In Focus: Family trusts

A trust is a legal entity that enables individuals to pass on assets while at the same time retaining some degree of control over them. Trusts have been part of the English legal system for centuries and are used for myriad reasons.

There is a common misconception that trusts are a way to avoid paying tax. Generally, the use of a trust will not in itself save tax. They are often used to manage assets for those less capable of doing so themselves and to protect assets that have been given away. Farming families and landed estates often use trusts to ensure land and properties can be managed effectively for the benefit of a family, rather than being broken up and sold off by future generations.

A trust involves three parties – the settlor, who creates the trust; the trustees, who take control of the assets; and the beneficiaries, who benefit from the trust.

The role of the trustees is to manage and administer the trust in accordance with the terms of the trust. They do not benefit from the trust themselves unless also named as beneficiaries, but they can claim expenses from the trust for its ongoing management and administration.

The beneficiaries are those entitled to benefit from the trust assets and/or the financial income generated by them. Depending on the terms of the trust, they may have a guaranteed entitlement from the trust, or they may only benefit at the discretion of the trustees.

Setting up a family trust can be done in two ways. It can be done by the settlor in their lifetime, under an instrument called a deed of trust. A deed of trust - also referred to as a declaration of trust - takes effect right away. It involves a gift by the settlor of the assets held on trust.

Alternatively, the settlor can instruct for a trust to be set up in their will to take effect on their death. In this case, the settlor retains ownership of the trust assets for the remainder of their life.

The trustees have a legal duty to administer the trust fairly, balancing the interests of all the beneficiaries. Sometimes, the settlor will write a ‘letter of wishes’ giving guidance to the trustees on how to administer the trust assets. However, this is not legally binding and acts only as an advisory note.

There are several different types of trust, all of which achieve slightly different objectives and different ways to classify them. Based on the type of benefit given to the beneficiaries, the main ones include:

• A bare trust
• An interest in possession trust
• A discretionary trust

All of these can be used by farming and landowning families to protect assets, although understanding which one is most relevant to your business and succession plan may require specialist advice.

A bare trust is the simplest form of trust, where the beneficiary is absolutely entitled to the trust assets straight away. In effect, the beneficiary is the real owner and is entitled to direct the trustees in the use of the assets, providing the beneficiary is 18 or over and of sound mind. They are often used to hold land or investments for children.

This type of trust entitles the beneficiary to the net income from the trust, but they don’t have a right to the underlying cash, property or investments that generate that income (i.e. the capital). It is commonly used to ensure that a dependant such as a spouse receives an income for life. The role of the trustees is to manage the assets on a day-to-day basis, including making investment decisions, and pay the income generated, minus any expenses incurred, to the beneficiary.

On the beneficiary’s death, the assets will then pass per the terms of the trust (e.g. to the settlor’s children or a discretionary trust).

A discretionary trust is a popular option for families aiming to protect their assets, given the high degree of flexibility they offer. The settlor hands the assets over to the trustees and will often give guidance as to how they would like them to be used. Crucially, however, this gives discretion to the trustees as to how both income and capital funds are to be distributed among the beneficiaries.

Discretionary trusts are particularly useful as a way of providing for children, as they enable the trustees to provide funds to each child as and when they are needed, such as to pay for their education, rather than equally and at the same time. Similarly, they can also be useful for providing for adult beneficiaries at key points in their life (for instance, buying a new home, setting up a new business, or financial hardship) while preserving a fund for future generations.

Trusts are an efficient and flexible way to give money or assets to your family during your lifetime or on death, enabling you to provide for future generations without giving up control entirely. A particular appeal to farming and landowning families is that they can separate ownership and control of land, meaning for instance that agricultural land can continue to be farmed as a single unit with the profits supporting various members of a family. This can be preferable to the land being split up between different beneficiaries, which may result in separate plots being sold off or being too small to be used economically.

Trusts also have more flexibility than other arrangements for passing on assets. For example, it is not always wise to give large gifts such as a farm, a large amount of agricultural land, or large sums of money over to children or grandchildren outright. An unexpected change in circumstances such as debt or divorce may mean that the assets end up in the hands of someone else entirely, outside of the family.

Potential benefits of family trusts include:

• Helping manage your exposure to inheritance tax.
• Avoiding the delay of waiting for probate to deal with assets when someone dies.
• Providing for disabled family members while ensuring they have the support they need to manage the money.
• Avoiding family assets being drained by the local authority to pay for care.
• Keeping family assets out of the reach of creditors should your child get into financial difficulty.
• Helping shield family assets from the consequences of a child getting a divorce.
• Protecting your assets should someone in your family have a gambling problem or other difficulty managing their finances.

Trusts are subject to various taxes in different contexts, but the main ones to consider are capital gains tax, income tax and inheritance tax. The level of taxation is dependent on several factors, including the type of trust, the value of the assets put into it, and the identity of the beneficiaries. Other taxes may also apply in specific circumstances (e.g. stamp duty land tax on the purchase of land).

Yes, trustees will need to pay tax on income received by them. The rate will depend on the type of trust (whether it is a discretionary trust or one in which a beneficiary has an interest in possession). A beneficiary who receives income from a trust will receive it net of the tax paid by the trustees. Depending on their own income, they may be required to pay further income tax or may be entitled to claim a refund of tax from HMRC.

Trustees will have to pay capital gains tax on any capital gains over the trust’s annual exempt amount, which is half that of an individual, at the rates payable by higher rate taxpayers (i.e. 28% for residential property and 20% for most other assets).

Do note that the creation of a trust in your lifetime will also potentially give rise to a capital gains tax liability for the settlor, although in certain circumstances this can be ‘held over’ (i.e. postponed until a later date).

There may be an inheritance tax charge payable on the creation of the trust. Where the trust is created by a will, the assets passing to the trust will be taxed as part of the deceased person’s estate in the same way as any other gift. Where the trust is created by a settlor during their lifetime, there will be an immediate inheritance tax charge if the value of assets placed into the trust exceeds the settlor’s available nil rate band (£325,000, unless they have made any other gifts in the last seven years). There may be a further inheritance tax charge if the settlor then dies within seven years.

Beyond that, most trusts are subject to rules known as the ‘relevant property regime’. This means they will be subject to a charge of up to 6% on every 10th anniversary of the trust’s creation, as well as a proportionate exit charge when capital assets are removed from the trust or the trust is closed.

The level is based on the most recent 10-year valuation and is charged pro-rata to the number of years since the last valuation.

There is an exception for a certain category of trusts (interest in possession trusts set up in a person’s will to take effect on their death) which are classed as ‘immediate post-death interests’ and are subject to their own special inheritance tax treatment, which means that the value of the trust is added to the value of the beneficiary’s own estate to determine the tax payable when they die.

There are also specific rules for trusts created for disabled persons and bereaved children.

It is possible in theory to create a trust of which the settlor is also a beneficiary, and there are certain circumstances in which this will be appropriate. However, this will rarely be the case if one of the goals is inheritance tax planning, since it will be classed as a ‘gift with reservation of benefit’ which means that the settlor is still treated for inheritance tax purposes as if they owned the assets placed in trust. In order to potentially save inheritance tax, it is therefore important to exclude the settlor from any possible benefit from the trust.

Yes, there is no reason that a settlor cannot also be a trustee of their trust, and this is not uncommon. In most cases, however, it will be better to have at least two trustees.

These should be people who will be capable of bearing the responsibility of acting as trustees and acting fairly between the various beneficiaries.

The potential benefits should be weighed against the additional compliance burden and costs they will involve. Professional advice should always be taken before setting up a trust.

While this article has set out some general information about family trusts, it cannot provide answers for your individual circumstances, if you are considering setting up a trust or dealing with an existing trust.

CLA members can benefit from free advice and expertise from our team of experts in land use, legal and tax affairs.

They can give advice on:

• What areas you should be considering in relation to trusts and general estate planning
• Actions you need to take to maintain value
• Information on all your different tax and legal options
• Which questions you should ask your professional advisors and what you should be instructing them to do, so you use their time more effectively

They also:

• Share best practice with other similar farms or smallholdings
• Provide updates whenever the law or tax regulations change
• Provide active, effective lobbying for the landowner and smallholder to defend the value of your assets.