A trust is a legal agreement between two or more parties that grants one party, or trustee, specified assets while the beneficiary, or the person for whom the trust is established, retains ownership of said assets. If you’ve ever wondered how to set up a trust or how they work, we explain below in detail how to set up a trust, from creation to distribution.

The five-step process:

  1. Creation
  2. Tax Recognition
  3. Funding
  4. Administration
  5. Distributions

1. Creation

The steps in creating a trust are:

  1. Identifying the person who establishes the trust, usually called the “Grantor.”
  2. Identifying an appropriate trustee. A Trustee is the person who holds, invests, manages, and distributes the money for the “Beneficiary” (“Beneficiary” = the person for whom the trust is established).
  3. Drafting it to meet any specifics for the trust that the law requires to avoid the trust assets being counted as a resource to the trust beneficiary.
  4. If a court must establish the trust, petitioning the court for an appropriate order “establishing” the trust.

2. Tax Recognition

Trust funds are invested under a federal employee’s identification number (a tax ID number). The trust is or could be a taxpaying entity. In practice, however, any income the trust earns will be distributed to the beneficiary, who would pay the taxes on the income earned. The trust would file a federal income tax return but usually would not have to pay any income taxes. Once the trust has been created, a tax ID number is obtained from the Internal Revenue Service. The easiest way to get one is by going online to the IRS’ website and filling out an application.

3. Funding

Needless to say, if there is no money, there is nothing to manage or distribute to set up a trust. After the trust has been created, the trust is funded. All this means for most trustees is that they go to the bank or brokerage company with a copy of the trust agreement and the federal tax ID number and open up an account in the name of the trust. Instead of a social security number, the tax ID number is used.

4. Administration

Understanding Fiduciary Obligations

The trustee is a fiduciary. A fiduciary is someone who acts solely for the benefit of trust beneficiaries. Unless the trust agreement says otherwise, local law limits the kinds of investments that a trustee may make. When you set up a trust, it is wise for a trustee to discuss trust investments with an investment adviser to help the trustee determine what investments of the trust assets should be made that further the intent of the trust.

A fiduciary is any person who:

  • Exercises any discretionary control or authority over the management of the trust or the disposition of its assets;
  • Offers investment advice regarding plan assets and derives compensation for it, either direct or indirect; or
  • Has any discretionary authority or responsibility regarding trust administration.

The fiduciaries involved in a trust are, therefore, at least these persons: the trustee, the trust administrator, and the investment adviser.

Back-End Duties of a Fiduciary

When you set up a trust, trust duties can be divided into two functions: back-end duties and front-end services. The fiduciary’s back-end services can themselves be split into two functions: trust administration and investment management. Both relate to the establishment, monitoring, and daily management of a trust fund. (Front-end services pertain to distributions for the beneficiary’s special needs, the trustee’s role that will be considered in the next section.)

A fiduciary’s responsibilities as administrator of the trust are as follows:

  • Open the trust account in accordance with a written trust agreement;
  • Operate the trust in accordance with the trust document and other operating procedures;
  • Operate the trust solely in the best interests of the trust beneficiary; and
  • Ensure that the trust remains in compliance with all legal and regulatory requirements.

For large trusts, most trustees work with a recordkeeper, service provider, or consultant to ensure that these administrative duties are properly handled. It is also the fiduciary’s responsibility to select the service provider and to monitor the service provider’s performance to ensure that the trust is being administered correctly. For small “family” trusts, the trustee may do most or all of this work.

The responsibilities of a fiduciary acting in an investment management capacity include the following:

  • Establish policy outlining how investment decisions are to be made and monitored;
  • Ensure diversification of assets in accordance with risk and reward objectives;
  • Monitor trust investment options to ensure that established objectives are met;
  • Utilize prudent experts to make investment decisions;
  • Control and account for all investment expenses;
  • Monitor money manager and service provider activities; and
  • Avoid conflicts of interest.

How to Stay Compliant

The trustee should monitor investments closely when they set up a trust. Look for a financial services firm that not only can relieve the burdens of recordkeeping, compliance, and administration but one that can assist with investment advisory services, too. Choose an investment adviser who understands the conservative approach that must be taken toward the trust funds. Document the file as to the investment advice given to the trustee.

Establish a regular schedule for accounting to the beneficiary or the beneficiary’s representative of investments and distributions from the trust sub-account.

Trustees must have a thorough understanding of their own fiduciary responsibility—and potential liability. It is not a privilege or an honor to be a trustee, it is a job.

5. Distribution

Front-End Services

Front-end services are those that the beneficiary and the beneficiary’s representative see when they interact with the trust. Although much of this is social service-type work, it nonetheless requires an exercise by the trustee of its fiduciary obligation on behalf of the beneficiary. Distributions to the beneficiary that are disqualifying may render the trustee liable to the beneficiary for a loss or diminution of public benefits.

The trustee will be entering into a potentially long-term relationship with the beneficiary when they set up a trust. From time to time, this is likely to be contentious because a beneficiary and their representative often do not understand the constraints under which trusts operate.

What Are Special Needs?

Some trust beneficiaries receive public benefits such as Medicaid or Supplemental Security Income. For these beneficiaries, care should be taken to make sure that distributions from the trust do not result in a reduction or elimination of these public benefits. In most instances, distributions for the beneficiary’s “special needs” are okay.

What are special needs? These may be defined with some specificity in the trust document itself or, for instance, would include:

  • Out-of-pocket medical and dental expenses
  • Eyeglasses
  • Annual independent check-ups
  • Transportation (including vehicle purchase) and maintenance of vehicles
  • Insurance (including payment of premiums)
  • Rehabilitation
  • Essential dietary needs
  • Materials for a hobby or recreation activity, computer, or electronic equipment
  • Trips or vacations
  • Entertainment like going to a movie, a ballgame, concert, etc.
  • Goods and services that add pleasure and quality to life: videos, furniture, television, stereo, or entertainment center
  • Personal care attendant, escort, or nursing home resident advocate

The trustee should never give cash directly to the beneficiary.

Occasionally, the trustee will be requested by the beneficiary or their representative for permission to use trust funds to make gifts on behalf of the beneficiary. These gifts are not special needs solely for the benefit of the beneficiary, and such requests should be refused.

Developing a Care Plan for the Beneficiary

When you set up a trust for the benefit of a person who is disabled or has special needs, the trustee should initiate an investigation into the nature of the beneficiary’s disability. This should include a review of an existing care plan, if available, and perhaps the development of an individualized care plan. The care plan will be used by the trustee as a guide when making distributions to or on behalf of the beneficiary.

The trustee should consider hiring a geriatric care manager to assist the trustee in ensuring that distributions will meet the beneficiary’s goals and objectives, that such distributions are made solely for the benefit of the beneficiary, and that such distributions are made for special needs only (that is, distributions that will not disqualify the beneficiary from any public benefits program that the beneficiary is receiving benefits from such as Medicaid). Care manager involvement also can help identify needs that are not currently identified or that have arisen because of changes in the beneficiary’s circumstances.

Are you ready to set up a trust? Contact Rothkoff Law Group to learn how our team can assist you in these five key steps.