What are bare trusts and what are their attractions?
Jelley: Bare trusts arise where someone gives assets to a trustee to hold for the beneficiary absolutely. The beneficiary cannot be changed. This means the donor has certainty that their gift will go to the person they intended and, for inheritance tax purposes, the gift will be treated as a potentially exempt transfer. There will be no immediate IHT liability and if the donor lives for seven years after the gift is made, there will be no inheritance tax to pay at all.
Brown: A bare trust is one in which each beneficiary has an immediate and absolute right to both capital and income. This provides certainty because once the trust has been set up, the beneficiaries cannot be changed. From a tax viewpoint, income and gains arising on the trust fund are treated as accruing to the beneficiaries.
This absolves the trustees from having to complete a tax return. It also means that the beneficiaries’ personal income tax allowances and capital gains tax annual exemptions can be utilised. For inheritance tax purposes, a transfer to a bare trust is a potentially exempt transfer.
Greenwood: A bare trust is created where a person holds property as nominee for an absolutely entitled beneficiary. In technical terms, there is no difference between the beneficiary’s legal and equitable interest.
The trustee has no discretion or any duties other than stewardship of the trust property on behalf of the beneficiary. This simplicity may, in itself, make a bare trust attractive and a transfer to a bare trust will generally be treated as an outright gift – a potentially exempt transfer for inheritance tax purposes.
Why do settlors establish bare trusts rather than discretionary or other types of trusts?
Jelley: Gifts to bare trusts are treated as Pets. They are not chargeable lifetime transfers and so they avoid the entry, periodic and exit charges that are applied to gifts to discretionary trusts. Bare trusts are often used to give assets to minors because they cannot manage the assets themselves and the appointment of trustees enables the effective management of the assets and certainty that they will go to the stated beneficiary.
Brown: Recent research commissioned by Revenue and Customs found that the main motivation behind the establishment of trusts was to have the ability to control assets, passing them on to children or grandchildren, providing for a beneficiary in a particular way, withholding assets until children reach a certain age and ensuring money stays within the “blood line” (for example, on divorce or remarriage).
Tax tended to be a secondary motive for creating a trust. Settlors establish bare trusts because of the desire for certainty, even at the cost of flexibility. Where flexibility is the primary concern, a discretionary trust would be the preferred vehicle.
Greenwood: Settlors who are content to decide at outset who should benefit may also want to avoid the reporting obligations and any potential inheritance tax charges under the settled property regime which governs other trusts established on or after March 22, 2006 (other than trusts for the disabled).
What are the limitations and restrictions of bare trusts?
Jelley: The tax efficiency of gifts to bare trusts is offset by a lack of flexibility. For example, as a beneficiary of a bare trust must be absolutely entitled to the gift, the donor cannot retain any rights over it. Additionally, there is no flexibility to change the beneficiaries of a bare trust if circumstances change, for example, to accommodate the birth of a new child or as a result of the beneficiary’s divorce.
Brown: There are two major downsides to the use of bare trusts. First, they are inflexible and cannot cope with changing circumstances. The beneficiaries must be established at outset and cannot be added to or changed.
Second, beneficiaries have an absolute right to capital and can demand the transfer of the trust fund, assuming that they have attained age 18 (age 16 in Scotland). This makes bare trusts unsuitable vehicles for protecting the financially immature.
Greenwood: Adult beneficiaries can demand payment of the trust fund at any time. From the settlor’s point of view, there is no element of control except this last opportunity for counsel and advice. A beneficiary’s share of the trust fund is an asset in the estate for inher-itance tax purposes and passes under the beneficiary’s will or the rules on intestacy (possibly bringing it back into the settlor’s estate).
It is also taken into account if the beneficiary gets divorced or becomes insolvent. The risk of the gift being wasted or leaking outside the family is real.
Why is there uncertainty about the tax treatment of lifetime transfers to bare trusts for minors, given that such transfers are regarded as outright gifts?
Jelley: The uncertainty arises because of the current view of Revenue and Customs’ solicitors. Their view is that a minor can only access the trust when they reach age 18 and any income is accumulated in whole or part. Therefore, they would not be treated as outright gifts but instead as settlements.
Thus, such gifts would be treated as chargeable lifetime transfers and subject to entry,10-yearly periodic and exit charges. Gifts to adult children through an absolute trust will be treated as Pets and avoid these tax charges.
Brown: Revenue and Customs has raised the point that where the beneficiaries are minors, trusts structured as bare trusts are, as a matter of law, “settlements” and thus subject to a different inheritance tax regime.
This is a valid point but the counter-arguments, in the view of most tax profess-ionals specialising in this area, carry more weight. Revenue and Customs, to its credit, has stated that it is considering the position before issuing final guidance.
Such guidance would, of course, be advisory in nature and a court hearing would be needed to establish the correct analysis.
Greenwood: After March 21, 2006, a lifetime gift is only a Pet if it is an outright gift to another individual or to a disabled trust. Thus far, Revenue and Customs is unable to confirm that creating a bare trust for a minor is a Pet.
The concern is that the inheritance tax definition of “settlement” includes trusts to accumulate income and that bare trusts for minors create this position.
If it is true, it brings in the settled property regime and means that non-exempt gifts are chargeable lifetime transfers, not Pets. Let us hope that common sense prevails.
What are your recommendations for people thinking about setting up bare trusts?
Jelley: The use of bare or discretionary trusts depends on a client’s individual circumstances. Financial advisers have a crucial role to play to ensure people are aware of the tax consequences of their decisions and use trust arrangements that are appropriate for their needs. The key question will be whether the potentially more favourable tax advantages of bare trusts outweigh the flexibility of discretionary trusts or vice versa.
Brown: Specialist tax and legal advice should be taken before establishing bare trusts, where any of the beneficiaries is a minor. Alternatively, any decision as to the desired trust structure could be deferred until Revenue and Customs has issued final guidance. Bare trusts can continue to be used where all the beneficiaries are adults. Consideration could be given to the use of other trust structures, depending on the potential settlor’s precise needs.
The flexibility of a discretionary trust could, for example, be restricted through use of the trustees’ power of appointment. Obviously, the inheritance tax consequences of such an approach would need evaluation but might be acceptable where the sums involved are within the settlor’s available nil-rate band.
Greenwood: A bare trust has its attractions and many family situations will allow clients to take action to reduce inheritance tax liabilities under the Pet regime, knowing that the chosen beneficiaries are stable and content for the funds to be invested and managed by the trustees until an appropriate time.
Until Revenue and Customs gives final guidance, a bare trust for minor beneficiaries is best avoided, certainly if the risk of the gift being a chargeable lifetime transfer is unacceptable.
We have included a warning on this with our post-Budget 2006 bar trusts from outset.
If bare trusts are subject to the same IHT regime as discretionary trusts, are there still attractions for using them?
Jelley: This is only relevant in the case of minor children and is an area where careful financial planning is essen tial. Anyone using a bare trust for a gift to a minor that is over the nil-rate band for inheritance tax should think very carefully about why they have given up the flexibility of a discretionary trust if the tax treatment prevails to be the same. Revenue and Customs has confirmed that it intends to resolve this uncertainty by providing final guidance soon.
Brown: The research commissioned by Revenue and Customs concluded that tax is a secondary motive behind the creation of trusts.
If the settlor’s requirements include a need for certainty, then a bare trust structure could still be attractive. It is only the inheritance tax treatment of bare trusts with minor beneficiaries that is shrouded in uncertainty.
Transfers to bare trusts with adult beneficiaries will continue to qualify as Pets. Trusts can be adapted to meet a variety of needs. Advisers should consider whether discretionary trust structures could be used to fulfil client requirements. There is more than one way to skin a cat.
Greenwood: Probably not. Perhaps for small gifts or where family trustees do not want to take decisions about who benefits and when.