Date27 Oct 2023
CategoryPrivate Client Services
When used appropriately, a trust can be an effective means of passing on wealth and protecting assets. Crucially, they allow for assets to be left to future generations often with reduced tax liabilities, so they form an important part of planning for the future.
There are, however, certain conditions that need to be met before the full benefits can be realised. In this insight, we explore what a trust is, how it can be used, and the opportunities from a planning perspective.
A trust is a separation of legal and beneficial ownership. It's typically established by a Deed, but you can create a trust without even knowing that you've done it, to a certain extent. An example of this would be a nominee bank account, opened on behalf of grandchildren; minors will not be able to legally open a bank account, and so a grandparent could open one on their behalf. The grandparent has legally opened the bank account, but the money that's in there beneficially belongs to the grandchildren. That is the most simple type of trust that can be in existence.
The person who creates the trust is known as a ‘settlor’. The settlor transfers assets to the trustees, who then hold and manage the assets. The trustees have a fiduciary responsibility to manage those assets for the beneficiaries in their best interests. The beneficiaries are the individuals who can receive the income and/or the capital from the trust; although that will very much depend on the terms of the trust.
There are a number of reasons as to why an individual may like to create a trust.
On the creation of a trust, a transfer of an asset other than cash is usually a deemed disposal for capital gains tax purposes, causing capital gains tax to be payable, however one of the reasons for using a trust structure is the availability of hold over relief for non-business assets, resulting in the deferral of a capital gains tax charge, and enabling gifts of chargeable assets in lifetime without incurring a charge. There can also potentially be inheritance tax savings, which are explored further below.
Many trusts are created for asset protection; they are often a more practical alternative than an outright gift. In this scenario, trusts are useful where the intended beneficiary is too young or vulnerable.
Another advantage of establishing a trust structure is to guarantee the succession of assets; it may be that you're worried about broken down relationships with partners or spouses; a trust can provide an element of legal protection and ensure guaranteed succession.
In this case, it might be particularly relevant where there's a re-marriage. As an example, you may have children from a first marriage, you then re-marry, and you want your second spouse to continue to benefit from your assets during their lifetime, i.e., to live in the family home and to have an income from your investment portfolio. However, ultimately, you want to protect the capital assets for your children. A trust deed can provide this protection of assets; it can enable the spouse to enjoy the assets during lifetime, and then pass the assets directly to the children on their death. Effectively, this arrangement prevents the second spouse from disposing of the trust property to a non-family member (which would have been a possibility if the original transfer had been an outright gift).
Generally, most lifetime trusts created post March 2006 are known as “relevant property trusts”, which are subject to their own inheritance tax regime. That regime dictates that the trust will be charged to a maximum of 6% inheritance tax every 10 years, however, that full 6% being levied is very rarely seen.
The rationale for this tax charge is that over a generation, 6% every 10 years probably adds up to around 40% in a lifetime. The relevance of this rationale is that 40% inheritance tax is applied to anything over £325,000 for a deceased individual’s estate subject to some exemptions. Therefore, the inheritance tax charge of using a trust is significantly lower.
An individual can gift up to the nil rate band (currently £325,000) into a lifetime trust every seven years without incurring any immediate inheritance tax charge. Therefore, at present, £325,000 can be put into trust without any inheritance tax charge, additionally, a spouse can also put in £325,000, meaning that contributions of up to £650,000 could be made without suffering an inheritance tax charge.
However, that gift does go onto the seven-year inheritance tax clock, meaning the individual needs to survive the gift by seven years. If transfers in excess of the nil rate band were made, there would be a 20% lifetime inheritance tax charge.
There is flexibility available with Will planning using trusts. When a Will is prepared, it is based on the facts at that point in time. For example, the individual drawing up the Will may have one child who is struggling financially, and their other child might have a successful career and not need any money.
With a discretionary Will trust, power is given to the trustees to apply the assets held by the trust as they see fit; dependent on the circumstances of the beneficiaries and tax legislation post-death. This provides maximum flexibility to allow any changes between the date of the Will being drawn up and the date of death to be factored in.
The person who has died needs to leave a clear letter of wishes that sits alongside the Will and the trust, to provide guidance to the trustees on how they would anticipate the funds to be used. The letter of wishes is not binding, so the trustees can ignore it if they wish, but it provides guidance.
As the trustees have the power to ignore the letter of wishes, they need to be trusted representatives who understand what they're doing, the family and the tax position.
Any distributions made out of the Will trust within two years of death read back to the Will, meaning from an inheritance tax perspective, it's as if the payment was made directly by the person who has died. As such, tax reliefs that are available can be realised.