Discretionary trusts and bare trusts: a beginner’s guide

Sam Barrett explains the value of different types of trusts in financial planning 

Trusts can conjure up images of tax avoidance schemes such as those uncovered in the Paradise Papers. But despite their complexity - the Office of Tax Simplification has now published two reports looking at simplifying inheritance tax – trusts can nonetheless play a valuable part in financial planning. 

Although trusts can offer tax advantages, the key reason to use one is to have greater control over how your wealth is distributed. ‘It’s all about asset protection,’ says Patricia Mock, tax director at Deloitte. ‘Using a trust enables you to pass your wealth down the generations more efficiently, with the trustees deciding when, and to whom, it is distributed.’

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Trust benefits

This means they can work particularly well where there are young children or grandchildren who might not yet be trusted to spend the money wisely, or there is a risk of a divorce or bankruptcy, when the money could potentially leave the family. A trust can also be a good planning tool when you want to provide for your grandchildren, but you’re not sure they’ve all arrived yet.

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As you pick the trustees – who can be friends, family, and even yourself, as well as professionals such as a solicitor or accountant – you can be confident your wishes will be carried out. For additional reassurance, the objective of the trust can also be set out in a letter of wishes to help guide the trustees’ decisions.

Changes in trust rules over the years do mean they’re less tax-efficient than they were, but the advantages shouldn’t be overlooked either. Gifts into trusts will fall outside your estate for inheritance tax (IHT) purposes after seven years, even though they might not be distributed to your beneficiaries for many more years; and, depending on the type of trust, there can also be income and capital gains tax (CGT) advantages.

A trust can also be used to hold just about any asset, with the notable exception of Isas as these must be held by individuals.

However, the asset you choose can affect the way you and the trust are taxed. Rachael Griffin, tax and financial planning expert at Old Mutual Wealth, explains: ‘With a share portfolio or property, you may find yourself with a capital gains tax liability when you move it into the trust, and there could also be stamp duty liabilities.’

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Types of trust

There are two main types – bare or absolute trusts, and discretionary trusts. The former is much less flexible, as Graeme Robb, tax planning expert at Prudential, explains: ‘A bare trust is usually set up for a child or grandchild and has the advantage that the money is taxed as if it belonged to them [using their personal tax allowances]. The disadvantage, though, is that at age 18, or 16 in Scotland, they have a right to the money, so it’s probably not recommended for large sums.’

Parents can also get caught out by the £100 rule. Under this, if the money a parent transfers into a bare trust for their child generates more than £100 of income, that income is taxed as the parent’s.

Discretionary trusts are much more versatile, allowing you to have a range of potential beneficiaries as well as greater control over when and even whether they receive any proceeds. This comes at a cost, though, as Bernadette Lewis, financial planning manager at Scottish Widows, explains: ‘The price for this control and flexibility is that these trusts come under complex inheritance tax, income tax and capital gains tax rules.’

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Discretionary taxes

On the IHT side, anything you pay into a discretionary trust is regarded as a ‘chargeable lifetime transfer’. As such, if you transfer more than the £325,000 nil rate band over a seven-year period and you’ll pay a 20 per cent tax charge on any excess. There’s also a further 6 per cent tax charge at each 10-year anniversary of the trust, which applies to any excess over the nil rate band, plus an exit charge of up to 6 per cent.

Robb adds: ‘The simple solution is to stay below the nil rate band, in terms both of what you transfer in and of how much it grows. This will minimise tax charges and make it much easier to manage.’

But, even if your trust stays under the radar for these tax charges, the trustees can still find themselves grappling with a variety of income tax charges. For example, where annual trust income exceeds £1,000, dividends are taxed at 38.1 per cent while all other income is taxed at 45 per cent. ‘Trustees pay 38.1 per cent on dividends in a discretionary trust, but have to account for tax at 45 per cent when they pay them out to the beneficiary,’ says Mock. ‘It can become very complex, so you must make sure your trustees are happy to take on these responsibilities.’

Careful selection of the assets held within a trust can avoid some of these tax complexities. For instance, as they’re non-income producing, investment bonds are a particularly popular choice for trusts.

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Financial planning

Trusts can also support financial planning strategies through a number of variations on the discretionary trust, allowing you to meet different objectives.

An example of this is a loan trust. This allows you to lend money to a trust with any growth earmarked for your beneficiaries and immediately outside your estate for inheritance tax purposes.

George Houston, senior technical and development manager at Mattioli Woods, explains: ‘As you can get the loan back at any time, this can be a good option if you can’t afford to give away the money but you don’t want your estate to grow any further.’

Another common option is a discounted gift trust. This time you give up the right to the money you pay into the trust, but you have a right to an income from it for the rest of your life. An actuary will work out a discount based on the amount you’re likely to receive. This discount is then subtracted from the value of the gift you placed into trust, meaning that you benefit from an immediate reduction in the value of your estate.

‘This is a good option if you need an income but want to reduce your estate from an inheritance tax perspective,’ adds Houston.  

Another common use for a trust is to hold a life insurance policy. This has several advantages, as Griffin explains: ‘On death the payout from the policy is available to the beneficiaries quickly and before probate. Writing the policy in trust also means the proceeds are outside your estate, so there’s no risk of them adding to an inheritance tax bill.’ 

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Simplification

As trusts clearly have their uses in financial and estate planning, the prospect of a consultation into simplifying the way they’re taxed is welcomed. ‘The taxation of trusts is hugely complicated, so any consultation is to be applauded,’ says Mock. ‘It won’t be the easiest project, especially as trusts encompass so many different forms of tax, but any simplification would be beneficial.’  

However, while this simplification might give more people the confidence to use a trust, Robb says it’s important not to see them as the only way to pass on your wealth. ‘There’s absolutely nothing wrong with giving someone money,’ he says. 

Case study: Discretionary trust

Richard is retired and lives in his own home, with his pension covering his living expenses. His two children are married, one with three kids and the other looking to start a family.

He has built up savings and investments that he would like to pass to his family, so he sets up a discretionary trust with his children and grandchildren as the beneficiaries. This enables future grandchildren to benefit from the trust but, unlike giving the money directly to his two children, it also ensures the money is protected in the event of either of them divorcing. 

Trustees will be responsible for any income tax arising from the investments held in trust, and it will take seven years for the transfer to be outside of his estate for IHT purposes.

Case study: Bare Trust

Graham and Elizabeth have three grandchildren, Peter, Iris and Lily. As the children are all under seven, the grandparents want to make sure they have some money when they’re older to help with expenses such as university, first jobs and travel. They invest £2,500 into a savings scheme in a bare trust for each grandchild.

Any income or capital gains tax on the investment is the grandchild’s responsibility, and is covered by their personal allowances; as the gift is a potentially exempt transfer, it will be outside Graham and Elizabeth’s estate if they survive a further seven years.

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