Setting Up a Common Law Trust

Setting Up a Common Law Trust

Quick answer

• Common law trusts are not recognized by the IRS for tax purposes and are generally not a valid estate planning tool for most individuals.
• Attempts to use them to avoid taxes or legal obligations can lead to severe penalties, including fines and imprisonment.
• For legitimate estate planning, consider wills, living trusts, or other established legal structures.
• Consult with an experienced estate planning attorney to understand your options and ensure compliance with U.S. law.
• Focus on proven methods for asset protection and estate planning that align with IRS regulations.

Who this is for

• Individuals exploring alternative or unconventional methods for managing assets and avoiding taxes.
• Those seeking to understand the legal standing and implications of common law trusts in the United States.
• People who want to ensure their estate planning strategies are legally sound and recognized by authorities.

What to check first (before you act)

• Goal and timeline: What are you trying to achieve by setting up a trust, and when do you need these goals to be met? Understanding your objectives, whether it’s asset protection, probate avoidance, or tax minimization, is crucial. Your timeline will dictate the urgency and type of solution required.

• Current cash flow: How do your income and expenses currently balance? A clear picture of your financial inflows and outflows is essential for any financial planning, including trusts. This helps determine affordability and the feasibility of maintaining any structure you put in place.

• Emergency fund or safety buffer: Do you have readily accessible funds to cover unexpected expenses? A robust emergency fund is a cornerstone of financial security. Before considering complex legal structures, ensure you have this basic safety net in place. Check the official source or your provider for guidance on recommended amounts.

• Debt and interest rates: What debts do you currently have, and what are their interest rates? High-interest debt can significantly impact your financial health and the effectiveness of any asset management strategy. Prioritizing debt repayment, especially for high-cost loans, is often a more impactful first step.

• Credit impact: How might a new financial arrangement affect your credit score? While trusts themselves don’t directly impact credit, the underlying transactions or the way assets are managed could. Understand the potential implications for your creditworthiness.

Step-by-step (simple workflow)

1. Define your genuine estate planning goals:

• What to do: Clearly articulate what you want to achieve with your assets, such as passing them to heirs, protecting them from creditors, or minimizing estate taxes.
• What “good” looks like: Specific, measurable, achievable, relevant, and time-bound (SMART) goals that align with established legal principles.
• Common mistake: Relying on vague or unrealistic objectives like “avoiding all taxes” without understanding legal limitations.
• How to avoid it: Research legitimate estate planning tools and discuss your goals with a qualified professional.

2. Research legitimate estate planning vehicles:

• What to do: Investigate options like wills, revocable living trusts, irrevocable trusts, powers of attorney, and guardianships.
• What “good” looks like: A solid understanding of how each vehicle functions, its benefits, drawbacks, and legal standing in the U.S.
• Common mistake: Believing that common law trusts are a universally accepted or effective alternative to these established methods.
• How to avoid it: Focus on resources from reputable legal and financial organizations.

3. Consult with a qualified estate planning attorney:

• What to do: Seek advice from an attorney specializing in estate planning in your jurisdiction.
• What “good” looks like: Receiving personalized guidance based on your specific situation and goals, with clear explanations of legal options.
• Common mistake: Hiring an attorney who is not experienced in estate planning or who promotes unconventional strategies.
• How to avoid it: Vet potential attorneys, check their credentials, and ask about their experience with common estate planning scenarios.

4. Understand the IRS stance on trusts:

• What to do: Learn how the Internal Revenue Service (IRS) views different types of trusts.
• What “good” looks like: Comprehending that the IRS recognizes standard trusts for tax purposes but does not acknowledge “common law trusts” as legitimate entities for tax avoidance or evasion.
• Common mistake: Assuming that simply creating a document labeled a “common law trust” will exempt you from tax obligations.
• How to avoid it: Review IRS publications or consult with a tax professional about how trusts are treated for tax purposes.

5. Assess your current financial situation:

• What to do: Review your assets, liabilities, income, and expenses.
• What “good” looks like: A comprehensive financial snapshot that informs the feasibility and appropriateness of any estate planning strategy.
• Common mistake: Underestimating the complexity of your finances or overestimating your ability to manage a complex legal structure.
• How to avoid it: Use budgeting tools and financial statements to get an accurate picture.

6. Evaluate your need for asset protection:

• What to do: Determine if you need to shield assets from potential creditors, lawsuits, or other liabilities.
• What “good” looks like: Identifying specific risks and understanding which legal structures offer appropriate protection, if any.
• Common mistake: Believing that a common law trust provides robust asset protection without legal backing.
• How to avoid it: Discuss your specific asset protection concerns with your attorney.

7. Choose the appropriate legal structure:

• What to do: Based on your goals and attorney’s advice, select a legally recognized estate planning tool.
• What “good” looks like: A formal legal document (e.g., a will, a living trust agreement) that is properly drafted and executed according to state law.
• Common mistake: Opting for a self-created “common law trust” document instead of a recognized legal instrument.
• How to avoid it: Follow your attorney’s recommendations precisely.

8. Fund and manage the chosen structure:

• What to do: Transfer assets into the trust or ensure your will is properly executed and updated.
• What “good” looks like: Assets are correctly titled and managed according to the terms of the legal document.
• Common mistake: Failing to properly transfer assets into a trust, making it ineffective.
• How to avoid it: Work with your attorney and financial institutions to ensure all asset titling is accurate.

Common mistakes (and what happens if you ignore them)

Mistake	What it causes	Fix
Attempting to use a common law trust for tax evasion	Significant IRS penalties, including fines, interest, and potential criminal prosecution.	Consult a tax professional and an estate planning attorney to understand legal and ethical tax strategies.
Misunderstanding the IRS’s recognition of trusts	Your “trust” will be disregarded for tax purposes, leading to back taxes, penalties, and interest.	Educate yourself on IRS-approved trust structures and their reporting requirements.
Failing to consult legal professionals	Creating invalid documents, overlooking legal requirements, and exposing yourself to significant legal risks.	Engage with an experienced estate planning attorney to draft and execute all necessary legal documents.
Not properly funding a trust	The trust will not control the assets you intended, defeating its purpose.	Ensure all assets are legally transferred and titled in the name of the trust according to your attorney’s instructions.
Using a common law trust for debt avoidance	Creditors may still be able to access assets, and such attempts can be seen as fraudulent.	Understand the limits of asset protection and focus on legitimate, legal methods advised by counsel.
Ignoring state-specific trust laws	Your trust may be invalid or not function as intended in your state.	Work with an attorney licensed in your state who is knowledgeable about its specific trust and estate laws.
Relying on online templates without review	Generic templates may not fit your specific needs or comply with legal requirements.	Always have legal documents reviewed and customized by a qualified attorney.
Expecting a common law trust to bypass probate	Without legal recognition, assets may still go through probate, causing delays and costs.	Utilize legally recognized tools like living trusts or wills to manage probate avoidance effectively.
Creating a trust for frivolous purposes	Such actions can be seen as an abuse of the legal system and may result in sanctions.	Ensure your intentions are legitimate and align with established legal estate planning practices.
Failing to update estate plans	Your assets may not be distributed according to your current wishes, especially after life events.	Schedule regular reviews of your estate plan with your attorney (e.g., every 3-5 years or after major life changes).

Decision rules (simple if/then)

• If your primary goal is to avoid taxes by claiming a common law trust exempts you from IRS regulations, then do not proceed with a common law trust because the IRS does not recognize them for this purpose and it can lead to severe penalties.
• If you are seeking to legally pass assets to heirs and avoid probate, then consider establishing a revocable living trust because it is a well-established legal tool for these objectives.
• If you need to protect assets from potential future creditors or lawsuits, then consult with an attorney about irrevocable trusts or other asset protection strategies because common law trusts offer no legally recognized protection.
• If you are creating a trust to manage assets for minor children, then establish a formal trust through a legal process because common law trusts lack legal standing to enforce such arrangements.
• If you have significant assets and wish to minimize estate taxes upon death, then work with an estate planning attorney to explore advanced trust strategies because common law trusts are not recognized by the IRS for tax planning.
• If you are attempting to use a common law trust to discharge debts or avoid financial obligations, then cease this action immediately because it is likely to be deemed fraudulent and ineffective, leading to legal repercussions.
• If you are unsure about the legality or effectiveness of any trust structure, then seek advice from a qualified estate planning attorney because their expertise is essential for navigating complex legal requirements.
• If you are considering a common law trust based on information from unverified online sources or forums, then disregard that information and consult official legal and financial resources because such sources often provide misinformation.
• If you are under audit by the IRS and have attempted to use a common law trust, then immediately consult with a tax attorney because you will need expert legal defense against potential penalties.
• If your intention is to simply organize your personal property and affairs, then a will or a simple personal property memorandum might be more appropriate and legally sound than a trust.
• If you are looking for a way to manage your healthcare directives or financial affairs in case of incapacity, then consider setting up powers of attorney and advance healthcare directives because these are the legally recognized instruments for such situations.

FAQ

What is a common law trust?

A common law trust is a type of entity that some individuals attempt to create outside of statutory law, often claiming it offers tax advantages or asset protection. These are typically not recognized by government agencies like the IRS.

Are common law trusts legal in the U.S.?

Common law trusts are generally not recognized as legitimate legal entities by U.S. courts or tax authorities for purposes such as tax evasion or bypassing legal obligations. Their validity is highly questionable.

Can I use a common law trust to avoid paying taxes?

No, attempting to use a common law trust to avoid taxes is not legally permissible. The IRS will likely disregard such trusts and impose penalties for non-compliance.

What are the risks of setting up a common law trust?

The risks include severe IRS penalties, fines, legal challenges, the invalidity of the trust for its intended purposes, and potential criminal prosecution for tax fraud.

What are legitimate alternatives to common law trusts for estate planning?

Legitimate alternatives include wills, revocable living trusts, irrevocable trusts, and other structures established and recognized under state and federal law.

How does the IRS treat common law trusts?

The IRS generally does not recognize common law trusts as valid entities for tax purposes. They are often seen as attempts to evade tax obligations.

Can a common law trust protect my assets from creditors?

Generally, no. Common law trusts do not offer legally recognized asset protection, and attempts to use them for this purpose can be viewed as fraudulent.

Where can I find reliable information about trusts?

Reliable information can be found through official IRS publications, state bar associations, reputable legal organizations, and by consulting with qualified estate planning attorneys.

What this page does NOT cover (and where to go next)

• Specific legal advice for your situation: This page provides general information. For personalized guidance, consult with an estate planning attorney.
• Detailed tax implications of various trust types: While common law trusts are addressed, the nuances of tax-advantaged trusts require consultation with a tax professional.
• How to draft specific legal documents: This guide outlines the process; an attorney will handle the actual drafting of wills, trusts, or other legal instruments.
• Investment strategies within trusts: This page focuses on the legal setup of trusts, not on how to invest the assets held within them.
• International estate planning: The focus here is on U.S. legal and tax frameworks. International considerations require specialized advice.