Use trusts to safeguard your assets

Although the widespread use of trusts as a tool for estate planning and reducing inheritance tax (IHT) liability was partially stymied by the rule changes introduced in April 2006, trusts still have their uses, both for lawyers and for financial planners.

A trust is a legal entity (a bit like a company in this respect) to which you (the settlor) can give assets such as cash, shares or property, to be managed according to your wishes by the trustee overseeing it.

Ultimately, those assets will pass to the person or people you want them to go to (the beneficiaries), but for various reasons you may not want to hand them straight over right now.

There are three main ways in which a trust may be used. First, it may be a means of protecting your assets, to ensure they are managed and distributed as you wish them to be, even after your death.

For example, you could use a trust to leave money to a grandchild until they are old enough to treat it responsibly; or to a mentally handicapped relation unable to manage their affairs; or to provide an income for your surviving spouse during their lifetime, while keeping the assets outside any subsequent remarriage and earmarked for your children.

Second, trusts can be used for convenience, to change the ownership of an asset. Stephen Tucker, managing director of financial advisers The Fry Group, gives the example of people who own several homes in different jurisdictions, and want to bring them together within a single offshore trust to avoid the complications of lots of probate on death.

Third, they may be utilised, as Tucker puts it, "to morph assets from one owner to another over time" ­ - a function that can be very handy in IHT planning.

Several types of trust may be used by advisers to provide a solution. Under a bare trust, the simplest arrangement, the assets placed in the trust ­ by a grandfather for his young grandchild, say ­ become the property of the beneficiary immediately, and once they reach age 18 they have an automatic right to the lot.

Clearly, although this is straightforward, it could bring complications, if, say, they develop a serious drugs habit.

Gifts made under a bare trust are known as potentially exempt transfers, or PETs. Provided the settlor lives at least seven years after making a PET, the assets in the trust, no matter how large, no longer count as part of the estate.

Typically, however, settlors may want to give the trustees more control over when, how or to whom the assets are given in the end.

Rather than named individuals, the recipients may often be a class of beneficiaries, such as "all grandchildren, including those not yet born". In such cases, advisers now generally use some form of discretionary trust, with a letter of wishes to guide the trustees' actions (although this is not binding).

Gifts made to discretionary trusts are treated as chargeable lifetime transfers. This means that if the settlor puts into the trust more than the nil-rate band (NRB) ­ the value of assets you can own before IHT kicks in, currently £325,000 per person - the excess will be subject to a 20% tax on entry.

"Most people are reluctant to pay that charge, so they only put in the NRB," says John Kelly, managing partner of Square One Financial Planning. Again, provided they survive seven years after making the gift to the trust, it falls out of their estate and they can put in another tranche of assets (typically up to the NRB again).

As far as tax is concerned, then, IHT is the big issue. Some trusts can also be used for capital gains tax (CGT) planning, as it's possible to move assets into and out of a trust without paying CGT on the transfer.

But as Stephen Tucker observes: "It's not clear that you'll make many savings under the new regime." Gains realised on a sale within a trust are taxed at 28%, while any income received from assets is taxed at 50%.

What about costs?

Unless you use a packaged off-the-shelf product (such as a discounted gift trust around an investment bond) from a life company, trusts are not cheap.

Expect to pay £1,000 or so to set up a discretionary trust, and £1,000 or so a year ­ or more for offshore trusts ­ to maintain it if a professional trustee is involved, says Tucker. "We would probably not set up a bespoke trust with less than £250,000 because it's generally not cost effective," he adds.

What kind of trust should you choose?

In regard to financial planning (where tax mitigation is a key element of the equation, rather than just asset protection issues), there are a number of variations on the discretionary trust theme.

The choice of trust depends on whether the settlor wants simply to give money away and has no concerns about later access to it (discretionary gift trust), or whether they may later want to withdraw capital (loan trust) or receive an income (discounted gift trust), says Matt Pitcher, senior client partner at Towry.

Discretionary gift trust

This form is the simplest one ­ and "ignored by IFAs too much", according to Pitcher. Unlike some of the others, it's not a packaged product, so a solicitor is needed to draw up the trust.

"You, the settlor, lose access to the capital, but you can be confident it's in trust until the trustees consider the beneficiaries are ready for it," he explains.

"The most common use is as a way of starting the clock ticking on the seven-year period before the assets fall out of your estate, when you don't want to hand them directly over at that point."

A couple can gift up to £650,000 (two lots of NRB) and still avoid the 20% entry charge.

Discounted gift trust

These trusts are complex wrappers used in conjunction with an insurance bond. They enable the settlor to make a gift to the trust, but receive a lifetime income ­ typically 5% ­ from it.

A discounted gift trust comes with a discounted value: the more income you want to draw and the younger you are, the bigger the discount. "Thus, £100,000 might be treated as a gift to the trust of only, say, £50,000, because the balance will be drawn as an income over your lifetime," says Pitcher.

"In that example, you could put in £650,000 and it would count as a discounted gift of £325,000." That discounted capital is treated as a PET, so after seven years it is outside your estate.

However, these trusts, although popular with IFAs, are controversial.

Pitcher points out that the beneficiary can have no access to the capital until the settlor's death, so the real focus of setting up the trust should be the income stream.

"I don't like them," says John Kelly. "The sales pitch can be persuasive but they're often not right for clients. They're only really suitable for people in their mid 70s or older, because with many of these products you're locked into a fixed income that is not inflation-proof. You should only do a DGT if you actually need an income."

He adds that one reason they're so popular with IFAs is that some underlying investment bonds pay up to 7% or 8% commission.

Loan trust

Pitcher suggests this type of trust, typically available as an off-the-shelf agreement, as a way of effectively freezing the value of the estate, without tying your capital up forever.

The settlor makes a loan rather than a gift to the trust; they can later take the capital back if needed, but the growth in the value of the assets remains outside the estate.

"These are very popular with younger clients as a kind of halfway house between gifting money and having access to it," he adds.

Excluded property trust

Trusts are also powerful tools for non-UK domiciled UK residents, who do not pay IHT on "excluded" property assets (those held outside the UK).

They may, for instance, use a trust to ringfence overseas assets due to become UK domiciled (which happens automatically after you are UK tax resident for 16 out of the past 20 years).

Business property trust

Stephen Tucker highlights the use of this type of trust for people with unquoted businesses or AIM shares, which qualify for business property relief from IHT after two years of ownership.

Your will might stipulate the shares in your bookshop business of 20 years are to go into a business property trust, he explains.

"There is no IHT on that transfer because the business is exempt. Your spouse can then buy the business from the trust for, say, £500,000 ­ so the trust now holds £500,000 of exempt cash ­ and run the business herself.

After two years, it again qualifies for business property relief in their name.

"The whole point is to exploit the relief twice."

This article was taken from the March 2011 issue of Money Observer.