Trusts in wills can play an important role in protecting family wealth across generations. However, Gill Steel of LawSkills explains how will trusts are affected by divorces and inheritance tax.
What is a will trust?
A will trust is a trust created within a person's will and is a relationship between three parties:
- the testator settlor is the person transferring assets into the trust
- the trustees are the persons who hold the asset for the benefit of a third party
- the beneficiary is the person who benefits from the trust
However, when it comes to helping family through trusts in wills, the ‘testator’ (the person making the will) needs to consider the impact of family law and taxation.
How does divorce affect trusts?
The matrimonial courts, for example, have powers during divorce cases to make financial settlement orders based on a person’s wealth, not just in their own name but also assets put into trust for them. While the court cannot force trustees to make provision from the trust to the beneficiary to meet their financial settlement obligations on divorce, they can use ‘judicial encouragement’ when they have explored the nature of the trust and the history of distributions made.
Nuptial settlements are made primarily for the benefit of one family member and their spouse and issue. If the key beneficiary is the one getting divorced and they have been used to having all their requests for funds met by the trustees then it is highly likely the matrimonial court will take the trust fund into account when making their order for financial settlement on divorce.
It is therefore risky to separate an ‘estate’ (money, property and possessions) between siblings, leaving each a share in their own trust, rather than leave the whole estate in a single trust for the benefit of a wide range of beneficiaries, such as all the siblings, their spouses or civil partners and their issue. This sort of trust is unlikely to be regarded as a nuptial settlement and therefore would not be considered on any beneficiary’s divorce.
How does inheritance tax affect trusts?
While inheritance tax (IHT) applies to an estate on death, it also applies going forward to trusts created under the will. The rule is that any trusts created by a will are deemed to start for IHT on the date of death.
Where a settlor creates trusts on the same day they are known as ‘related settlements’ and this means they must be added together when calculating IHT charges on each trust in the future. There is, however, an exception for spouses and civil partners under section 80 of the Inheritance Tax Act 1984 (IHTA 1984):
- For example, a testator may leave a nil rate band (NRB) discretionary trust to his children and other issue and the residue to his spouse for life with remainder to their children. Although, both trusts are deemed to start on the date of death, s.80 prevents the combination of the spouse’s trust with the NRB discretionary trust when it comes to calculating the periodic and exit charges in the discretionary trust.
- However, if a discretionary trust was created for each sibling, their spouse and their issue in a will then all the trusts would be deemed to start on the same day with no application of s.80. This would result in them being related settlements giving rise to a bigger IHT charge on the periodic and exit charge events in each trust.
For many years, a way around this dilemma was to create pilot trusts during the lifetime of the settlor, each trust being set up on a different date with say £10 in it – for example, one on a Monday, one on Tuesday and one on Wednesday. Then the settlor’s will would have provided for, say, one third of their estate to go to the Monday trust, one third to the Tuesday trust and one third to the Wednesday trust. As the trusts were not created on the same day and were not in the will this arrangement meant the trusts were not related settlements and they did not have to be aggregated for periodic and exit charge purposes.
Sadly, this route to save IHT was closed by the introduction of the ‘same day addition’ rules in ss.62A-C of IHTA 1984, which effectively links the three trusts once more because they are deemed to receive their funds on the date of death of the settlor and become related settlements then.
Should I create separate trusts for different members of my family?
If the family wish to have separate trusts for different branches of the family, and still wish to use the pilot trust system to achieve this, it should be considered that there is not a great deal of IHT saving and there are also potential family law issues. The costs of administering numerous trusts and complying with complex regulations are also increased.
It therefore makes sense for many clients to have one discretionary trust in the will which benefits all siblings and their families. IHT will be charged on the total relevant property, so there is no tax saving, but there will be some family law protection and hopefully less administration costs.
About the author
Gill Steel has been immersed in Wills, Probate, Trusts, Tax & Elderly Client law for the entirety of her long career as a solicitor, trainer & consultant. She curates www.lawskills.co.uk and the LawSkills Monthly Digest subscription service.
See also
Everything you need to know about will trusts
How do nil rate bands reduce inheritance tax?
Could gift allowance replace Inheritance Tax in the UK?
Find out more
Trusts and taxes (GOV.UK)
Inheritance Tax Act 1984 (Legislation)
Image: Getty Images
Publication date: 22 June 2020
Any opinion expressed in this article is that of the author and the author alone, and does not necessarily represent that of The Gazette.