In this excerpt from the report ‘How to Use Trusts to Reduce Property Taxes’, Jennifer Adams look at the different types of trusts available.
The two main types of trust available for use in the UK are:
- 'Qualifying Interest in Possession' ('QIIP') Trusts and
- ‘Discretionary’ Trusts (also known as ‘Relevant Property Trusts’).
Detail of the two main types trusts
- QIIP Trusts
Under a ‘QIIP’ trust, a beneficiary is entitled to the income received by the trust (which could include rental income) without any recourse to anyone else. HMRC's view is that a QIIP exists if the beneficiary has:
- a present right to present enjoyment;
- of the net income of the settled property; and
- without any further decision of the trustees being required.
(Pearson v CIS 1980 STC 318)
'QIIP' trusts are frequently created primarily to satisfy the settlor's desire to protect capital rather than saving tax. This would be particularly in point with reference to property.
Should this be the case then the trust can be written to enable a series of successive interests before the capital vests absolutely to the beneficiaries, if ever. QIIP trusts can be very flexible if drafted correctly.
- Discretionary trusts
In comparison, the beneficiary of a ‘Discretionary’ Trust is not entitled to either the income or the actual property, rather, it is at the absolute 'discretion' of the trustees as to how both are distributed (if distributed at all) dependent upon the terms of the Trust Deed.
It is, therefore, usual for there to be at least two beneficiaries so that the trustees can exercise their 'discretion'. However, it could be possible for there to be effectively one beneficiary so long as either there is also a default beneficiary such as a charity ( the trustees will then be able to exercise their 'discretion' between the two) or a power to accumulate.
If there is a power to accumulate with the accumulation effectively accruing to the default beneficiary, then upon the exercise of that power there may be nothing over which the discretion can be exercised .
This does not invalidate the discretionary trust and has been widely used. The only real problem arises if there is no fixed default beneficiary, or the trustees fail to exercise the power to accumulate.
A variation on a theme - other types of trust
- Bare trust – this type of trust is the simplest type of trust arrangement whereby the trustee holds property on behalf of the beneficiary and acts in accordance with that beneficiary’s wishes.
Although the trust is the legal owner of the property, the trustee has no discretion such that the beneficiary is absolutely entitled to all the trust assets and not just the right to receive income from any assets held within the trust.
A typical example of such a trust arrangement is where a parent sets up a bank account for his child. The parent will be acting as 'bare trustee' holding the property on behalf of the child.
Any interest earned on the account is the child's income and the child has the right to both the income and capital held in the account at any time.
However, for bare trusts created by parents for their minor child (under 18 and unmarried) where the income on the gifts between the said parent and beneficiary of the trust is £100 or more, then the income is taxable on the parent.
The feature of these types of trusts is its inflexibility not least because once the beneficiary is of full legal capacity (18 under the law of England, 16 under the law of Scotland) he can demand that the trust property is
distributed to him.
- Immediate post-death interest ('IPDI') trust – this type of trust is a 'QIIP' that can only be created by will or under Intestacy. The beneficiary has an immediate right to the income generated from the assets held within the trust (or the right to enjoy the asset in another way; e.g. by being allowed to live in a residence) but for a set period of time.
The time limit is often for the lifetime of the beneficiary (termed the 'life tenant'), however, it can be for another ‘fixed’ time (e.g. it might end when certain circumstances arise such as the death or remarriage of the beneficiary/surviving spouse).
The trust property is treated as belonging to the life tenant for inheritance tax purposes.
A typical example of the use of such trusts is of a married couple, one or both of whom have been married before and one or both of whom has children from a previous relationship.
The will of the first to die creates an IPDI trust allowing the surviving spouse (the 'life tenant') to receive the trust income for life (e.g. rental income) but not the right to the actual property, thus preserving the asset or the trust capital.
After the death of the surviving spouse, the trust ceases and the capital/property passes to the children (the 'remaindermen') of the first spouse.
This type of trust allows for the surviving spouse to receive an income or be allowed to live in a property, but on their death, the children from the previous relationship still receive an inheritance from their parent.
- Charitable trusts - Most charities are legally constituted as registered charitable trusts and are, therefore, exempt from tax. Such trusts have a Board of Trustees that decides how to apply the income and capital within the trust.
Charitable trusts are Discretionary trusts whose funds must be applied for charitable purposes. A charitable trust will normally continue in perpetuity, that is, it is not required to come to an end after any particular time.
- Protective trusts – this trust is a special type of 'QIIP' which gives the beneficiary a right to the income, that right ceasing either on the bankruptcy of the beneficiary or on any attempt by them to sell or otherwise dispose of his/her life interest.
By creating a protective trust, the settlor gives the beneficiary the right to income whilst at the same time, guaranteeing that the assets should not be put at risk by any irresponsible actions of that beneficiary.