Trusts in the UK: types, life insurance and Inheritance Tax

Many myths have grown up around trusts, and many of them miss the truth. Although trusts are often used for business purposes (e.g. asset management, building corporate structures) and tax purposes, it is also worth looking at their insurance and succession functions. What do you need to know about trusts and when is it worth setting one up? Read on to find out.

What is a trust?

People from countries whose legal systems are based on continental (civil) law, such as Germany, France or Poland, often do not fully understand the concept of a trust. This is because many civil-law systems have no direct equivalent. Similar arrangements exist, but they are never an exact equivalent of a trust. In the UK, the legal system is based on common (Anglo-Saxon) law, where the concept is well established and often used to manage assets.

A trust is a legal arrangement for managing assets on behalf of other people. It can be set up during your lifetime or by a will. The person who sets up the trust is called the settlor. The settlor appoints a trustee, who manages the assets for the benefit of the beneficiaries. Trusts can be set up in many different ways (there are several types of trust), but they share some common features.

Functions of the people in the trust

• Settlor: most likely, you will be that person. The settlor decides where their assets should go and who should manage them until then;

• Trustee: This is the person to whom you entrust your assets. The trustee becomes the legal owner of the trust assets and manages them under the trust’s terms for the beneficiaries. They are responsible for carrying out the terms of the trust and for managing distributions;

• Beneficiaries: These are the people who benefit from the trust, i.e. the people you have chosen to receive the money, property or property rights after your death. In the context of a life insurance policy, the insurer pays the trustees, who then deal with the money in line with the trust’s terms; under a bare trust a beneficiary is entitled to the funds from 18 in England and Wales or 16 in Scotland.

What is a trust used for?

A trust has 3 main purposes:

• Inheritance Tax planning (Inheritance Tax is charged at 40% above the threshold);

• Speeding up inheritance and insurance payouts;

• Simplifying the succession process.

It may seem surprising, but inheritance processes and life cover payouts in the UK can take a long time. Without a trust, a payout may be delayed until probate is granted. Mortgage payments still need to be met, so delays can put pressure on your family - unpaid mortgage repayments can become a real problem for your family if you die.

Main types of trust

Trusts can be divided into several types depending on how they work and what they are for.

Bare trust

A bare trust is one of the simplest types of trust. In a bare trust, the trustee’s role is very limited: they simply hold the assets for the beneficiary (or beneficiaries). When the beneficiary turns 18 (16 in Scotland), they can decide what happens to the assets, and the trustee must comply. Until then, the assets cannot be touched unless they need to be used in the child’s best interests, for example when a minor beneficiary needs money for education, food or medical treatment. In England and Wales, this comes from the trustees’ statutory powers to use money for a minor beneficiary’s maintenance, education or benefit, unless the trust deed says otherwise.

In short, a bare trust holds assets for the beneficiary until they turn 18 (16 in Scotland).

Interest in possession trust

The second fairly common type of trust in the UK is the interest in possession trust. It is slightly more complicated, as it is used where the assets transferred into it generate income and it has 2 groups of beneficiaries:

• Current beneficiary (life tenant);

• Future beneficiaries (remaindermen).

The current beneficiary is usually only entitled to the income generated by the capital, which the trustee must pay to them regularly. The capital itself, i.e. the income-generating assets, is reserved for the future beneficiaries. A simple example shows how an interest in possession trust works:

A husband and father leaves behind a large estate made up of several rental properties that generate rent every month. To pass on the inheritance as he wished, during his lifetime he transferred the properties into an interest in possession trust. As a result, after his death, his wife (named as the current beneficiary) will receive a large sum each month in rent, and when his children grow up (named as the future beneficiaries), they will be able to deal with the whole estate as they see fit.

Discretionary trust

In a discretionary trust, the trustees can decide which eligible beneficiaries receive payments, how much they receive and when, within the powers and limits set out in the trust deed and applicable law. Discretion does not mean unrestricted ownership for personal benefit: trustees must administer the trust for its beneficiaries.

Inheritance Tax

Depending on its type and your circumstances, a trust can help you control how and when your assets pass to your beneficiaries and may help with Inheritance Tax planning. However, trusts have their own Inheritance Tax rules. In the UK, Inheritance Tax is charged at 40% on the part of an estate above the tax-free threshold of £325,000.

For most trusts, transfers into the trust above the £325,000 threshold can carry an immediate 20% Inheritance Tax charge. There can also be charges of up to 6% every 10 years and when assets leave the trust. You can find more details in the GOV.UK guidance on trusts and Inheritance Tax.

There are also 2 important rules to be aware of:

• Firstly, if the trust is set up so that the settlor can also benefit from it, the rules on gifts with reservation may apply. If you can still benefit from the assets, HMRC may treat them as a ‘gift with reservation’ that still counts as part of your estate, so Inheritance Tax may be due on them when you die.

• The second important rule is the so-called 7-year rule. It applies to gifts made during your lifetime; for transfers into most trusts, the separate trust charges described above can also apply. If you live for 7 years after making a gift, no Inheritance Tax is normally due on it. If you die within 7 years, the gift may be taxed, although taper relief can reduce the rate on gifts made 3 to 7 years before death where your gifts exceed the £325,000 threshold. This means that if the settlor dies within 7 years, Inheritance Tax may still be due, with taper relief possibly reducing it.

It is also worth remembering that if you leave your home to your children or grandchildren, your threshold can increase to up to £500,000. Married couples and civil partners can pass unused allowances to each other, so their combined threshold can reach up to £1 million. The home allowance is reduced for estates worth more than £2 million. See the GOV.UK guidance on the residence nil rate band.

How do you calculate inheritance tax?

Here is a simple example. Suppose Michael inherits an estate worth £800,000 from his father. The tax-free threshold is £325,000. If no other allowances or reliefs apply, 40% is calculated on the £475,000 above the threshold, so the Inheritance Tax is £190,000.

How does a trust work in insurance?

A life insurance policy written in trust is normally paid to the trustees and does not form part of your estate. This can help with Inheritance Tax planning and usually means your family does not have to wait for probate. For an own-life policy payable to the estate, a payout without a trust normally forms part of the estate. A joint policy paying on first death may instead pay the surviving policyholder.

As mentioned above, trusts are often used for life insurance policies. When you set one up, you name the people who will receive the payout after your death. They can include your children, partner, friends, parents or charities. The trustee can be your partner, a friend or a solicitor. The trustee should be an adult (in England and Wales a minor cannot be validly appointed as a trustee) who has the mental capacity to manage the trust. It is important that the person you appoint is trustworthy, as they have a significant responsibility.

This type of trust is set up so that your loved ones do not have to wait as long for the payout: a policy in trust can usually be paid out without waiting for probate, so your family may receive the money sooner.

Trust with life insurance step by step

If you are considering setting up a trust to make the inheritance process easier and to help with Inheritance Tax planning, here is a brief step-by-step explanation of the whole procedure:

• The settlor takes out a life insurance policy and, at the same time, completes a trust deed (the form that sets up the trust). Some insurers provide their own standard trust forms free of charge that you fill in, although a solicitor may charge a fee if you use one;

• The settlor names the trustees and the beneficiaries on the form, such as their children;

• The form sets out the type of trust and the terms under which the beneficiaries will later be able to receive funds;

• Under the trust deed, the policy is formally “transferred” into the trust, i.e. to the trustees, although the settlor still pays the premiums;

• When the insured person dies, the insurer pays the money directly to the trustees. Where the policy is payable to the estate, the payout forms part of that estate. This means the executors would usually need to get probate first (GOV.UK says this usually takes up to 12 weeks after applying, and can take longer) before the family could receive the money. In addition, a payout forming part of the estate could be subject to Inheritance Tax if the estate’s total value is above the available tax-free thresholds and exemptions.

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 trust forms 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. You may come across it when you buy a property with a mortgage together with someone else. Put simply, a declaration of trust is a document in which the person making it declares that they hold a particular property on trust for the benefit of certain beneficiaries. In this case, the owner of the property also acts as the trustee and acknowledges that they are acting in someone else’s interest.

In England and Wales, a declaration of trust is often used when two or more people buy a property together, particularly as tenants in common where their shares are not equal. Property ownership works differently in Scotland. A declaration of trust can record how the co-owners hold the beneficial interest in the property, including each person’s share. It can also be useful in difficult situations such as death, separation or a conflict between co-owners - if it is written correctly and sets out how such situations should be handled, it can help avoid disputes.