A trust fund's advantages come from its separation of legal and beneficial ownership. Parents can use them to protect assets from creditors or divorce, allow controlled wealth distribution, and potentially offer tax benefits.
However, many make mistakes when setting them up, potentially compromising their children's financial security. The most significant often are in:
- choosing the wrong trustees;
- misunderstanding tax implications;
- inflexible trust terms; and
- inadequate funding strategies.
This article looks at why those mistakes arise, and how they can be avoided.
A little background
In England and Wales, the Trustee Act 2000 and the Finance Act 2006 establish trustee duties, beneficiary rights, reporting requirements and tax.
In law, what we think of as a trust fund is known as a 'settlement'. The 'trusts' are the rules under which the settlement must be managed. The settlor is the person who creates the trust and transfers ('settles') assets into it. The trustees are the people who hold assets (look after them) in the trust fund for the beneficiaries.
Setting up a trust fund for a child involves writing the trusts into a trust deed, executing it by signing it in front of witnesses, and then transferring assets into the settlement.
Mistake 1: choosing inappropriate trustees
When you appoint a trustee, you should choose someone you trust - both in terms of intentions to protect your children's inheritance, and ability to manage the assets.
Often it is not a case of making sure that you don't choose the wrong person, but rather that you do choose the best people given your options.
What you need to bear in mind is that although they have a fiduciary responsibility to act in the beneficiaries' best interests, trustees can only be held to account by the beneficiaries. Where the beneficiaries are children or young adults, and where the trustees are close family members or friends, the beneficiaries are unlikely to be able to, or want to hold the trustees to account.
Parents sometimes make the mistake of choosing trustees on the basis of family relationships or personal friendships. That is not to say family and friends aren't good trustees - they often are - but rather, you should consider their relationship to your children, and whether you would trust them to manage your money.
We'd suggest you look for people who have the following:
- financial acumen: ability to manage investments and understand complex financial matters;
- impartiality: capacity to make fair decisions for all beneficiaries;
- integrity: trustworthiness and ethical behaviour;
- communication skills: ability to explain decisions and work with beneficiaries; and
- understanding of trust law: knowledge of legal obligations and restrictions.
Also remember that every trust needs at least two trustees and that trustees must make decisions unanimously. So rather than looking for two trustees with all those characteristics, you might be able to find two or more who between them possess them.
You might consider a professional trustee. Certainly, they should have many of those characteristics. But for family trust funds, they are often an expensive choice. A professional is also likely to be more risk averse.
Mistake 2: misunderstanding tax implications
Several types of trust fund can be tax efficient. But others are not.
While your goal might not relate to tax, you need to be aware that there can be tax consequences for the trust and the beneficiaries depending on how the trust is structured and how and when distributions are made.
Careful planning is needed to make sure that the trust fund can achieve the parents wishes, but also does so in a way that is tax efficient. Without tax planning, taxes can significantly reduce the effectiveness of a trust as a mechanism for achieving an intended purpose.
Mistake 3: inflexible trusts
A trust allows you to plan for the future. What many parents forget is that many major life events are unforeseen. While you can plan for some things, you can't plan for everything.
Trusts need to be able to deal with life changes. If a goal of a trust is to fund a child through higher education, what if the child decides to study abroad where costs are different (and not only in terms of overall costs, but costs of different parts of the experience, such as college expenses and living expenses).
Common situations that are rarely planned for are marriage and divorce, further children, disability and/or health complications, and financial circumstances such as bankruptcy.
Too much planning can be worse than too little. It restrict the trustees from being able to react appropriately to unexpected events.
The best way to plan is not to consider every 'what happens if' but rather 'what do I want in the round', and then leave it to your trustees to decide what's best as it happens.
Mistake 4: inadequate funding strategies
The money has to come from somewhere. It is surprising, but many parents focus on setting up the trust fund, and not funding it.
Assuming that some assets are initially put into the trust fund, settlors and trustees need to check periodically whether there are sufficient assets to achieve the aims.
For example, if the aim is to provide a house deposit for each of three children, is the value of the assets in trust sufficiently high?
What types of trust funds are suitable for children?
There are different types of trust.
The most relevant for parents are bare trusts, discretionary trusts, accumulation trusts and lifetime interest trusts.
Bare trusts
Bare trusts are the simplest type. Beneficiaries gain full access to the capital at age 18.
While a grandparent might use a bare trust to gift money for a grandchild's school education, they are less commonly used by parents. Because the beneficiaries inherit at 18, bare trusts offer no control in early adulthood. Large sums could end up in the hands of immature beneficiaries.
Discretionary trusts
Discretionary trusts are ones where the trustees have complete discretion as to which of the beneficiaries inherits, and when. Thanks to this flexibility in respect to distributing assets, discretionary trusts are useful when the future is very uncertain. For example, you might have two children: one with a particular talent in an expensive sport, and another with a mental disability that is likely to require them to have care for the remainder of their life. Only where the trust is a discretionary one can the trustees distribute or spend money unequally as and when each child needs it.
The discretionary element of these trusts can lead to arguments. It can be less clear what the settlor (the person who set up the trust fund) wanted, or how guidance should be followed. Since all trust decisions have to be made unanimously, trustees can end up not making a decision at all, when a suboptimal decision would be better.
Discretionary trusts can also be expensive in terms of tax.
Accumulation trusts
Accumulation trusts allow or require income to be retained and added to the trust's capital. By accumulating income, they focus on long-term growth. They work well where beneficiaries are young children with less need for immediate income.
Certain types of accumulation trusts have preferential tax consequences.
Life interest trusts
Someone has a 'lifetime interest' if they have a right to use trust assets during their lifetime (such as to live in a property) but does not own the asset themselves. Often a parent is given a lifetime interest, with the children being the ultimate beneficiaries. On the death of lifetime beneficiary, the trust is distributed.
These sorts of trusts often have asset protection provisions written into them, that state how the assets should be used and maintained, so as to preserve the value of them. They often form part of a Will.
They are commonly used to protect the inheritance of children from previous relationships.
Certainties in trust deeds
These are not death and taxes, although those are certainties. Rather, for a trust to be legally valid, it must meet three fundamental requirements, known as the 'three certainties':
- Certainty of intention - clear evidence that the settlor intended to create a trust;
- Certainty of subject matter - specific assets or property to be held in trust; and
- Certainty of objects - clearly identified beneficiaries or class of beneficiaries.
Usually, these are all defined in the trust documents. If the trust fund is set up implicitly or if there is a poorly drafted deed, one or more of these might be missing, or might not be clear.
You can modify the trusts over time in light of life events. Many people mistakenly set one up and then only concern themselves with asset management. It is recommended to review a trust annually.
What are the tax implications of setting up a trust fund?
Setting up a trust fund requires tax considerations. Trust taxation isn't complicated, but it is different to personal taxation. Inheritance tax ('IHT'), income tax and capital gains tax ('CGT') can all apply. You need to consider not only the tax on the trust, but also the comparative tax you or your estate would pay.
Inheritance tax
When assets transfer into the trust, an initial charge applies. Most trusts have to pay ongoing charges every decade (known as the '10 year charge') and exit charges when assets leave. For transfers above the nil-rate band, a 20% entry charge currently applies.
Potentially exempt transfers ('PETs') may allow for IHT planning. If you settle assets into a trust for your child, no immediate tax applies. Should you survive seven years after the gift, it becomes exempt from IHT tax. If you survive less than seven years, a taper applies.
However, IHT planning is only useful if IHT will apply to your estate and if the IHT charges on the trust are less.
Income and capital gains tax implications
Income generated within the trust, for example, bank interest, rental income from trust-held property or dividends from investments can be taxed at a higher rate than individual earnings. Trust management expenses can offset some of this burden, but failing to plan for these taxes is a significant mistake many parents make.
Trusts have reduced annual exemptions for CGT. When trustees sell assets within the trust, they may trigger CGT liabilities. For example, if you set up a trust holding shares that appreciate significantly, selling them could result in a considerable tax bill.
Tax treatment varies between trust types, influencing the choice of trust structure. Bare trusts tax income on the beneficiary, while discretionary trusts tax trustees. This difference can significantly impact the trust's effectiveness in meeting family objectives and a child's financial future.