A Simple Guide to Understanding Trusts

A trust is a legal arrangement whereby money or other assets are securely set aside for the benefit of one or more people. There are essentially two different types of trusts that can be set up for children, grand-children or other beneficiaries: a discretionary trust or an accumulation trust. The trustees of a discretionary trust, as the name implies, have some discretion about what to do with the income earned by the trust, most likely to distribute all or some of it to the beneficiaries. This income could be interest earned or dividend income from share holdings. An accumulation trust, on the other hand usually accumulates income by adding it to the underlying capital sum.

Some trusts have elements of both discretion and accumulation.

Trusts can include property and land as well as money and will have one or more trustees assigned to maintain the trust on behalf of the beneficiaries. In law, the trustees are the owners of the assets held in trust.

Discretionary Trusts

With discretionary trusts the trustees are allowed to decide what to do with the trust's income i.e. whether to distribute it to the beneficiaries and, if so, how much to distribute or whether to add it to the capital sum. They also sometimes have some power to decide how to distribute the trust's capital.

They also have the power to distribute income to some, but not all, beneficiaries and to decide the frequency of payments. The exact details of what powers the trustees have will be defined in the trust deed.

Trusts are typically set up to provide financial security to a dependent relative, especially where that relative is a child and would not be expected to know how to manage large sums of money.

Accumulation trusts

With an accumulation trust any income earned, whether from interest, dividend payments, rent from property or land will be retained within the trust to increase the capital sum. There may be rules in the trust deed to state for how long income must be accumulated (sometimes dependent on a child's age, for instance) and under what circumstances any income can be paid out.

Income Tax

Any income earned by a trust is liable for income tax and it is the trustees' job to ensure that the appropriate amount of tax is paid. In both discretionary trusts and accumulation trusts, income is taxed atspecific trust rates although the first £1,000 of income is taxed at a lower rate. The actual rates used depend on the source of the income being taxed.

When a beneficiary receives income from a trust it is, therefore, treated as if income tax has already been paid at the trust rate currently in force because it is the trustees responsibility to do this. However, this can complicate the situation if the beneficiary is not a tax payer, for example, a child, who could then claim back the tax at the current trust rate of tax. The trustees have a responsibility to ensure that tax is not only paid on any distributions but paid at the correct rate.

Capital Gains Tax

Trusts can consist of assets such as shares, property or land and if a trust asset is sold then Capital Gains tax is due on the increase in value of the asset since it was purchased taking into account an annual exempt amount. As with income tax it is the trustees' responsibility to pay any CGT due so understanding these responsibilities is essential and this is where the help of a london accountants or tax advisor can be invaluable. The trustee must ensure they pay the right amount of tax but also avoid paying too much tax.

Inheritance Tax

Under certain circumstances a trust can sometimes be liable to Inheritance Tax particularly when assets are either added to the trust or removed from it.