How different types of trusts work?
There are a number of different types of trusts. Given the regularity with which I am asked what type of trust is best for a given situation I have provided a brief definition of some of the key types, setting out their advantages and disadvantages and briefly referring to their tax treatment.
Bare Trust
This is the simplest form of trust. It consists of one or more trustees and one or more beneficiaries. Some have described it as a half-way house between a full trust and outright ownership.
The beneficiary has an immediate and absolute right to both the capital and income of the trust at 18 years of age provided they have sufficient mental capacity.
The assets of the trust are held in the name of the trustee or trustees but the trustee has no discretion over the assets held in trust. The trustee of the bare trust is a mere nominee in whose name the property is held. Except in the case of bare trusts for minors, the trustee has no active duties to perform. The trustee must simply follow the instructions of the beneficiary provided they are lawful, in relation to the assets held in trust. A bare trust can be express or implied by conduct.
There can be more than one beneficiary provided each beneficiary is absolutely entitled to their share of the trust’s assets. The trustee has no discretion to change the shares or to use the income from one beneficiary’s share to benefit another beneficiary.
It is straightforward to administer which keeps running costs down and there is no limit on the number or amount of assets held by the trust and it can hold any kind of asset.
Advantages
Bare trusts are useful vehicles to pay for school fees since the amount can be estimated in advance and only that amount put into the trust. Often this is a vehicle used by grandparents to pay for grandchildren’s school fees, since once gifted into the trust the sum falls outside of the grandparent’s estate after seven years and they are not taxed on the income of the trust, which parents would be if they had settled the money into a bare trust.
Disadvantages
The lack of control for the trustees. They do not have a discretion. The beneficiary is entitled to take control of the trust fund as soon as they reach 18 years of age and to demand that the assets are put in their names, provided they have mental capacity. The age that the beneficiary becomes entitled to the trust assets is always 18 years of age and this cannot be altered. The assets in the trust are not ring fenced against creditors of the beneficiary and on the death of the beneficiary will form part of their estate for Inheritance Tax purposes.
The bare trust is a rigid structure. Once established the beneficiaries and their share of the trust assets cannot be changed. No future beneficiaries can be added as the trust has been set up absolutely for the named beneficiaries and this cannot be reversed. A gift to the bare trust is irrevocable and therefore cannot be undone once executed.
It is not a recommended vehicle for large sums of money since the beneficiary will have full access at 18 years of age.
Taxation of bare trust
Income Tax
Except where a parent has settled money into bare trust for a minor, the income received by a bare trust is taxed at the beneficiaries’ marginal rate of tax. It is treated as if the beneficiary had received it directly themselves.
If parents have set the trust up, then any trust income over £100 is taxed at the parents’ marginal tax rate as if they had received the income. This would not be the case for grandparents, as explained above.
Capital Gains Tax
A gift into a bare trust would be a deemed disposal for Capital Gains Tax purposes and to the extent that the then market value exceeded the original acquisition cost and any enhancement expenditure, Capital Gains Tax would be charged on the notional gain on the beneficiary.
Just as above, gains realised by the trustees are treated as if they were realised by the beneficiary and it is the beneficiary’s annual exempt amount that would be available to offset any gains.
Inheritance Tax
The assets of the bare trust are in the beneficiaries’ estate and will be subject to Inheritance Tax on their death. Just as with any other gift, if you make a gift into a bare trust you need to survive 7 years for the value of that gift to fall outside of your estate for Inheritance Tax purposes. This is the case where the beneficiary is not also the settlor of the trust funds into trust (i.e. the person gifting the money into the trust). The rules are different for settlor interested trusts
Discretionary trust
The definition of a discretionary trust is one where none of the beneficiaries has a present right to present enjoyment of the income generated by the trust property. The trustees have a discretion as to how to apply the trust capital and the income of the trust as it becomes available. The trust will contain a definition of the class of beneficiaries on whose behalf the trustees hold the trust property but it is up to the trustees to decide how much is paid, how often payments are made and to whom.
As no individual beneficiary can claim the income or capital as of right, such a beneficiary has a mere hope (to be distinguished from a right) that the trustees will at some time exercise their discretion in his or her favour.
The right of the beneficiary under a discretionary trust, subject to the terms of the trust, is to be considered by the trustees in the exercise of their discretion whether to appoint income or capital and, indeed how much.
Advantages
Discretionary trusts are useful if the settlor is unsure about which of the beneficiaries will need help in the future and in what proportions. They are also useful as asset protection vehicles because none of the beneficiaries have an enforceable right to the assets of the trust, nor do their creditors.
Discretionary trusts are useful in estate planning to benefit members of the family in the event of an unexpected death. Property within the trust is exempt from creditors. A creditor cannot take trust property in bankruptcy or liquidation (unless the debt was originally a trust debt). An exception to this will be where a settlor gifts assets into trust to prevent known creditors accessing funds. In these circumstances if it is established that the act of settlement was done to defraud creditors, the trust can be set aside via litigation.
This type of trust, if properly managed, can be a very tax efficient structure. There is freedom to implement tax planning after the trust has been set up in response to the changing circumstances of the beneficiaries.
Discretionary trusts allow the settlor of the trust funds to outline how they wish the trust fund to be used, during their lives and thereafter. The settlor’s wishes are not legally binding, but are useful guidance to the trustees. If professional trustees are used, the settlor may have the peace of mind that their wishes will be complied with, since there would be no conflict of interest, as there may be between a trustee who is also a beneficiary.
In terms of flexibility, the trustees can respond to changing family circumstances easily due to the control they have over the use and distribution of assets held by the trust because of the discretion they are given under the terms of the trust.
Disadvantages
This trust is more costly to administer. The services of accountants and lawyers may be required to submit trust tax returns and for trust documentation to be drafted. For example, for every distribution to beneficiaries there must be Deeds of Appointment drafted.
Only profits, not losses are distributed to beneficiaries.
Taxation
The funds fall fully outside of the settlor’s estate after seven years. The funds within the trust fund fall within the relevant property regime. In broad terms, ‘relevant property’ is property that is not comprised in the estate of the settlor or a beneficiary. In order to ensure that such assets are not therefore outside the scope of Inheritance Tax, relevant property is subject to exit and principal charges. These principal charges fall due on the tenth anniversary of the creation of the trust. The assets within the trust are revalued and a tax charge of 6% of the excess in value above the then nil rate band is charged to Inheritance Tax and paid at that point. In simple terms, this is repeated every ten year anniversary and/or on exit of the asset from the trust fund.
Trustees are responsible for paying tax on income received by discretionary trusts. The first £1,000 is taxed at the standard rate.
If the settlor has more than one trust, this £1,000 is divided by the number of trusts they have. However, if the settlor has set up five or more trusts, the standard rate band for each trust is £200.
The tax rates are below:
Trust income up to £1,000
| Type of income | Tax rate |
| Dividend type income | 7.5% |
| All other income | 20% |
Trust income over £1,000
| Type of income | Tax rate |
| Dividend type income | 38.1% |
| All other income | 45% |
Trustees do not qualify for the dividend allowance. This means trustees pay tax on all dividends depending on the tax band they fall within.
Interest in possession trusts/life interest trusts
The interest in possession trust is often referred to as a life interest trust or a fixed interest trust. In its simplest form, the beneficiary (or life tenant) is entitled to the net income from the fund in which he has an interest (after the trustees have deducted expenses properly incurred by them in the exercise of their management powers) for the rest of his life or for a fixed period.
On the death of the life tenant, the right to trust income will pass to another if the trust document provides for this or will end with the distribution to the capital beneficiaries or become part of a discretionary trust.
Interest in possession trusts created during the lifetime of the settlor before March 2006 were potentially exempt transfers. Inheritance Tax was only chargeable if the settlor died within seven years of setting up the trust.
The Finance Act 2006 made significant changes to the Inheritance Tax treatment of interest in possession trusts. These changes took effect from 22 March 2006. Since 22 March 2006, if an individual creates an interest in possession trust during his or her lifetime the transfer comes within the relevant property regime, and:
- The transfer is immediately chargeable to Inheritance Tax; the assets within the trust are ‘relevant property’ and are therefore subject to exit and principal charges. This was not the case for interest in possession trusts set up before March 2006.
- To understand the Inheritance Tax treatment of interest in possession trusts, we need to be able to differentiate between ‘relevant property’ and ‘qualifying interests in possession’.
- Where trust assets are held on ‘qualifying interest in possession’, such assets are comprised in the estate of a beneficiary. Therefore, where a beneficiary is a life tenant of a ‘qualifying’ interest in possession trust, the trust assets form part of his death estate. As ‘qualifying interest in possession trusts’ are already within the scope of Inheritance Tax, property within a qualifying interest in possession trust is not subject to exit and principal charges.
Finance Act 2006 changed the rules such that not all life tenants of interest in possession trusts are now treated as having a ‘qualifying interest in possession’.
The term ‘qualifying interest in possession’ is used to describe:
IHTA 1984, Section 59 (1);
- Assets in a trust for a disabled person;
- Assets in an interest in possession trust created on death; and
- Assets in a lifetime interest in possession trust created before 22 March 2006.
IHTA 1984, Section 3A (1):
Assets settled on ‘qualifying interest in possession’ trusts are treated as being part of the estate of the beneficiary with the interest in possession (the life tenant).
IHTA 1984, Section 49 :
Because such assets are taxed in the beneficiaries’ death estate, ‘qualifying interest in possession trusts’ are not subject to exit and principal charges.
If an individual dies with a qualifying interest in possession in a trust, the trust assets will form part of his death estate. The executors must declare the value of a qualifying interest in possession on the death estate return (form IHT400). If the beneficiary only has an interest in part of the trust fund, the same proportion of the assets in the trust is deemed to form part of his estate.
Assets held in the deceased’s own right – personal assets etc – make up his ‘free-estate’. We value the free-estate, deduct any liabilities and then add the value of a qualifying interest in possession to the assets in the free-estate. This total amount will be charged to Inheritance Tax.
Taxation
The trustees are responsible for paying income tax at the rates below.
| Type of income | Tax rate |
| Dividend type income | 7.5% |
| All other income | 20% |
The trustees are responsible for paying income tax at the rates above.
Sometimes the trustees mandate income to the beneficiary. This means it goes to them directly instead of being passed through the trustees. If this happens, the beneficiary needs to include this on their self-assessment tax return and pay tax on it.
Settlor interested trusts
This is where the settlor is also a beneficiary of the trust that they have set up. In these circumstances the settlor is responsible for income tax on these trusts, even if some of the income is not paid out to them. However, the income tax is paid by the trustees as they receive the income.
- The trustees pay income tax on the trust income by filling out a trust and estate tax return.
- They give the settlor a statement of all the income and the rates of tax charged on it.
- The settlor tells HMRC about the tax the trustees have paid on their behalf on a self-assessment tax return. The rate of income tax depends on what type of trust the settlor interested trust is.
On the death of the settlor the full value of the trust fund forms part of the settlor’s estate.
If you have any questions please call us on 020 7481 2422 or email us at enquiries@wellerslawgroup.com if you would like to know more.
This article was written by Wellers Law Group and the law is correct as at 24th November 2020. Please note that tax legislation changes frequently, so this article should not be relied upon without seeking further legal advice.
