Key takeaways
- Understand what a trust is and their most common uses
- Describe setting up a trust and the tax treatment of trusts
Trusts have been used for centuries, but today, Financial Planners are still making use of trusts to achieve a range of positive financial outcomes for their clients. Trusts can be extremely useful financial planning tools for families, particularly where large sums of money or different assets are involved. Trusts can be created at any time or written into a person’s will.
Trusts are also commonly used where relationships between family members are complex, after divorce and remarriage, when children and stepchildren are involved, or when certain controls need to be in place as to when family members can receive the assets.
This course aims to summarise the use of trusts, the different types of trusts, and their tax treatment.
What is a trust?
A trust is a legal arrangement created to manage assets. When a trust has been created, the assets placed into trust are managed or controlled by a third party for the benefit of another person, or for a specified purpose. It effectively separates the control of the assets from the right to the assets.
The most common uses of a trust
Typical reasons for setting up a trust can include:
- To control and protect family wealth and assets
- When a Beneficiary is too young to manage their financial affairs
- When someone is incapacitated and cannot manage their financial affairs
- To pass on assets while the Settlor is still alive
- To pass on assets when the Settlor dies (known as a ‘Will Trust’)
There are three main parties involved with a trust:
The Settlor: The act of putting an asset into trust is also known as ‘making a settlement’. Therefore, the individual or couple who establishes and places assets into the trust is called the Settlor(s). In Scotland, the Settlor is referred to as the ‘Truster’. The Settlor can either declare they hold certain assets on trust for the Beneficiaries, or transfer the legal title of assets to trustees for them to hold on behalf of Beneficiaries.
The Trustee: the person (or persons) appointed to control or oversee the trust. As the legal owners of the trust, their role is to deal with the assets in the trust according to the Settlor’s wishes, as set out in the Trust Deed or Will. They are responsible for managing the trust on a day-to-day basis and must pay any tax due. Trustees will often be required to choose how to invest or use the trust’s assets. Trustees are legally required to always act in good faith, and with honesty and integrity.
Anyone can act as a Trustee, provided they are 18 or older, and have full mental capacity. For large trusts, the role of the Trustee may be given to a professional wealth manager or solicitor. Trusts all require at least one Trustee.
You can read our article on trustee duties and responsibilities for more information.
The Trustee Act 2000 clearly lays out the duties and responsibilities of Trustees.
The Beneficiaries: the person (or persons) who stand to benefit from the trust. There might be more than one Beneficiary, such as an entire family or a defined group of people. Beneficiaries may be entitled to receive money from the trust (for example income from renting out a house held in the trust), or capital from the trust’s assets. Beneficiaries could also be given other benefits, such as the right to occupy a property for the rest of their life.
Some trusts give Trustees the power to determine how and when these benefits are given to the Beneficiaries.
What assets can be placed into a trust?
Different types of assets can be put in trust, including:
- Cash
- Property
- Shares
- Land
Inheritance Tax may be due on these assets depending on the type of trust.
Different types of trust
Trusts created expressly by the Settlor are called ‘Express Trusts’. The two main types of Express Trust are Fixed Trusts (where the Beneficiaries are named) and Discretionary Trusts, where the choice of Beneficiaries can be made by the Trustees (depending on any wishes stated in the Trust Deed).
With a Fixed Trust, the Settlor names the Beneficiaries and determines what income or capital they can receive from the trust. For example, one Beneficiary could be entitled to the income generated by the trust assets, whereas another could be entitled to the capital of the trust assets.
With a Discretionary Trust, the Trustee has the power to decide how the trust’s assets and income are distributed. However, they must operate under a duty of care to act in accordance with the Settlor’s stated wishes.
Express Trusts
For an Express Trust to be recognised as properly constituted, it must consist of a minimum set of requirements, otherwise known as ‘three certainties’ as established in the court case Knight vs Knight (1840) The three certainties are:
- Certainty of Intention: Whether the creator of the trust wanted someone to be under a duty to hold property for the benefit of another person.
- Certainty of Subject Matter: While trusts can be declared over different types of property (subject matter) the subject matter must be clearly defined. In other words, trustees must know exactly what is included in the trust.
- Certainty of Object: Beneficiaries must be clearly defined or there must be a suitable methodology to enable Trustees to identify them.
The most common types of Express Trusts are as follows:
Bare Trusts
A Bare Trust is also known as an Absolute Trust and is the most frequently used example of a fixed trust.
This type of trust is often used when the Beneficiaries of the trust are below the age of 18 and are too young to manage their financial affairs.
Under a Bare Trust, the assets in the Trust are held in the name of the Trustee, but the trust’s Beneficiaries are legally entitled to demand their share of the Trust’s assets when they reach 18 (or 16 in Scotland). Once a Bare Trust has been set up the Beneficiaries cannot be changed or removed.
The initial gift into a Bare Trust arrangement is a potentially exempt transfer (PET) and provided the Settlor survives for at least seven years there is no Inheritance Tax charge.
Learn more about understanding Bare (Absolute) Trust
We cover PETs in more detail in this article.
Interest in Possession Trusts
Under an Interest in Possession Trust, at least one Beneficiary has the right to any income from the trust at any time, but they have no control over the assets providing the income. Beneficiaries are required to pay Income Tax on the trust income they receive.
This type of trust is often used when the Settlor wants to give their partner an income throughout the partner’s lifetime, but ensures any assets pass to the Settlor’s children once the partner dies.
Therefore, the Beneficiary of the Interest in Possession Trust is referred to as the ‘Life Tenant’ in England or the ‘Life Renter’ in Scotland, and ‘Remaindermen’ is the name given to the Beneficiary who stands to inherit any remaining property after the Life Tenant’s death.
Discretionary Trusts
With a Discretionary Trust, the Trustees have total control over the assets as well as the income generated. The Trustees can also determine when the Beneficiaries receive that income.
This type of trust is often used when the Settlor wants to create a trust for their grandchildren and want to name the grandchildren’s parents as the Trustees. Discretionary Trusts often are accompanied by a letter where the Settlor gives the Trustees guidance on their wishes.
Discretionary Trusts fall within ‘the relevant property regime’ which means they are subject to Inheritance Tax, which can add a degree of complexity.
Learn more about Discretionary Trusts [link to article 39}
Discounted Gift Trusts
These trusts are particularly useful if the Settlor wants to start planning for Inheritance Tax and needs a regular payment stream for life. Discounted Gift Trusts are generally written under Discretionary or Absolute Trusts.
The Settlor makes a ‘gift’ to the trust, while retaining the right to pre-agreed capital payments made from the trust during their lifetime.
A discount may be applied to the value of the gift, based on the person’s age, sex and health, which means that the value of the gift may be less than the amount invested. This discount is created by virtue of the ‘Income for life’ that the Trust is designed to provide.
The transfer of value for inheritance purposes is the amount of money originally transferred into the trust less any discount granted. The discount is immediately removed from the Settlor’s estate for Inheritance Tax purposes, and the balance of the gift / settlement into trust will fall outside of the estate after seven years. Any growth on the investment is immediately outside the Settlor’s estate.
Loan Trusts
These trusts are particularly useful if the Settlor wants to start planning for Inheritance Tax and needs access to their capital. Loan trusts are generally written under Discretionary or Absolute Trusts.
A person can set up a Loan Trust with themselves as the Settlor and one of the Trustees, they then make a loan to the trust and decide how the money is invested.
Although this loan money is still considered part of the person’s estate for Inheritance Tax purposes, any growth in the value of the investment sits outside of the estate and is exempt from Inheritance Tax. Loan trusts are usually used to slow down the growth of an estate, and therefore to reduce a potential Inheritance Tax liability.
The Settlor can take back the loan at any point in time either by ad hoc withdrawals or regular withdrawals.
As the Settlor has made a loan there is no transfer of value for inheritance tax purposes. The Settlor is able to waive the loan, at any point in time, if it is no longer required which creates a Chargeable Lifetime Transfer (CLT) or Potentially Exempt Transfer (PET) depending on the type of trust used.
Tax treatment of different trusts
There are several types of trusts and each is subject to Income Tax, Capital Gains Tax and Inheritance Tax in different ways. The tax rates and tax allowances vary according to the type of trust and how the Beneficiaries stand to benefit.
This Link on Gov.uk provides further guidance on taxes paid by Beneficiaries and Trustees.
Bare Trusts
Where a Bare Trust has been set up by an individual, other than the beneficiary’s parents, the assets are classed as belonging to the named beneficiary for tax purposes. Even if they are under age 18 the beneficiary will have all the Income, Savings and Capital Gains Tax allowances of an adult. These allowances can be used to offset against income and gains on trust assets.
If the income from the trust goes above the allowances, the child’s parents or legal guardians should complete a Self-Assessment tax return on the child’s behalf. As the assets belong to children, this means the income is then taxed at the child’s marginal rate.
There is no Capital Gains Tax to pay once the Beneficiary becomes ‘Beneficially entitled’ to trust assets (usually at 18). However, Capital Gains Tax could be payable on the sale of assets.
Transfers into a Bare Trust will also be exempt from Inheritance Tax, irrespective of size of settlement, provided the person making the transfer survives for seven years after making the transfer.
Interest in Possession Trusts
Beneficiaries of Interest in Possession Trusts are entitled to the trust’s income (after expenses) as it arises. Any Income Tax due will depend on whether income from the trust is paid directly to the Beneficiary (or Beneficiaries) or is paid via the trust.
If trust income is received by the Beneficiary directly (without being taxed first), it must be included on the Beneficiaries’ Self-Assessment tax return.
Beneficiaries are entitled to use their personal tax allowances (savings rate band, personal savings allowance and dividend allowance) where appropriate to reduce their tax liability for trust income.
Basic rate taxpayers are required to pay the basic rate on mandated trust income, but otherwise the tax paid by the Trustees should eliminate their tax liability. Higher and additional rate taxpayers will have tax to pay, but the tax paid by the Trustees should meet part of their liability.
The Inheritance Tax treatment of an Interest in Possession Trust depends on whether it was created during the Settlor’s lifetime or upon their death. For lifetime trusts, the Inheritance Tax treatment will depend on whether the trust was created before or after 22 March 2006.
We cover Interest in Possession Trusts and their Inheritance Tax treatment in another article in this course.
Discretionary Trusts
The first £1,000 of trust income is taxed at the ‘standard’ rate of Income Tax (20%), with income from dividends taxed at 8.75%. This is split between the number of trusts created in the settlor’s lifetime up to a maximum of five. Everything over £1,000 is taxed at the rate applicable to trustees which is 45% and for dividends is 39.35%. However, the 2023 Spring Budget abolished the Standard Rate threshold of £1,000 with effect from April 2024 and as a result, all trust income will be taxed at 39.35% for dividends, and 45% for income.
Trustees are responsible for paying the tax due.
Gifts into a Discretionary Trust are chargeable lifetime transfers. There are three Inheritance Tax charges that may arise:
- An immediate charge of 20% of the value of the gift.
- A ten-yearly periodic charge: The rate is calculated on a notional chargeable transfer of the trust assets immediately after they entered the trust. The effective rate is calculated based on notional tax charge of 30% of lifetime rate of 20% even if the trust was created on death.
- An exit charge when money from the Trust is distributed to the Beneficiaries. The calculation for the exit charge is based on the value of the trust fund at the last periodic charge, not its present value, but uses the current nil-rate band for Inheritance Tax purposes.
There may also be an additional charge if the Settlor dies within seven years of setting up the trust.
While the Settlor is alive, tax charges on the trust do not take into account any Potentially Exempt Transfers (PETs). If the Settlor dies and there are PETs which then become chargeable, charges on the trust may be revised and extra tax may become payable.
Any gifts into a Discretionary Trust are classed as Chargeable Lifetime Transfers (CLTs), which means they are immediately subject to Inheritance Tax on the excess over the nil-rate band, in any 7 year rolling period. This charge is 20% if paid by the Trustees, or 25% if paid by the Settlor.
As an example, if a client gifted £500,000 into a Discretionary Trust, then assuming no other CLTs were made in the previous seven years, and assuming the current nil-rate band of £325,000, there would be an immediate charge of 20% on £175,000, equating to £35,000 which the Trustees would pay, which would be grossed up to £43,750 if paid by the Settlor. This also assumes no other previous gifts into Discretionary Trusts in the previous seven years (otherwise the values are cumulative).
Tax treatment of Discounted Gift Trusts
The creation of a Discounted Gift Trust will be a transfer of value for Inheritance Tax purposes. The Inheritance Tax treatment will depend upon the type of trust used:
- Discretionary Trusts: Chargeable Lifetime Transfer (CLT)
- Bare Trusts: Potentially Exempt Transfer (PET)
The value of the transfer for Inheritance Tax purposes may be discounted by the value of the Settlor’s retained payments.
Where a Discretionary Discounted Gift Trust is created, Inheritance Tax may be payable if the value of the CLT, net of any discount, exceeds the available nil-rate band. The amount of Inheritance Tax payable will take into account whether the Settlor also made other CLTs at any point in the previous seven years.
Provided the Settlor survives for seven years from when they made the initial transfer into the trust, no further Inheritance Tax is due on death.
With a Bare Trust, there’s no initial Inheritance Tax payable when the trust is created, and provided the Settlor survives for seven years from the date of that initial transfer, no Inheritance Tax is payable.
Loan Trusts
Because a Loan Trust involves an interest-free loan made to the trust, there is no transfer value for Inheritance Tax purposes when the loan trust is set up, as the amount is not considered a gift. As a result, it does not qualify as a PET or CLT.
However, Discretionary Loan Trusts are subject to Inheritance Tax relevant property charges. This means there is a periodic charge at each ten-year anniversary (usually of 6% on the value above the available nil-rate band). The periodic charge is calculated based on the value of the Loan Trust, minus the outstanding loan.
There is no Inheritance Tax exit charge when loan repayments are made to the Settlor. Exit charges may be incurred when capital is appointed to the Beneficiary. There will be no charge on exits made in the first ten years as there is no Inheritance Tax payable when the Loan Trust is created.
How does a Trust end?
Trusts have an ultimate lifespan of no more than 125 years, depending upon when they were set up, but usually come to an end when there are no assets left. With a Fixed Trust, this can happen when the Trustee has paid out the full capital of the assets to the Beneficiary. Similarly, assets held in a Discretionary Trust can become exhausted after the Trustees have chosen to pay out all of the assets to the Beneficiaries.
Trusts can also end when the Beneficiaries of the trust – as consenting adults – request that Trustees pay out all of the assets. In some instances, the courts can also exercise their power to vary the trust or to release assets to the Beneficiaries. A trust can also end when the Beneficiaries have died.
Conclusion
In an era of intergenerational wealth planning, trusts remain one of the most effective estate planning tools for families. Trusts also have a huge part to play in situations where clients wish to retain a greater element of control over their assets.
