How Trusts Work

Aug 2015

(Based on an Office Hours)

“I don’t trust people who don’t love themselves and tell me, ‘I love you.’ … There is an African saying which is: Be careful when a naked person offers you a shirt.”

– Maya Angelou

“I have come to accept the feeling of not knowing where I am going. And I have trained myself to love it. Because it is only when we are suspended in mid-air with no landing in sight, that we force our wings to unravel and alas begin our flight. And as we fly, we still may not know where we are going to. But the miracle is in the unfolding of the wings. You may not know where you’re going, but you know that so long as you spread your wings, the winds will carry you.”

– C. JoyBell C.

If I’m holding onto something of value for someone else. What I’ve accidentally created is a trust. A very informal one. But that is the basic principle. A trust is the name for the relationship whereby an asset changes ownership from one person to another but is managed by a third party in the meantime.

So if an elderly parent wants to leave a business to their young child. They can leave it to a trust who will manage the business until the child is old enough to inherit it and manage it properly. Usually what is left in a trust is money and is where the term trust fund came from. A person with a trust fund literally has a pool of money sitting for them.

Originally trusts were set up as a way for rich people to pass on assets from someone who died to their children. It was very useful in that way and existed primarily to protect assets. It was basically a way of transferring assets to someone without them really having much of a say in how exactly those assets are transferred.

They protect the person giving the assets almost as much as it protects the people receiving them because you can use a trust to add qualifiers and get creative and the creation of a trust literally changes ownership of the asset. For example, a dying family member can write conditions into a trust, such as a child will only inherit assets if they give up alcohol or hit a certain age. Or it protects the assets if the child is in trouble.

My favourite 2 examples of this is if a child is bankrupt or going through a divorce when their parents die. Say a family wants to leave their estate to their children. But their children are in debt and owe people money or they’re going through a nasty divorce and a partner is trying to take their assets. If the house went directly to the kid, it would immediately be taken by creditors or be split in the divorce settlement, losing the house completely. But if the house was instead left to a trust. Then the child could use the house without it ever being lost, even if they were bankrupt and owed people lots of money.

Now over time, people have started using trusts as a way to protect themselves from other people. So they are prematurely protecting their assets before they even die by signing them away to a trust. The way they are used is quite literally changing ownership of something. So the ownership isn’t yours anymore, it is the trusts. It’s like saying, they are owned by someone else, but just being managed by another party in the meantime.

There are 3 important people to a trust in Australia but most trusts in the world have something similar, they may just be called something else there.  The Trustee. The Beneficiary and The Appointer.

The Beneficiary or Beneficiaries is the person, entity or people who receive everything from the trust based on the terms written on the trust deed. They’re the people all the money and assets are being left to and benefit most from a trust.

The Trustee is the person who manages the trust and owns all of the assets of the trust on behalf of the beneficiary. They temporarily manage and distribute all of the trusts money and assets until it is time to give them all to the beneficiary. They can do whatever they want with it in the meantime, so long as they don’t lose anything. If they do, they are personally liable for any losses of the trust. If they lose anything, they have to pay it back.

The Appointer is like the watcher of the trust. They makes sure everyone is doing their job correctly. They don’t actually participate but are able to remove or change who the trustee is. So in a sense the appointer is the most powerful. If the trustee isn’t doing a good job or is being dishonest, it’s the appointers task to remove them and find a new trustee.

Under Australian law, the life of a trust is 80 years unless wound up sooner and the assets in a trust can be anything. Property, shares, businesses, money etc.

When the trusts assets are shares, the share register should always say so. The shares should be issued to the trustee clearly outlining their capacity as a trustee. The shares should literally say and be issued to “John Smith in his capacity as the trustee of the John Smith Family Trust” or “XYZ Corporation in its capacity as the trustee of the ABC Trust” for this to be the case.

A good way that I think about it is that a trust is basically the word for transit. It’s the transient state that assets fall under when they are in the process of being transferred from one person to another. And the trustee is the person who is managing the transfer. So the actual asset is owned by the trustee but only temporarily and on behalf of the beneficiary.

That is why a trust isn’t an official legal entity, though it may file tax returns, because it is just a legal definition for what is a relationship. A trust is basically a word for the relationship of one entity that agrees to give something to another entity, with a third entity holding it for a little while. So neither the first or second entity actually owns the assets anymore. These entities can be people, companies, charities, anything.

Because neither the first or second entity own the assets anymore. The assets are protected from the actions of both of them. A very common corporate setup for successful people is to create a company that acts as a corporate trustee of a trust and a second company that is their operating business. The trust names their family as the beneficiaries. They then issue all of their shares of the operating company to their trust but they can control the trust distributions by being the director of the trustee company.

Because the operating business owns no assets, they’re in the trust. If they ever get sued or go bankrupt. Their family is not left destitute because what they did was prematurely transfer all their assets to the trust which will then go to their children or whoever they want really. The only downside is it makes credit harder to get since a person no longer has any net worth. Their net worth becomes the net worth of the trust instead.

This is why there is asset protection benefits because the assets are in transit while in the trust. People can receive their benefits without the liability of actually owning them and the target that may paint on them. Since it can’t be lost because it isn’t owned. There’s a great quote I read once that the only people who are worth suing are people who own things. Because if you don’t own anything there’s nothing that can be lost when someone comes after you.

The benefits for society through asset protection are largely qualitative. Because by being able to protect core assets such as your family home in a downside scenario it allows entrepreneurs and business people to take more and bigger risks in business which is good for the economy and society. Whereas they wouldn’t take such large risks if they would lose everything if it goes wrong and the business fails. Society wants entrepreneurs to take risks and create new business and we don’t want them to lose everything when doing so.

Where it sometimes gets unpleasant is when a big unethical person or company uses trusts to protect themselves while operating a criminal enterprise or making products they know make people sick or something like that. But the legal system has the ability to apply justice and remove the asset protection a trust provides anytime it wants to. It’s just more difficult and they don’t do it for a divorce or bankruptcy but often do for negligence or malpractice where a person is hurt or injured.

Because a legal system through the application of trust can always throw out a person’s asset protection structure like trusts and companies anyway, a lot of the benefits of it are theoretical. Much of a person’s asset protection actually act as a deterrent for people to try to come after them  Because it costs tens or hundreds of thousands of dollars to be sued by someone, it raises the threshold for someone to try by adding ownership complexity.

If you’re doing the wrong thing, a trust won’t help you. But if you’re doing the right thing, a trust might help you and your family a lot. They’re an important structural element to running a successful business and protecting the proceeds if you become successful or the business does well.