Understanding Financial Trusts

What is a Financial Trust?

A financial trust is a legal arrangement where one party, known as the trustee, manages assets for another party, known as the beneficiary. The individual or entity who sets up the trust is the settlor. Trusts can hold various assets, including money, property, shares, and other investments. The trust document outlines the terms and conditions under which the assets are managed and distributed.

Types of Trusts in the UK.

There are several types of trusts recognised in the UK, each designed to serve different purposes. Below are some of the most common types:

• Bare Trusts: Also known as a simple trust, holds assets on behalf of a beneficiary without any special provisions or conditions. The beneficiary has the immediate and absolute right to both the capital and income of the trust, not just upon reaching the age of majority. Bare trusts are often used for tax planning purposes, such as transferring assets to children to take advantage of their personal tax allowances.
• Discretionary Trusts: In a discretionary trust, the trustee has the authority to determine how the income and capital are distributed among the beneficiaries. The trustee may consider a variety of factors, such as the needs and circumstances of each beneficiary. These trusts are particularly beneficial for families with children who have varying financial needs or for beneficiaries with potential creditors, enabling the trustee to withhold distributions if necessary. Discretionary trusts can also provide for beneficiaries with special needs without affecting their entitlement to state benefits.
• Interest in Possession Trusts: An interest in possession trust gives the beneficiary, often referred to as the "life tenant," the immediate right to receive income generated by the trust assets, but not the right to access the capital. The life tenant receives the income for a specified period, often for their lifetime. After which, the capital typically passes to another beneficiary known as the remainderman. These trusts are often used in conjunction with wills to provide for a surviving spouse while preserving the capital for children from a previous marriage.
• Accumulation and Maintenance Trusts: These trusts are typically established to benefit minor beneficiaries but do not automatically vest the assets in them upon reaching a certain age. The assets can be held in trust and accumulated until a future date, such as when the beneficiary reaches a specified age. Trustees have the flexibility to use the income and, in some cases, the capital, for the beneficiaries' education, maintenance, or benefit. Later legislation has largely replaced these trusts with 18-25 trusts. These types allow the property to be held in trust until the beneficiary reaches 25, with the flexibility to distribute income and capital as needed until that age. These trusts are subject to specific tax rules, such as the relevant property regime, which affects their tax treatment.
• Charitable Trusts: Charitable trusts are set up with the intention of benefiting charitable causes. These trusts can provide tax advantages, such as Gift Aid, which allows charities to reclaim 25p every time an individual donates £1. To qualify, the trust must be registered with the Charity Commission, support charitable purposes only, and meet specific legal requirements under the Charities Act 2011. Additionally, charitable trusts can benefit from other tax reliefs, such as relief from capital gains tax and stamp duty.

Purposes of Trusts

Trusts can serve a myriad of purposes, depending on the objectives of the settlor. Some common reasons for establishing trusts include:

• Asset Protection: Trusts offer a means to protect assets from creditors, lawsuits, and other claims. By transferring ownership of assets to a trust, individuals can shield their wealth and ensure it is preserved for future generations. For example, assets in a trust can be protected from divorce settlements and business failures, providing a robust shield for family wealth.
• Estate Planning: Trusts are commonly used in estate planning to manage the distribution of assets after death. They can help avoid probate, minimise estate taxes, and provide for dependents in a controlled and predictable manner. Trusts can also help avoid forced heirship rules in other jurisdictions, providing a way to distribute assets according to the settlor's wishes.
• Tax Efficiency: Certain types of trusts offer tax advantages, making them an attractive option for high-net-worth individuals looking to minimise their tax liabilities. For instance, charitable trusts can provide significant inheritance tax relief. Trusts can also be used to mitigate capital gains tax by spreading gains over multiple tax years or beneficiaries.
• Providing for Minors or Vulnerable Beneficiaries: Trusts can be an ideal solution for providing for minors or beneficiaries who may not have the capacity to manage large sums of money. Trustees can manage the assets and ensure they are used for the intended purpose, such as education or healthcare.
• Philanthropy: Setting up charitable trusts allows individuals to support causes they care about in a structured and tax-efficient manner. These trusts can be designed to provide ongoing support to charities or specific projects.

Benefits of Trusts

• Control and Flexibility: Trusts provide a high degree of control over how assets are managed and distributed. Settlors can set specific terms and conditions, ensuring their wishes are followed even after they are no longer able to manage the assets themselves. Specific conditions may include age milestones, educational achievements, or even provisions for care in the event of illness. Trusts can also include provisions for the appointment of new trustees or the amendment of trust terms under certain conditions.
• Confidentiality: Trusts offer a level of privacy that is not available with other financial instruments. The details of the trust do not become public record, which can be beneficial for individuals who value confidentiality. However, it's essential to note that while the details are private, the trust itself must comply with anti-money laundering regulations.
• Continuity: Trusts can provide continuity in asset management, ensuring that assets are managed according to the settlor's wishes over the long term. This can be particularly important for business owners or individuals with complex financial arrangements.
• Tax Planning Opportunities: As mentioned, certain types of trusts offer tax benefits. By carefully selecting the type of trust and structuring it properly, individuals can minimise their tax liabilities and maximise the value of their assets.

Tax Implications of Trusts

While trusts can offer significant tax advantages, they also come with specific tax obligations and considerations. Understanding these implications is crucial to ensure compliance and optimise the benefits of a trust.

• . Income Tax: The taxation of trust income can vary depending on the type of trust and how it is structured. Discretionary trusts, for example, are subject to higher income tax rates (currently 45%) on any income retained within the trust. Beneficiaries may be able to reclaim some of this tax on distributions they receive, depending on their personal tax situation. Trustees must provide beneficiaries with a tax certificate (R185) to help them reclaim any overpaid tax.
• Capital Gains Tax (CGT): Trusts can be subject to capital gains tax on the disposal of assets. However, there are specific reliefs and exemptions available. For example, Entrepreneurs' Relief provides a lower rate of CGT on the disposal of business assets, which may apply if the trust holds business interests. Trusts can also benefit from the annual CGT exemption, although it is usually lower than the individual exemption.
• Inheritance Tax (IHT: Inheritance tax is a significant consideration when setting up trusts. While certain trusts, like charitable trusts, can provide IHT relief, others may have periodic charges. For instance, discretionary trusts may be subject to a 10-year anniversary charge (currently up to 6%) and exit charges when assets are distributed. These charges are calculated based on the value of trust assets above the nil-rate band. Certain trusts, such as those for disabled beneficiaries, can benefit from special IHT treatment.
• Trust Registration: As of recent changes, most trusts in the UK must be registered with HMRC's Trust Registration Service (TRS). This includes providing detailed information about the settlor, trustees, and beneficiaries. The TRS requirements include providing information on the trust's beneficial owners and that trustees must keep this information up to date. Recent deadlines for registration must be adhered to, and failure to comply with registration requirements can result in penalties.