DIFFERENT TYPES OF TRUSTS AND HOW TO USE THEM
Trusts are an effective planning tool that when used correctly can mitigate large tax bills as well as smoothing the process of passing wealth on by avoiding probate. However, when set up incorrectly these structures can lead to problems or simply fail to achieve the financial planning goals they were intended for. Getting a trust right is very important and there is no ‘one size fits all solution. The type of trust you use will depend on your situation, what you are hoping to achieve from using a trust and the amount of flexibility you require.
WHAT IS A TRUST?
Trusts provide a method of protection for assets by keeping them separate from the person that has ‘settled’ them. This means that they will no longer belong to the original owner (the settlor) and will be owned by the trust. As such, trusts are an effective vehicle for the protection of assets if there is a foreseeable deterioration of an individual’s asset base. For example, tax payable is due on the death of the original owner of the assets.
They can also be useful to ensure that a benefactor’s wishes are enacted, by appointing trustees to oversee the use of the assets. For example, providing an income for a beneficiary after they reach the age of 18.
There are numerous types of trust such as Bare or Absolute trusts, and Discretionary trusts, some details of which are simply explained below.
- Bare/Absolute Trust – This is where the beneficiary is entitled to the trust proceeds and once the assets have been placed into the trust, i.e. they effectively belong to the beneficiary. These are considered potentially exempt from IHT. This means that if the settlor survives for 7 years after the trust has been set up, there will be no IHT to pay. The drawback of this type of trust is a lack of flexibility. The beneficiary cannot be changed and the beneficiary can access the entire capital at the age of 18 and use it as they wish, which may not be the intention of the original owner.
- Discretionary Trust – This type of trust is very common for families where the settlor can name a group of potential beneficiaries such as ‘all of my children and grandchildren’ and give the trustees the power to provide any capital or income to the beneficiaries as required. The naming convention allows for changes in the beneficiaries based on births of new family members or if a beneficiary is divorced and then remarries. A drawback of this is that the beneficiaries are not entitled to the proceeds and payments are at the full discretion of the trustee.
Why create a trust?
There are many reasons people use trusts, but easily the most common reasons are:
Once assets are placed in the trust, they are no longer part of the settlor’s estate and there is no requirement for probate upon the death of the individual.
A person may have assets that they no longer need, by creating a trust and transferring those assets into it, personal wealth is reduced and so is their exposure to inheritance tax.
For example, a son or daughter might risk bankruptcy, be in an unstable marriage or be incapable of managing their own financial affairs. Perhaps an individual wants to protect assets against divorce, or the settlor would like their wealth to be passed on in a structured manner rather than a young heir simply finding themselves in possession of a fortune overnight.
Essential elements of a trust
Put simply, a trust is a legal arrangement where assets are held by someone, ‘the trustees’, on behalf of someone else, the beneficiaries, subject to the terms of the trust. There are 3 key parties involved, the settlor, the trustees and the beneficiaries. The settlor transfers legal ownership of the trusted assets to the trustees and nominates a beneficiary. The trustee holds these assets separately from their own personal assets so they are insulated from the trustee’s creditors. The trustees are under a legally enforceable obligation to the beneficiaries to comply with the terms of the trust, and they must manage the assets for the benefit of the beneficiaries.
Types of trust
The beneficiary trust allows for assets to remain in the settlor’s name during their lifetime and the trust only comes into effect upon their death. This means they retain flexibility and control over those assets. This type of trust may not be suitable for UK domiciled individuals as they do not offer protection from inheritance tax. They do however mitigate probate and allow for the assets to be dispersed or managed in line with the settlor’s wishes.
A loan trust allows the settlor full access to their investment assets but will gift any growth to their beneficiaries. This growth will sit outside of their estate for inheritance tax. The settlor must be repaid the loan by the trustee and any amount that has not been repaid of the initial investment will be liable for inheritance tax.
Outright gift trust
An outright gift trust is used by someone that doesn’t need the assets they are passing on. Once the assets are in trust, they do not have the flexibility to access them. These assets will sit outside of their estate and will not be liable for inheritance tax.
Discounted gift trust
Like a loan trust, this type of trust allows for the settlor to draw an income from assets held in trust during their lifetime. This type of trust is typically used by people who are not confident about gifting away all their disposable capital and would like the ability to retain access to some of it should unforeseen circumstances occur.
Trust and Inheritance Tax
Trusts can be extremely useful for individuals wanting to maximise potential benefits for those they are paid out to. This is particularly apparent when looking at life insurance policies.
For example, when a life insurance policy is paid out and becomes part of the deceased individual’s estate, it may be likely to create or increase an inheritance tax (IHT) liability. IHT is currently payable on assets over £325,000 and levied at a rate of 40%.
Within a trust, the insurance is paid out and not included as part of the estate. Instead, it can be passed directly to the intended beneficiaries as stated in the ‘trust deed’ (which essentially details the intention of the trust) and will not be subject to IHT.
Before any trusts are set up it is important to speak with a specialist who can help you understand the best option for what you want to achieve and to make sure the terms of the trust are suitable and will not lead to any potential issues in the future. Almost everyone we speak to has an inheritance tax liability and could benefit from a conversation with a tax specialist. Get in touch with us today to schedule a call.