Types of trust
Bare trust
A bare trust (also known as an absolute trust) is the most straightforward type of trust arrangement. The donor sets up the trust and nominates a trustee(s) to hold assets on behalf of the beneficiary. If the beneficiary is a minor, the trustee holds the assets until they reach the age of 18 (or 16 in Scotland).
Many people, in the UK, see bare trusts as a tax-friendly way to pass on wealth, because any tax owed is usually based on the beneficiary’s tax situation. For this reason, bare trusts are also popular for inheritance planning, since the assets belong to the beneficiary from the very beginning.
For instance, someone may invest £5,000 in an investment held in a trust for their grandchild; while the trustee(s) manage(s) the funds until adulthood, the money (and any earnings) belongs to the grandchild.
Under a bare trust, the beneficiary has an absolute right to both the income and the capital. Once they reach legal age, they can access the assets within the trust at any time.
The beneficiary specified in the trust can’t be changed, even if it’s no longer desirable for this person to receive the trust benefits. So, the donor needs to be happy that the beneficiary, or beneficiaries, named cannot be changed and if the beneficiary predeceases them that any proceeds would go to the deceased beneficiary’s heirs.
Tax treatment of a bare trust
Income tax
The beneficiary of the trust is responsible for paying the tax on any income generated by the trust. The beneficiary includes the income in their self-assessment and pays tax at their marginal rate of income tax.
However, if a parent sets up a bare trust for their minor child, and the income exceeds £100 in any tax year the income is treated as the parents and taxed on the parent.
Inheritance tax
When assets are put into a bare trust, this is treated as a Potentially Exempt Transfer (PET) for inheritance tax purposes. If the person who sets up the trust lives for seven years after making the gift, no inheritance tax is owed. Bare trusts do not have the 10-year anniversary charges or exit charges that apply to discretionary trusts. However, if the beneficiary dies, the assets in the trust are included in their estate when calculating inheritance tax.
Capital gains tax (CGT)
Capital gains are taxed on the beneficiary therefore the beneficiary's CGT exemption (currently, £3,000) can be used.
And as the beneficiary is treated as owning the asset when it is removed from the trust there is no tax to pay if the asset is simply transferred directly to the beneficiary.
Discretionary trust
A discretionary trust is a type of trust where the trustees have the power to decide how the trust’s income and assets are distributed among the beneficiaries. Unlike a bare trust, the beneficiaries do not have an automatic right to the money or property in the trust. Instead, the trustees use their judgement to decide who gets what, and when. This flexibility is the main feature of a discretionary trust.
The settlor of the trust usually provides a letter of wishes to guide the trustee. This letter is not legally binding, but it helps the trustees understand the settlor’s intentions. For example, the settlor might want the trust to support family members who need financial help, or to pay for education costs. The trustees must act in the best interests of the beneficiaries and follow the trust deed.
Discretionary trusts are often used for family wealth planning. They can protect assets from being misused, and they allow money to be managed for people who might not be ready to handle large sums themselves. They are also useful when the settlor wants flexibility, such as changing who benefits over time. This makes them popular for situations where circumstances may change, like new family members or changing financial needs.
However, discretionary trusts can be more complex and expensive to run than simple trusts. They have specific tax rules, including higher rates of income tax and capital gains tax for the trust itself.
Tax treatment of a discretionary trust
Income tax
Trustees must pay tax on any income that comes into discretionary trusts.
If the settlor has set up more than one of these types of trusts, the £500 tax-free amount is shared among all the trusts they have. For example, if they have five or more, each trust only gets a £100 tax-free limit.
The tax rates for this income are shown below.
| Type of income |
Tax rate |
| Dividend-type income |
39.35% |
| All other income |
45% |
Inheritance tax
Entry charge
When a settlor transfers assets into a discretionary trust during their lifetime, the transfer is treated as a Chargeable Lifetime Transfer (CLT). The entry charge is 20% (or 25% if the settlor pays the tax) on anything over the nil-rate band (currently £325,000).
Ten-year periodic charge
Every ten years, the trust is assessed for a periodic charge, which can be up to 6% of the value of the trust assets above the trust’s available nil-rate band. The calculation takes into account the trust’s value at the anniversary and any previous distributions.
Exit charges
When capital is distributed from the trust to beneficiaries, an exit charge may apply.
Generally, if capital is distributed within the first 10 years and an entry charge wasn’t paid there is no exit charge. If capital is distributed after the first 10 years, the exit charge is a proportion of the periodic charge at the last 10-year anniversary.
Capital gains tax (CGT)
When a discretionary trust sells or transfers assets, it may have to pay CGT on any increase in value since the assets were acquired. The trustees are responsible for paying this tax. The current CGT rate for trusts is 24%, and the trust gets an annual tax-free allowance of £1,500. This will be split between all trusts created on the same day (up to a maximum of 5 trusts).
If assets are moved into the trust by the settlor, this counts as a disposal for CGT purposes, but holdover relief can often be claimed to delay the tax until the assets leave the trust. Similarly, when assets are transferred out to a beneficiary, holdover relief may also apply, so the tax is postponed until the beneficiary sells the asset.
Business trust
This is a discretionary trust designed mainly to allow the proceeds of the plan to be used by the remaining partners, members or shareholders to buy the interest or shares of the critically ill or deceased co-partner, co-member or shareholder.
It may also be used for a partnership established in England, Wales or Northern Ireland where the partners want a key person plan for the benefit of the surviving partners. In England, Wales and Northern Ireland, a partnership isn’t a separate legal person, so can’t directly own a protection plan. The key partner could therefore take out an own life plan and write it under the business trust for the benefit of the partners who may then introduce the funds back into the business.
This can also be appropriate for Scottish partnerships and limited liability partnerships (LLPs). However, as the partnership in Scotland and LLP are separate legal entities, it is perhaps more common for the partnership or LLP to own the key person plan.
Each business owner would set up an own life plan to be issued subject to a business trust. The business owners may need to consider putting in place a cross-option agreement and equalising premiums as part of an ownership protection arrangement.
The other co-owners involved in the business are included in the list of discretionary beneficiaries in the trust. The trustees can appoint funds to any of the discretionary beneficiaries including new partners, members or shareholders.
The settlor is also a discretionary beneficiary to allow for situations where it’s appropriate for the plan to be transferred back to them. For example, if the settlor leaves the business.
Any partners, members or shareholders who are not participating in the business protection arrangement should be excluded from benefiting. This is to ensure that the arrangement is on a commercial basis (no gift is involved).
Inheritance tax
Providing each partner, member or shareholder is placing their plan into trust only for the other individuals involved in the protection arrangement – and providing it is a genuine commercial arrangement – then the proceeds should fall outside the settlor’s estate on death for IHT purposes.
This is because the creation of the trust isn’t a gift but is part of a reciprocal commercial arrangement.
The plan needs to be placed in trust as part of the application process to avoid any tax implications. If an existing plan is assigned to a trust as part of a reciprocal commercial arrangement it could be treated as an assignment for consideration meaning that it could be subject to capital gains tax.
Example
Elizabeth, James and Duncan are equal shareholders. The business is worth £300,000. Each of them buys cover of £100,000 and, as part of the application process, places the plan into a business trust. An option agreement is drawn up under which the shares of the deceased can be sold to the remaining shareholders should the deceased’s executors or the surviving shareholders wish to do so.
As long as they all take out this cover under a proper commercial arrangement – the plan proceeds shouldn’t be within their estates at death for IHT purposes. The plan proceeds can be used to buy the shares from the deceased shareholder.
Pre-owned asset tax (POAT)
Under current rules, there is a risk that including the settlor as a discretionary beneficiary could result in POAT becoming payable. At commencement however, a POAT charge is initially unlikely as there’s little value inside the trust, that is, a life plan which hasn't paid out.
This may change if, for example, the plan pays out on a critical illness and the proceeds remain inside the trust, or if the life assured falls seriously ill and their ongoing plan is considered to have acquired a significant market value.
As a result of this, we offer a deed for the trustees to remove the settlor as a potential beneficiary. If they want to complete it, this can be done at the start or at a later date if they prefer. In any event, it doesn't need to be returned as we only deal with the trustees.
Relevant life plan (RLP) trust
This is a discretionary trust designed to allow employers to set up life cover for an employee in a tax efficient manner, without using a registered death in service group scheme. The trust is used to pay the benefit to the employee’s dependants.
A RLP must satisfy certain conditions, one of which is that “any benefits payable can only be paid to individuals (the employee’s dependants) or a charity”. This is why the RLP trust must be completed within the application journey, and the plan can’t start until the trust is received.
The trustees have the power to choose from a range of discretionary beneficiaries listed in the trust. The employee (member), their children, spouse or civil partner are included within the list of discretionary beneficiaries. The trustees can appoint funds to any of the discretionary beneficiaries of the trust, and these can be added to by the employee completing a nomination form. It’s also possible for the benefit to be paid to a further trust, such as a bypass trust. If this is required, then the name of the trust should be added to the list of discretionary beneficiaries.
Inheritance tax
As the death benefit is paid into the trust, the proceeds will be outside the employee’s estate for IHT purposes. However, as the trust is discretionary, depending on the circumstances IHT periodic and/or exit charges may apply as mentioned early under discretionary trusts.
