Bare Trusts and Discretionary Trusts
Since the changes to trust taxation in the 2006 Finance Act, whether a trust is for identified children on their reaching a specified age (previously an “Accumulation & Maintenance Trust”) or for a specific person and purpose, e.g. giving a house to trustees so that a named person can have the right to live in it for life, with it then passing to someone else (an “Interest in Possession” trust) or fully flexible with the Trustees being able to identify which of a wide class of persons should benefit, and when (a “Discretionary Trust”), all trusts created during lifetime are now subject to the same, rather complex, tax treatment. This has led to the fully-flexible Discretionary Trust becoming the most popular option, as the more restrictive forms of trust no longer have any particular tax advantages.
Where a settlor wishes to benefit particular people, however, and wishes to keep things as simple as possible, the creation of a “Bare Trust” is another option. The purpose of this note is to describe the characteristics of the two types of trust, so they can be compared.
The Bare Trust
Where a beneficiary is under the age of 18 (or 16 in Scotland) and cannot hold property in their own name, it can be held on trust for them and this gives a simple route to providing for, for instance, grandchildren. The beneficiaries have an absolute and immediate right to both capital and accumulated income, subject only to their attaining full legal age. Suppose that a grandparent, GP, sets up an account at a stockbrokers in the name of their son, S as bare trustee for S’s three children, G1, G2 and G3. The portfolio, although it may be managed as one common pool of money, is beneficially owned by each of G1, G2 and G3 as to their 1/3 share, and so is the income, in the form of dividends or bank interest, received into the account. G1, G2 and G3 (or S on their behalf) must include the income they receive in any one tax year on their tax declaration (although if they earn less than the individual personal allowance they may not have to submit a return) and can claim credit for their share of any income tax deducted. If securities are sold and a Capital Gain results then, similarly 1/3 of the gain as attributed to each of the beneficiaries, who must, if it exceeds their personal annual exempt amount, declare it and pay Capital Gains Tax on it via their personal Tax Returns. When the grandchildren G1, G2 and G3 each reach the age of 18, they are entitled to call for their share without any restriction. If they do not, the “bare trust” arrangement simply continues. From an Inheritance Tax point of view, the gift by GP is tantamount to an outright gift. It is a “Potentially Exempt” transfer and, provided GP survives the gift by 7 years, no Inheritance Tax will payable on it as it has left GP’s estate. If GP did die within 7 years and the Potentially Exempt transfer “failed”, the value at the time of the gift would be added back into GP’s estate for purposes of calculating the Inheritance Tax on their death.
The Discretionary Trust
If G wanted more control, however, or to vary the amounts beneficiaries received according to their circumstances at the time, they could elect to settle money on a Discretionary Trust. The terms of the trust would give the Trustees complete discretion whether to accumulate income or pay it out, to distribute capital or to retain it and to vary the amounts paid out to members of the class of beneficiaries defined by the trust deed, which may often mean giving no benefit at all to some members of the class. In the example above, the class of beneficiaries might include, say, all of GP’s adult descendants, their spouses, and the widows and widowers of descendants.
Here, the situation is very different. Suppose that GP and S are both trustees (it is more common to have two or more trustees for trusts of this type). They could still, if they wished, open an account at the same brokers for investment of the money. As far as Income Tax is concerned, however, it is the Trustees who would have to file a tax return and to prepare annual accounts for the trust. The first £1,000 of income on the trust assets would be taxed at 7.5% on dividends or 20% on bank interest (normally already automatically deducted) and 20% on other income but it would then be subject to Income Tax at the special rates applying to Trusts on any amount above this. For the 2017-8 tax year, the rates are 38.1% for dividends and 45% on other income. When and if the trustees later pay any income out to a beneficiary, they will issue a certificate for the amount of this tax, which will have already been paid by the trustees to HM Revenue & Customs, and the beneficiary may be able to claim it back if they are not themselves subject to these high rates. It may be simpler for the Trustees to make an appointment under the trust “mandate” the income in favour of the relevant beneficiaries, so the beneficiaries just treat the income as their own.
Where gains are made on the trust’s investments then, again, it is the Trustees who must pay tax on the gains. They have their own annual exempt amount, which applies to the whole trust fund and is currently only half the amount of the allowance available to individuals. Beneficiaries are not taxed on their share of the gains but cannot claim back any of the tax paid by the trustees.
As far as Inheritance Tax is concerned, again, it is different. The gift by G to the trustees is not a potentially exempt transfer, but a taxable one. If it is under the tax threshold (£325,000 for 2018-9) no Inheritance Tax is immediately payable, but any amount over that is taxable at the lifetime rate, which is 20%. If G died within 7 years of funding the trust, there would be an additional charge topping the rate up to 40%. Moreover, the trust is subject to the “periodic and exit” charging regime. On each 10th anniversary of establishment of the trust, or on withdrawing trust assets, an Inheritance Tax charge is calculated based on the value of the trust fund at inception, or the last 10-year anniversary. The charge is based on 30% of the lifetime rate of 20%. What this means is that most trusts, funded with an amount just below the tax threshold, are not taxable in the first 10 years or at the first 10-year anniversary but may be subject to quite small charges to inheritance tax (not more than 6%) thereafter, if the trust fund has grown faster than the tax-free limit, whenever there are distributions from the fund. Calculating the amount is not straightforward and adds to the administrative costs of the trust.
If you want to “keep things simple”, to treat minor beneficiaries equally and keep the costs of establishing and maintaining a trust down, a “bare trust” may be all that you need. It is the more tax-efficient option. Generally, it is just a question of explaining the arrangement to the institution(s) where funds are held, and perhaps drawing up a very simple one- or two- page declaration of trust. There is no obligation, as such, to even inform the beneficiaries of their entitlement, but they will be absolutely entitled to their share when they reach the age of 18 and this, for some people, is the major drawback.
If you want more flexibility and control, and to ensure that funds are released only when appropriate and not necessarily equally among the main beneficiaries, a Discretionary Trust will meet your needs better, but the costs of setting the arrangement up and administering it from year to year are considerably higher, and the tax treatment will be both more complex and more onerous by comparison
Updated August 2018