Trust funds 101: what, why, who, how, types and tax
Trusts have a reputation as mysterious legal instruments (or financial frameworks) favoured by the rich and used to avoid tax. While wealthy people certainly do use them, so do other people for different reasons.
Trusts are no longer particularly effective as means of reducing tax liabilities. Successive governments have brought trust taxation into line with personal and corporate taxation rates so that there is little tax advantage of creating a trust – especially when the cost of administering one is considered.
Instead, trusts allow better control over how assets are used and managed.
Trusts (and all they entail) is a vast topic. This concise guide helps you catch up on the vital aspects. Let’s start with the basics…
What is a trust?
What is normally called a trust or a trust fund is actually called a settlement in legal terminology.
A settlement is an arrangement or construct where person A transfers ownership of (settles) assets to person B, who manages them for the benefit of person C.
In legal terminology:
- person A is the settlor,
- person B is the trustee, and
- person C is a beneficiary
The terms on which this is done are known as the trusts, and the assets that are transferred are collectively known as the trust fund.
Trust fund is commonly abbreviated to trust.
But it is easier to talk about trusts and trust funds, so we'll do that for the remainder of this article.
Characteristics of trusts
In general, to benefit from all the advantages that trusts can give, the settlor, the trustee and the beneficiary are usually different people or groups of people.
But they don't have to be. A settlor or trustee can also be a beneficiary of same trust.
Prior to setting up a trust, the settlor holds equitable title to the assets intended to be placed in trust. Equitable title means that the assets belong wholly to them.
On creating the trust, the settlor transfers the legal title to the assets to the trustee. The legal title may then stand either in the trustee’s name or in the name of someone else on behalf of the trustee.
In transferring the title of the assets to the fund, the assets cease to be the personal possessions of the settlor. And so they become immune to claims against the settlor from creditors, bankruptcy cases, family disagreements, financial setbacks, and lawsuits.
The settlor appoints the trustee and the beneficiary. They also set the rules (the trusts) by which the trustee may manage the assets.
The trustee may be a person or an entity such as a company (often when management fees are charged). The settlor may nominate multiple trustees. Although the trustees of a trust may change, a trust must always have at least one trustee.
The beneficiary may be a person, an entity (for example, a charity organisation), or something else (for example, a pet or a cause). The settlor may also specify multiple beneficiaries.
The assets, also called trust property, may include real estate, cash, stock, shares, artworks, life insurance policies, pension scheme death benefits, or other investments.
Depending on who the settlor, the trustees and the beneficiaries are, and the rules under which the trust fund is managed, different rules regarding taxation apply.
Why would I want to set up a trust fund?
The reasons for setting up a trust fund vary widely. Although the majority of trusts are created for reasons that closely relate to those shared in the list below, the list is not exhaustive.
To protect and control family assets
For astute inheritance planning and transfer of assets to heirs. Placing assets in trust might minimise estate and inheritance tax (IHT) liabilities. It might also be a means by which someone can provide for a spouse while ensuring that assets are ultimately passed to children, or by which to enable a conditional transfer of assets.
For proper management of assets on behalf of a minor (child under the age of 18) or someone who is incapacitated.
To protect against excessive, detrimental, discretionary spending. Creating a trust is an ideal way of controlling assets for spendthrifts who have a hard time curtailing their compulsive spending habits.
To serve as a contingency fund to take care of the settlor and to maintain control of the assets should he or she become incapacitated (unable to take care of himself or herself or manage assets due to decline in mental or health fitness).
What are the roles of participating parties in a trust?
- Creates the trust
- Appoints the trustees and specifies the beneficiaries
- Transfers assets to the trust
- Stipulate rules that the trustee should follow while managing the trust
- Assumes legal ownership of the trust assets
- Faithfully follows the settlor’s wishes and guidelines
- Manages the trust in all ramifications, including complying with any tax obligations
- Ensures that the trust is managed in the best interests (or for the sole benefit) of the named beneficiaries, including making and reviewing investments, disbursing payments, and distributing assets
A trustee may only benefit from the trust assets when the settlor allows for such an arrangement. Even so, the trustee must agree that personal concerns will be ancillary to those of the trust’s beneficiaries.
- Entitled to expect that the assets in the trust will be managed for their benefit
- Receives income, capital, or both of the trust. Disbursements or assets received are contingent on specific rules laid out by the settlor.
Other noteworthy terminology
Trust Instrument or Trust Deed refers to the document that establishes the trust. It is executed by, but may not necessarily be written by the settlor.
A valid trust deed must demonstrate the intention to set up a trust. And in doing so, defines the trust property (assets to be placed in trust), appoints trustees, identifies beneficiaries, and specifies terms that the trustees should follow.
To be accurate, a trust instrument mustn’t always be a document—it can often be created through an individual’s will, or by law.
It could also be a spoken declaration, where the settlor establishes an intention verbally. However, spoken declarations are not as effective as documents in constituting trusts, as they have a high tendency of causing legal misunderstanding, conflict, and wrangling.
Fiduciary Duty refers to the obligation of the trustees to manage the trust is such a way that maximum potential gain accrues to the trust’s beneficiaries at all times.
In scenarios where interests of the trustee and those of the beneficiaries are at odds, a widely accepted next course of action is to consult another trustee. This underscores why it is important for a settlor to appoint at least two trustees.
In trust law, appointment carries several meanings. It could refer to:
- the act of selecting a trustee; 'to appoint a trustee'
- the transfer of assets from the trust to a beneficiary
- the document that authorises the transfer of the trust assets
- the ability to transfer trust property from the trust, called the 'power of appointment'. In general, trustees have the power of appointment. However, the settlor may also confer this power on other individuals.
A testamentary trust is a trust that is created before the date of effect, which is the death of the person who creates it. It is often established through a last will and testament.
For testamentary trusts, the person who creates the trust is not called a settlor, but a testator.
What are the different types of trust I can set up?
Categories of trusts
Just how many trust types are there? The short answer is a lot.
It doesn’t help that quite a number of them overlap. A trust may actually fit the description of two or more apparently different types.
To make sense of this, note that trusts can be classified using a number of different methods or elements. The element may be:
disbursement—a protective trust (where the settlor is a beneficiary) or a qualifying trust (where the settlor is not a beneficiary)
character—a charitable purpose trust (also called public trust, where the beneficiary strictly fits any of four charitable categories) or a non-charitable purpose trust (a private trust where the beneficiary isn’t necessarily an ascertainable individual)
revocability—a revocable trust (where the settlor retains ownership and control of trust assets and can alter the trust deed at any time) or an irrevocable trust (where the settlor cannot alter or make changes to the trust deed)
establishment—an express trust (where the settlor establishes or creates the trust) or one that is imposed by law (sub-types include statutory trust, resulting or implied trust, and constructive trust)
For clarity and continuity reasons, we’ll only discuss express trusts. Of course, as previously noted, a trust can be rightly classified as an express trust (established by you, the settlor), a protective trust (you specify yourself as beneficiary), and a revocable trust (you can make changes to the trust deed).
Types of express trusts
Express trusts come in different flavours. The type you choose depends primarily on the reason to establish it. The most commonly used types are:
Bare, simple, or absolute trusts
As the name suggests, this is the most basic kind of trust.
- You (the settlor) places assets in to the trust, appoint trustees, specify the intended beneficiaries, and state that all assets should be passed directly to them.
- The trustees assume ownership of transferred assets.
- The beneficiary or beneficiaries are entitled to, and have absolute right to all of the capital and the income of the trust at any time; as long as he or she is at least 18 years of age (in England and Wales) or at least 16 (in Scotland).
Usually the beneficiary cannot be changed after establishing a bare trust - that means the trustees have no say over what the beneficiary receives and do not perform any active duty.
Simple trusts are often used to transfer assets to minors (young people who do not meet the aforementioned age requirement), with the trustees looking after the assets until a beneficiary comes of age.
In situations where you intend to disburse assets in trust to multiple beneficiaries in specific proportions, you may use a variant of a simple trust called a fixed trust. Fixed trusts possess all the other characteristics of absolute trusts.
Furthermore, for a fixed trust, it is not compulsory that the value of the trust property is known. Quite often, it is impossible to know or predict the value as settlors often fund fixed trusts with private company shares.
These comprise of two categories of beneficiaries - income beneficiaries and capital beneficiaries.
The trustee transfers all trust income (less any expenses and tax) to the income beneficiary for a fixed period, an indefinite period; or more often, for the rest of the income beneficiary’s life.
An income beneficiary entitled to income for as long as he or she lives is called a life tenant. And the trust is called a life interest trust.
Regardless of the duration for which income is disbursed, the income beneficiary is said to have an interest in possession in the trust.
For life interest trusts, the interest in possession ends on the death of the income beneficiary with the capital beneficiaries receiving the entirety of the trust property afterwards.
Interest in possession trusts are often used to provide for a surviving spouse with the capital of the trust kept intact and passed on to heirs (usually children) when the spouse dies.
For example, you may create an interest-in-possession trust, where you designate your wife as the income beneficiary, your children as capital beneficiaries, and all your shares as the trust property.
You may state as part of the trust instrument that when you die, income from the shares should go to your wife for the rest of her life. And that the shares should be passed on to your children when she dies.
Typically, in this arrangement, the income beneficiary has no right to the shares themselves (or the powers that the shares confer) - just the income.
You give trustees the power to decide how to use the income, and sometimes, the capital of the trust.
You would have to stipulate how much power the trustees possess in the trust instrument, often in the form of a letter of wishes.
You may give the trustees the freedom to make a decision on what is paid out (income or capital), which beneficiary receives disbursements, the timing and frequency of disbursements, and/or whether or not to impose conditions on beneficiaries.
You may set up a discretionary trust if you’ve already identified intended beneficiaries but are unsure of how much help they would need in the future and in what proportions. For instance, a grandchild may be in need of more financial help than other beneficiaries at some point.
You may also create a discretionary trust to take care of beneficiaries who are not responsible or capable enough to handle cash themselves.
You may set up a variant of discretionary trust called an accumulation and maintenance trust, if you want to give trustees the ability to augment or accumulate the income and capital of the trust through savings and investments. Typically, you’d allow for this accumulation to continue until a specific date when the beneficiary is entitled to some income or all the capital of the trust.
Another variant of a trust is a trust for vulnerable beneficiaries also called a trust for disabled beneficiaries.
This can be any of the types of trust above, but where one or more of the beneficiaries is a vulnerable person - someone who is otherwise unable to look after the assets in the trust himself or herself.
It is commonly used for a child under 18 or for a beneficiary who is a mentally or physically disabled.
The trust may also be used to hold compensation payments for individuals who became disabled because of personal injury.
Vulnerable beneficiaries’ trusts have special tax exemptions.
Mixed or hybrid trusts
A hybrid trust incorporates characteristics of several types of express trusts. In other words, it does not strictly fit the description of only one trust type. Mixed trusts demonstrate just how flexible trusts can be.
Accordingly, tax rules for a mixed trust are a mixture those that apply to the different parts of the hybrid trust.
A good example of a mixed trust is a trust where some assets are treated as though they were part of an interest in possession trust, while other assets are treated as though they were part of a discretionary trust.
You may use this subtype of mixed trust when you intend for siblings of different ages (who meet the age requirement at different times) to benefit from the same trust fund.
This term generally refers to protective trusts, where the settlor is also a beneficiary.
However, according to UK trust law, a trust you create that specifies your spouse or civil partner as a beneficiary also counts as a settlor-interested trust (even though it isn’t exactly a protective trust).
A settlor-interested trust may take on the characteristics of either an interest-in-possession, discretionary, or accumulation trust.
For example, if an injury or illness erodes your ability to work, creating a discretionary trust is a smart way to ensure that you wouldn’t be short on cash in the future.
A non-resident trust is a trust administrated by trustees who are not resident in the UK for tax purposes.
It may also refer to a trust where some of the trustees are UK residents but the settlor of the trust was not a UK resident as at the time of setting up the fund or transferring ownership of assets.
It is often associated with very complex tax rules.
Charitable purpose trusts
For a trust to be a charitable purpose trust, it has to be created for one of the four following reasons:
- relief of poverty
- advancement of education
- advancement of religion
- other purposes that are beneficial to the community
Charitable purpose trusts typically have the lowest rates of tax applied to them.
A variant of charitable trusts is the heritage trust or maintenance fund set up to maintain historic buildings.
Non-charitable purpose trusts
If the beneficiary of a trust doesn’t fit any of the four categories outlined above and isn’t necessarily an ascertainable individual, then the trust is called a non-charitable trust.
An example is a trust established to maintain a tomb or to care for animals owned by the testator.
How can I set up a trust fund?
Case law demands that for an express trust to be validly declared, it has to establish three certainties:
- certainty of intention; that you clearly intend to create the trust
- certainty of subject matter; that you plainly and precisely define the trust assets
- certainty of objects; that you unequivocally delineate the beneficiaries
To create an express trust, you would need the help of an expert with specialised legal, financial, and tax knowledge to establish these certainties; decide on all the important aspects of a trust; and ensure proper, precise legal wording & constitution of your trust.
However, there is work you can do yourself:
Identify the assets you want to put in the trust
You should be detailed—list the specific assets and note their values. If there is an asset that you intend to place in trust but which you haven’t yet acquired, include it in your list as well.
Decide on the trustees that you would like to manage the trust
It is advisable to have between two and four trustees. Ideally, you want to choose someone who:
- is honest and dependable
- has experience with financial matters
- you believe has the best interest of intended trust’s beneficiaries at heart
- you reasonably expect to outlive you
You may also decide to note down alternative trustees who would take on the mantle should a first-choice trustee pass away.
You have the option to use a professional entity that manages trusts for a fee. But you would then have to weigh up just how much income or capital would eventually be passed to beneficiaries after fees.
Do not forget to determine the proportion of benefits that’d be passed to each beneficiary.
Make a concise outline of the terms
It isn’t the main deal, but a note of all touching guidelines you want the trustee to follow.
To give you an idea, your outline should include:
- objectives of the fund
- how benefits should be paid—as a lump sum or via an income stream
- how the trust would be terminated or settled
- how the trust bank account would be operated and/or how the trust assets would be managed
Trusts, taxes and your needs: why you should consider expert advice?
Tax rules for trusts differ between trust types. More importantly, they are dynamic. Combine that with the complex nature of trusts and the eccentricity of your needs, and it becomes abundantly clear why you need to discuss setting up a trust with an expert who has a robust understanding and keeps track of the ever-changing trust-related legal implications and obligations.