Setting up a trust for estate planning

Trusts have been used as a means of financial planning for centuries and go back as far as the Middle Ages. They are a way of ring-fencing assets in a place where they can be managed by one person or a group of people on behalf of others.

When it comes to estate planning, trusts are a good way to secure wealth so that it can be distributed to family members, protect assets that might otherwise be subject to divorce or bankruptcy proceedings, reduce tax such as inheritance tax and capital gains tax, and avoid delays when it comes to grant of probate. 

Whenever you set up a trust, it is generally advisable for it to be formally documented in a trust deed. The law surrounding trusts and the taxation of trusts is quite complex, so it is best for a solicitor to prepare the documents. Trusts must be registered with the Trust Registration Service.

Essentially, there are three parties involved in a trust, namely:

  • The settlor – the person whose assets are being placed in trust
  • The beneficiary or beneficiaries – those who are set to benefit from the trust
  • The trustees – the person or group of people managing the trust for the beneficiaries

Any trust must have at least one trustee and if the trust assets include any property or land then for legal reasons you need at least two trustees. There is also the option of appointing a professional trust company to act as trustee. Some of our clients appoint our trust company PMW Trust and can then feel reassured that our expertise and experience will be applied to the day-to-day management of the trust.

Unless specified, a trust lasts for 125 years but can be wound up sooner. 

Once the assets are in trust, they don’t belong to the settlor anymore, so they can’t just change their mind and try to get the assets back. There can be disadvantages from a tax perspective where a settlor names themselves as the beneficiary of a trust that they have set up, so generally this is not advised.

Bare trust

A bare trust is generally the simplest type of trust. An example of a bare trust would be if you owned a property and declared that you were holding it on bare trust for your children in equal shares. They would automatically become entitled to their share in the property once they reached the age of 18. Although in many ways this appears to be a straightforward arrangement we would always recommend that you obtain legal advice before setting up a trust so that all the implications can be explained. 

Life interest trust

With a straightforward life interest trust, a settlor places assets in a trust and names the beneficiaries who fall into two groups; life tenant/s and remaindermen. The life tenants are entitled to any income that is generated by the trust for the rest of their life (or until such other event as is specified in the trust document), but they are not entitled to the underlying trust assets, so for example, they might receive rent from a property but would have no absolute interest in the building itself. Alternatively, they may be able to live in a property owned by the trust for the rest of their life (or for such period as specified by the trust documents). When the life tenant’s entitlement comes to an end, the trust assets pass to the remaindermen.

Discretionary trust

A discretionary trust names a pool of beneficiaries, known as discretionary beneficiaries. This means they could potentially receive assets from the trust if the trustees decide to grant them – they don’t have an absolute right to anything. These trusts can be very complex and always need formal trust documentation. The settlor of a discretionary trust will generally be advised to write a letter of wishes to their trustees detailing what they would like to happen to the assets in the trust.

The differences between lifetime and will trusts

You can set up a trust while you are alive or create a will trust, which will come into effect when you die. There will be tax implications and other considerations when setting up both lifetime and will trusts, so it is always sensible to get professional advice. 

Trust administration

There can be a lot of admin involved in running a trust. First of all, you have to make sure it is registered properly and if there are any changes to it, it would need to be updated on HMRC’s Trust Registration Service. Certain trusts, especially those with a charitable element, need to provide detailed accounts, showing exactly where money is coming from and how it is spent. 

If there is a property involved with rental income or other investments that generate income or gains, these would need to be reported on an annual tax return, and trust tax would have to be paid.

 Discretionary trusts have tax charges that are payable every 10 years, so these would need to be calculated every decade on the anniversary of the trust. In addition, there may be exit charges when property leaves a discretionary trust.

In view of the complexities involving trusts, specialist advice is recommended.

Setting up a trust to mitigate inheritance tax

People have different motivations for setting up trusts and we regularly hear from people who ask if they can put property into trust to save inheritance tax. Careful planning is needed here as usually you cannot put your main residence into trust and remain living there, however, second properties can be put into trust. Also, you need to be aware that if you put assets into a trust and survive for seven years, the assets can potentially be considered outside of your estate and therefore not liable to inheritance tax, but you would have to be aware of the other potential tax implications of putting property into trust. The assets will also be protected from bankruptcy and divorce proceedings. 

If you have lots of spare capital and/or assets then a good way to mitigate inheritance tax, is to make use of the inheritance tax nil rate band. This is £325,000 for an individual. This means that if you gift this amount into a trust, it will generally not be considered part of your estate once seven years have passed. You can then transfer another £325,000 and so on.

Once a settlor places assets within a trust, they can no longer benefit from them unless they are named as one of the beneficiaries of the trust which can have adverse tax implications and so generally is not advised. For this reason, you need to think carefully about how much you can afford to put into a trust because you normally wouldn’t have access to the assets once they have been transferred.

Certain assets can qualify for inheritance tax relief and these include some types of business property and agricultural property. There can be tax advantages of transferring this type of property into a trust during lifetime or on death and a specialist will be able to advise on this. 

Setting up a trust to avoid care home fees

If you put assets into a trust that is not settlor interested then they no longer belong to you, the settlor, which means that the local authority shouldn’t be able to include the value of the assets in their calculations when assessing funding for your care. However, if it is deemed that you intentionally reduced your estate in order to avoid care home fees, the local authority may see this as a deliberate deprivation of assets, in which case, the value of your property will be taken into account when it comes to means testing. The same rules apply to the gifting of any large sums of money or valuables.

When trying to determine whether or not your actions were ‘deliberate’ the local authority will examine:

  • Motive – why did you gift your assets? 
  • Timing – there is no set time limit when it comes to deprivation of assets, but the time between the transfer and the need for care will be examined
  • Amount – if the assets were of a significant value 

At the end of the day, the local authority will look at whether or not you knew you’d be in need of care at the time of gifting the assets. The local authority can claim for care costs retrospectively if someone has deliberately deprived their assets. They can do this with court proceedings and may try and recover the assets from whomever they were transferred to. 

If you own a home with a spouse, which is part of a will trust, i.e. it passes into the trust when one of you dies, the surviving spouse has a ‘life interest’ which means they can continue living at the property and benefiting from either rent or a sale. When it comes to care, only your share of the property value will be included in local authority assessments. 

The share of the property that remains in trust is protected when it comes to means testing for care home fees, but it could still be considered a deprivation of assets if the authority feels that you deliberately divided your assets to avoid care home fees.  

The role of trustee

A trustee has a duty to behave in a responsible manner and to adhere to the terms of the trust. They must also act in the best interests of the beneficiaries, be impartial, and ensure that all trust admin is completed, and that includes tax returns. A trustee can step down and a new one is appointed in their place; you must update HMRC’s Trust Registration Service to reflect such changes. Trustees are liable for their actions, so the duties should be taken seriously – a failure to act in good faith or stick to the terms of the trust is known as a breach of trust. Legal advice should be sought if there are concerns about the behaviour or conduct of any trustees.  

Trust taxes

Trusts have their own tax laws, which need to be considered when using them for estate planning purposes, for example, if you transferred an asset worth more than £325,000 which is the nil rate band for IHT, into a lifetime trust, you would have to pay  20% tax on anything over that amount within 6 months. 

The trustees would then have to review the trust assets every 10 years to see if they are liable to pay a 10-year periodic tax charge. This is charged at a maximum of 6% of assets over the £325,000 band but the calculation is complicated. Income taxes can also be levied on any payments from the trust. 

Inheritance tax is usually charged at 40% of assets over the nil rate band of £325,000 with a potential extra £175,000 allowance for a residence handed down to direct descendants, so you could still save a considerable amount of tax by setting up a trust rather than paying tax on a valuable estate.

If the trust is taxable then the trust would also need to submit annual tax returns and pay income tax and capital gains tax on taxable income and gains. The trust would also be subject to a separate tax regime for trusts.                                                                                                                                                                                                                                                                                                                                                 

Avoiding sideways disinheritance

In cases of a second marriage where there are surviving children from the first, a life interest can be included in the will which will allow the surviving spouse the right to live in the property for their lifetime. Your share of the property would then pass in line with your wishes.

In summary…

Trusts are an important consideration when it comes to estate planning. They can reduce tax and ensure that your assets are distributed in the way you want them to after your death. Trusts have unique tax rules and require a lot of administration, so it is always best to seek legal and financial advice if you consider them as part of your estate planning.