Understanding lifetime trusts: the basics

Trusts are often seen as overly complicated or only for the very wealthy. The truth is, they are accessible, simple, and valuable tools used by many to protect assets, support generations to come, and plan for the future. Learn the basics of trusts and how they may help you protect your financial future. 

What is a trust, and when might you consider creating one?

A trust is a vehicle for an individual to pass the benefit of their assets onto their loved ones without them legally owning the assets. Typically, this is because it would be disadvantageous for such a gift to be given outright to the individual’s loved ones.

A trust is a legal arrangement, subject to its own law and tax rules. Whilst trusts can be created on death, this article will focus on Lifetime Trusts, which, as the name suggests, are created during a lifetime. 

What situations might you consider creating a trust?

There is no set scenario in which someone would create a trust. Trusts are a suitable tool for a variety of different people with wildly varying lifestyles and wishes. Trusts are designed for your individual situation, ensuring it meets the needs of both you and your chosen beneficiaries.

Maintaining family wealth is often of great importance; a lifetime trust provides people with the tools to effectively manage how their assets are passed to future generations. If you are beginning your estate planning journey and are conscious of Inheritance Tax, a trust can be a very useful tool to mitigate tax. They can help you move assets you no longer require out of your taxable estate and into a structure that allows the assets to be controlled outside of your estate. 

The basics of a trust structure

A trust comprises three independent parties (Settlor, Trustee(s) and Beneficiary(s)), the Trust Document and the Trust’s Assets.

The Settlor

This is the person who creates the trust and transfers assets into the trust. The settlor may face a tax charge on any transfers they make into the trust, so careful planning is required.

The Trustees

The trustees are the people who hold and manage the assets within the trust. They are duty-bound to act in the beneficiaries’ best interests, so careful consideration is required when choosing trustees. The trustees hold the legal title for all of the trust assets and are required to keep on top of trust administration. This means paying the relevant taxes and producing yearly accounts.

The Beneficiaries

The beneficiaries of the trust are the parties nominated by the settlor to benefit from the trust. Beneficiaries can be named as individuals or as a class (e.g. the grandchildren of the settlor). If you are a beneficiary of a trust, this may impact your own personal tax position.

The Trust instrument

The legal document that governs the trust is called the trust instrument. This will name the parties involved and detail the powers of the Trustees. These powers will include what assets may be distributed to beneficiaries and when these distributions may take place.

Ultimately, the trust instrument binds trustees in their duties, making it a complex document. It is extremely important that this document is prepared by a qualified individual. Failure to do so could result in unexpected consequences from a legal and tax perspective that may be expensive to correct or render the trust unfit for the purpose it was created.

Trust assets

The trust assets may be those originally gifted by the settlor on commencement or added during the trust. This includes gifts into the trust made by anyone else. Legally, the assets will belong to the trustees, but they can only use them for the benefit of the beneficiaries.

What types of trusts are available? 

 The trust document will define what type of trust has been created, which is important for legal and taxation reasons.

Bare Trust

A ‘bare trust’ means that there is a defined beneficiary to whom the funds are distributed in accordance with the trust instrument. Transfers into a bare trust are treated as transfers to an individual and are classed as Potentially Exempt Transfers (PETs). This means the Seven-Year Rule applies to taxation. Beneficiaries of bare trusts are, for tax purposes, treated as personally owning the assets. This means they will suffer tax on them (including income tax, capital gains tax and inheritance tax).

Interest in Possession Trust

An ‘interest in possession’ trust will typically name two different groups of beneficiaries: the “life tenants” and “the remaindermen”. The life tenants will have a right to the income produced by the assets in the trust, usually for the duration of their lives. After the life tenants have died, the assets of the trust will pass outright to the remaindermen. These trusts can be structured differently from that set out above. Traditionally, they were often used to provide an income for a widow or widower from a second marriage, whilst making sure the assets passed to the deceased’s children from the first marriage. 

Discretionary Trust

 A ‘discretionary trust’, on the other hand, grants the trustees discretion towards the maintenance and distribution of trust property. Broadly, this means the trustees can decide which beneficiaries get how much and when. The trustees do not have to treat all beneficiaries equally, but must consider the needs of all beneficiaries.

Discretionary trusts are often accompanied by a ‘Letter of Wishes’, in which the settlor sets out how they would like the trust to be administered. Due to their flexibility, discretionary trusts are often popular choices for long-term, inter-generational trusts as their flexibility allows adaptation to changing family circumstances, such as marriage, divorce and financial difficulties.

For tax purposes, transfers into discretionary trusts are treated as Chargeable Lifetime Transfers (CLTs), which can face an immediate IHT charge at up to 25%. With tax planning, it is possible to mitigate this tax liability. The trust document will define what type of trust has been created, which is important for legal and taxation reasons.