In this excerpt from the popular report ‘How to Use Trusts to Reduce Property Taxes’, Jennifer Adams look at the different types of trusts available.
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The Different Types Of Trust
There are two types of trust – express and implied. The deliberate intention of the settlor creates express trusts; implied trusts are generally not. Instead, they arise by operation of law: through equity deciding that a trust should apply to a particular situation.
This text deals with express trusts being trusts that are deliberately created with the parties being aware of their positions and duties.
All trusts which are expressly created and hold land must be evidenced in writing.
There are different types of express trust, the type of trust determining any tax liabilities that may arise.
The main types of trust are:
- qualifying interest in possession trusts (QIIPs);
- discretionary trusts; and
- bare trusts;
QIIP Trusts
Under a QIIP trust, a beneficiary is entitled to the income the trust receives as it arises (which could include rental income) without any recourse to anyone else. The entitlement usually continues for life (the beneficiary being termed a 'life tenant') but can be for a shorter period.
The House of Lords in Pearson v CIS [1980] S.T.C. 318 (with which HMRC now agrees) decided that an interest in possession was “a present right to present enjoyment” of the trust income and did not depend upon any decision of the trustees. In that particular case, the beneficiaries were held not to have possessed an interest in possession as the beneficiaries’ right to enjoyment was subject to a decision of the trustees as to whether or not to accumulate the trust income.
QIIP trusts are frequently created primarily to satisfy the settlor's desire to protect capital rather than saving tax. This would be particularly in point regarding property. Should this be the case, then the trust can be written to enable successive interests before the capital vests absolutely to the beneficiaries, if ever. QIIP trusts can be very flexible if drafted correctly.
Discretionary trusts
In comparison with a QIIP trust, the beneficiary of a discretionary trust is not entitled to either the trust income or the trust property; instead, it is at the absolute discretion of the trustees as to how both are distributed (if distributed at all) dependent upon the terms of the trust deed. Therefore, it is usual for there to be at least two beneficiaries so that the trustees can exercise their discretion. However, it could be possible for there to be effectively one beneficiary so long as either there is also a default beneficiary, such as a charity (the trustees can then exercise their 'discretion' between the two), or a power to accumulate income received.
If there is a power to accumulate with the accumulation effectively accruing to the default beneficiary, then upon exercising that power, there may be nothing over which the discretion can be exercised; this does not invalidate the discretionary trust and has been widely used. The only real problem arises if there is no fixed default beneficiary, or the trustees fail to exercise their power to accumulate.
Bare trust
A bare trust may be express or implied and is the simplest type of trust arrangement whereby the trustee holds property on behalf of usually one (but possibly more) beneficiary and acts in accordance with that beneficiary’s wishes. Although the trustees are the property's legal owners, they have no discretion to exercise such that the beneficiary is absolutely entitled to all of the trust assets and income of the trust.
A typical example of such an arrangement is where a parent sets up a bank account for their child and provides the cash as a deposit. The parent is referred to as a bare trustee holding the assets comprising the bank account (i.e., the monies in the account) on behalf of the child. Any interest earned on the account belongs to the child and the child has an absolute entitlement to both income and capital held in the account at any time. However, for income tax purposes, the income is taxable on the parent (not the child) where parents have created a bare trust for their minor child (i.e., under 18 and unmarried) and the income is more than £100 per annum. It is for this reason that it is more usual and tax efficient for the monies to be provided by the child’s grandparents. The bare trustees can also be the grandparents as in this instance the income will be treated as the child's (allowing use of the child’s personal allowance).
A limitation of the use of bare trusts is their inflexibility, not least because once the beneficiary is of full legal capacity (18 years under the law of England, 16 years under the law of Scotland), they can demand that the trust property be distributed to them.
A variation on a theme – Other types of trust
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Immediate post-death interest (IPDI) trust
An IPDI trust is a creature of inheritance tax and qualifies as a QIIP. It can only be created by will or under the law of intestacy. The beneficiary has an immediate right to the income generated from the assets held within the trust or the right to enjoy the asset in another way (e.g., by being allowed to live in a residence). The entitlement may be for the beneficiary's lifetime (termed the life tenant); however, it can also be for another fixed time (e.g., it might end when specific circumstances arise, such as the death or remarriage of the beneficiary or surviving spouse). The trust property in which the IPDI subsists is treated as belonging to the life tenant for inheritance tax purposes and is therefore treated as part of the life tenant’s estate on death.
A typical example of such a trust is one created by a married couple, one or both of whom has been married before and one or both of whom have children from a previous relationship. The will of the first to die creates an IPDI trust allowing the surviving spouse (the life tenant) to receive the trust income for life (e.g., rental income) but not the right to the actual property, preserving the asset or trust capital. After the surviving spouse's death, the trust ceases and the capital or property passes to the first spouse's children (the remaindermen). This type of trust allows the surviving spouse to receive an income or be allowed to live in a property during their lifetime, but on their death, the children from the previous relationship still receive an inheritance from the parent.
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Protective trusts
This trust is again a special type of QIIP that still gives the beneficiary a right to income but that right ceases either on the beneficiary's bankruptcy or on any attempt by them to sell or otherwise dispose of their life interest. By creating a protective trust, the settlor gives the beneficiary the right to income while guaranteeing that the assets should not be put at risk by any irresponsible actions of that beneficiary.
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Charitable trusts
Most charities are legally constituted as registered charitable trusts and exempt from tax. Charitable trusts are discretionary trusts run by a Board of Trustees and whose funds must be used for charitable purposes. A charitable trust will typically continue in perpetuity, i.e., it is not required to come to an end after any particular time.
