What is a trust and how does it work?
Saturday 22nd May, 2021
Trusts can be very useful in passing your estate to your loved ones and avoiding Inheritance Tax. However, for many, trusts are only used by rich people and therefore remain a mystery. The following article is a basic guide which will explain what trusts are, how they work and some of the advantages of using a trust. It will highlight how all people, rich or not, can make a huge difference for themselves and their loved ones if they use a trust correctly.
What is a trust and how does it work?
Trusts are nothing if not resilient. They have existed in one form or another from Roman times, when the concept of trust (fideicommissum) was developed through wills and the law of succession. It developed further during the Crusades to allow a knight to split out ownership of his property, granting legal ownership to a trusted individual, while he was away fighting in the Middle East. This would allow the “trustee” to manage the property on his behalf, on the understanding that ownership would be returned to the knight on his return.
The law has since developed to encompass a number of different uses and this can be seen in the fact that many pension contracts are trust based, thus allowing the pension assets to be treated as not forming part of the member’s estate for IHT purposes.
So, what is a trust?
A trust is a separate legal entity that is set up to hold assets for the benefit of certain named beneficiaries or classes of beneficiaries.
The trust itself normally consists of three parties:
- The settlor, who creates the trust and gifts assets into it
- The trustees – who are the legal owners of the trust and are responsible for managing the trust assets for the benefit of the trust beneficiaries. The trustees may also have to exercise a discretion about who inherits, in what proportions and when, depending on how the trust has been set up
- The beneficiaries are the beneficial owners of the trust assets and are therefore legally entitled to benefit from the trust assets when they are distributed
How does the trust work?
The settlor first creates a trust, appointing the trustees and nominating specific beneficiaries (Bob Smith, Jane Doe etc) or classes of beneficiaries (such as children, grandchildren or great-grandchildren). They then gift assets into the trust. Now, provided that the settlor survives for 7 years after making the gift, the value of the gift should fall out of their estate for IHT purposes.
The settlor determines the parameters of the trust and may also provide an expression of wishes to the trustees, depending on what type of trust it is. The expression of wishes provides guidance to trustees with regards the intentions of the settlor in situations where the trustees are able to exercise a discretion over how the assets are distributed and who should benefit.
The trustees then become the legal owners of the trust assets. The settlor can also be a trustee, which gives them a more hands-on say in how the trust assets are managed and distributed. The trustees must administer the assets in the best interest of all the beneficiaries. This can become quite a complex task where there are multiple interests to consider.
For example, Mrs A dies and her will stipulates that her money should be put in trust and invested, with the income from the portfolio going to her husband while he is alive, and the underlying investments to her children upon his death. In this situation, the trustees will have to balance the husband’s need for income with the children’s need to achieve growth and maintain the value of the underlying investments in real terms. No mean feat.
The trust itself can continue for 125 years, but it is more likely that the trustees will distribute the assets long before that occurs. The trustees can also be beneficiaries of the trust, but it can cause problems for a trustee to have a vested interest in how the assets are distributed or managed. As a general rule, trustees need to unanimously agree any course of action taken with regards the trust assets. It is therefore easy for a trustee to be obstructive, if they are unhappy with the approach being applied. I often suggest to clients that it is better to simply use a corporate trustee that has no link to the bequest, in order to ensure neutrality and simplicity in the trust decision making.
How and when are trusts created?
A trust is very often created by a clause in a will, which then allows certain assets to be ringfenced for specific beneficiaries, such as financial dependents. I have had many clients who have arranged for a clause to be put in their will, leaving a property in trust for the benefit of a dependent child or loved one.
Alternatively, the deceased’s share of a property could be passed into trust, with the surviving spouse having a right to continue using the property until their death, at which point the share of the property is passed to the children. The idea behind this is to protect the property from being taken into consideration for care home fees. The theory is that the trust owns one half of the property, while the surviving spouse owns the other half. Since there is no market for the purchase of half a house, the value of the share of the property owned by the surviving spouse is zero. However, with cash strapped local authorities desperate for funds, I cannot see this approach continuing unchallenged.
Many trusts are also created during life by the settlor, with the aim of passing benefits on to loved ones and simultaneously reducing the size of their estate for IHT purposes.
Former Labour Chancellor Roy Jenkins famously described Inheritance Tax as ‘a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.’
While the sentiment is possibly tongue in cheek, the principle is sound. If you want to reduce your future IHT bill, reduce the size of your estate. The simplest way to do this is to spend it or give it away.
The trust allows the settlor to gift away assets and ring fence them for specific beneficiaries, to be received by them at a time, in an amount and subject to conditions of the settlor’s choosing.
A trust may also be created by a court in cases where the deceased dies intestate. This is normally done with the aim of setting aside assets for the benefit of minor children and financial dependents.
Why gift into a trust?
There can be little doubt that the easiest way to gift assets to a person is by making that gift directly to them. Apart from possible Capital Gains Tax implications of the disposal, this is the simplest way to transfer ownership of the assets. Provided the settlor survives for 7 years, the cost and simplicity of an outright gift makes it by far the most effective method of gifting.
So, why do people gift assets into trusts? There are a multitude of reasons, such as the beneficiaries being too young to own the assets in their own name.
However, the main reasons that settlors gift into trust are the following:
let's just look at that the element of control. How would a trust help a settlor retain control of gifted assets? Let's consider a scenario to highlight how a trust can help. Say that when you die, you pass all your assets to your spouse and your spouse then remarries. When your spouse dies, there is a strong possibility that they might choose to leave all their assets to their new partner. When this happens, is there any guarantee that the new partner won’t pass all of their newly gained wealth on to their own children, thus excluding your own children from any benefit? However, there is a simple solution. You simply put a trust in place which allows your spouse to continue benefiting from the assets from your estate, but ensures that those assets then pass on to your children upon your spouse’s death, and not anywhere else. It’s a simple solution, but it can save so much heartache and confusion in the future.
Then there is the protection element. I have come across many clients who want to gift assets to their children and to their grandchildren. However, they are hesitant to do so, as they are justifiably concerned that if they make a gift to their children, that child might get divorced, and their ex-partner will walk away with 50% of a gift that was not intended for them.
Once again, there is a solution. By gifting into a trust, you can ring-fence those assets for specific beneficiaries and prevent the situation where the assets you've gifted are attacked and taken by third parties. That not only holds true in cases of divorce, but also in cases of bankruptcy, or in situations where your selected beneficiary is going into care.
So why would you actually use a trust? Well, you use a trust, where you want to retain control over how the assets are distributed, when they're distributed, and to whom they’re distributed. You do that by setting up the trust, appointing trustees and nominating specific beneficiaries or classes of beneficiaries, which limits who can benefit from those assets. In addition, you protect those assets by putting them into a trust and by using the correct trust, ensuring that those assets can't be attacked by third parties.