Trusts

Trusts are legal arrangements that allow assets to be held by trustees for the benefit of specified beneficiaries. They can be powerful tools for inheritance planning, asset protection, and tax efficiency when used correctly.

Types of Trusts

Different types of trusts serve various purposes in estate planning with distinct tax treatments and benefits.

Bare Trusts

• Simplest form of trust where beneficiaries have absolute entitlement to the assets and income
• Beneficiaries must be at least 18 (16 in Scotland) to receive the assets
• For tax purposes, assets are treated as belonging directly to the beneficiary
• Commonly used for holding assets for children until they reach adulthood
• No inheritance tax advantages as assets are treated as belonging to the beneficiary

Discretionary Trusts

• Trustees have complete discretion over how and when to distribute income and capital
• No beneficiary has an absolute right to trust assets
• Provides maximum flexibility and control for settlors
• Useful for protecting assets from beneficiaries’ divorce or bankruptcy
• Higher tax rates apply to income and capital gains
• Subject to IHT charges on creation, every 10 years, and when assets leave the trust

Interest in Possession Trusts

• Beneficiaries have a right to income from the trust as it arises (life interest)
• Trustees have no discretion over the income
• Capital is usually preserved for ultimate beneficiaries
• Often used to provide income for a spouse while preserving capital for children
• Life tenant (income beneficiary) is treated as owning the assets for IHT purposes
• Tax treatment varies depending on when the trust was established

Accumulation and Maintenance Trusts

• Designed for beneficiaries under 25
• Income can be accumulated or used for maintenance, education, or benefit of beneficiaries
• Special IHT treatment for trusts set up before 22 March 2006
• Now largely replaced by 18-25 trusts under current tax rules

Disabled Persons Trusts

• Specifically for beneficiaries who are disabled
• Beneficial IHT and income tax treatment
• Assets can be used to supplement state benefits without affecting eligibility
• Must meet specific criteria under the Trustee Act 2000

Bereaved Minors Trusts

• Set up under the terms of a will or intestacy
• For children who have lost a parent
• Beneficiaries become entitled to the assets at age 18
• Favourable tax treatment with no IHT 10-year charge

18-25 Trusts

• Similar to bereaved minors trusts but can extend to age 25
• Beneficiaries become entitled to assets between ages 18 and 25
• Proportionate IHT exit charge applies if assets are distributed after age 18

Charitable Trusts

• Established exclusively for charitable purposes
• Exempt from income tax, capital gains tax, and inheritance tax
• Must be registered with the Charity Commission if income exceeds £5,000

Trust Taxation

Trusts are subject to specific tax rules that differ from individual taxation, with potential charges for income tax, capital gains tax, and inheritance tax.

Income Tax

• Trustees pay income tax at:
  • 45% on non-dividend income above £1,000
  • 39.35% on dividend income above £1,000
• Beneficiaries receiving income from the trust may be able to reclaim some tax if they are basic rate taxpayers
• Bare trusts: income taxed on the beneficiary at their marginal rate
• Interest in possession trusts: income taxed on the beneficiary who has the right to income

Capital Gains Tax (CGT)

• Trustees pay CGT at 20% (or 28% for residential property)
• Annual exempt amount is £3,000 (half of an individual’s allowance)
• No entrepreneurs’ relief or main residence relief available to trusts
• Bare trusts: gains taxed on the beneficiary with full annual exempt amount
• Hold-over relief may be available when assets are transferred into or out of certain trusts

Inheritance Tax (IHT)

• Initial charge of 20% on lifetime transfers into most trusts above the nil-rate band
• Periodic charges of up to 6% every 10 years on the value exceeding the nil-rate band
• Exit charges when assets leave the trust, calculated at a proportion of the 10-year rate
• Potentially exempt transfers (PETs) only apply to gifts to individuals, not trusts
• Special rules apply to trusts created before 22 March 2006

Tax Returns and Compliance

• Trustees must register the trust with HMRC’s Trust Registration Service if liable for tax
• Annual tax returns required for trusts with income or gains
• Trustees are personally liable for tax payments
• Strict record-keeping requirements and deadlines apply
• Professional advice often necessary to navigate complex reporting requirements

Setting Up a Trust

Establishing a trust requires careful planning and consideration of legal requirements.

Legal Requirements

• Settlor must have capacity and clear intention to create a trust
• Trustees must be appointed (usually 2-4 individuals or a trust corporation)
• Beneficiaries must be clearly identified or identifiable
• Trust property must be clearly defined and transferred to the trustees
• Trust deed must be properly executed according to the type of assets involved

Choice of Trustees

• Consider financial acumen, availability, willingness to serve
• Mix of professional trustees (solicitors, accountants) and family members often best
• Power to appoint new trustees should be included in the trust deed
• Consider including a protector to oversee trustees’ decisions in complex situations

Trust Deed Contents

• Clear identification of trust property
• Detailed powers of trustees
• Defined beneficiaries and their entitlements
• Administrative provisions
• Trust period (usually limited to 125 years maximum)
• Provisions for appointment and removal of trustees
• Letter of wishes (non-binding guidance from settlor)

Funding the Trust

• Cash or assets can be transferred into the trust
• Timing of transfers is critical for tax planning
• Consider using the nil-rate band to minimize immediate tax charges
• Life insurance policies can be written in trust to provide future funding

Trust Administration

Proper administration of trusts is essential to ensure they operate effectively and comply with legal requirements.

Trustee Duties

• Act in the best interests of beneficiaries
• Act impartially between different classes of beneficiaries
• Invest trust assets prudently
• Keep accurate records and accounts
• Distribute trust assets according to the trust deed
• Comply with tax and legal reporting requirements
• Seek professional advice when necessary

Investment Responsibilities

• Trustees must follow the “prudent investor rule”
• Diversification of investments is usually required
• Regular review of investment performance
• Consider risk profile appropriate to the trust’s purpose
• Document investment decisions and rationale

Record Keeping

• Maintain minutes of trustee meetings and decisions
• Keep detailed financial records of all income and expenditure
• Retain tax records for at least 6 years
• Maintain an up-to-date schedule of trust assets
• Document all distributions to beneficiaries

Distributions to Beneficiaries

• Must be made in accordance with the trust deed
• Consider tax implications for both the trust and beneficiaries
• Maintain records of all distributions
• Consider timing of distributions for tax efficiency
• Keep beneficiaries informed as appropriate

The Home Loan Scheme (Double Trust Scheme)

The Home Loan Scheme, also known as the Double Trust Scheme, is a complex inheritance tax planning arrangement that has been the subject of HMRC scrutiny.

How It Works

• Homeowner creates an interest-free loan to a family member
• The loan is repayable on demand or on death
• Family member uses the loan to purchase the homeowner’s property (or a share of it)
• The loan becomes an asset of the homeowner’s estate, not the property
• The loan is then placed into a trust (often a discretionary trust)
• On death, the loan is an asset of the estate, but its value may be discounted for IHT purposes

Legal Status

• HMRC has challenged these schemes for many years
• In a recent case (2023), HMRC lost its challenge against a home loan scheme
• The court found that in that specific case, the scheme was not caught by anti-avoidance rules
• However, HMRC may appeal this decision or introduce new legislation
• Each case is judged on its specific facts and circumstances

Considerations

• These schemes are complex and require specialist legal and tax advice
• Set-up costs can be significant
• HMRC continues to scrutinize these arrangements closely
• Future legislative changes could affect the tax efficiency of existing schemes
• Professional advice should be sought before implementing such a scheme
• Regular reviews of the arrangement are essential in light of changing legislation
• Alternative, less contentious planning strategies may be more appropriate for many families