Understanding trusts

Jeremy Pearson discusses the pros and cons of choosing trusts

Do you feel the general public is now more aware of the need to make inheritance tax provisions?

Yes, they are, but you have to have a lot of patience before they do anything about it! Estate planning business has always had a long lead time and the recent change that allows the transfer of nil rate bands and the recent drop in property and stockmarket values has seemingly extended this. Given the recent improvement in discounted gift trust discounts, hopefully estate planning will be being promoted more heavily by financial advisers.

The key factor in increased awareness is through press coverage, for example the tabloid IHT campaigns before the last election and the introduction of transferable nil rate bands. As the number of estates suffering inheritance tax had been growing rapidly, more people than ever before are becoming aware as it has affected them directly.

What are the pros and cons of different trust structures?

Trusts are an invaluable tool for a financial planner to have in their armoury when dealing with a client's potential inheritance tax bill or succession planning. Although saving tax is important, for some people an IHT bill will not occur or it will be secondary to their family situation.

Consider the example of Mr Jones, a widower, who is married with children from his first marriage. In later life, he remarries Mrs Smith who has children from a previous marriage herself. He might think to himself "when I die, I'll leave all my money to my wife, but when she subsequently dies it will all go to her children. I'd rather my kids got it". So, not wishing to leave her financially embarrassed on his death, he includes an interest in possession trust in his will to give her an income for life and leave the capital value on her death to his children.

The advantages of each of the three basic trust structures are that discretionary has the widest selection of beneficiaries - it being at the discretion of the trustees at any time. Interest in possession is useful for granting life interests as described above and bare trusts have a welcome inherent simplicity and generate a potentially exempt transfer.

The main drawback of a discretionary trust or a new interest in possession trust is that they generate a chargeable lifetime transfer, with added inheritance tax complexity and lifetime charges. There is no 'give it away, live seven years and forget it' with these trusts. Bare trusts are sometimes avoided because any beneficiary over the age of age 18 can demand their share of the trust from the trustees, something that the settlor probably didn't want to happen. So it is best to use bare trusts in conjunction with assets of no current value (e.g. term assurance) or which cannot be cashed-in (such as some discounted gift trust bonds).

What factors do advisers need to bear in mind when choosing a trust structure for clients?

If a trust is being recommended because an individual has concerns about inheritance tax, the structure selected should reflect the client's needs. We all know that the way to save inheritance tax is to give money away and then live seven years; job done. But that simplistic outlook does not sit well with clients; they may need investment income, want to call on capital if required or be worried what the recipient will do with the gift. Trusts will certainly prevent a beneficiary wasting a gift, or losing it through the beneficiary's divorce settlement or bankruptcy. In broad terms the greater the access, the less effective the trust is at mitigating inheritance tax. So the short answer to the original question (in the estate planning context) is to ask the client what, if any, capital or income do they really need to ring-fence?

How easy is it to amend a trust once it is made? What options are available to advisers should changes need to be made?

To amend the actual wording of a trust is very difficult and often impossible. As a general rule the court will have no real power to permit a departure from the terms of the trust. Trustees must follow the terms laid down by the trust instrument. It may also be possible where all parties to the trust are over 18, of sound mind and absolutely entitled to vary the trust.

The Variation of Trusts Act 1958 will also, in exceptional cases, allow a variation of the terms of the trust.

However, when it comes to the question of changing beneficiaries, most trusts are old interest in possession trusts or discretionary trusts where this is possible. The beneficiaries under a bare trust cannot be changed, although the actual beneficiaries (if they are over the age of 18) can assign their interest to another person.

One has to be very careful nowadays with changing beneficiaries under old interest in possession trusts set up prior to March 2006, otherwise known as power of appointment trusts. Under Finance Act 2006, unless the change is made because a beneficiary has died, the change will bring the trust into the relevant property regime with the associated periodic and exit charges. In addition, the removed beneficiary must also be excluded from the list of potential beneficiaries as otherwise it will be a gift with reservation by them.

What are the common mistakes people make when dealing with tax and trusts? How can these mistakes be avoided?

The most common mistake is not completing the trust form correctly! It could be said that some forms are complex and difficult to understand, but given that any mistakes can be far-reaching, even ending up in court, it is of paramount importance to complete the trust form correctly.

Generally most life assurance trusts appoint lay people as trustees. A common mis-apprehension is for them to be solely concerned with the IHT aspects of the trust and forget about the other taxes, such as income tax and capital gains tax.

Jeremy Pearson is technical support manager at Canada Life

Jeremy has many years experience in financial services, having worked for life companies and an IFA in technical roles. In his current role he helped to establish the Technical Support Team, bringing with him his analytical skills as well as his technical knowledge of financial planning and taxation.

Canada Life

Canada Life began operating in the United Kingdom in 1903 and has developed a wide offering of services to suit clients. The product portfolio encompasses solutions for successful retirement income planning, inheritance tax planning, saving and investments as well as group and individual protection.