Different types of trusts

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.

Advantages of bare trusts

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.

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 of bare trusts

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.

Discretionary trusts

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 of discretionary trusts

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 of discretionary trusts

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.

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.

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.

  1. The trustees pay income tax on the trust income by filling out a trust and estate tax return.
  2. They give the settlor a statement of all the income and the rates of tax charged on it.
  3. 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.

Enter your details and we will get back to you as soon as possible

"*" indicates required fields