Trusts have been used by families for centuries – Dick Whittington (of pantomime fame) used a trust to create a charity for the elderly which still exists to this day. Still on pantomimes, the “Babes in the Wood” really lived and were left their father’s estate in trust. A trust is the formal transfer of assets (it might be property, shares or just cash) to a small group of people (usually two or three) or to a trust company with instructions that they hold the assets for the benefit of others.
If the trust is to be made in your lifetime, to take immediate effect, then it is usually evidenced by a trust deed. “Trust” and “Settlement” have broadly the same meaning. If it is to be created on or shortly after your death then the trust rules must be set out in your Will – a “Will Trust”. Whether by lifetime settlement or by Will, the trust document states who are responsible for looking after the gifted assets (the trustees), who are to benefit (the beneficiaries) and any rules or conditions which the trustees and beneficiaries must adhere to. The separation of the legal ownership and beneficial ownership, which were once inseparable, is the unique characteristic of the trust concept; trustees are the legal owners but the beneficial owners are the beneficiaries. How long a trust shall last is entirely as you think is appropriate but you must stipulate the trust period in the trust document. It might be for just a few years, perhaps during a person’s widowhood or until a child attains a certain age or marries. However, trusts can last for much longer – up to 80 years – or forever if it is a charity (ask Dick Whittington!). It is usually advisable to give the trustees the power to terminate the trust at their discretion. If you are creating the settlement in your lifetime then you can appoint yourself and your spouse as trustees, if you wish, so that you retain some control of the assets and the decision making.
Why make a trust?
Throughout their history, trusts have been used to avoid or address problems in two main areas: taxation and domestic matters.
In your lifetime you can create a trust into which you can place chosen assets which you no longer need yourself. This reduces your own wealth and thus your exposure to inheritance tax. By creating a discretionary trust in your Will for the benefit of your spouse and children, you can take advantage of the nil rate band of inheritance tax and save literally thousands of pounds of tax – see our companion article “Why Make a Will?” You could settle assets in trust for your grandchildren in your lifetime or after your death. Skipping a generation in this way reduces your children’s exposure to tax. A charitable trust created in your lifetime or in your Will can receive unlimited assets, all of which can be free of all forms of taxation.
Most trusts fall into one or two main categories depending on how the income or benefit (dividends, interest, rents, free use of property etc) is dealt with:
Those where the income or benefit must be given to the specific beneficiary – it is his or hers by right.
There are several types but the common feature is that the benefits are allocated at the trustees’ discretion to any one or more of several beneficiaries. The trustees might even decide, for a time, to benefit no one; the income being accumulated for a future use.
Let us consider these in more detail:
The Interest-in-Possession Trust (sometimes called a “Fixed interest” or a “Life-interest” Trust or in Scotland a “Liferent”) is often used in a Will when a person dies leaving a surviving spouse e.g. “To my wife for her life and then to my children”. The widow can enjoy the assets placed in the trust (shares, cash etc or the use of the family home) but it is prevented from dissipating the trust capital. This can ensure that the children receive their inheritance. The same trust can be created in the Wills of two people marrying for the second time each having children by their first marriage. It ensures that the children of the first marriage do not see their parents’ wealth passing to the children of the surviving step-parent. You might leave your Estate to your spouse, in part as an absolute legacy and the remainder in trust for life. You can give the trustees wide powers to use their discretion over the capital to help in case of need, including the power to make capital advances or interest-free loans to, say, your widow. You may want to give shares of the family company to your children or grandchildren but fear that they might sell or gift them outside the family. To avoid this, the shares can be held in trust for, say, “my children equally for their respective lives and thereafter for my grandchildren who survive”. By this means the children and grandchildren benefit from the share holding but cannot control the voting power of the shares nor dispose of them only the trustees can do that.
There are three main kinds of discretionary trust, all of which give the trustees power to make gifts of capital and/or income to a stated class of potential beneficiaries. These are:
- An Accumulation & Maintenance Trust
- A General Discretionary Trust
- A Charitable Trust
the accumulation & maintenance trust (A&M)
This is ideal if your intended beneficiaries are under 25 years of age. Whilst under that age the trust can be managed in a discretionary fashion – using income or capital to assist anyone or more of the young people. Moneys may be paid to the parents or guardians to help with school fees and other forms of maintenance. Alternatively the income maybe retained and re-invested (“accumulated”) for use at a later date – hence the name Accumulation and Maintenance. Although it is a discretionary trust it is not liable to inheritance tax in the same way as other discretionary trusts. The most important qualifying condition for this favoured tax treatment is that the beneficiary must, on or before attaining 25, either receive the capital or be entitled to the income as of right. If you wish, you could stipulate that the trust capital be paid over to the young once they attain 25. However, to protect a beneficiary who might be, or become, financially unstable then you can stipulate in the trust deed that, when they attain 25, they can only enjoy the income until the trustees feel it is sensible to release the capital to them. This might be at any time – or never. Parents of children under 18 who create such a trust should consider the tax consequences. Such parents will be taxed on any income they claim for maintenance. This disadvantage does not apply to a trust created by a grandparent or other benefactor.
the discretionary trust
A general discretionary trust may suit you if you have identified a particular group of people you want to benefit but you are unsure which of them, in the future, will need help or in what proportions. For example, as a grandparent you might like to set aside capital for your grandchildren – including those who may be born later, even after your death. Some of them might be more in need than others and family and financial circumstances could change from year to year. Alternatively, you might wish to benefit your children but are aware that some of them are already wealthy and may not wish to be made wealthier by your intended gift.
A discretionary trust in favour of all your children and grand children would allow your children the choice of taking the benefit themselves or passing it on tot heir own children according to their particular circumstances. Being a beneficiary of a discretionary trust gives no entitlement to receive anything from the trust. Who receives capital advances or the income arising is entirely at the trustees’ discretion – no one has an “Interest in Possession” as described in the other type of trust. As a consequence, the death of a beneficiary has no effect on the Trust Fund because the capital of the trust is not regarded as part of the estate of a deceased person. To be tax efficient, you, as settlor, and your spouse must be excluded from all benefit otherwise the capital will still be regarded as yours for all tax purposes as if you had never created the trust. However, this rule does not apply if the discretionary trust is created in your Will – as you would of course be dead.
The most favourable characteristic of the Discretionary Trust is its flexibility. An English Discretionary Trust can last for up to 80 years and income can be accumulated for 21 years or more. Even the beneficial class can be enlarged by giving the trustees the power to introduce new beneficiaries as the need a rises. You might wish to make a lifetime settlement for the benefit of just your children and grandchildren but be worried that, if you died, your widow(er) might be in further need of capital or income; the trust funds would not then be available to help. To quell your fear you could include as beneficiary my widow(er) so that when (and only when) you die, your spouse joins the beneficial class and the capital and income becomes available for his/her use if required. Your elderly parent or other dependent could be helped with this type of trust as the subsequent death of that person would not cause inheritance tax to be paid at that time and so the trust would continue for the benefit of other class members.
the discretionary will trust
Just as a discretionary trust can be created to commence in your lifetime, it can also be a feature of your Will, becoming effective only on your death. It is often used in the Will of the first of a couple to die to ensure that the nil rate band is not wasted. Alternatively you might prefer that your executors decide how your estate is to be dealt with in the light of the tax and domestic circumstances existing at the time – a Discretionary Will Trust could achieve that.
Flexible trusts are the result of modern drafting. They are written to give the trustees all the power of a discretionary trust as described above to appoint the income or capital to any one or more of a class of individuals. However, the trust deed states that, until the trustees exercise their power of appointment, the trust income shall be paid to “x” for life (Interest-in-Possession) or retained in trust until “x” attains 25 (A&M). The trustees’ ability to switch the benefit from “x” to another member of the class at any time means that the flexible trust, like a chameleon, can change its form to suit any changing family or tax situation. Thus you might create a flexible trust for your son for life but should he risk bankruptcy or his marriage fail, the trustees can use their power to remove the benefit of the trust fund from him and switch it to his children or his sister or accumulate it until the danger has passed. It may be possible to restore the benefit to him at a later time if the trustees so wish.
the charitable trust
You may be inclined, or are expected, to make regular donations to charity or you may have a particular interest in some worthy cause. Rather than make regular payments out of taxed income or a legacy to a national charity over which you have no control, you could create your own family charity either in your lifetime or on your death by creating a charitable trust in your Will. Gifts to such a trust are free of capital gains tax and inheritance tax. The income arising will not generally be assessed to tax. Of course the trust can only be used for charitable objects i.e. the relief of poverty, the advancement of religion, education or the public good. Charitable trusts can last forever – a truly lasting memorial.
matching a trust to your needs
It has been said that for every family problem or situation, there is a trust that can be constructed to suit the need. Creating the right type of trust to match your particular situation requires specialist help. Whether creating the trust by Will, or in your lifetime, selecting the trust type and its terms are very important. In this brief summary we have mentioned only the main types of trust; there are many variations – the protective trust which automatically terminates the interest of a profligate beneficiary who attempts to dispose of his interest, the (once popular) marriage settlement and the “bare” trust which makes the beneficiary the actual owner, to name a few. These and the other trust types have differing tax effects which must also be considered and specialist advise sought. For maximum flexibility it is usual to give the trustees wide management powers so that they are better able to respond to any changes in family matters or taxation – not least changes in Government. With such wide trustee powers be sure to choose your trustees carefully. Remember, the Trustee of the Babes in the Wood was their wicked uncle! A trust which might last for 80 years or even 800 years needs careful planning but the benefits can last just as long if you take specialist advice beforehand.
some common problems-and their possible solutions
Problem: Parents, grandparents and others have always been concerned that children and grandchildren are at risk if they receive or inherit too much too soon.
Solution: Create a trust to hold the assets until the children are older and wiser.
Problem: You may feel that, by giving in your Will all your wealth to your spouse absolutely, it will be frittered away so that little or nothing will remain
Solution: A Will Trust for your surviving spouse can ensure that the capital is protected but without loss of benefit during widow(er)hood.
Problem: You might currently have an aged dependent – a widowed mother perhaps or retired housekeeper who would need continuing care should you die before her.
Solution: A trust can be created to hold sufficient capital to continue the help. On her death the funds can return to you or pass to your family.
Problem: Your son or daughter might risk bankruptcy or an unstable marriage or other relationship, be handicapped and in need of special care or for some other reason be incapable of managing their own financial affairs.
Solution: In any of these situations cash, shares, property or other forms of wealth can be placed into a suitable family trust carefully worded to take account of the perceived risks surrounding the intended beneficiary.
Problem: You might be fearful of losing mental capacity or that your possessions will be taken over by Government Agencies or even fortune hunters.
Solution: You could place your assets (say your house) in trust for yourself for life, so that only the trustees you have chosen can deal with them according to your wishes, rather than the Court of Protection or Social Services.
This article was written by the Society of Trusts and Estate Practitioners.
© The Society of Trust and Estate Practitioners www.step.org