Also known as Interest in Possession or IIP trusts… or in non-legal terms, a means of having your cake and eating it!
A couple of general definitions that may help
Capital: is the value, and is as opposed to income. The £200 in your bank account is the capital, and the 2p interest is the income.
Estate: what someone owns. For example a deceased’s estate will include their house, their bank accounts, their shares and their belongings.
Testator: is someone that makes a Will. If Fred made his Will he is the testator. You may also see the term ‘Testatrix’, which is used when a woman makes a Will, however Testator is often used for both men and women.
Definitions relating to trusts are explained below.
So what is a Trust?
Most people think of trusts as complicated legal arrangements - but they need not be. Trusts can be as simple or as complicated as you want.
A trust is simply the separation of legal and moral (often referred to in legal circles as ‘equitable’ or ‘beneficial’) ownership.
Take the following examples:
- Fred gives Joe the sum of £5.00 and says that Joe can have it as a present. Joe legally owns the Fiver (he has it) and morally owns it (as Fred said he can keep it for his own benefit).
- Fred gives Joe the sum of £5.00 and says – please take this and buy us both a Gin and Tonic (probably not enough to cover it but that’s another subject). Again, Joe legally owns the Fiver (as he has it) but this time he doesn’t morally own it - morally he holds it to buy a Gin and Tonic for himself and Fred. Fred has created a simple Trust over the Fiver.
- Fred who created the Trust is called the – Settlor (he settled the Fiver into Trust for a G&T). If the trust is created by Will then the Settlor is known as the ‘Testator’.)
- Joe who holds the Fiver legally is called the – Trustee
- Joe and Fred as the ultimate recipients of the G&T are the – Beneficiaries
- The Trust Fund is the Fiver
- The Terms of the Trust are – to go and buy a G&T for Fred and Joe.
There are a number of different trusts, the most common being Flexible Life Interest Trusts and Discretionary Trusts.
What is a Flexible Life Interest Trust?
A Flexible Life Interest Trust is a trust where the terms of the trust are:-
- The trust fund is to be used so that ‘A’ can enjoy it for his/ her life (‘A’ is called the ‘Life Tenant’)
- On ‘A’s death the trust fund goes to, say ‘B’ (or to ‘B’ and ‘C’ equally) (‘B’ is called the ‘Remainderman’)
- The flexible element is that whilst ‘A’ is alive the Trustees can – at their discretion (i.e. if they think it is the right thing to do) do various things such as: - stop ‘A’ from enjoying the trust fund, or give capital of the Trust fund to ‘A’ or to ‘B’.
The trust fund can just be a property or share in property, or it could be someone’s entire estate.
What is the Benefit of a Flexible Life Interest Trust? – Why have one?
Consider the following scenario:-
Fred is a successful businessman with two children from a first marriage. Fred has re-married a young lady called Anna – as yet they have no children together. Fred travels a lot and is worried that if he were to die and have left everything to Anna by his Will she would enter into a new relationship and Fred’s fortune would go to some unknown person and not to his own children. At the same time however, Fred wants to make sure that Anna is well looked after in the event of his death (or certainly whilst she remains widowed).
If, Fred were to make no Will or a Will leaving everything to Anna, then Anna would have Fred’s wealth when he dies and could then pass it onto whoever she wanted. His children may never see any of it.
If, however, Fred made a Will which created a Life Interest Trust for Anna with Fred’s children as ultimate beneficiaries, then Anna would have use of the monies during her life (or re-marriage) but she could not re-direct the monies herself – ultimately they would end up with Fred’s children. If, following Fred’s death Anna needed private medical care the Trustees could (with their flexible powers) decide that they will use capital from the Trust to pay for this. i.e. Fred can have his cake and eat it!
The above illustrates one of the benefits of a Life Interest Trust.
Other Advantages of such Trusts are:
- Mitigation of Care Fees: If the trust is created by Will (which it most usually would be) and the survivor (Anna in the above example) has to go into residential care then any assets that are held in the trust are protected from being used to fund the Care Fees. Any income from the trust would be taken to pay for care but not the capital. The capital can however, at the trustees’ discretion, be used to pay a top-up to ensure that the survivor can live out his or her life in the best possible way.
- If the trust is created by Will and the Life Tenant is the spouse or civil partner of the Testator then the trust will have the full benefit of the Inheritance Tax (IHT) spouse exemption. This means that if the whole estate is left to the surviving spouse either wholly or partially on trust, no IHT will be payable on first death. Also, as the estate will (even though wholly or partly in trust) go to the surviving spouse then the so called IHT ‘Nil Rate Band’ (currently £325,000.00) of the first to die will be preserved and become available when the second one dies to reduce any charge to IHT.
Take the following example:
Fred and Anna have an estate worth £1,000,000.00. Fred dies and leave his estate on a Flexible Life Interest Trust to Anna. On his death no IHT will be due as all is spouse exempt. When Anna dies the NRB has gone up to £500,000.00. IHT will be charged as follows:-
Anna’s estate £500,000
Fred’s trust £500,000
Total = £1,000,000.
As Fred’s NRB has been preserved both his and Anna’s NRB can be deducted both at the rate when Anna died (i.e. 2 x £500,000.00) nothing chargeable to tax.
The same would have happened if Fred had left all to Anna without a trust but, as set out above, his estate would have been left exposed in other ways.
- Given the above deferral of IHT it will be possible for the survivor to make gifts from the trust. If these are survived by 7 or more years they will fall outside the taxable estate of the survivor. Additionally, the trustees can make the gifts. This is valuable if the survivor loses mental capacity. An attorney (acting for a person who has lost mental capacity) would not be allowed to make such gifts without permission of the court. The trustees however could.
- Any assets that are in trust are protected. So if the surviving spouse becomes frail or forgetful the trustees will be able to ensure that no-one can take advantage of the situation.
Are there any downsides?
There is no such thing as a Win-Win in life.
The main downsides are:
- Having a trust always adds a layer of additional administration and hence potential costs. However, the trust only arises on death – not before then. Also if the trust is in relation to a property which is lived in by ‘A’ then there will be little, or no administration. In any event we consider that the administrative burden is far outweighed by the benefits of the trust.
- The survivor is at the trustees’ mercy as regards access to capital. This is true as the terms of the trust only allow the survivor access to the capital of the trust fund if this is agreed by the trustees. This should not be seen as a barrier to use of the trust but more to highlight the need to choose your trustees wisely – as the term suggests they should be ‘trusted’ to do the right thing.
- For Capital Gains Tax (CGT) purposes, if the asset of the trust is a house lived in by the survivor then the Principal Private residence Exemption will still apply. As regards other assets the rate of tax, if gains were to arise would likely be higher for the trustees and the trustees only have half of an annual exemption. However, if all assets are kept until the death of the survivor all gains will be wiped out and no CGT would be payable.
- For Inheritance Tax (IHT) purposes the value of the trust is added to the estate of the Life Tenant. The same would apply if the assets had been left to the life tenant without a trust. As explained above, provided the life tenant is the spouse the Nil Rate Band of the first to die will become transferable to the surviving spouse if a Life Interest Trust is used so in such cases the IHT position should be no different from an outright gift.
If the trust is over property can the survivor move/downsize?
Yes they can.
If the trust is over property can the survivor get an equity release?
Usually not, although the flexible element of the trust could make this possible, it would essentially involve ending the trust in favour of the survivor and that is not likely to be done by the trustees.
How can Glanvilles help?
A Will is an important legal document and failure to prepare it properly can result in stressful and expensive problems.
Similarly, although trusts need not be complicated, they must be prepared correctly to avoid costs mistakes and problems.
For expert advice on writing Wills or Trusts, contact us at your local Glanvilles office and speak to one of our Private Client Team colleagues.