What Is a Trust and What Are The Benefits of Setting One Up?
For many people, just the mere mention of forming any sort of Trust will have them saying "it’s too complicated" and shying away from it.
We have been using trusts for estate planning and for asset protection for many years. Governments over the years have muddied the waters which has certainly complicated matters, but let’s try to break it down and give an overview of what they are and when they can be useful.
There are 3 main types of trust:
- Bare Trust – Usually in existence because minors cannot hold certain assets if under the age of 18, so the asset is held by the adult for the benefit of the minor.
- Life Interest Trust – Whereby a named beneficiary is entitled to the income of the trust during their lifetime (the life interest) and, on their death, the assets in the trust pass elsewhere. These are commonly seen in wills (although can be created during lifetime) where a life interest may be left to the surviving spouse but on their death, the assets pass to the children for example.
- Discretionary Trust – Usually set up during lifetime as part of an asset protection or estate planning objective. There is usually a range of beneficiaries (children/grandchildren etc.), and the trustees have the “discretion” as to who within the class of beneficiaries receives any income or capital from the Trust.
It is the latter that we are going to concentrate on in this article.
The Discretionary Trust
The Discretionary Trust has a basic trust structure which comprises 3 main components:
- The Settlor(s) – The person or persons setting up the trust and who will be placing assets into the trust.
- The Trustees – These are effectively the custodians of the trust assets.
- The Beneficiaries – The individuals or class of individuals who are to benefit from the trust assets.
For tax purposes, the trust is treated as a separate taxable person and therefore has its own reporting obligations with HMRC with the need to file tax returns to report any income or gains.
Taking that into consideration, here are the various taxes that apply to the trust:
- Income Tax - The trust pays tax on its income at the highest tax rate (currently 45%). However, if this income is distributed to lower or non-taxpaying beneficiaries, the tax can be reclaimed by them submitting refund claims to HMRC. This means that, although there is administration involved, the tax on income can flow effectively at the tax rate that applies to the beneficiaries, which could of course be 0% (see the example below).
- Capital Gains Tax (CGT) - The trust pays capital gains tax at the same rate as higher rate individuals, i.e. 20% or 28%, for residential property disposals.
- Inheritance Tax (IHT) - The trust assets do not form part of any individual’s estate, so the trust has its own IHT rules. The transfer of assets into a discretionary trust is treated as a Chargeable Lifetime Transfer (CLT) and chargeable to IHT. Provided the value transferred is below the IHT Nil Rate Band (currently £325,000), the tax rate charge is at 0%; above this, the charge is at 20%. If assets leave the trust, there may be an IHT exit charge and there is a charge to IHT on the assets of the trust every 10 years. The 10-year charge calculation is complicated, but it usually produces a very low effective tax rate and certainly less than the potential 40% exposure if the assets formed part of an individual’s estate.
One of the main planning points which makes the discretionary trust very useful is that any gain on an asset transferred into the trust can be held over, so the gain doesn’t crystalise at the time of entry. The trust is deemed to acquire the asset at the transferor’s base cost and pays CGT when the asset is sold within the trust – very useful if, for example, property is being transferred into the trust and the property is pregnant with gain.
So let’s look at an example to see how this all works in practice...
Albert and Doris are in good health and want to make provision for their 3 grandchildren to assist with their school fees etc. They have an investment property portfolio which they have had for many years. Their portfolio is made up of several properties, and they have decided that they no longer need the income from 2 of the properties (each worth £325,000 with no mortgage on them). They are looking at ways to assist with their grandchildrens' education costs. The properties have built up significant gains over the years and they're keen to avoid any capital gains tax arising on the transfer of the assets.
They set up the 'Albert and Doris Discretionary Settlement'; they are the settlors and also the trustees along with a professional trustee (their accountant); the beneficiaries are their grandchildren and remoter issue (as the trust period is 125 years).
They transfer the 2 properties into the trust for Nil consideration; the tax consequences being:
- SDLT – Nil, as there is no consideration and no mortgage on the properties.
- IHT – Nil, as the Chargeable Lifetime Transfer is £650,000 – treated as a £325,000 transfer from Albert and a £325,000 transfer from Doris on which the IHT rate for CLT’s is at 0%.
- CGT – Nil, as the gain on the property transfers can be held over.
If Albert and Doris survive 7 years from the date of the transfer, the value of the transfer (£325,000 each) falls out of their estates for IHT purposes, which saves them 40% in IHT (£260,000 in total).
The rental income from the properties of £25,000 after expenses is received by the Trust. The Trust files a Tax Return and pays 45% income tax over to HMRC. The income after tax is used to pay part of the school fees for 2 of the grandchildren. These are treated as distributions to the grandchildren (gross distribution of £12,500 and tax deducted of £5,625 each). As the grandchildren are non-taxpayers and have their personal allowances of £12,570 each to set against this income, they can submit a refund claim to HMRC to reclaim all of the tax deducted at source (£5,625 each) – the income therefore effectively suffers no tax once it flushes through the trust to the non-tax paying beneficiaries!
Moving forward 10 years for the 10-year charge on the Trust, let’s assume the value of the properties has increased to £400,000 each; It’s a complicated calculation, but the 10-year charge that the Trust has to pay would be less than £10,000…and bear in mind that if Albert and Doris have survived 7 years from the original transfer of the property into the trust, they have reduced their own IHT liability by £260,000.
The other key point in this is that the grandchildren don’t actually own the assets. As such, from an asset protection point of view, they can enjoy the income from the assets but there is a layer of protection against 3rd party predators - that being creditors and, more commonly these days, divorce. We have seen many occasions when individuals have gifted assets to the family, only for half the value to leave the family unit in a divorce settlement many years later! It leaves a very sour taste – the discretionary trust route adds in a layer of protection against this.
As you can see from the above example, the discretionary trust can be a very useful planning tool. It’s not for everybody, and individual professional advice must be taken so that any advice is tailored for your particular circumstances.
If you would want to explore any of this further, please don’t hesitate to contact your relationship partner here at Raffingers who will of course be pleased to assist. Alternatively, please don't hesitate to email me at firstname.lastname@example.org or click here.