This piece first appeared in Saga Magazine in January 2007
The text here may not be identical to the published text

 

Putting your faith in trusts

Trusts began in the 11th century when some of the wealthiest and most powerful men in the country went to the Middle East to fight the religious wars we call the crusades. At best they would be gone for years. At worst they would die with no-one ever certain of their fate. So they wanted to ensure that while they were away their wives would be cared for and ultimately their heirs would inherit. But if they returned safely their property would be intact and belong to them. Trusts were invented to achieve that. Three parties were involved. The ‘Settlor’ who owned the property. The ‘Trustee’ who looked after the property for the Settlor. And the Beneficiaries, usually the Settlor’s family, who had the use of the property and money while he was away but did not own it.

Solving problems
Although trusts began with the wealthy – and are still widely used by them – they can have a place in financial planning for people of more modest means. If you want to give money to grandchildren, if you want to enable someone to live in a house but not to own it, or if you want to help relatives after your death then trusts can be the best way of achieving those objectives.

Trusts can also be used in tax planning. Originally they were not a way to avoid tax –the crusaders were men who collected taxes rather than paid them, that is why they were wealthy! But traditionally trusts have been taxed more favourably than individuals and that led to a massive industry to help the very wealthy use trusts to avoid, or at least reduce, the tax they had to pay. Over the years those gaps have been plugged and in March 2006 tough new rules began which ended most of their remaining tax advantages. These new rules only affect people who set up a trust with more than about £300,000.

Types of trust
The simplest trust is what is called a Bare Trust. It can be set up for a child under 18 where you want to control the money until they reach that age. The beneficiaries own the property in the trust and any income it earns. Once the child reaches 18 (16 in Scotland) they will be able to take the property and do what they want with it. But there are two safeguards. First, they have to know it is there. Second, if you say ‘no’ they have to go to court. So it may be possible to persuade them to let you continue to control it until they are older. Bare trusts were not affected by the recent changes. However, as the beneficiaries own any income earned by the property they will have to pay tax on it if it exceeds their personal allowance – currently £5035 a year. The trustees have the duty to pay the tax. If you are a parent of the beneficiary, then any income earned by money you have put in the trust can be taxed as your income if it exceeds £100 a year. That limit applies separately to each parent.

By contrast a Discretionary Trust owns the property and the trustees have to use it for the benefit of the people named in the document which set up the trust. The trustees have absolute discretion about how they do that. They can make payments or not to some or all of the beneficiaries.

Under the new regime, large discretionary trusts may have to pay more tax. If the money put into the trust is less than the current threshold for Inheritance Tax (£285,000 this tax year and £300,000 next) then there is no tax to pay. But if it is more, the excess is taxed at 20% when the trust is set up. Every ten years the trust is valued and if it is worth more than the IHT threshold at the time the excess is taxed at 6%. And when the trust is finally handed over to the beneficiaries there is an exit charge calculated in a similar way. So for amounts under the IHT threshold – which covers most of us – a discretionary trust can be a good idea.

A trust set up in a will is taxed differently. There is normally no set up charge because the money going into the trust comes out of the estate where inheritance tax has already been paid. If the trust is set up by a parent and the money is passed to the child when they reach 18 there is no exit charge either. But if that is delayed until they are 25 – the latest possible – then there is an exit charge of 4.2% of the excess over the threshold for Inheritance Tax. That can be seen as the price for keeping the money out of the young person’s hands until they are 25. But if the total in the trust is less than the IHT threshold there is no tax to pay. Trusts of any size set up for disabled people are generally exempt from these tax charges.

One popular way to leave money to grandchildren in the past was an Accumulation & Maintenance Trust. They are a form of discretionary trust with the money being used for the education or maintenance of the young person with the capital normally handed over to them at 25. Large A&M Trusts set up before 22 March 2006 should be changed before 6 April 2008 to give the young person full ownership to the capital at some time between 18 and 25. There will be a tax charge when the money is handed over on a sliding scale on the excess above the threshold at that time. It ranges from zero at 18 to 4.2% at 25. If an existing A&M trusts is not changed by that date and the property in it is worth more than the threshold for Inheritance Tax, the tax will be heavier. Nowadays, a discretionary trust is an easier option as the advantages of A&M trusts have disappeared.

Finally, there are Interest in Possession Trusts. They enable the family home to be left to the children but give the surviving partner the right to use it for his or her lifetime. If the home was simply left to the surviving partner then he or she would be free to leave it to someone else, cutting out the children. When set up in a will, these trusts have not been affected by the changes made this year. But they have been given a new name – Immediate Post Death Interest trusts or IPDIs. Whatever the value of the home they can be a good way to ensure that ultimately it passes to the children. However, the value of it will form part of the estate of the surviving partner – even though they have no control over what happens to it – and IHT could be due. If such a trust is set up before death – after a separation for example – then there may be tax to pay if the value of the home is more than the threshold for inheritance tax at the time.

Life insurance
When you die any life insurance is normally paid into your estate and becomes potentially subject to Inheritance Tax. That can be avoided by having the life insurance policy left to a trust – often called being ‘written in trust’. In other words when you die the beneficiary is not your estate – and thus your heirs – but a trust. Normally the trustees are the insurance company itself and you give instructions about what should happen to the money when you die. Because the proceeds of the policy are not part of your estate they are free of Inheritance Tax even though your heirs would normally end up with them. Under the recent changes in the law, if a life policy contains investments and is worth more than the threshold for Inheritance Tax when it is written in trust then a tax charge may be due. But for most people that would not be an issue.

Trust law is complicated and mistakes can be so expensive so anyone considering setting up a trust should get professional advice from a lawyer or accountant who specialises in them – preferably a member of STEP, the Society of Trust and Estate Practitioners www.step.org

January 2007

 


All material on these pages is © Paul Lewis 2007