Trust - Everything you need to know

Many myths have grown up around trusts, but a large part of them miss the truth. Although this type of agreement is often used for business purposes (e.g. asset management, building corporate structures) and tax purposes, it is worth mentioning the insurance and succession function of trusts. What do you need to know about an agency agreement and when is it worth entering into one? Feel free to read on, everything will become simpler in a moment :)

What is a trust?

People from countries whose legal system is based on continental law (civil law), i.e. Germany, France or Poland, for example, often do not fully understand the concept of a trust. This is because** in continental law, trusts simply do not exist.** It is true that similar arrangements are created, such as family foundations or trusts, but this is never the exact equivalent of a trust. In the UK, the system is based on Anglo-Saxon law (common law), where the term already exists and is often used to manage assets.

A trust is a written contract that, as a general rule, 2 people enter into with each other. The person setting up the trust (the Trustor) is called the Settlor and appoints his trustee, called the Trustee. The Settlor obliges the Trustee to manage the assets and to transfer them to the beneficiary, also known as the Beneficiary. The agreement can be shaped in many different ways (there are several types of trusts), but they share universal features.

Functions of the people in the trust

• Settlor: most likely, you will be that person. Settlor decides where his estate should go and who should manage it until then;

• Trustee: This is the person to whom you entrust your estate. The trustee will represent your will once you are gone. This is the person who will be responsible for fulfilling all the provisions of the contract and for managing distributions on your behalf;

• Beneficiaries: These are simply the beneficiaries of the trust agreement. These are the people you have appointed to receive the funds/property/property rights after your death. In the context of a life assurance policy, it is the trustee who receives the funds but passes them on to the beneficiaries immediately, provided they are of the appropriate age (16 in Scotland, 18 in England and Wales).

What is a trust contract for?

The trust agreement has 3 main purposes:

• Reduction in taxation (inheritance tax in the UK is up to 40%);

• Speeding up inheritance/insurance procedures;

• Simplifying the succession process.

It may seem strange, but inheritance processes as well as life cover payouts in the UK can take a very long time. Regardless of the insurer you choose, the whole process of dealing with your family’s claim can stretch out over many months. This is a big risk as the bank won’t wait too long for their money - unpaid mortgage repayments can be a real threat to your family if you die.

Main types of trust

Trusts can be divided into several types depending on their principles and purpose.

Bare trust

A bare trust is the most common and simplest type of trust.** This is the term used to describe a trust in which the role of the trustee is very small - he or she only holds the assets owned by the beneficiary (or beneficiaries)**. When the beneficiary turns 18, he or she can decide on the assets held, and the trustee is obliged to comply. The assets are untouchable until the beneficiary reaches the age of majority, unless they need to be used in the best interests of the child. We are referring to situations where a minor beneficiary needs money for education, food or medical treatment. Such an exception arises from the general fiduciary duties regulated by Equity Law.

In summary, a bare trust only serves to hold assets by the trustee until the beneficiary turns 18.

Interest in possession trust

The second fairly common type of trust in the UK is the Interest in possession trust. This is a slightly more complicated creation as it is used where the property transferred into it generates income and there are 2 groups of beneficiaries in it:

• Current beneficiary (Life Tenant);

• Future beneficiaries (Remaindermen).

The first group of beneficiaries is usually only entitled to the income generated by the capital - the trustee is obliged to pay it to them regularly. In contrast, the capital itself, i.e. the income-generating assets, is reserved for the future beneficiary. To illustrate the principles of the Interest in possession trust, it will be easiest to imagine a simple situation:

A man - husband and father - leaves behind a large estate in the form of a number of rental properties that generate rent every month. In order to dispose of the inheritance as he saw fit, during his lifetime he transferred the property to an Intrest in possession trust. As a result, upon his death, his wife (enrolled as current beneficiary) will receive a large sum of money each month in the form of rents, and when his children grow up (enrolled as future beneficiaries), they will be able to dispose of the entire estate as they see fit.

Discretionary trust

A discretionary trust is a type of trust in which the settlor gives the trustee full discretion over its assets. The trustee is in this situation its formal owner and can manage it as he sees fit, taking into account the instructions of the settlor and the designated beneficiaries. He or she can also exercise complete discretion when it comes to distributions to beneficiaries - for example, if there are three designated beneficiaries, the trustee can pay the first £4,000, the second £300 and the third nothing at all. Therefore, this type of trust is less common now and, as you can guess - it carries a high risk that the trustee will not manage the settlor’s estate in the way the settlor would wish.

Inheritance Tax

As I mentioned earlier, setting up a Trust allows you to avoid inheritance tax, or Inheritance Tax. In the UK, this is as high as 40% on the portion of the amount above the tax-free threshold, i.e. £325,000. The whole mechanism is very simple - a Trust makes a property formally not the property of its original owner, but belongs to the Trustee. This ensures that Inheritance Tax cannot be imposed on it.

However, there are 2 exceptions:

• Firstly, if the trust is written in such a way that the settlor is also the beneficiary of the trust (Settor-Interested Trust) - that is, he benefits from the property in any way - HMRC may consider that he still owns it. This will make it so that on his death, although the money will go to the trustee, tax will have to be deducted from it.

• The second important catch to be aware of is the so-called 7 years rule. It applies to gifts made during one’s lifetime, i.e., among other things, the very assets secured by the trust. This rule states that** the donated assets are not taxable until 7 years after the transfer**. This means that if Setlor creates a trust and dies within, say, 6 years, Inheritance Tax will still be imposed.

It is also worth remembering that** if the property being passed on is a property and the heirs are the children or grandchildren of the deceased, the tax-free amount increases **up to £1 million if the house was previously owned jointly by the parents. This relief means that for most family homes that are passed down from generation to generation, no tax will need to be paid.

How do you calculate inheritance tax?

The rules for calculating Inheritance Tax are very simple and not very different from other taxes. Suppose Michael is to inherit from his father an estate worth £800,000. The tax-free amount is £325,000, so 40% will only be calculated on the amount of £475,000. The Inheritance Tax in this case is £190,000.

How does a trust work in insurance?

The advantage of a trust is that the funds paid out under it are not taxed, as is the case with conventional inheritances. However, this does not apply to insurance policies because, as a rule, the benefits derived from them are never subject to compulsory tributes.

As we have already mentioned, a trust agreement is often used for life insurance policies. The mechanism is very simple - when setting it up, you designate the people who are to receive the benefit in the future after your death. This can range from your children to your partner, friends, parents or charities. The trustee can be your partner, a friend as well as a solicitor. The criteria are not too high - this person must be of legal age, of sound mind and not in consumer bankruptcy. It is important that your appointee is trustworthy, as he or she has a huge responsibility.

This type of contract is set up so that your loved ones do not have to wait as long for a benefit payment - instead of several months, your family will wait a few weeks. However, you need to bear in mind that there are costs involved in setting up and executing a Trust agreement, for example legal services, official fees, etc.

Trust with life insurance step by step

If you are considering drawing up a trust to facilitate the inheritance process and reduce Inheritance Tax, we have prepared a brief step-by-step explanation of the whole procedure for you:

• The settlor takes out a life insurance policy and, in parallel with this, draws up a Trust Deed, or form for the establishment of a trust. Remember that it costs nothing to set up a trust, and such a form will often be provided by the insurance company at the settlor’s request;

• He or she indicates on the form the trustees (trustee) and the beneficiaries, such as his or her children;

• It establishes the type of trust and the specific terms under which the beneficiaries will later be able to receive funds;

• Under the Trust Deed, the policy formally “transfers” to the trust, i.e. to the trustees, although it is the Settlor who pays the premiums;

• Upon the death of the insured person, the insurance company pays the funds directly to the trustee. If the trust had not been set up, the money would have gone to the estate first. This means that there would have to be an inheritance procedure, which often takes several months, before the family could recover it. In addition, if the trust had not been set up, the amount would have been subject to Inheritance Tax.

Can I set up a Trust on my own?

In theory, it is possible to write up and set up a trust yourself, but it is not always worth going for it. Hiring a solicitor is good in that the risk of errors is drastically reduced and there is much more certainty about the enforceability of the contract itself. If the contract is only to cover the insurance policy, but no longer the house, it is possible to use an insurance adviser from Extend Finance. We have experience with this type of procedure and many insurers offer ready-made and free fomulas that you just need to fill in. The whole procedure is, of course, free of charge.

What is Declaration of Trust?

You have probably come across the term “declaration of trust” at some point. When it comes to mortgages, this is a very important concept and in some situations its knowledge is extremely necessary. You could say that a declaration of trust acts a bit like a reverse trust. Namely,** it is a declaration in which the person making it declares that he or she will hold the property in question in trust for the benefit of certain beneficiaries.** It is a situation in which the settlor simultaneously becomes the trustee and recognises that he or she is acting in someone else’s interest.

The Declaration of trust is mainly used in situations where several people take out a mortgage on a dwelling together (Joint Mortgage), and especially if the shares are not divided equally. The Declaration of Trust precisely defines the co-borrowers’ rights to the property, their shares and safeguards the interests of all parties. It is also useful in critical situations such as death, separation or conflict between co-owners - if written correctly, outlining the rules for dealing with such situations, it will save them a lot of stress, arguments or even hours spent in court.