Take care when setting up trusts, Rose Phelps outlines the common mistakes that could land you with an unexpected tax bill.

Beware: trusts are not tax free

Many clients are aware in broad terms that they might save inheritance tax by making a gift and surviving seven years after doing so.

However, not all gifts qualify, and it sometimes comes as a surprise that giving away cash or assets by creating a trust or adding to an existing trust can mean an immediate inheritance tax charge of 20 per cent, whether or not one survives seven years after setting up the trust. The problem can arise with most types of trust, including a discretionary trust, a life interest trust, a trust for children or grandchildren in one’s lifetime or even a trust for oneself.

In addition, the trust is exposed to potential inheritance tax charges, currently at a maximum rate of 6%, for as long as the trust exists, payable every ten years and when the trust ends or when capital leaves the trust, such as when paid out to a beneficiary.

It is important to double check the tax implications when seeking advice on inheritance tax planning, or on making provision for others through generosity or family concern or when a relationship ends.

You can then consider all the immediate and long-term tax consequences in the round. For example, you may have some of the nil rate band tax allowance available to use when setting up the trust, or you may want to consider alternatives to a trust such as an outright gift or a bare trust. You may have some assets enjoying inheritance tax relief that you could put into the trust instead, such as certain unquoted company shares, or you might decide to think again and keep the cash or assets in your estate and under your control.

Accidental trusts

It is not uncommon to come across a trust of an asset or cash that someone has created without realising they have done so, perhaps several years ago, ignorant of the fiscal and practical consequences.

Creating a trust "by accident" is easier than one might think. A trust can come into existence in several ways, without the words "trust" or "settlement" being used, and with the minimum formality.

A trust is a arrangement where control and legal ownership rest with one party (the trustee) and enjoyment and benefit belong or will belong later to another (the beneficiary), whether or not one has the right to revoke it later. Generally a trust creates a "succession of interests", for example:

  • signing a declaration that "this house now belongs to my girlfriend while she is alive and on her death goes to her son"
  • by giving £100,000 cash to a brother to look after "for my son when he is 21".

The actual formalities required depend to a large extent on the asset concerned. Creating a trust of land or an interest in land has to be in writing, but a simple informal signed and dated letter could suffice in many cases. It is not necessary to intend to create a trust; it is enough that what one does has that effect.

One of the common situations where this can happen is when a relationship breaks down, such as a marriage, a civil partnership, cohabitation or indeed a business relationship. Sometimes the parties decide between themselves to arrange their property and finances to provide for each other and children, without professional legal and tax advice and this turns out to be a false economy in the long run.

Another problematic situation arises when people co-own a property or properties and enter an arrangement where in addition to setting out who contributed what, who pays the mortgage and outgoings, and who is entitled to what percentage share as a result, they also go on to specify a future beneficiary, for example by saying that the children will be entitled to a share once they are 18.

From a practical point of view, a trust is a legal entity, which has an existence independent of the person who creates it and of the trustees personally and so when a trust is created, HM Revenue and Customs should always be informed. HMRC can then say whether annual tax returns need to be submitted for the trust and can assess any other tax implications.

When people do not realise they have created a trust, naturally they will not have told HMRC what has happened. They tend to be discovered by HRMC via tax returns or on death and sometimes lawyers discover them in dealing with something else. Dealing with tax returns for those missing years can be time-consuming and paying any tax plus interest and possible penalties can be complex and expensive.

If you are not aware that you are a trustee, it is unlikely that you will have received advice on your duties and you and the beneficiaries may not have abided by the terms of the trust.

If a trust comes into effect as a result of what someone has done, rather than as a result of a conscious decision taken with the benefit of proper advice, there may also be considerable confusion and room for discussion or litigation about what the document or arrangement actually means. The arrangement may be in an unconventional form, may use inaccurate or unclear language, and may result in an unworkable arrangement with technically irreconcilable or inflexible provisions. You may therefore find yourself needing legal advice even for a trust of modest value.

If one sets out to create a trust, taking appropriate advice in advance ensures that the practicalities are dealt with in a proper and timely manner. Taxation implications will be known in advance, even if they are not welcome, and matters can be arranged as cost-effectively and as tax-efficiently as possible.

If you are considering how to arrange your assets for the future, for whatever reason, you should always take legal advice before forging ahead. This is particularly so for those whose relationships are breaking down, or entering into joint ownership of assets. The dangers of not doing so are many, arrangements already in place can seldom be undone without further adverse consequences, and dealing with the implications of ill-advised arrangements is seldom straightforward and too often a very expensive business.

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This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.