UK Trusts, passing assets to beneficiaries

You may decide to use a trust to pass assets to beneficiaries, particularly those who aren’t immediately able to look after their own affairs. If you do use a trust to give something away, this removes it from your estate provided you don’t use it or get any benefit from it. But bear in mind that gifts into trust may be liable to inheritance tax.
Trusts offer a means of holding and managing money or property for people who may not be ready or able to manage it for themselves. Used in conjunction with a will, they can also help ensure that your assets are passed on in accordance with your wishes after you die. Here we take a look at the main types of UK family trust.

When writing a will, there are several kinds of trust that can be used to help minimise an inheritance tax (IHT) liability. On March 22, 2006 the government changed some of the rules regarding trusts and introduced some transitional rules for trusts set up before this date.

A trust might be created in various circumstances, for example:

– when someone is too young to handle their affairs

– when someone can’t handle their affairs because they’re incapacitated

– to pass on money or property while you’re still alive

– under the terms of a will

– when someone dies without leaving a will (England and Wales only)

What is a trust?
A trust is an obligation binding a person called a trustee to deal with property in a particular way for the benefit of one or more ‘beneficiaries’.

Settlor
The settlor creates the trust and puts property into it at the start, often adding more later. The settlor says in the trust deed how the trust’s property and income should be used.

Trustee
Trustees are the ‘legal owners’ of the trust property and must deal with it in the way set out in the trust deed. They also administer the trust. There can be one or more trustees.

Beneficiary
This is anyone who benefits from the property held in the trust. The trust deed may name the beneficiaries individually or define a class of beneficiary, such as the settlor’s family.

Trust property
This is the property (or ‘capital’) that is put into the trust by the settlor. It can be anything, including:

– land or buildings
– investments
– money
– antiques or other valuable property

The main types of private UK trust

Bare trust
In a bare trust the property is held in the trustee’s name but the beneficiary can take actual possession of both the income and trust property whenever they want. The beneficiaries are named and cannot be changed.

You can gift assets to a child via a bare trust while you are alive, which will be treated as a Potentially Exempt Transfer (PET) until the child reaches age 18, (the age of majority in England and Wales), when the child can legally demand his or her share of the trust fund from the trustees.

All income arising within a bare trust in excess of £100 per annum will be treated as belonging to the parents (assuming that the gift was made by the parents). But providing the settlor survives seven years from the date of placing the assets in the trust, the assets can pass IHT free to a child at age 18.

Life interest or interest in possession trust
In an interest in possession trust the beneficiary has a legal right to all the trust’s income (after tax and expenses), but not to the property of the trust.

These trusts are typically used to leave income arising from a trust to a second surviving spouse for the rest of their life. On their death, the trust property reverts to other beneficiaries, (known as the remaindermen), who are often the children from the first marriage.

You can, for example, set up an interest in possession trust in your will. You might then leave the income from the trust property to your spouse for life and the trust property itself to your children when your spouse dies.

With a life interest trust, the trustees often have a ‘power of appointment’, which means they can appoint capital to the beneficiaries (who can be from within a widely defined class, such as the settlor’s extended family) when they see fit.

Where an interest in possession trust was in existence before March 22, 2006, the underlying capital is treated as belonging to the beneficiary or beneficiaries for IHT purposes, for example, it has to be included as part of their estate.

Transfers into interest in possession trusts after March 22, 2006 are taxable as follows:

20 per cent tax payable based on the amount gifted into the trust at the outset, which is in excess of the prevailing nil rate band

Ten years after the trust was created, and on each subsequent ten-year anniversary, a periodic charge, currently 6 per cent, is applied to the portion of the trust assets that is in excess of the prevailing nil rate band.

The value of the available ‘nil rate band’ on each ten-year anniversary may be reduced, for instance, by the initial amount of any new gifts put into the trust within seven years of its creation.

There is also an exit charge on any distribution of trust assets between each ten-year anniversary.

Discretionary trust
The trustees of a discretionary trust decide how much income or capital, if any, to pay to each of the beneficiaries but none has an automatic right to either. The trust can have a widely defined class of beneficiaries, typically the settlor’s extended family.

Discretionary trusts are a useful way to pass on property while the settlor is still alive and allows the settlor to keep some control over it through the terms of the trust deed.

Discretionary trusts are often used to gift assets to grandchildren, as the flexible nature of these trusts allows the settlor to wait and see how they turn out before making outright gifts.

Discretionary trusts also allow for changes in circumstances, such as divorce, re-marriage and the arrival of children and stepchildren after the establishment of the trust.

When any discretionary trust is wound up, an exit charge is payable of up to 6 per cent of the value of the remaining assets in the trust, subject to the reliefs for business and agricultural property.

Accumulation and maintenance trust
An accumulation and maintenance trust is used to provide money to look after children during the age of minority. Any income that isn’t spent is added to the trust property, all of which later passes to the children.

In England and Wales the beneficiaries become entitled to the trust property when they reach the age of 18. At that point the trust turns into an ‘interest in possession’ trust. The position is different in Scotland, as, once a beneficiary reaches the age of 16, they could require the trustees to hand over the trust property.

Accumulation and maintenance trusts that were already established before 22 March 2006, and where the child is not entitled to access the trust property until an age up to 25, could be liable to an Inheritance Tax charge of up to 4.2 per cent of the value of the trust assets.

It has not been possible to create accumulation and maintenance trusts trust since 22 March 2006 for Inheritance Tax purposes. Instead, they are taxed for Inheritance Tax as discretionary trusts.

Mixed trust
A mixed trust may come about when one beneficiary of an accumulation and maintenance trust reaches 18 and others are still minors. Part of the trust then becomes an interest in possession trust.

Trusts for vulnerable persons 
These are special trusts, often discretionary trusts, arranged for a beneficiary who is mentally or physically disabled.  They do not suffer from the IHT rules applicable to standard discretionary trusts and can be used without affecting entitlement to state benefits; however, strict rules apply.

Tax on income from UK trusts
Trusts are taxed as entities in their own right. The beneficiaries pay tax separately on income they receive from the trust at their usual tax rates, after allowances.

Taxation of property settled on trusts
How a particular type of trust is charged to tax will depend upon the nature of that trust and how it falls within the taxing legislation. For example, a charge to IHT may arise when putting property into some trusts, and on other chargeable occasions – for instance, when further property is added to the trust, on distributions of capital from the trust or on the ten-yearly anniversary of the trust.

A gift with reservation

Making sure the gift is not a gift for Inheritance Tax purposes

A gift with reservation is a gift which is not fully given away. Where gifts with reservation were made on or after 18 March 1986, you can include the assets as part of your estate but there is no 7 year limit as there is for outright gifts. A gift may begin as a gift with reservation but some time later the reservation may cease.

In order for a gift to be effective for exemption from Inheritance Tax, the person receiving the gift must get the full benefit of the gift to the total exclusion of the donor. Otherwise, the gift is not a gift for Inheritance Tax purposes.

An outright gift 

For example, if you give your house to your child but continue to live there rent free, that would be a gift with reservation. If after 2 years you start to pay a market rent for living in the house, the reservation ceases when you first pay the rent. The gift then becomes an outright gift at that point and the 7 year period runs from the date the reservation ceased. Or a gift may start as an outright gift and then become a gift with reservation.

Alternatively, if you give your house to your child and continue to live there but pay full market rent, there is no reservation. If over time you stop paying rent or the rent does not increase, so it is no longer market rent, a reservation will occur at the time the rent stops or ceases to be market rent.

The value of a gift for Inheritance Tax is the amount of the loss to your estate. If you make a cash gift, the loss is the same value as the gift. But this is not the case with all gifts.

Term assurance

 You can’t rely on always being there for those who depend on you

It’s essential to have the right sort of life assurance in place. You can’t rely on always being there for those who depend on you. There are various ways of providing for your family in the event of your premature death, but term assurance policies are the simplest and cheapest form of cover. The plans have no cash-in value or payments on survival as their design is limited to protecting your family. However, you could also use term assurance in relation to estate planning and for the payment of mortgages or other debts.

Term assurance provides cover for a fixed term, with the sum assured payable only on death. You can choose how long you’re covered for, for example, 10, 15 or 20 years (the term). Premiums are based primarily on the age and health of the life assured, the sum assured and the policy term. The older the life assured or the longer the policy term, the higher the premium will generally be.

Term assurance policies can be written on a single life, joint life (first or second death) or on a life-of-another basis. You must have a financial interest in the person that you are insuring when taking out any life-of-another policy and the provider may require proof of this before cover is given.

There are several types of term assurance:

Level term – this offers the same payout throughout the life of the policy, so your dependants would receive the same amount whether you died on the first day after taking the policy out or the day before it expired. This tends to be used in conjunction with an interest-only mortgage, where the debt has to be paid off only on the last day of the mortgage term. With level term assurance, premiums are fixed for the duration of the term and a payment will be made only if a death occurs during the period of cover. A level term assurance policy is taken out for a fixed term. This type of term assurance policy can also be useful for providing security to dependants up to a certain age.

Decreasing term – the cash payout reduces by a fixed amount each year, ending up at zero by the end of the term. Because the level of cover falls during the term, your premiums on this type of policy are lower than on level policies. This cover is often bought to run alongside repayment mortgages, where the debt reduces during the mortgage term.This type of term assurance is less expensive than level term assurance.

Increasing term – the potential payout increases by a small amount each year. This can be a useful way of protecting your initial sum assured during periods of rising inflation.

Index-linked term – some insurers provide you with the option for the premium to be increased each year in relation to the Retail Price Index.

Convertible term – you have the option to convert in the future to another type of life assurance, such as a ‘whole of life’ or endowment policy, without having to submit any further medical evidence. This conversion option allows you to adapt your plan if your circumstances change. You can convert (usually within certain limits) part or all of your life assurance cover at any time during the term. And, importantly, you won’t be asked any health questions at the date of conversion.

If the level of cover you selected at the start remains the same, then the premiums will too. If you survive the policy term without any conversion of the plan, there will be no pay out. As this type of policy provides cover only in the event of death (plus the option to convert), there is no surrender value. So if you stop paying the premiums at any time, your cover would cease immediately and you would not receive any money back.

Renewable term – some term assurances are ‘renewable’ in that, on the expiry date, there is an option for you to take out a further term assurance at ordinary rates without providing evidence of your health status, as long as the expiry date is not beyond a set age, often 65. Each subsequent policy will have the same option, provided the expiry date is not beyond the limit set by the life office.

Family income benefit – instead of paying a lump sum, this offers your dependants a regular income from the date of your premature death until the end of the policy term. This is one of the least expensive forms of cover and differs from most other types in that it is designed to pay the benefit as an income rather than a lump sum. In the event of a claim, income can be paid monthly, quarterly or annually and under current rules the income is tax-free. To ensure that income payments keep pace with inflation, you can usually have them increased as inflation rises. It’s also possible to take a cash sum instead of the income option upon death.

Family income benefit can also include critical illness cover, which is designed to pay the selected income if you are diagnosed with a critical illness within the chosen term. It is a fixed term and you won’t be able to increase your cover or extend the term. If you become ill towards the end of the term (duration of your policy), you might not be able to obtain further cover.