What is an Interest in Possession Trust?

Setting up a trust can be an ideal way to control and protect family assets, ensuring these assets are passed to future generations, while minimising liability to inheritance tax on death. However, there are various types of trusts to choose from, with different practical, legal and financial implications.

The following guide on interest in possession trusts looks at what these are, when they are used, how they work, how they are managed, their benefits and drawbacks, as well as the key considerations when using this type of trust.

 

What is an interest in possession trust?

 

A trust is a way of managing assets for people, including money, investments or property, where there are various different types of trusts, all with very different rules and implications.

An interest in possession trust, as with any other type of trust, will involve three parties: a settlor – the person who puts the asset(s) into the trust; the trustees – the people who manage the trust and holds the asset(s) for the benefit of others; and the beneficiary or beneficiaries – the person or people who benefit from the trust asset(s).

An interest in possession trust is a type of trust in which at least one beneficiary has the right to receive any income generated by the trust, where trust funds are invested, or the right to enjoy the trust assets in another way. Typically, with this type of trust, a single beneficiary will be entitled to receive any income from, or to use property comprised in, the trust fund for a defined period of time. Usually, either upon their death or other eventuality, such as marriage or entering into a civil partnership, a different beneficiary or class of beneficiaries will automatically become entitled to the capital assets within the trust fund.

Any beneficiary entitled to the actual capital contained within the trust is known as the capital beneficiary or the remainderman, while anyone entitled to receive an income from the trust assets(s) is often described as the income beneficiary or life tenant. The income beneficiary will not ever own the capital assets, but will derive the benefit and enjoyment of their use, or any income generated from them. In short, a person will be classed as having an ‘interest in possession’ if they have the immediate right to receive income from the property or to the use or enjoyment of it. Often this interest will be for the life of that beneficiary, unless they re-marry or enter into a civil partnership, where on their death or other eventuality, the trust assets will pass absolutely to the remaindermen.

 

When is an interest in possession trust used?

 

Trusts can be set up for various different reasons, depending on the circumstances of the settlor. This can include where the settlor wants to control and protect family assets, to pass assets on while the settlor is still alive or to pass on assets after the settlor dies, in all cases seeking to minimise the tax implications both on transfer and death.

An interest in possession trust is often used to pass on assets after the settlor dies, most commonly when they have remarried and wish to provide an ongoing income for their current spouse or partner, or a home for them to live in, while ensuring that their assets are preserved and later passed to any children from a former marriage or civil partnership.

This type of trust is typically used for residential property, where the settlor is able to use this mechanism to place the marital home in trust for the benefit of their spouse or partner after they die, ensuring that they have a roof over their head or an income to live on for the duration of their lifetime, but with their children to eventually inherit the property itself.

 

Examples of interest in possession trusts

 

An interest in possession trust can give the ‘interest in possession’ to the income beneficiary for either a fixed period, an indefinite period or for the rest of the beneficiary’s life. A life interest trust is the most common example of an interest in possession trust.

This would cover the scenario where a surviving spouse or civil partner is granted a right to income of the trust and/or a right to remain in the marital home for the rest of their life, but once they die, the remainder of the fund passes to the settlor’s children or any other individual or named class of beneficiaries. In the example of a life interest trust, the ‘interest in possession’ will come to an end when the income beneficiary dies.

When it comes to interest in possession trusts, distinctions can also be drawn between a trust which takes effect during the settlor’s own lifetime and upon their death. These are commonly referred to as either a living trust or a testamentary trust. In many cases, an interest in possession trust will be created as part of the settlor’s will. Again this covers the scenario where a surviving spouse is granted the use of, or income generated from, the trust asset(s), with the capital beneficiaries inheriting those assets on the death of that spouse.

In contrast, a living trust would cover a scenario, for example, where the settlor prepares a declaration of trust, settling property in favour of their children, while granting themselves a life interest in that property. This would be done via a trust deed, rather than in a Will.
If the settlor also benefits from the assets in a trust, this is called a ‘settlor-interested’ trust.

 

How do interest in possession trusts work?

 

When placing assets into trust, ownership of those assets will transfer to the trustees. The trustees are therefore the legal owners of the assets held in the trust. Their role is then to deal with the assets according to the settlor’s wishes, as either set out in the trust deed or their Will, as well as to manage the trust on a day-to-day basis and to pay any tax due. If the trustees change, the trust can continue, but there must always be at least one trustee.

In the context of an interest in possession trust, the trustees will be tasked with passing on all the trust income as it arises, less any trustee expenses, to the income beneficiary. For example, if the settler had created a trust for all the shares that they own, where the terms of the trust state that on their death all of those shares will be for the benefit of their husband or wife, for the remainder of their life, and when they die, the shares will pass to any children. Here, the surviving spouse is the income beneficiary and has an ‘interest in possession’ in the trust assets, but does not have a right to the shares themselves.

The decision-making powers of the trustees will be determined by the trust deed or Will. Depending on the assets within the trust, the trustees may be given wide investment powers, which must usually be used in the best interests of all the beneficiaries. For example, in the case of life interest trusts, the trustees would need to act fairly between the different classes of beneficiary, striking a balance between a reasonable yield for the income beneficiary, while giving the opportunity for capital growth for the capital beneficiaries.

 

How are interest in possession trusts taxed?

 

Different tax rules apply to different types of trusts. For the purposes of Income Tax, the tax treatment of the interest in possession trust will depend on whether the income from the trust is mandated directly to the income beneficiary or is paid to them via the trust funds.

If the trustee pays the income beneficiary directly, they will not need to include this in the trust tax return, but they cannot deduct expenses from the trust income. When trustees do not pay the income beneficiary directly, income tax is payable at the basic rate. This means that dividend tax is currently payable at 8.75%, and 20% on all other income, although no personal allowance or dividend allowance will be available to the trustees.

If the trustees elect to mandate the income to the income beneficiary, this means that it goes to that beneficiary directly, instead of being passed through the trustees, where the beneficiary would need to include this income on their self-assessment tax return. The amount of Income Tax they will be liable to pay will depend on how much of their income is above any personal (or dividend) allowance and how much falls within each tax band.

For Inheritance Tax (IHT) purposes, lifetime gifts to most interest in possession trusts will be classed as chargeable transfers that are subject to IHT at 20% if they exceed the settlor’s nil rate band of £325,000. The trust itself will also be subject to periodic IHT charges every 10 years, as well as exit charges when capital is paid out to the beneficiaries.

For an interest in possession trust that establishes an immediate post-death interest, ie; where the trust is created under the terms of the settlor’s Will, any transfer to a spouse or civil partner will be classed as an exempt transfer, and will not be subject to periodic or exit charges. However, the trust will be treated as though the assets belonged to the life tenant and will form part of their taxable estate on death for IHT purposes.

Capital Gains Tax (CGT) may also be payable on the transfer of assets into or out of the trust, although it may be possible to defer CGT in some circumstances.

 

What are the benefits and drawbacks of an interest in possession trust?

 

An interest in possession trust can be especially useful for spouses and civil partners, where following the death of the first spouse or partner, the surviving spouse can continue to live in the family home for the rest of their life, or benefit from any other trust assets, while the children will remain entitled to the remaining trust funds after they die.

In this way, the settler can ensure their other half has money and/or a home for life, while also ensuring that their children will benefit at a later date. The alternative would be to gift their assets outright to the surviving spouse or partner on death, but this runs the risk that assets could be depleted during their lifetime and/or they leave everything to someone else. The use of an interest in possession trust will also mean that any assets held in trust, but used by the surviving spouse or partner, could not be used for care home costs.

However, although an interest in possession trust can enable a settlor to provide for their other half with a stable income or home for life, while still preserving the family’s wealth for the benefit of their children, this can be limiting for the surviving spouse or partner. In cases where that person is especially young, and they jointly own the family home, only having access to half of its capital can cause significant obstacles for them.

There are also significant drawbacks in the context of lifetime trusts, which do not offer the same tax benefits as they once did. This is because, since 2006, these types of trusts will be taxed in the same way as discretionary trusts, with lifetime transfers above the settlor’s nil-rate band subject to 20% IHT. They will also be subject to periodic or exit charges.

 

Key considerations when using interest in possession trusts

 

There are various key considerations when it comes to interest in possession trusts, including the potentially significant practical, legal and financial implications that could arise for the settlor and their family. The benefits of this type of trust will always depend on the circumstances involved, including the nature and value of any assets to be transferred.

Specialist independent and impartial advice must be sought as to the benefits of using this type of trust as a tax and succession planning vehicle based on each person’s circumstances.