The most common forms of trusts are described in this guide but it should never be seen as a substitute for proper face to face legal and tax advice on trusts, their uses and the options available to you, whether you are a settlor, trustee or beneficiary.
Trusts can be set up by operation of law (such as on the death of someone who has small children and no will) in wills (generally known, not unsurprisingly, as will trusts) or during lifetime as part of a tax planning or asset protection exercise. Often lifetime trusts are called settlements. A "trust" or a "settlement" is exactly the same and the terms are interchangeable.
Generally trusts are set up for tax planning or asset preservation purposes. Trusts give capital gains tax and inheritance tax advantages but the rules are inevitably complicated. Trustees are also taxed in their own right and therefore they will need to complete annual tax returns and ensure that the rules are fully complied with.
Life Interest Trusts
Sometimes also known as interest in possession trusts, a person who has a life interest (or an interest in possession) has the right to receive the income generated by the assets in the trust. If the trustees hold property as part of the trust’s assets this would also mean that the beneficiary would have the right to live in the property.
As the name suggests the beneficiary generally has the right till he dies and then on his death the terms of the trust would dictate who then inherits the trust’s assets. However such trusts can often come to an end on other events – for example often wills are written so that the surviving spouse has the right till she remarries or cohabits and then the rights to the income comes to an end in favour of the children then inheriting the estate free from trust.
Although the 2006 Finance Act changed the way some life interest trusts are taxed for inheritance tax purposes, generally the assets in this kind of trust are treated as belonging to the person who has the interest in possession. Therefore when this person dies not only is his own estate subject to inheritance tax but also the value of the trust assets from which the beneficiary received the income. The general exception to this tax treatment is a lifetime trust set up since 22 March 2006 where the value of the trust is not brought into account on the death of the beneficiary.
From an income tax perspective the trustees are only liable for lower and basic rate income tax. The income beneficiary, if he is a higher rate tax payer, will then be responsible for paying the extra higher rate income tax liabilities as part of his own annual tax compliance.
Discretionary Trusts
These types of trust are more flexible that life interest trusts. They are characterized by a number of beneficiaries being able to potentially benefit from the assets in the trust, but the extent to which they may actually benefit being at the discretion of the trustees. Under current law a discretionary trust can last 80 years.
Because the trustees of a discretionary trust have a wide power over the destination of the funds in the trust it is important that they understand how they are meant to exercise their discretion. Often the settlor of the trust will put together a note of his wishes which, although not binding on the trustees, will be persuasive and guide the trustees on what they should take into account when coming to a decision.
From an inheritance tax perspective because none of the beneficiaries has a fixed interest in the assets in the trust the value of the assets in the trust has no bearing on the inheritance tax payable when that beneficiary dies. Instead discretionary trusts have their own peculiar inheritance tax charging regime, which sees the possibility of inheritance tax being charged every time capital is paid out of the trust or on every tenth anniversary of the creation of the trust.
Discretionary trusts are widely used in tax planning, particularly in wills. Prior to the introduction of the transferable nil rate band in October 2007, they were widely used within wills of married couples to ensure that both nil rate bands were available on the death of the survivor.
The income tax rules for discretionary trusts differ from life interest trusts. The trustees benefit from a “basic rate band” of up to a maximum of £1,000. Annual income above this level is then taxed at the higher rates – 32.5% for dividend income, 40% for everything else. Like individual higher rate tax payers, these rates will increase to 42.5% and 50% respectively from 6 April 2010.
Accumulation & Maintenance Trusts
These kinds of trust had "favoured status" within the tax regime, in that they were discretionary trusts that escaped most of the complicated inheritance tax rules that normal discretionary trusts have to contend with. It is perhaps for this reason that this favoured status was brought to an end under the terms of the Finance Act 2006.
These kinds of trust came into existence when assets were directed to be held by trustees till (generally) children reached a certain age. At a basic level if an estate was left for the children of the deceased "who survive and reach the age of 25" then this (prior to March 2006) created an accumulation and maintenance trust.
Now there is virtually no distinction between these kinds of trusts and other discretionary trusts.
Bare Trusts
The final type of private trust is where assets are held by trustees but they actually belong entirely to the beneficiary. Effectively the trustees have no discretion or ability to prevent the beneficiary receiving the trust assets.
Often assets are held for children under the age of 18 "on a bare trust". This means that the assets belong to the children but because some assets can not legally be transferred into the name of an individual until he is 18 they are held by trustees.
Bare trusts can be used legitimately to mask the true ownership of an asset; or at a more benign level they can simply be used as protection against the true owner of the asset being tempted to cash in or dispose of the asset.
Charitable Trusts
As the name suggests these are trusts set up specifically to benefit "charitable" causes. They can last for ever and there are a number of tax advantages. Broadly charitable causes under English law fall into one of four categories:
- the advancement of education
- the relief of poverty
- the advancement of religion
- other public benefit not covered by the above.
The primary difference of a charitable trust from a private trust – those described above which benefit a defined group of individuals – is that they benefit the public or a large section of it.
