Questions about setting up trust funds for children and other members of your family. How to set up a trust, putting houses and investments into trusts, the costs, the advantages including avoiding inheritance tax (and the seven year rule), and the disadvantages
Normally, whoever owns assets also benefits from them. But in a trust, ownership and benefit are separated. The trustees (or a trust company) own and look after the assets of the trust on behalf of the beneficiaries (who are not usually the same people as the trustees).
Broadly speaking, the trustees have a duty to act in the interests of the beneficiaries. A trust deed, or some other form of documentation, should set out the purposes of the trust and how it is to operate.
Setting up a trust is a flexible way of giving away assets without simply passing them directly to the beneficiaries. For example, you can use a trust to:
A trust can also be used as part of your tax planning to help reduce potential tax liabilities.
You can set up a trust at any time during your life. You would normally do this by having a trust deed drawn up saying who the trustees are, who the beneficiaries are, how the trust is to be run and what assets you are putting into the trust. You then pass these assets to the trust.
Alternatively, a trust may be created when you die under the terms of your will.
A bare trust is a very simple form of trust, where one or more trustees (also referred to as a nominee) passively holds the assets for the beneficiary. The beneficiary is entitled to both capital and income, and to take possession of the assets when they like - provided the beneficiary is legally capable (ie of sound mind and aged 18 or over).
Bare trusts are often used to hold shares for children under the age of 18. The trust can be created with minimal paperwork and expense, and can offer tax advantages.
While this can be a very simple and cost-effective way of passing shares to a child, it does have disadvantages. In particular, the child has the right to take possession of the shares at the age of 18 and deal with them as he or she sees fit. Some parents worry that this will result in the shares being sold and the proceeds wasted.
You can set up a bare trust without telling the beneficiary, though this could cause complications if the child has a substantial income (or capital gains) on which tax is payable.
However, the trustees must inform the child of the trust's existence once the child reaches the age of 18.
The tax treatment of a bare trust depends on whether the assets are put into trust by a parent of the beneficiary (or beneficiaries) or by someone else.
If you put assets into a bare trust for someone who is not your child, the income and capital gains are taxed as the beneficiary's income and gains. This can be very advantageous: for example, a child's income may well be less than the annual personal and dividend allowance, and so tax-free. Similarly, any capital gains realised in a particular year might well be less than the annual capital gains tax allowance, and so also tax-free.
If assets, such as savings, are put into a bare trust by a parent, the situation is different. If income of more than £100 is produced, the entire income is taxed as the parent's income, not the child's, until the child reaches 18 or marries, whichever happens earlier. The £100 rule applies separately to each parent.
For inheritance tax purposes, putting assets into a bare trust is treated as a 'potentially exempt transfer'. If you put assets into a bare trust, and survive for at least seven years, there will be no inheritance tax charge. Nor are the trust assets 'relevant property' so there is no ten-yearly charge.
An interest in possession trust is a trust where a beneficiary is legally entitled to the income generated by the trust, as it arises. The trustees must hand over the income (after any expenses and tax) to that beneficiary.
Interest in possession trusts are commonly used to provide a lifetime income for one beneficiary, with the assets then benefiting another beneficiary (or group of beneficiaries) when the income beneficiary dies. For example, your will might set up a trust that provides a lifetime income for your spouse, with the assets then passing to your children when your spouse dies.
A discretionary trust (also known as a “relevant property trust”) is one where the trustees have some discretion over how they use the trust's income. For example, they can usually decide how much (if any) income or capital to pay out, to which beneficiaries, and how much income to accumulate and add to the trust's capital rather than pay it out.
A discretionary trust can be a flexible way of providing for several children, grandchildren or other family members. For example, you might set up a trust to help pay for the education of your grandchildren. The trust deed could give the trustees discretion to decide what payments to make, depending on which children go to university, what financial resources their families have and so on.
An accumulation and maintenance trust is a trust set up for a group of grandchildren, and which complies with various restrictions on how the income and capital are used for the benefit of these beneficiaries.
There used to be inheritance tax advantages to accumulation and maintenance trusts. However, this no longer applies to trusts set up on or after 22 March 2006. All accumulation and maintenance trusts are now taxed in the same way as discretionary trusts. Setting up a discretionary trust is now a more appropriate (and flexible) way of providing for grandchildren.
Trustees have significant powers and responsibilities, particularly if the trust deed gives them discretion over the distribution of the assets. The overriding consideration should be to appoint trustees who you believe will make sensible decisions, in the best interests of your chosen beneficiaries.
It's a good idea to appoint at least two and perhaps three trustees. You may want to consider appointing a professional trustee - though alternatively the trustees can take advice from professionals as necessary.
You can be a trustee of the trust yourself, as can any of the beneficiaries, though this may risk causing a conflict of interest. Whoever the trustees are, they must act fairly where different beneficiaries' interests are concerned.
Whoever you choose, you should make sure they are willing to act as trustees - for example, if you are naming them in your will.
Costs vary enormously, depending on the circumstances.
For example, a bare trust can be set up at minimal cost, and the costs of setting up a basic trust under your will might make little difference to the overall cost of drafting your will. By contrast, setting up a trust as part of a complex tax planning exercise might require specialist advice and involve substantial costs.
The trust will also have to bear the ongoing costs of trustees' expenses and any tax charges. Costs typically include preparing annual accounts and the trust tax return.
Your solicitor can advise you on the likely costs for your particular requirements.
The trustees are responsible for the management of the trust's assets, in accordance with the terms of the trust deed. Unless the trustees have sufficient expertise themselves, they should take professional advice.
As the trustees have a duty of care to the beneficiaries, the assets should be managed prudently. Unless the trust deed states otherwise, the trustees are required by law to diversify the trust's investments.
Where the trust has more than one beneficiary, the trustees must act fairly between the different beneficiaries. For example, if one beneficiary is entitled to the income and another to the capital, the trustees must manage the assets in a way that balances their interests.
When you set up the trust, you should ensure that your adviser understands what you are trying to achieve. This will help in the drafting of an appropriate trust deed, setting out what the purpose of the trust is and what discretion the trustees have.
You should also appoint trustees that you trust to do what you want. Where the trust deed gives them wide discretion, you may also want to prepare a letter of wishes. While the trustees will still exercise their discretion, the letter gives them guidance on how they should act.
Putting assets into a trust is treated as a disposal of the assets - so you may be liable to capital gains tax if the assets have increased in value since you acquired them.
There may also be an inheritance tax charge.
Apart from bare trusts, where the income is taxed directly as if received by the beneficiary, trust income is normally taxed in two stages:
In the first case, the tax rate paid by the trust on income it receives depends on the type of trust, the source of income and the level of income The trustees are responsible for paying any tax liability.
For example, discretionary trusts (where the trustees can accumulate income and have a discretion whether to pay it out) are normally taxed on income such as savings, rent and business income that they receive at 45%. The rate is 38.1% for dividends and other similar income. If income is below £1,000 the rates are reduced to 20% and 7.5% respectively.
Interest in possession trusts (where the beneficiary has a current right to all of the trust income as it arises) are usually taxed on income such as savings, rent and business income at 20% and dividends at 7.5%. There are some special types of trust income that are taxed at 45% or 38.1%. The rules are complex and professional advice should always be taken.
There is no annual tax-free dividend allowance for trustees (unlike individuals holding company shares) so tax is payable on all dividends.
In the second situation, when income is paid out to the beneficiary, the beneficiary has to account for it on their own tax return. However, the beneficiary can claim a tax credit based on the tax already paid by the trust. So lower rate taxpayers and non-taxpayers may be able to reclaim some or all of the tax paid (but not dividend tax credits).
In a simple case, this may mean that the overall tax paid on the income is the same as if the beneficiary had simply received it directly. But the detailed position can be more complex and there are exceptions for certain types of trust such as settlor-interested discretionary trusts where tax credits cannot be claimed. You should take advice on the likely tax consequences of any trust you plan.
Note that beneficiaries are not taxed on distributions of capital (as opposed to income) paid to them.
Most trusts are subject to capital gains tax in a similar way to individuals. There is an annual exemption, which is normally half the level of the exemption for individuals (unless the beneficiary is disabled, when it is the same). Tax on gains in excess of the annual exemption is payable at 28% for disposals of residential property or 20% for other disposals. But this rate may be reduced if the trustees can claim a relief such as Entrepreneur's Relief. The trustees are responsible for paying any tax liability.
Beneficiaries are not taxed on any capital paid out to them, and cannot reclaim any of the capital gains tax the trust has paid.
Different rules apply to bare trusts, where capital gains are taxed as if the assets were owned directly by the beneficiary.
This is now much more difficult under rules introduced in 2006. Note, however, that there are different rules for some trusts created by your will or to benefit a disabled person.
When you put assets into most kinds of trust during your lifetime, this counts as a 'chargeable transfer' for inheritance tax (IHT) purposes. If the total value of the amounts you have put into trust over the last seven years is in excess of the nil rate band (£325,000), there is usually an immediate tax liability of 20% if the trustees pay. It may be higher if the settlor pays.
If you die within seven years, your estate will face a further charge of up to 20% based on the value of the original transfer. Beyond that, your estate will have no further IHT liability in respect of the trust.
In addition, once the trust is established (and regardless of whether there was any initial tax charge), up to 6% is payable every ten years on the value of 'relevant property' remaining in the trust in excess of the nil rate band, and after deducting any debts and reliefs such as Business or Agricultural Relief. 'Relevant property' includes money, shares, house or land, but not assets put into an interest in possession trust before 22 March 2006 or assets in a bare trust. The calculation is complicated - you can ask HMRC to work out the ten-yearly charge for you, but many trustees prefer to take their own advice.
There are also IHT 'exit charges' on the value of relevant property in a trust when, for example, the trust ends, some of the assets within the trust are distributed to beneficiaries or a beneficiary becomes 'absolutely entitled' to enjoy an asset. The exit charge rules differ, depending on whether the transfer out of the trust is within ten years after it was set up or not, or if it is an '18 to 25 trust'.
The overall inheritance tax consequences of setting up and operating a trust will therefore depend on how much you place into trust and how long you survive. You should take advice on what best suits your circumstances.
If the child is under 18 at the time of your death, there will be no immediate inheritance tax charge on the assets passed into the trust. As long as the child becomes entitled to the assets on reaching the age of 18, no inheritance tax is payable.
If you prefer the child to be older before taking control of the assets, the trust can continue up to the age of 25. An 'age 18 to 25 trust' is a trust created by a parent or step-parent in their will, in which the trust property is held for a child under twenty-five, who will become absolutely entitled to it on or before their 25th birthday. If the trust is an 'age 18 to 25 trust', there is only an IHT 'age 18 to 25 exit charge' when, after their 18th birthday, a beneficiary becomes absolutely entitled to the property, when some of the trust property in the trust is distributed to the beneficiary or the beneficiary dies aged over 18. The calculation is complicated and advice is strongly recommended.
Any gift to your spouse in your will is free of inheritance tax, and that includes assets that are put into trust for their benefit.
One option is for your will to create an interest in possession trust, where your spouse is entitled to receive the income from the trust for life. On your spouse's death, the assets can then pass to your children (or into trust for them). Such an arrangement incurs no more inheritance tax than if you had simply left your estate to your spouse outright.
Special trusts can be set up for individuals who are incapable of looking after themselves, or who are significantly disabled. The trustees can manage the assets on their behalf and make payments to help the beneficiary.
Putting assets in trust (rather than giving them outright to the beneficiary) helps ensure that these assets are not taken into account when calculating their entitlement to state benefits.
Income and capital gains are taxed in the normal way. However, the trust is not subject to the normal initial and periodic inheritance tax charges. Instead, inheritance tax becomes payable on the assets of the trust - plus any other assets owned by the beneficiary - when the beneficiary dies.
Over recent years, changes to tax legislation have made it more difficult to use offshore trusts to shelter income from taxes. However, offshore trusts can still be used to help reduce tax liabilities, particularly where one or more of the beneficiaries is not subject to UK taxation. This includes UK residents who are 'non-domiciled' for tax purposes.
You can retain control of the assets, but not benefit from them.
For example, you might put shares in your family business into trust, but effectively retain control of how the shares vote and whether they are sold. Provided that you are not a beneficiary of the trust, the normal trust taxation rules apply and the liability for tax will fall on the trust and the beneficiaries, not you.
If you are the beneficiary, then the trust's income and capital gains will be taxed as yours. Your estate would also be liable for inheritance tax on the trust's assets on your death.
Setting up a trust for another beneficiary (eg a child) can be a way of protecting the assets if that beneficiary subsequently goes bankrupt or gets divorced.
It is far more difficult to use a trust to protect against the risk of your own divorce or insolvency. For example, your right to benefit from a family trust would be likely to be taken into account in a divorce settlement. Similarly, placing assets into trust when you are insolvent is unlikely to prove effective.
There is scope to plan appropriate trusts if you do so well in advance of a marriage or financial difficulties. You should take advice on your particular circumstances.
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