Discretionary trusts an how they can be used by UK domiciled investors. This article only considers UK inheritance tax and does not take into account other taxes or local rules.
What is a trust?
Simply put, a trust allows your clients (the settlors) to gift their assets (the trust fund) to the trustees for the benefit of their beneficiaries. It is the responsibility of the trustees to take control of, manage and ultimately distribute the trust fund to beneficiaries.
A trust is one way to move money out of your clients’ estates, perhaps to reduce potential liability to certain taxes. It can also avoid the potentially lengthy delays often associated with administering estates so that, in the event of a death, the people the deceased want to benefit from their estate do so as quickly as possible.
All manner of assets can be placed in a trust, including investments and life assurance policies.
Certain trusts not only allow your clients to pass on wealth when they die but can also give them access to regular withdrawals when alive. However, you should be aware that with trusts designed to achieve a tax saving, your clients usually have to forgo access to at least some of the original capital as well as any capital growth.
Types of trust
There are a number of different forms of trust but in their basic form they can be categorised as absolute/bare or discretionary trusts.
The main differences between the types of trust are the beneficial rights that the beneficiary may or may not have. For example, with an absolute trust the beneficiaries are named and they have an absolute right to benefit under the trust – so much so that in England and Wales once an absolute beneficiary reaches age 18 they can demand that the trustees advance that beneficiary’s entitlement.
However, with a discretionary trust there are no named beneficiaries. Instead, there are predetermined lists of beneficiaries. These can be family members including spouses or civil partners, friends, registered charities and even companies. With a discretionary trust, the trustees have absolute discretion over who may benefit under the trust, so even if a beneficiary is within the class of beneficiaries there is no guarantee that they will benefit from the trust in any way.
Uses of a trust
There are a number of reasons why a trust may be used. Some examples are:
- Tax planning
- Succession/generation planning
- Avoid probate
- Protection of asset
Let us take the example of a widower, Mr Brown, who has recently passed away. He leaves £500,000, net of any inheritance tax (IHT) due, to a discretionary trust with his son David, daughter-in-law Alison and their two children, Ben and Jessica, as potential beneficiaries.
Assuming that the trustees decide to create an interest free loan of say £500,000 from the trust to David, he has enjoyment of the money during his lifetime and, on his death, £500,000 would be repaid to the trust free of IHT. The whole process may then be repeated for subsequent generations subject to the perpetuity period – 150 years Manx Law, 125 years English Law.
Alternatively, it may be that David and Alison already have a potential IHT problem of their own and never require access to the assets and the trustees choose to skip a generation, allowing Ben and Jessica to benefit.
Loss of control
One of the main concerns raised by clients when considering a trust is the loss of control, due to the fact that the trustees become the legal owners of the trust assets and the fact that sole discretion over the use of the trust property is with the trustees and not the settlor of the trust.
There are some practical solutions which may help to alleviate some of these concerns:
- Choice of trustees
- Use of a letter of wishes
- Appointment of a protector
Choice of trustees
Consideration should be given as to whom to appoint as a trustee. It is possible to appoint a family member or a friend, but it is imperative that they understand their legal obligations and of course fulfil any reporting requirements. For these reasons, as well as financial planning considerations (eg if the trust is to be used for a number of generations), professional trustees may be considered.
For UK domiciles more information on using a professional trustee can be found in:‘a guide to trusts by Old Mutual International Trust Company’. For non UK domiciles more information can be found in: ‘a guide to trusts for international investors’.
Use of a letter of wishes
A letter of wishes is a document which the settlor provides to the trustees setting out their wishes. For example: ‘On my daughter obtaining age 21, I would like the trustees to consider advancing $100,000 to her’. A letter of wishes is not binding on the trustees but helps to provide some guidance of the settlor’s wishes. This is especially useful where a professional trustee is used.
Appointment of a protector
It is also possible to appoint a protector. The term ‘protector’ is used to describe a person who is generally granted by a settlor (under the terms of a trust deed) some powers over the administration of a trust; such power to be exercised in addition to powers granted to the trustees. It is possible for the settlor to be appointed as the protector of the trust.
The protector does not have the same powers as a trustee and whilst the protector would not be involved in the day-to-day administration of the trust, they will have to fulfil certain duties and responsibilities. For more information on appointing a protector please click here for our article ‘The role of a protector’.
Types of discretionary trusts available from Old Mutual International & Wealth
The following is a very high level overview of the types of discretionary trusts available through Old Mutual International, Old Mutual Wealth or Old Mutual International Trust Company. For more information on these and other trusts available please contact your Old Mutual consultant.
Settlor included discretionary trust
As with all discretionary trusts there are no named beneficiaries, just a list of predetermined people and other legal entities who may become a beneficiary. The trustees have complete discretion over whom on the list benefits from all or part of the trust property.
This type of discretionary trust includes the settlor as one of the beneficiaries of the trust property. As the settlor is included as a possible beneficiary, any gifts made into the trust are considered as a gift with reservation (GWR), which means that the value of the asset is still considered inside the settlor’s estate for UK IHT purposes.
Although this type of trust offers no UK IHT benefits for a UK domiciled individual, there are a number of non-tax benefits which make this type of trust attractive.
As the legal ownership of assets is transferred to the trustees, this will avoid the need to wait for grant of probate on the settlor’s death before assets may be distributed or loaned to beneficiaries.
Settlor excluded discretionary trust
With the discretionary trust settlor excluded the settlor is not within the class of potential beneficiaries, in fact the settlor is specifically excluded from benefiting from the trust. This type of trust is used where the settlor is able to make a gift and does not ever need to benefit from that gift.
Flexibility is maintained for the trustees (sometimes with the guidance of a protector) to distribute or loan capital to beneficiaries at any time in the future. This is often preferable to a bare or absolute trust where beneficiaries are fixed and cannot be changed.
This type of trust is often used to provide funds for school fees or to pass funds to children or grandchildren once they are sufficiently mature to deal with the inheritance.
The loan trust is a means of providing access to the original capital investment for the settlor yet precludes access to the growth and removes it from the settlor’s estate for UK IHT purposes. However, the original capital is still very much in the estate for UK IHT purposes until it has been repaid to the settlor and spent.
Under the loan trust scheme a settlor appoints trustees for a discretionary trust and makes a loan to them on an interest-free basis, repayable on demand. The trustees then typically invest the cash into a single premium bond (life assurance or capital redemption version) in the name of the trustees. The loan is repayable to the settlor on demand and can be paid on an ad hoc basis or as regular payments (withdrawals).
All growth on the trust fund for the discretionary loan trust immediately sits outside the settlor’s estate.
As a discretionary loan trust, there are no named beneficiaries, just a list of pre-determined people and other legal entities who may become a beneficiary. The growth on the trust fund can subsequently be distributed to beneficiaries at the trustees' discretion within certain parameters.
This type of trust can be used by settlors who are not willing to give up access to the capital yet wish to start UK IHT planning by freezing their liability on the capital at 40% of the original premium.
Discounted gift trust
A discounted gift trust is a trust which allows clients to give away assets for UK IHT purposes, whilst still retaining a right to take regular withdrawals during their lifetime. The value of the gift (the premium paid to the bond) is potentially discounted by the value of this retained right (in basic terms, the right to receive withdrawals is valued) to reduce the liability to UK IHT immediately.
The discounted gift is considered a gift for UK IHT purposes and if the settlor of the discretionary trust were to die within seven years of declaring the trust then IHT may be due.
As a discretionary discounted gift trust, there are no named beneficiaries, just a list of pre-determined people and other legal entities who may beome a beneficiary.
The trust fund for the beneficiaries is known as the residual fund, and it is not ultimately determined until the death of the settlor, because the residual fund is the trust fund less the settlor's fund (the settlor's right to receive pre-determined withdrawals throughout their lifetime).
On the death of the settlor, the trustees may exercise their discretion to distribute the residual fund to one or more of the beneficiaries.
There are various reasons why your client may wish to use a trust, and the purpose of this document is to provide a general overview of the variations of discretionary trust available and the access versus UK IHT efficiency trade-off. A key consideration for a settlor will be based on whether they wish to retain the right to withdrawals from their investment or whether they wish to gift away any of their capital.
It is common for settlors to use a combination of these options and to develop the planning as they progress through life and circumstances change.
Ultimately the objective is to minimise UK IHT on death but, perhaps more importantly, pass assets to the next generation via a trust rather than outright. All of these trusts will achieve the latter and the level of UK IHT efficiency depends on the option chosen.
A by-product of the use of a trust may also be an element of asset protection. Consider a situation where the settlor declares a discretionary trust of say £1 million. A number of years later he is getting divorced and has been asked to state all his assets. The settlor does not declare the trust fund as this is no longer an asset he is the legal owner of.
It is very important that advice is sought before this planning is instigated as there are many other factors to consider.
All of the discretionary trusts described are subject to the UK relevant property regime and as such are potentially liable to tax not only on death but also during life. Establishment charges, exit charges and periodic charges may all apply and must be considered with all of the planning. The order in which the trusts are created and the interaction with other gifts are very important and again advice should be sought.