In the first of a two-part series, Jeremy Pearson weighs up the pros and cons of using bare and discretionary trusts
Many advisers are in a conundrum when recommending a trust to clients. Should they go for a simple, straightforward but accessible bare trust, or a sophisticated but complex discretionary trust?
That is, a bare trust which will be a potentially exempt transfer but can be claimed by a beneficiary over 18 years old?
Or a discretionary trust with flexibility of beneficiaries but with immediate inheritance tax (IHT) payable if an amount more than the nil rate band is invested?
This is a rather simplistic synopsis of two multi-faceted arrangements, so it is important to compare the differences between them. There is nothing to stop someone having one of each: a discretionary trust up to the nil rate band and a bare trust on top.
For the purposes of this article, it has been assumed that an interest in possession trust is not appropriate for lifetime planning, although they are now often used for will planning.
But to help us compare the two types, let's look at Mr and Mrs Down and their children, daughter Pat and son Luke.
Mr & Mrs Down want to make sure their children will be financially secure and not be broken by a substantial IHT bill. They are prepared to put money in a gift trust, as joint settlors, but which type is best?
The beneficial interests
Mr and Mrs Down want to give their children half each of the trust fund, when the time comes. The intention is that the trust fund will be distributed after both of them have died.
In a bare trust, the absolute beneficiaries are Pat (50%) and Luke (50%).
If a percentage or share is not stated, and just the names given, a deceased beneficiary's share is passed onto the surviving beneficiary or beneficiaries, not the deceased's heirs.
In a discretionary trust, the possible beneficiaries are:
- Any children of the settlors now living or born after the date of this settlement and all grandchildren of the settlor both living and born hereafter
- Any person or class of persons (other than the settlors) not already included as a beneficiary or as beneficiaries, and subject to the prior written consent of the settlors during their lifetime.
You will notice that Mr and Mrs Down have chosen to follow their bloodline and are not including Pat and Luke's spouses or any step-children. Any of these could be added at a later date by the trustees.
But what happens after Mr and Mrs Down die? "How can we be sure that the right thing will happen after our deaths?" asks Mrs Down. "We won't be around and there's a lot of money in this trust - can we be sure it goes to the right people?"
In a bare trust, the beneficiaries cannot be changed, so therefore Pat and Luke will always be entitled to the trust fund.
In a discretionary trust, the distribution of the trust fund is at the absolute discretion of the trustees, so Mr and Mrs Down should choose their co-trustees very carefully.
After all, after they have both died, the trustees decide which of the beneficiaries are to receive anything. In practice, it might be wise to appoint a third party as one of the trustees.
In addition, to ensure that their intentions are known, Mr and Mrs Down should prepare a "letter of wishes" for the attention of trustees, whoever they may be. This can outline who is intended to benefit in all circumstances and when.
But what of trust income and capital? Although we are mostly used to dealing with investment bonds in trust (which are non income-producing assets), most trusts of all types allow the trustees unrestricted power of investment. It is common for trusts to hold income-producing assets and while an investment bond trust may not hold these at outset, there is no reason why it could not do at some time in the future.
For income in a bare trust, Pat has an absolute right to a half share of any trust income and Luke has the right to the other half. So if any income arises, it belongs to them, is taxed on them and must be paid over if demanded.
As for capital, the situation is similar, with Pat having an absolute right to a half share of the trust capital and Luke having the right to the other half.
For income in a discretionary trust, the trustees can pay out any of the trust income, as and when they think appropriate, to any named beneficiary or anyone who is in a class of beneficiaries.
As for capital, the trustees only pay out capital as and when they think appropriate to any of the beneficiaries.
A few years after the trust is set up, Pat is having money troubles and asks her parents for some help. They are disapproving of her somewhat profligate lifestyle and tell her to "sort her life out" first. However, her parents had told her about the trust when they set it up and that it was looked after by their solicitor, Mr Davis, as co-trustee. Pat decides to approach him for an "advance" of what she is due from the trust.
In a bare trust, Mr Davis explains to Mr and Mrs Down that, unfortunately, as Pat is over 18, she is entitled to demand her share of the trust fund. So they are forced to pay her money, while not confident that she will spend it wisely.
If it had been a bare gift and loan trust, the settlors' rights of loan repayment will take priority over the beneficiaries' rights. This acts as a block on any beneficiary who tries to demand their share of the trust capital while the loan is still outstanding.
With discounted gift trusts, the settlors' right to the fixed regular payment will also take priority over the beneficiaries' rights while they are still alive.
In a discretionary trust, Mr Davis tells Pat to "get lost", although he is much more diplomatic than that in practice.
No beneficiary can demand that any of the trust capital be paid to them, as that decision is at the complete discretion of the trustees.
Pat should make sure that her behaviour does not upset her parents because they may decide to not include her when the trust fund is being paid out.
They can change their letter of wishes at any time, for example making clear that they would not want her to benefit at all. Though such a letter is not binding on the trustees, they would need compelling reasons to ignore it.
But what if one of the children dies first? It is typical for clients to think about estate planning when they are elderly - in their seventies or eighties in the most part.
This means that their children could easily be in their fifties or sixties and it is not unheard of them to die first. Even at younger ages, it could happen because of illness or accident.
In a bare trust, if a beneficiary dies before the trust has been fully distributed, their right to a share of the trust capital will be an asset of their estate.
This right will then pass on to whoever inherits under the deceased's will or the intestacy rules. If the heirs are over 18, they can then demand payment of their inherited share of the trust fund.
If a percentage or share is not stated on the trust deed, and just the names given, the deceased's share is passed onto the surviving beneficiary or beneficiaries.
In a discretionary trust, all a beneficiary has is a mere possibility of a share of the trust fund. They have no vested right to anything, so when a potential beneficiary dies, none of the trust capital is included in their estate.
The trustees may now feel that it is appropriate to include the deceased's spouse or heirs as potential beneficiaries (subject to the settlor's agreement if they are still alive).
Although Luke is the apple of his parents' eye, he runs a scaffolding business that is going through financial difficulties. This is causing marital problems at home. Mr and Mrs Down want to know what would happen if he became bankrupt or got divorced.
In a bare trust, it is common practice for divorce arrangements to split the divorcing couple's combined wealth between them.
Luke's absolute right to a half share of the trust capital would normally be included when calculating the settlement.
On bankruptcy, Luke's half share could not be claimed by his receiver (trustee in bankruptcy) as the policy was in trust from outset and is classed as an MWPA trust.
In a discretionary trust, Luke may get something from the trust at some time in the future. But it is just as possible that he may never get anything at all. So his possible future trust payout is normally not included when calculating the divorce settlement.
On bankruptcy, the fact that Luke is one of the potential beneficiaries is of no relevance in working out what he has available for paying off his creditors.
Hopefully, this covers all the practical side of the trust arrangements.
But what if Mr & Mrs Down change their mind and want their money back? And what about the inheritance tax considerations? We will look at both of these in part two next month.
Jeremy Pearson is technical support manager at Canada Life
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