Common misconceptions of trusts
The use of trusts by legal and financial advisers as a way of managing assets on behalf of other people has tried and tested benefits. Trusts are often used in inheritance planning, tax mitigation, lifetime estate planning to name a few.
However, there are several common misconceptions when it comes to setting up and administering trusts and Jodi Howe, a tax and trusts senior within the Trust and Taxation team at Clarke Willmott LLP, says these myths often put people off unnecessarily. We look at some of those misconceptions here.
Trusts can only be set up during lifetime
A trust can be created and constituted during a person’s lifetime. The Lifetime Trust can either be set up with a nominal sum, for example £10, and would sit dormant until further assets are transferred to the Trust. This is known as a Pilot Trust. The Pilot Trust can be activated during the lifetime of the settlor by the settlor transferring assets to the trustees. If the Pilot Trust is not constituted during the settlors lifetime then they can direct assets from their estate to the Pilot Trust by making a provision within their Will.
Trusts can also be created by a person’s Will, which come into effect on death. For example, nil rate band trusts, trusts for relievable assets (i.e. agricultural or business property relief), discretionary and life interest trusts of residue or life interest trust of property.
Another way a trust can be created is by Deed of Variation (“DOV”). A DOV is a document that can be executed within 2 years of a person’s death to vary an absolute entitlement under a person’s estate. The beneficiaires receiving assets from an estate may not always want or need those assets. It may therefore be advisable in some circumstances to redirect their inheritance onto a discretionary trust. The effect of a DOV is that it is read back to the testators Will as though the testator had originally intended for their assets to pass onto a discretionary trust. The benefit of a DOV is that person varying their entitlement is not making a gift and therefore does not need to survive 7 years.
Trusts are only for the rich and wealthy
Trusts are useful legal devices for asset protection purposes and offer great help to individuals in a range of financial positions.
Trusts can be used for a range of reasons, and the most common examples I come across are second marriages and trusts for general asset protection. Trusts can also be used to protect assets from vulnerable persons, and these can be set up in the form of a disabled person’s trust or personal injury trust, depending on the circumstances.
Starting with second marriages. People often marry more than once and blended families with children from more than one relationship are becoming more common. As you can imagine, tensions between family members can become heightened when a death occurs, and questions begin to arise as to the allocation and protection of the family’s assets and wealth.
In these circumstances, it is often advisable for a life interest trust to put in place for the surviving spouse and on their death, the assets pass to the children of the first spouse to die. By creating a trust in this way, it ensures the surviving spouse can continue to live in the marital home and/or to receive an income for their lifetime, and for the underlying capital to pass to the children on the life tenant’s death.
Moving to a disabled persons trust. An individual may wish to make a financial provision for a disabled person, for example their child. The trust can be created during lifetime or by Will, which will come into effect on death.
Why would you want to use a disabled persons trust over a discretionary trust? The child’s disability may mean that they are unable to manage money or that any benefits they are entitled to could be affected if money was left to them outright. Whilst a discretionary trust will protect the money for the disabled person, a disabled person’s trust will have certain tax advantages that a normal discretionary trust would not benefit from. It is for that reason that a disabled person’s trust may be more appropriate than a discretionary trust.
With personal injury trusts, if an individual is awarded compensation caused by a criminal act or negligence, it can be advantageous for them to set up a personal injury trust. The main benefit of a personal injury trust is that the compensation award is ignored when calculating the injured person’s entitlement to benefits or what financial help they would be entitled to for residential care.
Loss of control of assets placed into trust
When a trust is created, the person who settles assets into the trust is known as the settlor.
Upon creating the trust, whether that is during the settlor’s lifetime or by their Will, the settlor will have the opportunity at that stage to decide who the trustees of the trust will be.
If the trust is created during the settlors lifetime then it is quite common for the settlor to be one of the trustees. The other trustees might be family members, long-term friends, professional trustees, or a combination.
Once the trust has been created and the settlor has transferred the assets over to the trustees, the settlor at that stage relinquishes their control over those assets.
One way which the settlor can maintain a form of control over the trust and how it is managed is by providing the trustees with a document known as a Letter of Wishes. A Letter of Wishes is a document prepared by the settlor and is intended to provide the trustees with a guide as to how the trust should be managed and administered, and in some circumstances, says how to divide the trust assets.
It is important to point out that a Letter of Wishes is not a binding document and as such, if the trustees do not follow the settlor’s wishes, then they would not be breaching the terms of the trust. However, the trustees would need to have good reason to not want to fulfil the settlor’s wishes and could be scrutinised by the beneficiaires. It is therefore important that from the outset the settlor chooses people they can trust to act as trustees to fulfil and carry out their wishes. A professional trustee may be the most appropriate choice, especially if family relationships are fractured. Professional trustees are held to a higher duty of care than that of lay trustees and professional trustees would seek to follow the settlors wishes.
Trusts are used for tax avoidance
A big common misconception is that trusts are used for tax avoidance.
Trusts are subject to their own tax regimes and in fact, tax rules applicable to trusts are often higher than those applying to individuals or companies, with trusts paying the highest rates of income tax, capital gains tax and stamp duty, not to mention having minimal tax-free allowances as well.
Nevertheless, many consider the tax charges are worth paying for the protection afforded to beneficiaries of a trust structure.
Some trusts will be subject to inheritance tax on the death of a lifetime beneficiary, for example an immediate post death interest trust, and other trusts will be subject to inheritance tax on every ten-year anniversary of the trust and when assets are transferred out of a trust to a beneficiary absolutely, known as an exit charge. The calculation for a 10-year anniversary charge and exit charge can be complicated but often result in nominal tax liabilities with the maximum rate of tax applied being 6%.
Trusts are expensive and costly
It is no secret that there are costs involved with creating a trust, whether that is during lifetime or on death, and there is likely to be ongoing administration costs. However, depending on the circumstances and assets contained within the trust, there are ways to mitigate administrative fees, for example by making loans to beneficiaires therefore reducing the annual administration, and other costs associated to the trust, for example income tax and capital gains tax mitigation.
Jodi Howe is a member of the Chartered Institute of Legal Executives (CILEx). She deals with a large variety of trusts and specialises in trusts which have vulnerable beneficiaries.
Speak to a member of our private capital team by calling 0800 652 8025 or by sending an enquiry.
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