A 5 Minute Guide to TrustsFirst Published: November 2012 | Available in: Property Articles Your Property Network
Using a trust is not something that only ‘the rich’ should be interested in. Trusts have been used for centuries to pass on wealth from one generation to the next, and to enable people to control how their money is used by others both while they are alive and after death.
Although the use of trusts is a complex area – specialist advice should always be sought – this article gives a summary of what trusts are, how they work, and what they are used for.
1. What is a trust?
A trust is a private legal arrangement that enables the owner (‘settlor’) of assets (whether cash, property, shares etc) to transfer these to another person, (‘trustee’) to look after the assets for the benefit of a ‘beneficiary’.
The details of the trust arrangements are summarised in a ‘trust deed’ and the assets are known as the ‘trust fund’. For property investors, most trust funds will contain mortgage-free property that produces a rental income.
Unlike a company, the trust cannot itself own assets – the assets are legally owned by the trustees, but the trustees must act in the interests of the beneficiaies. The trustees manage the trust assets, and ensure the funds are used as directed by the trust deed that the settlor drew up. The trustees (usually at least two) are often a family member, plus a solicitor.
The trust may have one beneficiary, or many beneficiaries, who benefit from the trust. This may mean they receive income only, or capital only (e.g. at a pre-defined age), or a mixture of both.
A trust can be set up during the lifetime of the settlor (a ‘lifetime settlement’) or shortly after death (a ‘will trust’).
There are many types of trusts, to match the varied needs of all parties, but the underlying basis for a trust is for assets to be owned by trustees who act in the interests of beneficiaires.
2. Why use a trust?
Firstly, it is important to understand that the use of trusts is often more about controlling how assets are to be used in the future, than about saving tax.
A trust enables a settlor (investor) to have confidence that his/her wishes will be carried out when the assets are transferred into trust. Many investors are concerned – quite rightly – about passing significant assets to children before they are ready for it, or the risk to family wealth of divorce and business failures.
A trust can also be used to control and protect family assets, for when beneficiaries are too young to handle their own affairs, and where someone is incapacitated and so can’t deal with their own affairs.
It is important to note that properties subject to a mortgage usually can’t be transferred into a trust – only unencumbered assets.
The other main reason to use a trust to avoid inheritance tax on death. In your lifetime, you may choose to place assets that you no longer need into a trust. This reduces your estate for IHT purposes, and this your exposure to IHT on death.
3. Types of Trust
There are two main types of trust:
Interest-in-possession (IIP) trust
This trust is used in a will so that on death, a spouse can benefit from any income, with the children inheriting the capital on the second spouse death. This ensures that children receive their inheritance, but the spouse is looked after until death as s/he has an entitlement to the income that the children cannot challenge – but there is certainty that the children will inherit the assets eventually.
Similarly, after a second marriage, a parent can leave funds to children without any danger of the ex-spouse’s new partner gaining the capital.
This trust allows for trustees to use future discretion where, for example, it is not yet known how many children are to be provided for, or perhaps grand-children, or where some beneficiaries may be more in need that others.
Unlike an IIP trust, the beneficiaries of a discretionary trust have no entitlement to anything from the trust – this is down to the trustee’s discretion and the settlor’s wishes. It is therefore important to choose trustees carefully.
However, pretty much any wishes that the settlor may have can be accommodated via a discretionary trust.
4. How are trusts taxed?
Cash and investments held within a trust usually produce an income, which is taxable – the type of income and type of trust governs how. The trust may also pay capital gains tax if it sells assets at a gain. The trustees manage the trust assets and pay any tax due on income and gains.
The tax regime for trusts depends on the type of trust – e.g. trusts for vulnerable people (such as disabled children) have their own special tax rules, as do trusts in which the settlor (investor) can continue to benefit from the assets.
For 2012-13, discretionary trust income is taxed at 20% up to £1000, and at 50% above this (for rental income and other trading / savings income).
Beneficiaries also pay tax on their ‘trust income’, however trust income comes with a ‘tax credit’ attached, which means that beneficiary can reclaim the difference between their own tax rate, and the trust tax rate – typically, a beneficiary paying 20% income tax can reclaim the 30% difference between their own tax rate and the discretionary trust tax rate of 50%.
This effectively means that the tax rate for a discretionary trust that doesn’t pay out its income is the same as a person earning over £150k per annum i.e. not very attractive.
This contrasts with an IIP trust where the Basic Rate (20%) of tax is payable, with the beneficiary paying further tax only on income in the Higher Rate bracket.
Beneficiaries don’t pay tax on any trust capital gains – the trust pays any CGT.
5. Tax when transferring funds into trust
For most types of trust, Inheritance Tax is due when transfers total more than the Inheritance Tax threshold (£325,000 in 2012-13 tax year). Transfers of assets above this rate are taxable, usually at a rate of 20%. This then means that a ‘serial trust’ can be used i.e. a new trust set up every 7 years to continually make use of additional IHT thresholds, below which no tax is payable.
Also, there is a tax charge of no more than 6% of the net value of the trust assets, every 10 years (and on any funds transferred out). This is a complex calculation and requires specialist advice to get it right when reporting to HMRC.
6. Using trusts confidentially
An interesting feature of using a trust is that other than the trustees, and HMRC, (trusts must be registered with HMRC) being aware of the existence of the trust, any beneficiaries and the outside world may be unaware of the trust existing.
This can be useful, for example, where a parent may not want a child to know that a trust has been set up to benefit them in the future.
It is also useful in that unlike a company or LLP, there is no trust equivalent of Companies House, which ‘interested’ parties may use to find out about the trust’s assets.
Using a trust is a decision that requires careful consideration, professional advice, a clear objective, and to be made at the right stage of life to make it worthwhile. Unlike a company, trusts are more about control than tax-planning, but remain a very useful way of using one’s wealth to benefit family and charity during life, and after death. Most trust and estate-planning work will be undertaken as a joint exercise between your accountant and family solicitor.