What Happens When the Settlor Benefits?
In many cases, trusts are established with the intention of separating the settlor from certain assets. There are a number of potential reasons for this, the most common being a desire to mitigate an inheritance tax bill for the settlor’s beneficiaries. In some instances, however, the settlor will maintain an interest in the trust. In these cases a separate tax liability for the settlor may arise.
DefinitionsIn the first instance, it may be useful to define a ‘settlor’. Clearly, a settlor is an individual who makes a settlement. The definition of settlement is very broad; it includes trusts and covenants, as well as agreements and, sometimes, the outright transfer of assets. There are a number of exceptions to this, however; transfers of assets between spouses, for example, will not be treated as settlements on the condition that there are no contingencies associated with the transfer.
You do not need to have directly or explicitly entered into such an arrangement in order to be deemed a settlor; frequently, trusts arise without an explicit declaration of intent on the part of the settlor, as is explained elsewhere on this site.
A tax liability may arise for the settlor in a number of situations. In broad terms, if you or your spouse continue to receive any income from the assets that have been settled then you will ‘retain an interest’ for tax purposes. Furthermore, you will be deemed to have retained an interest if you draw any other benefit, financial or otherwise, from the asset. You will retain an interest if, for example, you continue to live in a house that has been settled in trust.
Frequently, the settlor is deemed to continue to benefit from assets placed in trust when contingencies are placed on that trust. Sometimes, for example, individuals choose to transfer assets into a trust with the intention that they should be passed to a child or grandchild when they reach a certain age. If there are no instructions given in the trust instrument regarding the correct handling of those assets in the event that the intended beneficiary dies before they reach that age, then the settlor will be deemed to have retained an interest.
Tax ConsequencesIf you have retained an interest in assets placed in trust, any income derived from those assets will be treated as if it were part of your regular income for tax purposes. In these cases, trust management expenses cannot be deducted; this is only allowable in instances where the settlor is not a beneficiary. However, if this pushes you over a tax rate threshold, you may be able to claim a refund equivalent to the difference from the trustees. This will be paid from the trust assets.
Finally, it is important to remember that you will also be deemed to have retained an interest if one of your minor children stands to benefit from the asset held in trust. The rules regarding children and settlor-beneficiaries are complex and beyond the scope of this article; if you think this may affect you, you should seek independent financial advice.