictions. Foundations are typically set up to hold assets for a particular purpose—such as to promote education or for philanthropy. When set up and funded by an individual or family and managed by its own directors, it is called a private foundation.
Similar to trusts, foundations survive the settlor, allow the settlor’s wishes to be followed after the settlor’s death, and can accomplish the same types of objectives as a trust. A foundation is based on civil law and, unlike a trust, is a legal person. Often, the choice of a trust or foundation depends on a client’s residence or nationality.
As the only assets transferred by the grantor are the premiums paid, life insurance policies represent a very efficient means for transferring assets or even helping beneficiaries pay inheritance taxes. In most jurisdictions, life insurance proceeds pass to beneficiaries without tax consequences, and, depending on jurisdiction, the policy might provide tax-free accumulation of wealth and/or loans to the policy holder on beneficial terms.
Life insurance can be used in combination with a trust. By establishing a trust on behalf of the beneficiaries and making that trust the direct beneficiary of the life policy, the policy holder can transfer assets to young, disabled, ect., beneficiaries outside the probate process.
Companies and Controlled Foreign Corporations
Companies may also be a useful tool in which to place assets. For example, a controlled foreign corporation (CFC) is a company located outside a taxpayer’s home country and in which the taxpayer has a controlling interest as defined under the home country law. A possible benefit of placing income generating assets in a CFC is that tax on earnings of the company may be deferred until either the earnings are actually distributed to shareholders or the company is sold or shares otherwise disposed. In addition, a CFC may be established in a jurisdiction that does not tax the company or its shareholders.
Many countries have CFC rules designed to prevent taxpayers from avoiding the taxation of current income by holding assets in a CFC. CFC rules can be triggered if a taxpayer owns more than, say, 50 percent of the foreign company’s shares, although the ownership threshold will vary from one jurisdiction to the next. CFC rules may also look beyond direct ownership of CFC shares and consider beneficial ownership in a trust, for example, or even ownership attributed to related parties, such as a taxpayer’s family members. Therefore, CFC rules may tax shareholders of a CFC on the company’s earnings as if the earnings were distributed to shareholders even though no distribution has been made. This treatment of earnings is called a deemed distribution.