The Lifecycle of Interest in Possession and Discretionary Trusts

Interest in Possession and Discretionary Trusts for Settlors, Trustees and Advisers

By Meg Saksida BA FCA CTA (Fellow) TEP

When a private trust is deliberately set up, during life or by will, it will generally be either an interest in possession (IIP) trust or a discretionary trust (DT). The two work in very different ways, and the difference affects how the trust is created, how it is run, how it is eventually wound up and how it is taxed at each of those stages.

Written by trusts expert Meg Saksida, this practical guide takes you through the lifecycle of both types of trust. You'll learn the difference between IIP and discretionary trusts, the roles of the settlor, the trustees and the beneficiaries, and the UK income tax, capital gains tax and inheritance tax implications of each stage, together with tax saving opportunities and common tax pitfalls.

What Are Interest in Possession and Discretionary Trusts?

A trust splits the ownership of an asset in two. The settlor transfers or gifts assets into the trust. The trustees become the legal owners and must look after those assets for the beneficiaries, who hold the beneficial ownership and can enforce the terms set out in the trust deed.

An interest in possession trust gives a beneficiary, the life tenant, a present right to the trust income as it arises, while the capital passes to the remainderman when that interest ends, often on the life tenant's death. In a discretionary trust, no beneficiary has a fixed right to income or capital. The trustees decide whether to make payments, when, how much and to which members of the class of beneficiaries, and they can choose to accumulate the income in the trust instead.

Tax Charges and Pitfalls Through the Life of a Trust

The type of trust has a direct effect on the tax bill. IIP trustees pay income tax at the basic rate, because all the income must be paid out to the life tenant each year, whereas discretionary trustees, who can accumulate income, pay the much higher trust rate. For inheritance tax, the treatment depends on whether the trust is a qualifying interest in possession, where the trust property is taxed as part of the life tenant's estate, or a relevant property trust, which can be charged when assets are settled, when capital leaves the trust and every ten years.

Tax can arise before the trust even starts. Settling land, shares or other chargeable assets is treated as a disposal at market value for capital gains tax, which can leave the settlor with a tax bill and no proceeds to pay it, unless holdover relief is available. The legal detail matters too: a trust can fail for lack of certainty, a settlor who keeps too much power may find themselves in an unwanted tax situation or see the trust treated as a sham, and trustees who breach the trust may have to compensate the beneficiaries out of their own funds.

What This Report Covers

In eight chapters, with 18 worked examples and practical points throughout, this guide covers:

• The essentials of trusts
• The types of trusts that exist
• The lifecycle of a trust
• Interest in possession trusts (IIP)
• Discretionary trusts
• Taxation of trusts
• Plus much more...

Trust essentials and creating a trust

What a trust is, the roles of the settlor, trustees, beneficiaries and protectors, and the difference between statutory, express, implied, resulting and constructive trusts. The report then sets out what is needed to create a valid trust: the settlor's capacity, the three certainties of intention, subject matter and objects, and the complete constitution of the trust by transferring legal title to the trustees, together with the deadlines for registering the trust with HMRC's Trust Registration Service.

Running and winding up the trust

The trustees' administrative and dispositive powers, from insuring and investing the trust property to maintaining and advancing funds to minors, and their fiduciary and general duties, including the duty of care, the standard investment criteria and regular investment reviews under the Trustee Act 2000. It also covers the appointment, retirement and removal of trustees, keeping trust accounts, and how a trust comes to an end, including the rule in Saunders v Vautier and the CGT effect of Crowe v Appleby.

Interest in possession, discretionary and bare trusts

How life tenants, successive life tenants and remaindermen are treated in an IIP trust, why the trustees must balance income for the life tenant against capital for the remainderman, and the reasons for choosing an IIP, including protective trusts for spendthrift beneficiaries. For discretionary trusts, the guide explains the letter of wishes and why it is not binding, the 125-year perpetuity period, the default beneficiary, the risk of "puppet" or sham trusts and the income and capital clauses the trust deed needs, before explaining how bare trusts differ from both.

Tax on creating a trust: IHT, CGT and holdover relief

How the residence of the trustees and the domicile of the settlor affect the tax treatment of a trust, why a gift into trust is usually a chargeable lifetime transfer for inheritance tax, and how the nil-rate band is refreshed after seven years. It also explains why settling a chargeable asset is a disposal at market value for capital gains tax, how holdover relief can pass the gain to the trustees, and when the relief is not available.

Ongoing tax and the end of the trust

How IIP and discretionary trustees are taxed on trust income, how beneficiaries use Form R185, why IIP income keeps its character in the beneficiary's hands while discretionary trust income does not, and why discretionary trustees must keep a tax pool. The report covers the trustees' CGT reliefs, including business asset disposal relief, which only IIP trusts can use, and the inheritance tax treatment of qualifying interest in possession (QIIP) and relevant property trusts, with worked exit and ten-year charge calculations. It ends with the tax on winding up a trust, including the tax-free uplift on the death of a QIIP life tenant and why an exit charge should be calculated before and after the ten-year charge.

Who Will Benefit From This Report?

If you want to know more about trusts and the benefits of using them, this report is perfect for you, whether you are a settlor thinking about putting assets into trust, a trustee who needs to understand their powers and duties, or a beneficiary of an existing trust.

It is equally useful for accountants and tax advisers who want a clear, practical overview of IIP and discretionary trusts and their tax consequences, from the creation of the trust to its winding up.

About Meg Saksida FCA CTA TEP

Megan Saksida BA FCA CTA (Fellow) TEP runs her own business lecturing, examining and writing about private client taxation issues. Her speciality is inheritance tax and trusts and estates.

Meg writes widely on income tax, capital gains tax and inheritance tax, and is a regular contributor to Tax Insider, Property Tax Insider and Tax Insider Professional.