I wish to set up a trust for my two grandchildren but am not sure which type of trust to use. Could you please explain to me in simple terms the main types of trusts that I could consider and in what circumstances they would be used?
The type of trust that would suit you best really depends on your precise objectives in terms of the level of control and flexibility you want to maintain.
There are two main types of trust, namely, those under which your grandchildren would have an enforceable interest and those under which they would have only a prospective interest.
Each of these types of trust is divided into two further sub-categories:
Vested-interest trust type
Interest in possession trust. These trusts can take a number of forms:
– Life interest trust. This is a trust where one person (the life tenant) has a right to income for life or for a fixed period and others (the remaindermen) are entitled to the capital on the death of the life tenant or the expiry of the fixed period. For example, it could use the wording “on trust for my wife X for life, thereafter to my grandchildren A, B and C in equal shares absolutely”.
A transfer into this type of trust will qualify as a potentially-exempt transfer for inheritance tax purposes.
– Flexible or power of appointment trust. This is a form of trust under which trustees have the power to appoint among or vary the beneficiaries.
There are usually two classes of beneficiaries – actual and potential. The trustees have the power to replace an actual beneficiary by anyone from the list of potential beneficiaries. For example, the trust could use the wording “on trust for such of my wife, children and remoter issue as the trustees shall from time to time by deed or deeds revocable or irrevocable at their absolute discretion appoint and in default of any appointment for my grandchildren in equal shares absolutely”.
Absolute or bare trust. This is a trust where the beneficiary has an absolute interest to income and capital which cannot be taken away. For example, it could be worded: “on trust for X absolutely”.
There does not need to be a formal trust deed as the Inland Revenue has confirmed that an irrevocable designation of a unit trust investment for the benefit of someone other than the unitholder constitutes a bare trust. The trust can have more than one beneficiary provided that their shares are specified.
The most common example of a bare trust is where an investment is made by a grandparent but designated as being for the benefit of a minor child. This is tantamount to an outright gift, with the trustees acting as nominees until the child can give a valid receipt.
When the child reaches 18, he or she can demand that the assets held in trust are transferred into their own name. If they die before 18, the assets will form part of their estate.
Non-vested-interest trust type
Discretionary trust. This is a power of appointment trust with no interest in possession. Therefore, there are no actual beneficiaries, only potential ones.
The trustees (of whom you may be one) retain the flexibility to decide who should benefit from either the capital or the income.
For example, the trust may be worded “for such of my grandchildren as the trustees shall in their discretion appoint by deed or deeds revocable or irrevocable”.
The creation of the trust constitutes a chargeable lifetime transfer on which inheritance tax will be payable at the rate of 20 per cent if it takes the cumulative total over the threshold of the nil-rate band and additional tax may be payable if the settlor dies within seven years.
Consequently, these types of trust are often set up within the settlor's nil-rate band and/or with assets attracting business property relief, for example, shares in the settlor's family company.
Assets transferred into the trust are eligible for capital gains tax holdover relief.
Accumulation and maintenance trust. This is a special form of discretionary trust which is exempt from some of the tax rules which normally apply to discretionary trusts.
In order to qualify, one or more beneficiaries must acquire an interest in possession and become legally entitled either to the capital or to any income on attaining a specified age of not more than 25.
Meanwhile, income must be accumulated or applied for the maintenance, education or benefit of a beneficiary.
The trust must either be for 25 years or less or for the benefit of grandchildren of a common grandparent.
The creation of an accumulation and maintenance trust during the lifetime of the settlor is a potentially-exempt transfer, so inheritance tax will only be chargeable if the settlor dies within seven years.