Put simply, a trust is a legal arrangement that assets such as cash, investments and property can be transferred to a third party (the trustees) to look after for a third person (beneficiaries).

HM Revenue & Customs (HMRC) sets out a number of purposes for a trust:

• To control and protect family assets
• When someone is too young to handle their affairs
• When someone can’t handle their affairs because they’re incapacitated
• To pass on money or property while still alive
• To pass on money or property under the terms of your will.

Types of trust commonly used

There is a whole manner of different types of trust that can be used for effective financial planning, however, the three most common types are:

Interest in possession (IIP) Trust: under this trust, the beneficiary has no right to the trust property but instead has an absolute right to the income generated by the trust property and the beneficiary pays income tax on the income that they receive from the trust.

A common use of an IIP trust is for it to form part of the will of someone who remarries after divorce and wants their children from the first marriage to be supported.

Discretionary Trust: this type of trust gives the trustees absolute discretion to decide how the assets in the trust are distributed. This type of trust typically has a number of different beneficiaries and allows the trustees to decide what each beneficiary receives from the trust, for example whether capital or income and at what point the beneficiary gains from the trust.

Bare Trusts: in their simplest form, beneficiaries have a right to both the capital and the income, but also assets placed into a bare trust are not subject to the ‘Chargeable Lifetime Transfer’ (more on this below) and periodic charges so can be a cost-effective way of setting aside capital for the children, for their future.

Ultimately a trust provides an arrangement to control and protect the family wealth during your lifetime and then ensure that the estate is distributed according to your wishes once you pass away.

They provide a means by which the potential inheritance tax charge that is payable upon death can be reduced. But it’s important to understand that the proper use of trusts in estate planning is not a tax avoidance strategy; it’s a way in which the amount of tax payable can be reduced. You may enlist the services of an estate planning attorney to properly draft your will or any other documents.

Another main benefit of using a trust is that they provide a means of maintaining control. When the settlor (person setting up the trust and gifting the assets) puts assets into a trust, they set out in a document (Trust Deed) how those assets are to be dealt with in the future. They are able to stipulate who is to benefit from the trust and to what extent they will benefit.

The day-to-day responsibility of the trust property becomes the responsibility of the trustees but the settlor (assuming they are still alive) can also be a trustee. Therefore, a settlor can still control and manage the property that they have given away.

Further, trusts allow trustees to adapt to changing circumstances as they arise, whereas if you are to make an outright gift to a person you cannot then later change your mind and give it to someone else.

With a trust you are making the gift but the trustees have control to distribute the trust property. Some trusts offer the flexibility to make a gift into trust, for chosen beneficiaries, but still continue to receive a benefit – discounted gift trusts and flexible reversion trusts allow this flexibility.

Where the settlor is worried about a beneficiary not being mature enough, some trusts allow the trustees to retain control beyond age 18 but without it being or becoming a discretionary trust.

Points to be aware of with trusts

Loss of control: While there is great benefit of a trust for being able to continue to have control of the asset within your lifetime it is also important to bear in mind that some trusts mean you lose control of your money. For example, a discounted gift trust can be an excellent way in which to take steps to reduce your inheritance tax liability in return for an income for the remainder of your life.

However, you lose all right to the capital and therefore have to be certain you will never need the capital in your lifetime before setting up the trust.

Costs: Depending on the type of trust being used, the complexity and the amount of administration involved on an ongoing basis, they can prove to be expensive to establish as well as on an ongoing basis. It’s important to understand the associated costs with the trust.

Taxation: While one of the most common reasons for trusts is to help reduce the inheritance tax burden, trusts themselves are subject to taxes and the tax rules over the years have become less favourable.

In 2004, the tax rates applied to the underlying trust property was increased from 34% to 40% then in 2010 it was pushed up to 50% before dropping to 45% in 2013.

However, the biggest consideration is that on 22 March 2006 Gordon Brown introduced the concept of ‘Chargeable Lifetime Transfer’ which in its simplest terms mean that any transfer into a trust in excess of the nil rate band is subject to an entry tax of 20% and the ‘periodic charge’ which is 6% of the trust property every 10 years. There is then also the potential for an ‘exit charge’ to be paid when money is distributed to beneficiaries.

Therefore, it is important to understand the tax rules that apply when setting up a trust and on an ongoing basis, and on the beneficiaries when they receive the assets from the trust.

In summary, trusts can be a very beneficial estate planning tool for many but they can be complicated and it is important to ensure professional advice is sought to ensure that the trust being set up is appropriate for what you are looking to achieve.

Sarah Lord is partner at Mazars LLP