Parents writing wills should avoid creating unnecessary trusts for their children unless they are disabled or otherwise vulnerable, or stand to inherit large sums of money, a law firm warns.
The extra costs, taxes and administrative burden involved in setting up and running a trust after your death mean it is only worthwhile in limited circumstances, according to Osbornes Law.
If under-18s inherit money, a basic or ‘bare’ trust is automatically created in any case, and executors, parents or guardians look after the money until they are adults, explains lawyer Jenny Walsh.
A lawyer warns: ‘Parents often get the idea that setting up a trust for their children will have tax advantages’
‘We see a lot of people coming to us convinced they need to set up a trust for their children.
‘For many it is simply not worth the trouble and expense and is invariably not the tax break they think it is,’ she says.
Common pitfalls are parents wrongly believing a trust will be more tax efficient, wanting to assert control over adult children’s behaviour after their death, trying to guard against unlikely future eventualities, and not having enough money to make setting up a trust worthwhile.
Walsh, an associate solicitor specialising in wills and trusts at Osbornes, says she advises clients to ask themselves the following questions before deciding to set up a trust.
– Why do you need it?
– What benefits will it achieve?
– How much money is at stake that makes it worthwhile?
She adds that much of her work involves unpicking trusts that people have realised were unnecessary or too costly.
Walsh says you should seek legal advice if you want to dissolve a trust, because a deed needs to be drawn up and there can be tax consequences.
The types of trust involving inheritance are as follows.
Bare trusts – These are very simple, as described above. The child gets the money at 18 and taxes are borne by them, and subject to their personal allowance.
18 to 25 trusts – These are a kind of ‘hybrid’ according to Walsh as they don’t fall under a full-blown tax regime. But there is an exit charge of up to 6 per cent levied on money in the trust over and above £325,000.
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Discretionary trusts – These are more complicated, and involve running costs and 10-year anniversary charges of up to 6 per cent of the value above £325,000. Read more here, and see the box on the right.
Vulnerable beneficiaries trusts – These are not subject to the same tax regime, but only if the beneficiary is proven to qualify as vulnerable, explains Walsh. Read more here.
Life interest trusts: These are often used by couples so that if one dies their half of a property or their assets is passed to children and doesn’t fall into the hands of a future spouse and their offspring. Read more here.
‘There are situations where creating a trust is important, to protect a vulnerable person from misspending their inheritance or from being taken advantage of by others,’ says Walsh.
‘If your child is set to inherit millions and you are concerned that at 18 they may make poor decisions with the cash, there is a case for keeping it in trust until they are older.’
Walsh goes on: ‘Parents often get the idea that setting up a trust for their children will have tax advantages and protect them against inheritance tax charges.
‘The reality is, that for those without large fortunes and years of tax planning behind them, trusts can have negative tax consequences, with beneficiaries losing money through fees, and trustees, who are usually unpaid friends or family, finding they have to take on the burdensome admin associated with managing a trust and ensuring all appropriate taxes are paid out.’
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What should you consider when setting up a trust?
‘The tax legislation that applies to trusts aims to be broadly tax neutral, with no benefit or loss when compared to a person holding those same assets outside a trust,’ says Ian Dyall, technical manager at Tilney Financial Planning.
‘That said, trust taxation can be complex and depending on how the trust is run, and the assets that are held within the trust, there can be tax benefits or losses.
‘Rather than looking at trusts as a method of tax mitigation it is better to consider their benefits in protecting the assets they hold, and weighing that against the additional administrative burden.
‘It is certainly simpler to pass assets outright to a beneficiary, but trusts can help protect assets in situations where a beneficiary divorces, or becomes bankrupt, or perhaps is not able to handle money wisely.
‘That protection is attractive to many people, but it needs to be balanced against the additional administration.
‘Trusts may need to submit annual tax returns, and most trusts will need to register with HMRC as part of international measures introduced to prevent trusts from being used for money laundering or tax evasion purposes.
‘The level of administration required and the tax due will depend on the assets held in the trust.
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‘Whilst it is possible for a trust to be administered by amateur trustees, it is worth seeking advice from the outset to ensure that the administration is no more complex than it needs to be and that the trust is run efficiently from a tax perspective.’
Emily Deane, technical counsel at the STEP trade body of inheritance professionals, says: ‘There are a lot of good reasons for setting up a trust.
‘They provide control and flexibility in a way that is difficult to replicate using other structures – this can be particularly important in situations where you have a family member with specific needs, or when you have a more complex or blended family and you want to ensure everyone is provided for and flexibility is required to cater to changing needs over time.
‘Setting up a trust purely to gain tax advantages, however, is rarely advisable, due to the fact that trusts are subject to three separate inheritance taxes.
‘Tax should really be considered a secondary issue, and should be balanced carefully against the other objectives.
‘Setting up a trust will involve the cost of the legal adviser who set it up in accordance with your circumstances alongside any ongoing maintenance costs and any taxes payable.
‘Taxes include an entry charge that is paid when you transfer assets into the trust; an exit charge that is payable when a trustee pays out of the trust to the beneficiaries; and a 10-year charge, also known as the periodic charge, which is payable if the trust contains relevant property where the value is over the £325,000 inheritance tax (the nil-rate band).
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‘These costs and taxes are time consuming and complex to calculate, and trustees generally need to consult a professional adviser to arrive at the correct figure.
‘This can be expensive, but is worthwhile, as delayed or incorrect payments to HMRC will result in interest charges and/or financial penalties.
‘The rules around inheritance tax and trusts are very complicated and variable since each person’s individual circumstances will dictate their tax position.
‘Some trusts for vulnerable beneficiaries are entitled to special tax treatment from HMRC but they need to meet specific and stringent conditions.’