Amy Lane, Solicitor at Thomson Snell & Passmore joins us again to answer another Will related question.
Duncan Orr, Director and Chartered Wealth Manager at Swindells, said, “Amy, last time we talked about asset protection, particularly when there are spendthrift children. This time it’s about clients who have been told that setting up a trust can have multiple benefits during their lifetimes and not simply Inheritance Tax (IHT) benefits, what are these other benefits?
It is probably best to start with what a trust is – it is a framework to hold assets which are held by a body of people called trustees. There are a number of different type of trusts including:-
- Bare trusts – this is where legal control of an asset vests in trustees but for beneficial purposes, the underlying beneficiary is treated as owning the asset. This can often be used for instance for parents or grandchildren wanting to hold assets or property for the benefit of minors.
- Discretionary trusts – these can be set up in lifetime or on death (as per our previous article). They are called discretionary because no beneficiary has a fixed entitlement and the trustees have complete discretion to decide what, if any, benefits should be given to each of the beneficiaries. The trustees are given powers of appointment which enable them to pay capital and income to one or more beneficiaries or to create new trusts for the beneficiaries.
- Life interest trusts – again, these can be set up in lifetime or on death in a Will. Life interest trusts are so called because they give a particular beneficiary the legal right to receive the income from, or to use property comprised in, the trust. This right normally lasts throughout the beneficiary’s lifetime. Sometimes the right terminates on, for example, the beneficiary’s remarriage or on the death of some other person, but this information sheet deals only with life interests which continue until the beneficiary’s death.
There are other types of trusts including death benefit trusts, personal injury trusts and pension trusts, which I can answer questions about separately.
Duncan asks, taking a Bare Trust first, what are the benefits of setting up a Bare Trust?
Bare Trusts are the simplest form of trusts and are a halfway house between outright ownership and a full trust.
They can be a useful conduit for lifetime gifts for minors, and any transfer to a Bare Trust requires the transferor to survive 7 years failing which the value of the gift to the Bare Trust is brought into play for the purposes of Inheritance Tax on their death.
Bare Trusts do not require registration with HMRC, like Discretionary Trusts (see below). They are often used to build a nest egg for children, particularly for their school/university fees without the complication of a Discretionary Trust. Once the beneficiary turns 18, they can demand the asset be transferred to them, but if they do not do so, the Bare Trust continues.
For Income Tax and Capital Gains Tax (CGT), as the beneficiary is treated as owning the underlying asset, they can be useful as their full personal allowances can be used (rather than the reduced rates that apply to Discretionary Trusts – see below), although there is one exception to this when a parent puts assets into a Bare Trust for the benefit of their minor children.
Duncan asks, what would you suggest to a client who does not want the beneficiary to inherit the asset outright at 18?
This often comes up in practice, particularly when young minors are involved and it is too early to say how they are going to develop and be able to manage money as they get older.
In this instance, a Discretionary Trust is useful because of the flexibility that it offers insofar as distributions are at the discretion of the trustees. The trustees are often guided by a Letter of Wishes, which is a separate and standalone document, which your clients would set out how they envisage the trustees act (although they cannot bind / force them to act in a certain way).
Discretionary Trusts are subject to their own tax regime. Below is an outline but is not an exhaustive summary:-
- IHT – The creation of a Discretionary Trust is treated as a gift by the Settlor and constitutes an immediately chargeable transfer. If the value of the gift exceeds the current IHT threshold of £325,000 (after deducting exemptions and reliefs), IHT is charged on the excess at 20%. If the Settlor dies within 7 years, additional IHT may be payable. Any chargeable transfers in the preceding 7 years will reduce the available threshold. The value of the property when settled will continue to form part of the Settlor’s cumulative total of chargeable lifetime gifts for the full 7 years.
The trustees will be liable to IHT on the value of the trust fund every 10 years. There is also an exit charge when distributions of capital are made. On each 10-year anniversary of the creation of the trust, and when capital distributions are made, the maximum rate of IHT on each occasion is currently 6%.
- CGT – The trustees will be liable to CGT currently at 20% (28% on residential property) in respect of any gains exceeding the trustees’ available annual exemption, presently being a maximum of one-half of the individual’s annual CGT exemption.
It should be possible to avoid any liability to CGT either on the creation or on the termination of a Discretionary Trust. The liability may be deferred irrespective of the nature of the assets by an election for hold-over relief.
- Income Tax – Like you and I, trusts are subject to their own income tax regime too. Trustees generally have to pay Income Tax at 45%. This will be the rate on income which is accumulated within the trust. However, a beneficiary who receives a distribution of income is given a credit for the 45% tax paid by the trustees. If the beneficiary is a non-taxpayer or a taxpayer at the basic or higher rate, they may reclaim the surplus tax previously paid. If the beneficiary is taxable at the top 45% rate, they will have no further tax to pay.
It should also be noted that a Discretionary Trust needs to be properly administered. This usually involves the trustees registering the Discretionary Trust with HMRC’s online Trust Registration Service, filing annual Tax Returns and issuing appropriate tax deduction certificates to beneficiaries who have received income. The trustees should also maintain trust accounts and properly manage the trust’s property or investments. The amount of administrative work will depend on the nature of the trust assets and on the frequency or otherwise of distributions of income and capital.
Duncan says, it seems as though Discretionary Trusts are complicated, should that put people off using them?
Trusts are complicated because of their nature but that should not deter clients from considering them as part of their estate planning, particularly when they have concerns about a beneficiary.
They can often be very beneficial in the long term for succession planning. You and I have both seen in practice where a trust which is discretionary in nature, particularly where a beneficiary struggles with managing money or assets. What I would say is that the key is taking proper advice, both on the legal side, as well as the accounting side and the financial side about the management of the underlying asset(s).
It is worth pointing out that Discretionary Trusts have other key features such as:-
- The assets do not aggregate with the beneficiaries’ own assets so it would not worsen their personal IHT position;
- Because the beneficiaries do not own the underlying assets, the Trust provides protection from redirection through a conscious decision or otherwise.This could include;
II. Financial difficulty
III. Protecting any State benefits to which the beneficiary may be entitled, which would otherwise be prejudiced and protecting eligibility for State Care funding (for the elderly or other beneficiaries who might qualify);
- The flexibility means the trust assets can be used to benefit someone without an outright appointment to them, such as a loan.
Duncan says, in what circumstances would a Life Interest Trust be a better option than a Discretionary Trust?
They give a particular beneficiary (known as the Life Tenant) the legal right to receive the income from trust assets and to use property comprised in, the trust. This right normally lasts throughout the beneficiary’s lifetime.
If the client has concerns about trustees giving effect to their wishes, this can often by a useful mechanism as it gives the person in question a fixed entitlement. The trust specifies what happens on the Life Tenant’s death (or in other circumstances) so it gives an element of certainty for the client.
The trustees still have the responsibility of safeguarding the assets for the Life Tenant and reversionary beneficiaries.
Life Interest Trusts still have broadly speaking the same tax consequences as a Discretionary Trust.
Duncan says, can you give me an example of when this has worked in practice?
The example in last month’s article is a good one, but another example is a client who had two daughters, one of which had learning difficulties and lived with her.
In her Will, she set up a Discretionary Trust with an accompanying Letter of Wishes specifying the daughter living with her should be allowed to live in the property for a period of time after her death to give her time to adjust, after which the trust should buy her a smaller property to live in, which the trustees did.
The other daughter’s share of the trust was appointed out of the trust for her to use as she wished. Once the trust had been reorganised a few years later, the income was mandated to the daughter with learning difficulties to provide her an income with which to maintain her new home (which also simplified the administration of the trust) whilst protecting the underlying capital.
Should you have a question regarding your Will or other financial matters then please get in touch.