Types of Trusts

The most basic example of a trust involves transferring assets to trustees, who will then hold the assets on behalf of one or more beneficiaries. Both the trustees and the beneficiaries will have some ownership rights over the assets, although these rights are very different from each other.

Who is involved in a Trust?

The parties to a trust are referred to using specific terms. These are set out here:

Settlor – the creator of a trust is often called the settlor. They are the original owner of the assets being ‘settled’ (put) into the trust.

Trustee – a trustee is responsible for holding and managing the trust assets. They have authority to deal with the trust assets in certain ways, but they are under a strict duty to act in the best interests of the beneficiaries. They may also have other powers and duties depending on the terms of the trust.

Beneficiary – a beneficiary is someone who can, or will, benefit from the trust. This may take different forms and the rights a beneficiary has over the trust assets will vary depending on the trust. When a trust ends, it will be the beneficiaries who will receive the trust assets.

Someone may fulfil more than one of these roles in a trust; a trustee may also be a beneficiary, for example.

Settlor-interested Trusts

If you create a trust and continue to hold some rights over any of the trust assets – either as a beneficiary of the trust or through trust terms which allow the possibility of assets coming back to you – the trust may be classed as ‘settlor-interested’. This can lead to situations where you are still treated as owning the trust assets for tax purposes. In most cases, you will want to avoid this as it risks ‘undoing’ the tax benefits you may hope to achieve through creating the trust.

Bare Trusts

Bare trusts arise where property belonging to one individual (the beneficial owner) is held in the name of another (the legal owner). The assets belong absolutely to the beneficial owner and the legal owner is simply holding the assets at the direction of the beneficial owner. A common example is a bank account in the name of a parent which holds funds for a minor child. On turning 18 that child can demand that the bank account to be transferred to them.

It is this lack of control that often makes bare trusts less attractive as an asset protection and tax planning tool than other trust arrangements. However more formal trust arrangements are often viewed as overly complex and for people who do not wish to enter into a formal trust arrangement for whatever reason a bare trust can still prove to be a suitable alternative. A gift of assets or monies onto bare trust is a potentially exempt transfer (PET) for Inheritance Tax purposes (IHT). That means no immediate charge to IHT occurs, whatever the value of the gift, and if the donor survives the gift for 7 years it will escape any charge to IHT on the subsequent death of the donor. This compares favourably with more formal trusts where any gift to that trust is an immediately chargeable transfer for IHT purposes, meaning that there may be an upfront charge to IHT at a rate of 20% if the value of the gift exceeds the donor’s available nil rate band (currently a maximum of £325,000).

A gift onto bare trust is still a disposal for Capital Gains Tax (CGT) purposes so it may well lead to a CGT liability. Unlike a gift to a more formal trust, no “holdover relief” from CGT is available as there has been no immediate charge to IHT. It is therefore crucial that CGT is considered before any decisions are taken. Subject to certain anti-avoidance provisions a bare trust is essentially ignored for subsequent tax purposes. For example, income is taxed in the hands of the beneficial owner as are any gains arising on subsequent disposals.

Life Interest Trusts (or ‘Interest in Possession’ Trusts)

When you set up a life interest trust, you will specify who will receive the life interest. That person is referred to as the ‘life tenant’. You will also indicate one or more beneficiaries who will become absolutely entitled to the trust assets after the life tenant’s death. Following the death of the life tenant, their entitlement to income from the trust ceases. The capital assets forming the trust then pass in accordance with the terms of the trust, namely to the person or persons named by the testator (the remaindermen).

The life tenant is entitled to any income produced by the assets held in the trust and they are entitled to occupy any property owned by the trust. However, as mentioned above, the life tenant will have no control over where the trust assets will pass after their death.

The life tenant is not, however, automatically entitled to access the capital assets owned by the trust. Instead, the chosen trustees are in control of those assets and they can decide how the assets are invested. The trustees can be guided by a letter of wishes produced by the settlor.

Possible uses for a Life Interest Trust

A common situation in which this may be useful is where you live with your spouse/civil partner (Spouse) in a house which belongs to you, and you both have children from previous relationships. You may want to ensure that your children receive your house, but also want your Spouse to be able to live in the house following your death. A life interest trust, naming your Spouse as the life tenant and your children as the remaindermen beneficiaries, would be able to guarantee this. Your Spouse will be entitled to live there for the rest of their lifetime but would be unable to then transfer the house to their own children, either in life or upon their death. Your children would become absolutely entitled to the house when your Spouse dies.

You can also draft alternative terms for a life interest trust to allow for greater flexibility. For example, you might include a term which allows your trustees the power to end the life interest prematurely. This could be helpful to the beneficiaries and/or the life tenant. For example, if the life tenant and beneficiaries are in need of capital, the trustees could end a life interest over a house in order to sell it and distribute the proceeds. In addition, the trustees can be granted additional powers to enable them to advance capital in addition to the income to the life tenant.

How are Life Interest Trusts taxed?

Income tax – as the income passes belongs to the nominated beneficiary or beneficiaries it is taxed at their income tax rates.

Capital Gains Tax – the treatment is the same as it is for Discretionary Trusts – see below

Inheritance Tax – taxed under different regimes for IHT purposes and the relevant regime will depend on the date of creation, any subsequent events and how the trust was created.

For Life Interest Trusts created on death through a Will or an intestacy, the trusts are taxed by reference to the named beneficiary or beneficiaries. The beneficiary is treated, for IHT purposes, as owning the capital held in the trust. On their death the value of the trust fund is aggregated with their own estate before their IHT liability is calculated.

Life Interest trusts created during lifetime are taxed under the Relevant Property regime (see below) for IHT purposes.

Discretionary Trusts

Under a discretionary trust the trustees are given the discretion to pay or apply income or capital, or both, to or for the benefit of all, or any one or more of the beneficiaries exclusively of the others, or to a specified class or group of persons.

No beneficiary is able to claim as of right that all or any part of the income or capital is to be paid to him or applied for his benefit.

The trustees therefore have power to decide who shall benefit and what the benefits shall be. A potential beneficiary is not entitled to any share in the trust fund unless and until the trustees exercise their discretion in his or her favour.

A discretionary trust has a specified trust period of 125 years, which is the maximum life of the trust.

The practical advantage of a discretionary trust is that the settlor can allocate an asset or fund to the trust for the benefit of a group of beneficiaries, and the benefits derived from the trust over the period of its existence can be adjusted to the circumstances and needs of that group of beneficiaries. Thus, unforeseen events can be catered for.

The asset protection aspect of a discretionary trust derives from the fact that no beneficiary has a right to capital or income. The fund can be protected (to some degree) against claims on a beneficiary’s estate through bankruptcy and divorce, as well as from HM Revenue on death.

The trust will also protect the value of the fund from a Local Authority or the Benefits Agency if a beneficiary (often the surviving spouse) requires nursing or residential home care. The assets in the trust cannot be included in any assessment of that beneficiary’s means, but can be called upon to provide third party assistance should the maximum assistance available from State sources be insufficient to fund the particular care desired.

Possible uses for a Discretionary Trust

You can use a discretionary trust as a way to provide for beneficiaries whom, for whatever reason, you do not yet wish to receive the assets. Reasons for this could be that:

those in second marriages;
those who own an asset which has potential to increase in value significantly (such as land with development potential);
those who wish to leave assets to a potentially vulnerable beneficiary, perhaps through learning difficulties, or one who is likely to go into long term care, or facing divorce or bankruptcy proceedings, or someone who is simply ‘naive’ with money; and
securing unused nil rate bands for the benefit of the estates of widows or widowers.
protect the assets held in them from being consumed in long term care fees;
provide peace of mind by ensuring that, following the death of a surviving spouse, partner or civil partner, the assets that had belonged to the first to die pass to their chosen beneficiaries in accordance with their own Will;
protect some or all of the deceased’s estate from being dissipated by a surviving spouse, partner or child;
allow for Inheritance Tax planning for subsequent generations by ensuring that the trust assets do not form part of the estate of the deceased’s children and even grandchildren on their eventual deaths;
offer special opportunities to mitigate Inheritance on business and agricultural assets;
keep any significant increase in value of the trust assets outside the named beneficiaries’ estates for IHT purposes;
prevent assets being lost to an addiction, divorce or bankruptcy; and
Discretionary trusts may also allow you to provide for beneficiaries whom you may never meet, such as great-grandchildren or perhaps even more distant descendants. As long as the class of beneficiaries specified in the trust covers them, a discretionary trust could benefit someone born long after the trust was created.

Discretionary trusts also place a lot of power into the hands of your trustees. You must select your trustees very carefully as a result and you may wish to provide them with additional guidance as to how you wish them to administer the trust by creating, for example, a letter of wishes to sit alongside the trust.

An added benefit of discretionary trusts is their flexibility. Even if the Will of the deceased contains a discretionary trust the trustees do not have to implement that trust following death if the reason for including the trust in the first place has disappeared. For example, a child the deceased thought might get divorced has in fact already divorced and the financial settlement concluded. If the deceased leaves a detailed letter of wishes explaining their reason for including the discretionary trust in their Will their chosen trustees can consider the circumstances of the beneficiaries at the time of the deceased’s death and the laws in place at that time before deciding how best to deal with the estate to achieve the deceased’s wishes in the most IHT efficient and asset protective way possible.

The Relevant Property Regime

Income Tax – Discretionary Trusts have a basic rate band of up to £1,000 (it will be less if the settlor of the trust has created more than one trust) with any income exceeding this allowance being taxed at 45%, or 38.1 % for dividends. If income is distributed to a non-income tax paying beneficiary or a beneficiary with a lower income tax rate that beneficiary may reclaim the additional income tax that has been paid.

Capital Gains Tax – Discretionary Trusts have an annual allowance of up to half that available to an individual), although again this is reduced if the settlor has created other trusts. All gains that exceed this annual allowance are taxed at a flat rate of 20% or 28% for residential property.

Inheritance Tax – Discretionary Trusts are taxed under the Relevant Property Regime (RPR). This means that the value of the trust is kept separate from the estates of any of the potential beneficiaries of the trust, meaning that on the death of any of the beneficiaries the value of the trust will not be considered when calculating their inheritance tax liability.

The gift to the trust in excess of the settlor’s available nil-rate band (currently £325,000) will be chargeable to Inheritance Tax at 20%. Once in the trust, the property will be subject to two charges: a charge every ten years from the date of the creation of the trust (the so-called ’10-year anniversary charge’) and if and when property leaves the trust (the so-called ‘exit charge’). The calculation of these charges is complicated, but the maximum liability is 6% of the value in excess of the then applicable nil-rate band allowance of either the trust fund itself (in the case of a 10-year anniversary charge) or the property leaving the trust (in the case of an exit charge).

Personal Injury Trusts

There can be a number of benefits to diverting any compensation received in relation to a personal injury award to a trust, as opposed to it passing directly to the claimant, such as protecting means tested benefits, ensuring ongoing asset protection and, in more severe cases, allowing trustees to look after the award on behalf of the claimant.

Personal injury award trusts can be used whenever a lump sum is received in relation to accidental or criminal injuries, clinical or other negligence resulting in mental or physical harm or a disease or an injury caused by a disease. The definition of funds that can be settled is not limited to purely compensation so can also include some insurance payments, such as critical illness, and also damages for the professional negligence of a litigator, as the claimant is essentially deemed to have received what they would have received in compensation had it not been for the negligence of their litigator.

Unlike many situations, the creation of a personal injury trust is not seen by Local Authorities as a deprivation of assets for the purposes of calculating means tested benefits. The reason is that trusts arising as a result of such an award are specifically disregarded within the legislation.

For means tested benefits, the lower capital limit is £6,000 and the upper capital limit is £16,000; for means tested care, the lower capital limit is £14,250 and the upper capital limit is £23,250.

When should a personal injury award trust be set up?

The trust should ideally be created at the point of the settlement, which can be as a result of a court order, mediation or negotiation.

Although in many cases the primary benefit of such a trust is the reduction of the claimant’s estate for benefits means testing purposes, a trust can be particularly beneficial for a claimant who has suffered mental harm and whose behaviour is likely to be erratic or eccentric as a result of this harm.

If the claimant has suffered mental harm to such a degree that the Court of Protection is involved, the Court would have to approve the creation of such a trust.

As a general rule a personal injury trust has no added tax benefits. The income will generally always belong to the claimant of the award and so will be taxed in relation to the claimant. Although there may well be more flexibility over the use of the capital, capital gains will still be taxed by reference to the claimant. For inheritance tax purposes the claimant will be treated as owning the trust assets on their death.

Trusts for Disabled Persons

There are several reasons why someone might consider setting up a trust for a disabled person:

*The disabled person may not always be able to manage their own finances. This could be due to a physical or mental disability that affects their ability to make sound financial decisions. In such cases, a trust can be set up to ensure that the disabled person’s financial needs are met.

*A trust can also ensure that the money is protected from dissipation, perhaps because of the disabled person’s own behaviour, or because they are vulnerable to exploitation from others. The trustees retain control over the capital and are under a duty to ensure that it is invested wisely.

*A trust can be established by a parent or relative for a child, an individual for themselves if they think they may need protection in the future, or to receive compensation monies, for example, from a personal injury claim. In such cases, the trust can be used to provide ongoing financial support to a disabled person while also protecting their assets from being depleted too quickly.

*If a disabled person is unable to work, they may be reliant on means tested benefits. Many benefits are not payable if the claimant has savings of £16,000 or over. Most carers of a disabled person would be reluctant for a gift of capital, whether given on death or during lifetime, to result in the beneficiary’s entitlement to state assistance being reduced or removed. If, however, the financial provision is placed in a trust then the trust assets will not be taken into account in assessing the beneficiary’s entitlement to benefits and the capital is preserved.

*The issue of control of the money is a vital one and where a trust can be very helpful. For example, the trust could ensure that there is always a fund available for “extras” such as holidays or other large items of expenditure which the beneficiary could not otherwise afford. Such a fund can also be useful for a beneficiary who is generally able to work, but who might have gaps in their earning capacity due to their disability, to maintain their usual standard of living during the non-working periods.

Who qualifies as a disabled person?

For a trust to qualify as a disabled person’s trust, at least one beneficiary is considered disabled at the time the assets are transferred into the trust.

The criteria that need to be met to be considered a disabled person can vary depending on the circumstances, but some common examples include the following:

The definition of disabled persons includes:

those suffering from a mental disorder as defined by section 1 of the Mental Health Act 1983 (MeHA 1983) such that they are unable to administer their property or manage their affairs
those in receipt of (as opposed to merely qualifying for) attendance allowance under section 64 of the Social Security Contributions and Benefits Act 1992 (SSCBA 1992) (this allowance applies only to those over 65)
those in receipt of disability allowance under SSCBA 1992, s 71, by virtue of entitlement to the care component at the highest or middle rate or the mobility component at the higher rate (this allowance has no age restriction):
those in receipt of a personal independence payment for mobility or care at either the standard or enhanced rate
those in receipt of a constant attendance allowance, or
those in receipt of armed forces independence payment

It’s important to note that just because someone may have a disability or health condition, it doesn’t necessarily mean they will automatically qualify as a disabled person for the purposes of a trust. Each case will be assessed on its own merits, and it may be necessary to provide evidence of the disability or condition in question.

Special Tax Treatment and conditions that need to be met

The beneficiary must meet the above definition of ‘disabled’. In addition, the trust itself needs to be a “qualifying trust”. This means that there must be certain restrictions on who can receive benefits from the trust during the disabled person’s lifetime. These are as follows:

any capital leaving the trust must be used for the benefit of the disabled person
the disabled person must either be entitled to all of the income outright, or, if the Trustees have the discretion as to if and when the income is paid out, then any payments made must be used to benefit the disabled person during their lifetime.

Once these conditions have been met, then then the trust will be treated more favourably than normal trusts in respect of Income Tax, Capital Gains Tax and Inheritance Tax.

Income Tax – The trustees can make an election so that tax on income within the trust will be charged as if it had accrued directly to the vulnerable beneficiary. This enables the trust to take into account the beneficiary’s personal allowances and means that Income tax would likely be charged at a marginal rate, rather than the normal trust rate tax of up to 45%. To gain this special treatment, the Disabled person must be entitled to all income arising during their life (or, alternatively no income can be applied during life of disabled person for benefit of anyone else).

Capital Gains Tax – Capital Gains Tax may be due if assets are sold, given away, exchanged or transferred in another way and they’ve gone up in value since being put into trust. Tax is only paid by trustees if the assets have increased in value above the ‘annual exempt amount’. Any gain above this amount is taxed a flat rate of 20% or 28% for residential property. The trustees are responsible for paying any Capital Gains Tax due.

Inheritance Tax – Most trusts are liable to pay Inheritance tax every ten years (an ‘anniversary charge’) and when assets leave the trust (an ‘exit charge’). Disabled trusts are not subject to these charges. On the death of the disabled person, the trust property is treated as being owned by them. If the disabled person’s estate exceeds £325,000, there will be an Inheritance tax charge of 40% on anything over and above this amount.

These are the situations when trusts for vulnerable people get special IHT treatment:

for a disabled person whose trust was set up before 8 April 2013 – at least half of the payments from the trust must go to the disabled person during their lifetime
for a disabled person whose trust was set up on or after 8 April 2013 – all payments must go to the disabled person, except for up to £3,000 per year (or 3% of the assets, if that’s lower), which can be used for someone else’s benefit
when someone who has a condition that’s expected to make them disabled sets up a trust for themselves
for a bereaved minor – they must take all the assets and income at (or before becoming) 18

There’s no Inheritance Tax charge:

if the person who set up the trust survives 7 years from the date, they set it up
on transfers made out of a trust to a vulnerable beneficiary

When the beneficiary dies, any assets held in the trust on their behalf are treated as part of their estate and Inheritance Tax may be charged.

Types of disabled person’s trusts

The type of trust is important to consider when setting up a trust for a disabled person. Different types of trust are available, and the type of trust that is most suitable will depend on individual circumstances.

Discretionary Trusts: A discretionary trust gives the trustees discretion regarding how the trust’s income and capital are distributed among the beneficiaries. This type of trust can be beneficial for disabled people who may not be able to manage their own finances or make decisions about their own care.

Bare Trusts: A bare trust, also known as a simple trust or express trust, is a trust where the beneficiary has an absolute right to the trust assets. This means that the beneficiary has the right to all income and capital from the trust and the power to make decisions about how the trust assets are used.

Interest in Possession Trusts: An interest in possession trust is a trust where the beneficiary has a right to the income generated by the trust assets. This type of trust is suitable for disabled people who can manage their own finances but may not be able to work or earn income.

If you are interested in using a trust to make financial provision for a disabled person we can guide you through the process, and ensure that the most appropriate type of trust is chosen, taking into account both tax and all other relevant factors.

Life Insurance Policy Trust

On the death of the life assured under a life policy any proceeds become an asset in the estate of the policyholder and are therefore exposed to a possible inheritance tax (IHT) charge on their death. Therefore, anyone who owns a life policy, be it term assurance, mortgage insurance or life insurance should consider placing that policy in trust to avoid an IHT charge on the proceeds.

To achieve this IHT saving the policy is placed in trust while the life insured is still alive. Most life insurance companies offer a flexible trust document themselves but if something more bespoke is needed then this can be produced. The trust must be worded in such a way that the policyholder cannot benefit from the trust, meaning that that if, for example, the policy is surrendered while the life assured is still living neither the policyholder nor their spouse can have access to the funds but there is no difficulty in the policyholder being one of the trustees.

The policyholder continues to pay the annual premiums. If the premiums are not fully covered by IHT allowances available to the policyholder, such as the £3,000 annual gift exemption or the surplus income exemption, then any excess premiums paid in the 7 years prior to the death of the policyholder are brought back into any IHT calculation. Following the death of the life insured the policy proceeds are paid to the trustees and usually but depending on the type of trust the trustees will have complete discretion as to who in the family shall benefit from the income and the capital held in the trust. The trustees will generally be guided by any letter of wishes left by the policyholder.

To make this type of trust as IHT efficient as possible trustees often choose to loan capital to the beneficiaries of the trust as opposed to outright appointments of capital. This means that on the death of those beneficiaries the amount loaned to them is repaid to the trust, producing a liability on their estate for IHT and so reducing the IHT liability on their estate. Retaining capital assets in the trust also has an asset protection benefit as those assets may be protected in the event of the divorce or bankruptcy of any of the named beneficiaries.

However, such trusts are potentially liable to an ongoing charge to IHT if the value of the trust exceeds the IHT nil rate band at any given point in time. The maximum rate (currently 6%) compares favourably with the charge on individuals (currently 40%). In most circumstances, however, the income tax, capital gains tax and IHT consequences of trusts can be mitigated, if not removed altogether, with careful planning.

Pension Death Benefits

Most pension schemes provide that a lump sum death benefit is payable in the event of the scheme member dying before they reach the age of 75 and prior to taking full benefits from their pension. This lump sum will usually be paid free of inheritance tax (IHT) in accordance with any nomination form completed by the scheme member during their lifetime.

Once that lump sum has been paid out to the beneficiary, (which is often the scheme member’s surviving spouse), it then forms part of that person’s estate for IHT purposes. There is, however, an alternative way of dealing with such a lump sum. During their lifetime the scheme member can put in place a trust, usually known as a pilot trust, created with the initial trust fund comprising £10 cash. That trust is then nominated as the recipient of any future lump sum.

Having received the funds, the trustees of the pilot trust then have complete discretion as to who in the family shall benefit and in what proportions. Usually, the scheme member will have left a letter of wishes as guidance to the trustees. To make the pilot trust as IHT efficient as possible trustees often choose to loan capital to the beneficiaries of the trust as opposed to outright appointments of capital. This means that on the death of those beneficiaries the amount loaned to them is repaid to the pilot trust, producing a liability on their estate for IHT and so reducing the IHT liability on their estate. Retaining capital assets in the pilot trust also has an asset protection benefit as those assets should be protected in the event of the divorce or bankruptcy of any of the named beneficiaries.

H M Revenue & Customs accept the IHT effectiveness of this type of pilot trust provided the trust and nomination process were put in place at least two years prior to the death of the scheme member and at a time when the scheme member had no reason to believe he or she would die in the following two years.