Chapter 11 - Trusts

Trusts have a long history in England and are said to go back to feudal times. The subject is highly complex and it would need a whole book to explain them in any detail. What follows is hugely simplified to cover the most common planning arrangements and you must not do anything involving a trust without professional advice from a solicitor.

In simple terms a trust involves someone giving someone else legal title to something; that person is trusted to hold the asset for beneficiaries.

There are three types of trust which are most relevant to IHT Planning

• the discretionary trust and
• the interest-in-possession trust
• the bare trust 

The difference largely rests on whether any particular person has an ‘interest in possession’. This means they have a specific income from, or the specific enjoyment of the use of, the trust assets.

Before we consider how these fit in with your family, it is worth touching on the basic make-up of a trust. There are three levels of “stakeholder” in a trust:

• The “settlor”, who settles property into a trust. 
• The trustees, who look after the property.
• The beneficiaries, who are entitled to something from the property (income or capital or both).

Discretionary trusts

Under a discretionary trust, anyone could be a beneficiary unless you define a list of people who may benefit. How the beneficiaries actually benefit is at the discretion of the trustees. It is very important that the trustees know your wishes. If you set up a discretionary trust, write down your wishes, a “letter of wishes”, and give it to the trustees. Even knowing your wishes, the trustees are not obliged to follow them.

A discretionary trust is quite powerful as in theory you could give away money, saving IHT, while not really giving the money to anyone.  

Since this is open to abuse, you will be charged a lifetime rate of tax of 20% if you give more than the nil-rate band (£325,000 in 2009/10) to a discretionary trust within a seven-year period. If you die within seven years your estate would pay a further 20%.

There is also a periodic charge, every ten years, of 30% of the 20% lifetime Inheritance Tax rate (i.e. 6%). This is charged on the value of the assets in excess of the nil-rate band. This was explained in Chapter 2.

If money is withdrawn from the trust between the ten year periods,  a pro-rata tax charge will be made. This charge is based on the rate of tax at the last ten year charge. If there was no tax on setting up the trust, there is no tax on any withdrawals in the first ten years.

Interest in possession trusts

A “interest in possession” trust defines someone’s interest in the income from or use of trust assets throughout a period – possibly all of their lifetime. Since the beneficiaries effectively “own” the assets in the sense that they have the benefit of them, they are treated for IHT purposes as if they owned the assets outright.

You can see that if you made the beneficiary a grandchild, the tax would  be paid two generations later (depending on the grandchild’s own circumstances on death and the tax and rates applying at that time). It is much better to let your children or grandchildren enjoy all your money before giving the government 40%, than letting them enjoy 60% of it  – and then pay another 40% when they die.

In March 2006 the tax treatment of the different types of trust were brought into line so for IHT planning purposes there is now little difference between them. 

Bare trusts

A bare trust is an arrangement where assets are simply held in someone else’s name, but where the beneficiary has an immediate and absolute entitlement to the income and capital.

Such trusts are common for minors simply because they cannot legally hold property until they are 18 (sometimes 16 in Scotland). Assets held in a bare trust are not settled property at all for IHT – they form part of the beneficiary’s estate. Consequently gifts into a bare trust are not chargeable lifetime transfers, they are ‘potentially exempt transfers’.

The danger with a bare trust is that the beneficiaries cannot be changed,  the asset is in the beneficiary’s estate for IHT and it is their property in  the event of divorce or bankruptcy.

Now let’s put these trusts into context. For the average family, legal costs are going to make setting up and running trusts impractical. We will look  at trusts again when we consider insurance and investment-based planning In those cases there is normally little or no cost of using the trusts.