Trusts are often viewed upon as being overly complicated and complexed. However, they can be an effective tax planning tool in retaining wealth and keeping it ringfenced for the benefit of future generations.
In this blog I look at the benefits of using a trust and the scenarios in which creating one works particularly well.
Regardless of whether your wealth has been accumulated through hard work or whether it has been inherited, a key concern is often around it being frittered away by future generations or ending up in the wrong hands. Assets within a trust are safeguarded, whereas a family member’s own assets are subject to attack in the event of bankruptcy or divorce.
Control & Flexibility
Understandably, many people want to maintain control rather than make a direct gift. Setting up a discretionary trust can be an excellent way of doing this. If you make a gift into a discretionary trust you can act as a trustee and have an element of control and ensure the right people benefit at the right time. Lifetime trusts created “today” can last for up to 125 years so several future generations may benefit!
Providing you survive seven years from the date the gift is made your taxable estate for Inheritance Tax purposes will reduce by the value of the gift.
However, it is important to be mindful that a tax liability at the lifetime rate of 20% will arise if the value of all gifts made into a discretionary trust exceeds £325,000 over the previous seven years. For couples making joint gifts this would be £650,000.
Furthermore, there may be periodic (10 yearly) and exit charges if assets are transferred out of the trust, although there are strategies where this can be minimised or avoided altogether.
A simpler solution, but less flexible
An alternative to setting up a Discretionary Trust would be to use a Bare Trust (also known as an Absolute Trust). A key difference is the beneficiary has to be nominated at outset and the trustee has no say in how and when they benefit. Once the beneficiary turns 18 they have an absolute right to the assets within the trust. This may not be desirable.
They are therefore a lot less flexible although are commonly used by parents and grandparents to fund a future known liability for a family member such as funding education costs. Bare Trusts offer tax advantages as the tax liability falls on the beneficiary. Furthermore, there are no potential tax charges on the way in.
There are pros and cons for using one or the other. Care should be taken when considering the most appropriate and it is advised that professional advice is sought.
Capital gains deferral
A trust may also work well where there is an asset holding a capital gain, such as a property or shares. In making the transfer the settlor (the person who creates and puts assets into trust) can elect to hold over the gain to the trustees. What this means is the trustees acquire the shares at the original purchase price and the gain is transferred to the trust.
Any sale of shares within the trust would be subject to a capital gains trust rate of 20% (the trust capital gains allowance is 50% of the individual allowance which is currently £12,300). With further planning the gain can potentially be passed on to a beneficiary whereby they can use their capital gains exemption to offset any taxable gain.
Retaining the Residence Nil Rate Band
A trust can also be used to potentially reduce the value of an estate to below £2 million in order to benefit from the full Residence Nil Rate Band (RNRB). In addition to the Standard Nil Rate Band (SNRB), the RNRB is an allowance which can be offset against the value of a main residence on first or second death (providing specific criteria are met). Much like the SNRB any unused RNRB can be transferred to a surviving spouse.
The value of the RNRB is currently £175,000 per individual or £350,000 per couple if unused on first death. Higher value estates above £2m will see the RNRB reduced by £1 for every £2 over this threshold. This means that the current RNRB would be completely lost if the estate is greater than £2.35m. Alternatively, where someone receives an unused RNRB from a former spouse they will lose both allowances once the surviving spouse’s estate is more than £2.7m.
However, although gifts made (either directly or into trust) in the 7 years prior to death will form part of the estate for IHT they are not caught by the tapering of the RNRB. This means some later life planning may be possible which could save as much as £140,000 in IHT if both RNRB’s can be retained.
Conversely, assets which may be IHT free due to the availability of business relief are included in the tapering test. However, this can be avoided if some or all of these assets are transferred into a discretionary trust during lifetime. Furthermore, if the assets have been held for at least 2 years there will be no lifetime tax charge on the way in.
Post death planning
A trust can be set up to receive a lump sum death benefit from a life policy. The benefit of doing this is that the trustees will receive the money very quickly and can pass it on to the beneficiary without waiting for probate. The lump sum won’t be counted as part of the estate and will not be assessable to IHT. Furthermore, if the policy has been set up to fund an IHT liability the funds will be available immediately to pay any tax due.
There are pros and cons of putting assets into trust. One of the main drawbacks for setting up a lifetime trust is loss of access. Once assets go into trust they can’t be used for the benefit of the person(s) who put them in there. This can’t be changed at a later date so an understanding of the implications of this is really important. However, there are some structures whereby the individual can retain a right to a regular stream of income or capital.
If it can be shown via financial forecasting that it is affordable for one generation to transfer wealth to another, using a trust can work particularly well to ensure there is peace of mind that the right people will benefit and at the right time. Along with the potential tax saving benefits, trust planning as part of a comprehensive family plan can work really well in protecting family wealth down the bloodline.
Any reference to legislation and tax is based on Ontrak’s understanding of current UK legislation which may be subject to change in the future.