Foundations vs. Trusts
“What is the difference between a Foundation and a Trust?”
“Which is better between a Foundation and a Trust?”
These are common questions asked from the thousands of people annually scouring the web, asking friends, contacting lawyers, offshore practitioners, etc. Depending who you speak with, the answers are likely to be nearly as abundant as the number of people asking the questions!
The following is a comparison (albeit grossly oversimplified) between Trusts and Foundations that should offer some kind of relief to the confused reader by providing a basic understanding of the two structures as well as the key differences, advantages and disadvantages of each.
Trusts
The classic definition of a Trust is (from Underhill & Hayton, Law of Trusts and Trustees):
“A Trust is an equitable obligation, binding a person (called a Trustee) to deal with property owned by him (called Trust property, being distinguished from his Private property) for the benefit of persons (called Beneficiaries or, in old cases, cestuis que Trust), of whom he may himself be one, and any one of whom may enforce the obligation.”
A further definition of Trusts, which is more in the form of a description, is that in the Hague Convention on the Law Applicable to Trusts and on their Recognition:
“For the purposes of this Convention, the term ‘Trust’ refers to the legal relationships created – inter vivos or on death – by a person, the Settlor, when assets have been placed under the control of a Trustee for the benefit of a Beneficiary or for a specified purpose."
At the very basic level, the concept of the Trust is relatively easy: a person (Settlor) places assets in the legal custody of another (Trustee) held for the benefit of some third party (Beneficiary). The Trust is not a separate legal entity, but more of a legal “obligation” agreed between two parties: the Settlor and the Trustee. This sounds simple enough, correct? Trusts are of course much more complicated than this, but this is the basic concept anyway.
There are three minimum certainties for a Trust to be valid:
- Intention: the Settlor must have clearly intended to settle the Trust and confer legal control of assets.
- Assets: the Trust is not operative until assets have been transferred.
- Objects: it must be clear for whom the Trust was created and subsequent assets transferred to the Trust are being held.
These are only the bare minimums for the Trust to be valid. Surprisingly, a good percentage of offshore Trusts being established fail at least one of these critical criteria and then a great deal of money is spent on legal fees trying to defend the validity of the Trust at some later date when the Settlor is sued by a creditor, family member, someone who slipped and fell on their property, etc.
Common validity issues are:
- the Settlor wants to maintain full control of the Trust assets and just gives orders to the Trustee
- assets are never transferred since the Trust was only created as a safety net in case something adverse happens to the Settlor;
- the Settlor wants to be the sole Beneficiary of the Trust, etc.
Failing any of these three can lead to all sorts of potential legal issues for the Settlor. A court could determine that the Trust is a “sham Trust” and order any assets transferred (assuming they ever really were) to be repatriated and part of a settlement.
Private Interest Foundations
So we have established that Trusts are susceptible to validity issues and can lead to legal issues and adverse consequences in situations whereby the Trust is labeled a “sham Trust”. So what about Private Foundations? How many Private Foundations being created could be labeled “sham Foundations”? The answer is “none”. Surprised? How can that be?
The main reason is relatively simple: unlike Trusts, Private Foundations are separate legal entities ...... similar to a corporation. So a Private Foundation is like a corporation? It does have a few common characteristics, but there are also clear distinctions. First and most important is that Foundations typically may not carry on commercial (operating, for profit, etc.) activities. Secondly, the Foundation has no shareholders.
Perhaps it is best to first start by defining the Private Foundation. One of the most comprehensive definitions of a Private Foundation comes from John Goldsworth, founding editor of “Trusts and Trustees” and an internationally renowned expert on Trusts and Private Foundations:
“A Private Foundation is an independent self-governing legal entity, set up and registered or recorded by an official body within the jurisdiction of where it is set up, in order to hold an endowment provided by the Founder and/or others for a particular purpose for the benefit of Beneficiaries and which usually excludes the ability to engage directly in commercial operations, and which exists without shares or other participation.”
Just from this definition, even the casual observer should begin to see some differences between Private Foundations and Trusts. Looking at this carefully:
1st phrase: “A Private Foundation is an independent self-governing legal entity”
We can see that, unlike the Trust, a Private Foundation is a separate, self-governing legal entity. It is not an “obligation” as with a Trust, but a completely separate legal entity.
2nd phrase: “set up and registered or recorded by an official body within the jurisdiction of where it is set up”
Here we see that a Private Foundation is registered or recorded (usually publicly) which is not always an obligation with a Trust.
3rd phrase: “in order to hold an endowment provided by the Founder and/or others”
Assets placed into a Foundation may come from the Founder and/or others. This is different from a Trust whereby the Settlor places assets into the custody of a Trustee to be administered and held on behalf of the Beneficiaries named by the Settlor. Third parties may contribute to an existing Foundation!
4th phrase: “for a particular purpose for the benefit of Beneficiaries”
Ok. So the Private Foundation is somewhat similar to a Trust in this regard.
5th phrase: “and which usually excludes the ability to engage directly in commercial operations”
Trusts may be used for certain commercial purposes which will be explained in more detail later so this is another difference.
6th phrase: “and which exists without shares or other participation”
So unlike corporations, there are no shares or shareholders. Rather there are Beneficiaries”. Unlike the Beneficiaries of a Trust however, the Beneficiaries of a Foundation generally have no legal or beneficial participation in the Foundation until the assets are actually distributed to them from the Foundation. Now for those reading this and running scared, there are plenty of statutory (civil and criminal penalties) and other safeguards (such as the appointment of a Protector, etc.) of a Foundation to ensure that the interests of the Beneficiaries are protected.
So which is better?
Trusts have their uses and are very good for many purposes:
Probably the biggest advantage of a Trust lies in the fact that it can be used for business purposes whereas most Foundation jurisdictions limit the use of a Foundation to non-commercial uses. Trusts may be used to purchase property, accrue capital in mutual funds, sign international contracts in order to facilitate exchanges and avoid taxes. In this regard, unit Trusts are particularly popular in the real estate and financial fields whereby investors purchase “units” in real estate investment trusts “REITS” and mutual funds or hedge funds.
For the majority of individuals researching this topic however, a strong case can be made that a Private Foundation is “better” than the Trust for most common purposes. Let us examine some of the advantages:
1. A Foundation is a separate legal entity unlike a Trust.
2. Assets placed into a Foundation become the property of the Foundation itself both legally and beneficially and are separate from the Founder and any Beneficiaries whereas with Trusts ownership is less clear and is split between the Trustee and the Beneficiaries.
3. Reassurance to the client that the Foundation is an incorporated body with clear statutory laws and regulations governing it in the jurisdiction.
4. No question about the “validity” of a Foundation.
5. Foundations are clearly governed by the law in the jurisdiction where established. Trusts are somewhat similar, however questions about where they are “managed and controlled” and hence what law should apply are not always so apparent.
6. One can place assets into a Foundation and then transfer “ownership” of the Foundation in a number of ways to indirectly transfer the underlying assets of the Foundation. This is not possible with a Trust.
7. For succession planning, a Trust that is to take affect after the death of the Settlor must conform to the formalities of a will. When a Foundation is created to take effect after the Founder’s death, the formalities need not conform to making a will.
“The Foundation sounds great, but I want something I can use for commercial purposes!”
No problem. This is a common request and one that is easily accommodated by inserting an underlying International Business Company whose shares will be 100% owned by the Foundation. This offers all of the protection and advantages of the Foundation while allowing for a wide range of business uses to be carried out through the underlying IBC.
This is by no means a thorough comparison of the two structures; however it is a good start and should help clarify some of the major points. A further analysis of the specific Trust and/or Foundation laws in each jurisdiction would be necessary to make any further distinctions. Additionally, confusing matters even more, many Trust jurisdictions have enacted specific Trust laws which may contain several of the characteristics of the Private Foundation!
Contact Sterling Offshore with any additional questions and/or to set up your Private Foundation today.