Why Make a Trust?

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Trusts have been used by families for centuries – Dick Whittington (of pantomime fame) used a trust to create a charity for the elderly which still exists to this day. Still on pantomimes, the ‘Babes in the Wood’ really lived and were left their father’s estate in trust until they reached 21.

A trust is the formal transfer of assets (it might be property, shares or just cash) to a small group of people (usually two or three) or to a trust company with instructions that they hold the assets for the benefit of others. If the trust is to be made in your lifetime, to take immediate effect, then it is usually evidenced by a trust deed. ‘Trust’ and ‘Settlement’ have broadly the same meaning. If it is to be created on or shortly after your death then the trust provisions must be set out in your Will – a ‘Will Trust’. Whether by lifetime settlement or by Will, the trust document states who are responsible for looking after the gifted assets (the trustees), who are to benefit (the beneficiaries) and any rules or conditions that the trustees and beneficiaries must adhere to. Additionally it must specify clearly the initial trust property sometimes called the Trust Fund. The separation of the legal ownership and beneficial ownership is the unique characteristic of the trust concept; trustees are the legal owners but the beneficial owners are the beneficiaries, and the trustees owe duties to the beneficiaries; in particular a duty of loyalty and a duty to put the beneficiaries’ interests first, above their own.

How long a trust should last is entirely as you think is appropriate, but you must stipulate the trust period in the trust document. It might be for just a few years, perhaps during a person’s widowhood or until a child attains a certain age or marries. However, trusts can last for much longer – up to 80 years – or forever if it is a charity (ask Dick Whittington!). It is usually advisable to give the trustees the power to terminate the trust at their discretion.

If you are creating the settlement in your lifetime then you can appoint yourself and your spouse as trustees, if you wish, so that you retain some control over the assets and the decision making power though you must exercise this for the benefit of the beneficiaries.

Why make a trust?

Throughout their history, trusts have been used to avoid or address problems in two main areas: taxation and domestic matters.

Domestic matters

Trusts have been created in this country for almost 1,000 years for the same family reasons then as now; you can find a few common problems and solutions at the top of these pages.

Taxation

In your lifetime you can create a trust into which you can place chosen assets that you no longer need yourself. This reduces your own wealth and thus your exposure to inheritance tax.

By creating a Discretionary Trust in your Will for the benefit of your spouse and children, you can take advantage of the nil rate band of inheritance tax and save literally thousands of pounds of tax – see our companion leaflet ‘Why Make a Will?’

The Finance Act 2006 made radical and far reaching changes to the taxation of trusts. There had been a settled pattern of taxation of trusts – each type of trust had its own tax regime. However, the Finance Act 2006 changed this settled pattern and now the position is much more complex and much more dangerous because of the new rules. Some people say that the Finance Act 2006 spells the death knell of trusts. Others say trusts will always exist in one form or another – it is simply that we are so overwhelmed by the dramatic changes that we are lost in the wood and cannot yet find the path to lead us out of it. These people say that a path will appear in due course if we look hard enough. Only those with a crystal clear ball know what the position will be in five, ten or 15 years’ time.

A Charitable Trust created in your lifetime or in your Will can receive unlimited assets, all of which can be free of all forms of taxation.

A pattern is now emerging whereby trusts are still being created, but often they are of a lower amount (e.g. within a nil rate band so no IHT is payable when it is established) yet conversely more frequently – e.g. every seven years to take continuous advantage of the nil rate band.

Trust Types

Most trusts fall into one or two main categories depending on how the income or benefit (dividends, interest, rents, free use of property etc) is dealt with:

Interest-in-Possession Trusts

Those where the income or benefit must be given to the specific beneficiary – it is his or hers by right.

Discretionary Type Trusts

There are several types but the common feature is that the benefits are allocated at the trustees’ discretion to any one or more of several beneficiaries. The trustees might even decide, for a time, to benefit no one; the income being accumulated for future use.

Let us consider these in more detail:

Interest-in-Possession Trusts

The Interest-in-Possession Trust (sometimes called a ‘Fixed-interest’ or a ‘Life-interest’ Trust or in Scotland a ‘Liferent’) is often used in a Will when a person dies leaving a surviving spouse e.g. ‘income to my wife for her life and after her death capital to my children’.

The widow can enjoy the income from the assets placed in the trust (shares, cash, etc. or the use of the family home), but is prevented from dissipating the trust capital. This can ensure that the children receive their inheritance. The same sort of trust can be created in the Wills of people marrying for the second time, each having children by their first marriage. It ensures that the children of the first marriage do not see their parents’ wealth passing to the children of the surviving step-parent.

You might leave your estate to your spouse, in part as an absolute legacy and the remainder in trust for life. You can give the trustees wide powers to use their discretion over the capital to help in case of need, including the power to make capital advances or interest-free loans to, say, your widow.

You may want to give shares of the family company to your children or grandchildren but fear that they might sell or gift them outside the family. To avoid this, the shares can be held in trust for, say, ‘my children equally for their respective lives and thereafter for my grandchildren who survive’. By this means, the children and grandchildren benefit from the shareholding but cannot control the voting power of the shares nor dispose of them – only the trustees can do that.

Discretionary Trusts
There are now only two main kinds of Discretionary Trust, both of which give the trustees power to make gifts of capital and/or income to a stated class of potential beneficiaries. These are:

• A General Discretionary Trust
• A Charitable Trust

The Discretionary Trust

A General Discretionary Trust may suit you if you have identified a particular group of people you want to benefit but you are unsure which of them, in the future, will need help or in what proportions. For example, as a grandparent you might like to set aside capital for your grandchildren – including those who may be born later, even after your death. Some of them might be more in need than others and family and financial circumstances could change from year to year.

Alternatively, you might wish to benefit your children but are aware that some of them are already wealthy and may not wish to be made wealthier by your intended gift. A Discretionary Trust in favour of all your children and grandchildren would allow your children the choice of taking the benefit themselves or passing it on to their own children according to their particular circumstances.

Being a beneficiary of a Discretionary Trust gives no entitlement to receive anything from the trust. Who receives capital advances or the income arising is entirely at the trustees’ discretion – no one has an ‘Interest in Possession’ as described in the other type of trust.

With regards to tax efficiency, you, as settlor, and your spouse must be excluded from all benefit otherwise the capital will still be regarded as yours for most tax purposes as if you had never created the trust. However, this rule does not apply if the Discretionary Trust is created in your Will – as you will of course be dead by the time the trust comes into force!

The most favourable characteristic of the Discretionary Trust is its flexibility. An English Discretionary Trust can last for up to 80 years and income can be accumulated for 21 years or more. Even the beneficial class can be enlarged by giving the trustees the power to introduce new beneficiaries as the need arises.

You might wish to make a lifetime settlement for the benefit of just your children and grandchildren but be worried that, if you died, your widow(er) might be in further need of capital or income; the trust funds would not then be available to help. To quell your fear you could include as a beneficiary ‘my widow(er)’ so that when (and only when) you die, your spouse joins the beneficial class and the capital and income becomes available for his/her use if required.

Your elderly parent or other dependant could be helped with this type of trust. On the subsequent death of that person, the trust would continue for the benefit of other class members.

The Discretionary Will Trust

Just as a Discretionary Trust can be created to commence in your lifetime, it can also be a feature of your Will, becoming effective only on your death. It is often used in the Will of the first of a couple to die to ensure that best use is made of the nil rate band. Alternatively you might prefer that your executors decide how your estate is to be dealt with in the light of the tax and domestic circumstances existing at the time – a Discretionary Will Trust could achieve that.

The Finance Act 2008 has made amendments as to how the nil rate band can pass between spouses and civil partners. You need to take advice on this point and whether your current Will remains appropriate to your wishes and requirements.

Effects of the Finance Act 2006

Such a complex piece of legislation cannot be described fully here and you must take detailed advice. A summary of the main changes made by this Act are as follows:

1. Accumulation and maintenance settlements are now treated for tax purposes as discretionary settlements from 6 April 2008. In practical terms this has meant the demise of the accumulation and maintenance settlement. If you want to make provision for grandchildren, a discretionary trust is in many ways just as good as the old accumulation and maintenance trust because both will be taxed in the same way and with a discretionary trust you have more flexibility – hence its name.

2. New lifetime trusts, of whatever kind, except Charitable Trusts and certain trusts for disabled beneficiaries, are all to be taxed as if they were Discretionary Trust. This means that there is a limit on the amount that can be put into the trust initially without giving rise to an immediate charge to inheritance tax, i.e. the nil rate band, and the system of taxation for discretionary trusts will apply while the trust is in existence. Thus every ten years there will be a charge to tax on the value of the trust fund. At present the rate of tax is no more than 6 per cent. If capital is taken out of the trust within a ten year period then a proportionate amount of tax is charged.

3. Interest-in Possession trusts in Wills that take effect immediately on your death still escape the Discretionary Trusts regime and lead to a charge of up to 40 per cent on the death of the beneficiary who is entitled to the income.

4. By his Will, a parent (but not a grandparent) can create what is known as an 18-25 trust, which means that the trust will be outside the Discretionary Trust tax regime but there will be an extra charge to inheritance tax for each year over the age of 18 before the child inherits. The rate is 0.6 per cent per annum so that if you delay the child receiving capital to the very end of the permitted period, that is when the child attains 25, the rate of tax payable will be 4.2 per cent at that time – that 4.2 per cent rate of tax will be additional to the tax payable on your death which may well have been at 40 per cent.

5. The advantages of the so called flexible trust, whether a life interest trust or an accumulation and maintenance trust, are largely now historic.

6. There are various complicated but valuable transitional provisions upon which you will need to seek advice. These expire on 5 October 2008.

7. All trustees of trusts in existence at 22 March 2006 should seek advice before 5 October 2008 as to whether the Finance Act 2006 has altered the taxation of their trust, and if so, in what way.

The Charitable Trust

You may be inclined, or are expected, to make regular donations to charity or you may have a particular interest in some worthy cause. Rather than make regular payments out of income or a legacy to a national charity over which you have no control, you could create your own family charity either in your lifetime or on your death by creating a Charitable Trust in your Will.

Gifts to such a trust are free of capital gains tax and inheritance tax. The income arising will not generally be assessed to tax. Of course the trust can only be used for charitable objects i.e. the relief of poverty, the advancement of religion, education or the public good. Charitable Trusts can last forever – a truly lasting memorial.

Matching a Trust to Your Needs

It has been said that for every family problem or situation, there is a trust that can be constructed to suit the need. Creating the right type of trust to match your particular situation requires specialist help.

Whether creating the trust by Will, or in your lifetime, selecting the trust type and its terms are very important. In this brief summary we have mentioned only the main types of trust; there are many variations – the protective trust which automatically terminates the interest of a profligate beneficiary who attempts to dispose of his interest, the (once popular) marriage settlement and the ‘bare’ trust which makes the beneficiary the actual owner, to name a few. These and the other trust types have differing tax effects which must also be considered and specialist advice sought. For maximum flexibility it is usual to give the trustees wide management powers so that they are better able to respond to any changes in family matters or taxation – not least changes in Government. With such wide trustee powers be sure to choose your trustees carefully.

Remember, the trustee of the Babes in the Wood was their wicked uncle!

A trust which might last for 80 years or even 800 years needs careful planning, but the benefits can last just as long if you take specialist advice beforehand.

FAQs

Can a settlor be a trustee?
Yes

Can a trustee be a beneficiary?
Yes

Can I be a sole trustee?
Technically yes (unless the trust holds land) but it is not preferred.

How many trustees should there be?
Two or three are preferred. Four is usually the maximum.

Must I appoint a professional trustee?
No, but be extra careful to whom you give the power and responsibility of trusteeship.

Can a trust protect assets from divorce or bankruptcy proceedings?
The courts have wide powers so protection is only available up to a point. Much depends on the terms of the trust, the timing, the purpose for which it was created and the way it has been administered.

Can I put assets into a trust but keep the income from (or use of) the assets myself?
The tax consequence of this is usually unacceptable as income would be taxed as yours. On your death the trust assets would be added to your own estate and IHT charged on the total. In certain limited circumstances however it might be appropriate particularly if tax is not an issue.

My chosen executor/trustees for my modest estate are relatives — but laymen. Is this wise?
If they are an adult and sensible this should not cause a problem. They will have the power to hire (and fire) professionals who would (or should) be able to advise them what to do.