When you consider how to pass on your estate efficiently and securely, trusts offer significant advantages for wealth transfer. They provide valuable tax benefits. They also give you a remarkable degree of control over how your hard-earned wealth is distributed to future generations.
For some, particularly those with substantial assets, trusts are an indispensable tool for comprehensive estate planning. For others, the crucial control trusts offer over who benefits from your wealth and how, is paramount. This guide will help you understand the fundamentals of trusts and how they can safeguard your legacy.
What is a trust?
At its core, a trust is a robust legal arrangement where you (the settlor) transfer assets to be managed by someone else (the trustee) for the benefit of another person (the beneficiary).
It’s common to have multiple individuals in each role. Sometimes one person might even fulfil more than one role. However, for Inheritance Tax (IHT) planning purposes, it’s vital that the settlor is not also a beneficiary of the trust. This is a key principle for tax effectiveness.
In a typical estate planning scenario, you might be the settlor. Your adult child could join you as a trustee, and your junior grandchildren would then be the beneficiaries.
Understanding the roles in a trust
- The Settlor: This person creates the trust. They place their assets into it. The settlor carefully chooses both the trustees and the beneficiaries. Crucially, they also set out the rules governing how the trustee must manage the trust within the trust deed.
- The Trustee: The trustee takes nominal legal ownership of the property within the trust. Their paramount duty is to manage these assets strictly in accordance with the trust deed and all relevant trust and tax laws. Trustees must always act in the beneficiary’s best interests.
- The Beneficiary: This individual or group receives the proceeds from the trust. These could be assets or income. They receive them in line with the terms set out in the trust deed and on the trustees’ instruction.
In summary, you give up legal possession of the assets you place in a trust. However, you retain immense control. You choose the trustees, beneficiaries and define the rules they must follow. This unique characteristic brings significant benefits:
- By not personally owning the assets, they can fall outside your death estate after seven years. This makes them potentially exempt from Inheritance Tax, though other charges might apply.
- You retain real influence over the trust’s future, its beneficiaries, and how assets are used. You achieve this by setting clear rules and potentially acting as one of the trustees (where appropriate for tax purposes).
Main types of trusts for wealth transfer
Trusts are incredibly versatile. You can use them for purposes beyond just Inheritance Tax (IHT) planning. However, when focusing on wealth transfer and IHT efficiency, two main types are most commonly used: bare trusts (also known as ‘simple’ or ‘absolute’ trusts) and discretionary trusts. Both are powerful tools. You choose them based on your desired level of control and overall tax position.
Discretionary trusts also have variations. These variations achieve specific goals. Examples include interest-in-possession trusts, loan trusts and discounted gift trusts.
Tax-planning scenarios: protecting your legacy
If you’re familiar with the basics of Inheritance Tax (IHT) planning, you’ll know one primary way to reduce IHT liability. You can gift assets to beneficiaries during your lifetime. In its simplest form, if you give up all ownership and associated rights, the gift becomes exempt from Inheritance Tax after seven years. The liability reduces on a sliding scale during those seven years.
Outright gifting can be perfect for some situations. However, it means accepting a complete loss of control over the gifted asset. This lack of control can expose your assets to unintended and unwanted consequences, depending on your family circumstances. Consider these common scenarios:
- You gift a significant sum of cash to your adult son who, unbeknownst to you, has undisclosed debts. His creditors could claim the money.
- You gift a house to your married daughter, who then goes on to separate from her spouse. Half the house’s value could be claimed in divorce proceedings.
- You want to pass money directly to your grandchildren, but they access it during their adolescence and, lacking financial maturity, fritter it away.
In all these unfortunate circumstances, trusts offer robust protection. When structured correctly, trusts for wealth transfer can prevent such unintended outcomes while simultaneously securing valuable tax benefits for your estate.
Bare trusts: simplicity for specific gifts
Bare trusts are the simplest form of trust. The beneficiaries are chosen at the outset and cannot be changed. Most commonly, these are used when parents wish to pass money to their children, with the parents often acting as trustees.
- The assets placed into a bare trust are treated as an immediate gift for Inheritance Tax purposes. This means that after seven years, the assets typically fall outside your estate for IHT.
- When the children reach adulthood (18 in England and Wales, 16 in Scotland), the bare trust technically ceases to exist, and the assets belong solely to the beneficiaries. As such, bare trusts may be too simple a solution if significant sums are being gifted, or if you desire more control beyond the beneficiary’s 18th birthday.
- Important note: If a parent has settled money into a bare trust for a child and it produces more than £100 in income per annum, that income would be taxed as if it were the parent’s income, not the child’s.
Example:
John and Laura, in their late 60s, have five young grandchildren living in England. They wish to provide them with a lump sum when they reach adulthood, perhaps for a house deposit or further education. They believe their grandchildren will use the money responsibly.
Aware that gifting money now improves the chances of the assets being outside their estate for Inheritance Tax after seven years, they gift £10,000 each into five separate bare trusts, with the five grandchildren as beneficiaries. The grandchildren’s parents act as trustees, responsible for saving or investing the money. When each child turns 18, the money becomes fully available to them.
Discretionary trusts: maintaining flexibility and control
A discretionary trust more closely resembles the classic trust structure, where the settlor sets out detailed rules and guidance that the trustees must follow. There must be at least two trustees, and you can have as many beneficiaries as you like.
- A discretionary trust offers a powerful way to retain a degree of control over how your assets are used. Rather than assets becoming fully accessible merely by virtue of a beneficiary reaching 18, you can specify precisely who benefits, when and how. For instance, a beneficiary might receive an annual income, or benefit from the use of an asset (like a property) without actually owning it outright.
- This inherent flexibility allows you to protect the underlying assets from a wide range of risks, such as those mentioned earlier – divorce, bankruptcy or impulsive spending by young beneficiaries.
Taxation of discretionary trusts
While offering significant control, discretionary trusts do come with their own specific tax implications:
- Running Costs: More complicated trusts typically incur higher running costs, including ongoing adviser fees for compliance and management.
- Dedicated Tax Regime: Discretionary trusts operate under their own tax regime, which can expose assets to Capital Gains Tax, Income Tax (including tax on dividends) and even Inheritance Tax.
- Inheritance Tax Charges: Inheritance Tax can apply not only when you transfer assets into a discretionary trust (known as an ‘entry charge’) but also at key milestones during the trust’s existence (known as ‘periodic charges’ or ’10-year charges’) and when assets leave the trust (‘exit charges’).
- You can generally transfer up to £325,000 (the nil-rate band) into a discretionary trust in a seven-year period without an immediate entry charge.
- Anything above this may be subject to a 20% entry charge.
- A 10-year charge of up to 6% on any excess above the nil-rate band can apply, plus an exit charge of up to 6% when capital is distributed from the trust.
The taxation of trusts has become more complex in recent years, and the rates of capital gains, income, and dividend tax are generally not as favourable as for individuals. However, with careful planning, precise timing and the right investment mix within the trust, these tax liabilities can still be effectively managed and mitigated.
Therefore, for wealthy individuals for whom maintaining control over the assets they are passing to the next generation is paramount, trusts will almost certainly play a significant and strategic role in their estate planning.
Navigating the complexities of wealth transfer
As you can see, navigating the world of trusts and wealth transfer can be complex. Making a false step can have significant tax consequences. Always seek professional advice when you consider or set up trusts. This ensures they align perfectly with your financial goals and family circumstances.
Ultimately, trusts for wealth transfer offer a flexible and powerful tool for safeguarding your family’s future, ensuring your legacy is protected and distributed exactly as you intend.
Want to explore the best wealth transfer strategy for your family? Speak to our expert team today.
Contact our tax team for advice. Alternatively, call us on 0161 761 5231 or email us at theteam@horsfield-smith.co.uk.
