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Drip Feeding Successors – Anna Coakes’ Article in Private Client Advisor

Anna Coakes' article was published by Private Client Advisor in November 2015

Written by Anna Coakes

Recent tax legislation affecting trusts combines a political view in some quarters that inheritance is anti-social, and trusts exist only as tax avoidance devices.   Although this has created a relentless drive to impose tax and reporting obligations on trust structures, and inevitably an impression that they have become mostly unattractive, there are good arguments to support the conclusion that trusts are still worthwhile in the context of sustaining and managing family wealth, and dealing with succession issues.

The motivation for settling assets into trust, or for maintaining an existing trust, is not invariably tax driven. Rather, the settlor or the testator, and the trustees, understand the potential advantages to be gained by adopting a trust structure to enable the trust assets to be used for the benefit of beneficiaries, as and when appropriate, and at the same time protected from misfortune or misbehaviour.

Now that the tax treatment of most UK based trusts is identical, the flexibility afforded by a correctly drafted discretionary trust can allow for wealth to be protected throughout several generations, supporting the extended family, rather than the more restrictive situation which would arise if an outright gift confined to a specific beneficiary or beneficiaries were made in a Will.

It can be difficult for a parent or grandparent to foresee at what age it might be appropriate for a young child or grandchild to receive an inheritance. The statutory age of 18 is viewed by many as prospectively too young, and the use of a trust arrangement allows the decision on distribution of an inheritance to be made in the light of the circumstances at the time, and not predicted many years in advance.

Whether wealth has been acquired across multiple generations, or by the endeavours of the current generation, the prospect of that wealth being dissipated by an outright gift to a “wayward” beneficiary is often unpalatable, and hardly in the interests of the wayward beneficiary himself. It is a far more attractive option in those cases of doubt for the provision to be made by way of a discretionary trust, which allows for the wayward and less wayward beneficiaries to be supported by the trust, as and when appropriate, and potentially over a long period of time.

Inheritance Tax (IHT) – Trusts

The interaction between inheritance tax and trusts has always been an important consideration for those interested in inheritance tax mitigation.

Post Finance Act 2006 most settlements come within the scope of relevant property.  Even so, the inheritance tax regime applicable to relevant property is not so onerous as to be off-putting to those for whom the flexibility of a discretionary trust is attractive.

The main benefit is of course that the death of a beneficiary does not incur a death charge to IHT at 40%, as most trusts are subject to a different charging regime.  Broadly, and with some exceptions, most trusts and settlements are charged IHT at up to 6% every ten years, and somewhere between 0% and 6% when capital is appointed to beneficiaries.

As an example,  a gift into trust of assets of £341,000 by an individual who has made no gifts in the previous seven years can potentially save IHT on his/her death of £132,400.  The gift is first reduced by the two annual exemptions of £3,000 a year for the current and previous tax years, leaving £325,000 which is covered by the nil rate band.

After 7 years the trust could be wound up and assuming modest growth of 2% per annum it would be worth circa £375,000.  An IHT exit charge based on that value for the time within the trust would be around £280.  If the trust were to reach the ten year anniversary date, 6% IHT on the value above the nil band would mean a charge of £3,000.  Although CGT would also be payable, the overall amount would be  considerably less than the 40% Inheritance Tax charge on the equivalent of the trust fund had it been left in the hands of the settlor, and he had died at the same time.

Trusts and Divorce

The divorce jurisdiction in financial matters in England has a very wide reach.  England is likely to respect a family trust established well in advance of the celebration of a marriage, and more so in respect of what is already a multi-generational dynastic trust.

However, a successful entrepreneur acquiring substantial wealth during a marriage and then creating a trust during the marriage cannot be confident that an English divorce court would accept that the transfer of assets into such a trust puts the trust beyond the power of an English divorce order.

Trusts created which have any apparent connection or reference to the marriage and have a “nuptial element” are very likely to be considered susceptible to the English divorce courts’ long standing powers for variation of a nuptial settlement.

Arrangements where assets are transferred in the settlor’s lifetime to a discretionary trust and where the trustees regularly listen to the requests of the settlor for distribution are likely to be “looked through”, and effectively the assets within such arrangements will be treated for the purpose of the financial division on the settlor’s divorce as still available and within the power of the settlor.

The best prospects of preserving wealth in a trust created during marriage arise if at the time the trust was established it was genuinely intended as a dynastic one to benefit future generations, and this was something in which the other spouse was also actively involved and supported.  A second situation would be the establishment of a trust for charitable objects to which money was transferred to realise the advancement of the charity’s purpose.  That however is not so much a matter of the preservation of wealth for the family but to avoid what had been put away from the family being brought back into it from the charity at the time of a divorce.

Otherwise the spouse looking to keep wealth unavailable for a divorce is better served by a pre or post-nuptial agreement with their spouse, either before or after the marriage, which keeps defined assets completely outside the status of being an asset of the marriage.

Trusts and Insolvency

But what of the use of trusts in an attempt to protect assets against bankruptcy? Section 283 of the Insolvency Act 1986 (IA 1986) provides that a bankrupt’s estate comprises all property belonging to, or vested in, the bankrupt at the commencement of the bankruptcy, with the exception of exempt property, which includes property held by the bankrupt on trust for any other person.  A Trustee in Bankruptcy acts for the benefit of the unsecured creditors and he is under a duty to realise assets for the benefit of those creditors. The Trustee will consider whether a trust is capable of being challenged to increase the sum available to unsecured creditors.  Further, with regard to the trust exception, the onus of proof is on the person asserting that a trust has been created.

Accordingly, settling assets in trust will not necessarily avoid creditors’ claims and ensure carte blanche protection.

The Trustee in Bankruptcy has far reaching powers to challenge a trust. The timing of the trust is of significant importance.  If the trust was settled within the relevant time before presentation of a bankruptcy petition (6 months or extended to 2 years if the transaction is with an associate of the bankrupt), it could be challenged as a preference (section 340 of the IA 1986).

Alternatively, a declaration of trust could be considered a transaction defrauding creditors (section 423 of the IA 1986), whereby assets are intentionally put beyond the reach of creditors.  An application can be made by the Trustee in Bankruptcy or the victim of the transaction.

The Trustee in Bankruptcy will not only be looking at the timing of the trust but also the genuine purpose and use of the trust.  Was the settlor simply using the trust as a bank account?  He will also investigate whether the beneficiaries have knowledge of the trust and its intended purpose.

With Confidence?

The use of trusts has never been fool proof, and should never be considered as a potential solution for “hiding” assets. Even in the current drive for transparency however, trusts still have a valid, and valuable, role to play in managing wealth across generations and protecting vulnerable beneficiaries.

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Anna Coakes

Gordon Dadds