An interest in possession trust allows a beneficiary to get income from the trust assets without owning them. It gives income now and protects assets for future beneficiaries. Here’s how they work and what to know.
Key Points
- An Interest in Possession Trust lets a life tenant get income from trust assets without owning them, preserves capital for future beneficiaries.
- Trustees must manage the assets responsibly and are bound to act in the best interests of life tenants and remaindermen.
- Tax treatment for IIP trusts varies depending on when they were set up, big differences between pre and post March 22 2006.
Interest in Possession Trusts
At the core of an Interest in Possession Trust is the concept of a life interest. This trust gives a named beneficiary, the life tenant, the right to receive income from the trust assets without owning the assets themselves. This way the life tenant gets the benefits of the trust income and the capital is protected for future beneficiaries.
The life tenant’s right to the trust income continues until they die or enter into a new relationship, such as remarry or civil partnership. The assets within a qualifying IIP trust are included in the life tenant’s estate for Inheritance Tax purposes. This way a steady income stream without transferring ownership of the trust capital, which is preserved for the remaindermen, who are the final beneficiaries of the trust.
Trustees play a big role in managing the trust. They distribute the income to the life tenant and ensure the trust assets are managed responsibly. Trustees cannot accumulate income, it must be distributed to the life tenant as it’s generated. This way the life tenant gets a continuous income stream, which can include benefits like living in a residential property owned by the trust without claiming ownership.
Setting up an IIP trust involves transferring assets such as cash, insurance bonds or shares into the trust. These assets are the foundation for the income for the life tenant, so the role of the trustees in selecting and managing these assets is crucial for the trust to work.
What is an Interest in Possession Trust?
An Interest in Possession (IIP) trust is a type of trust that gives a named beneficiary, known as the life tenant, the right to receive an income from assets placed in the trust. The life tenant may also benefit from the trust property without owning it, such as living rent-free in a residential property owned by the trust. The trust assets are not owned by the beneficiary, but they derive the benefit and enjoyment of their use. The interest usually continues for the life of the beneficiary unless they re-marry or enter into a civil partnership.
Setting Up an IIP Trust
Creating the Trust
An IIP trust can be created during a lifetime or on death. It is commonly used in wills to give the surviving spouse the right to trust income for their lifetime, with the capital passing on death to designated children. These are referred to as life interest trusts. Prior to 2006, IIP trusts were often used with life policies, including investment bonds, known as ‘flexible’ or ‘power of appointment’ trusts.
Interest in Possession Trust
An Interest in Possession Trust has several key features that define how it works and the benefits. The life tenant gets income from the trust assets but doesn’t own them. This separation of income rights from ownership means the trust capital is preserved for future beneficiaries.
The trust deed is the foundation document for an IIP trust, it outlines the rights and interests of all parties, the life tenant and the remaindermen. The life tenant’s interest usually lasts for their lifetime but can end if they remarry or enter a civil partnership. This provision allows the trust to adapt to the significant life changes of the beneficiaries.
As the legal owners of the trust assets, trustees must manage the assets responsibly, balancing the income needs of the life tenant with the capital growth needs of the remaindermen. This means making sensible investment decisions that consider current income generation and future capital appreciation. Trustees are bound to act impartially and in the best interests of all beneficiaries.
When the life tenant dies the trust capital passes to the named remaindermen. The trust deed names the beneficiaries so the trust assets are distributed according to the settlor’s wishes. This way there is continuity and clarity in the management and distribution of the trust assets.
When to use an Interest in Possession Trust
Interest in Possession Trusts are often included in wills to ensure a surviving spouse gets income for life while preserving capital for children from the same or previous marriages. This dual benefit makes IIP trusts very useful in blended families where there is a need to balance the interests of a surviving spouse and children from different relationships.
These trusts are also useful for individuals who want to provide for their spouse after death without transferring outright ownership of significant assets. Life tenants can live rent free in properties owned by the trust, use the asset without depleting the capital. This way the life tenant gets financial security while the children’s inheritance is protected.
A deceased’s will or the rules of intestacy can affect the creation and operation of an IIP trust. Including an IIP trust in a will means assets are managed and distributed according to specific wishes rather than the default rules of intestacy.
Taxation of Interest in Possession Trusts
Taxation of Interest in Possession Trusts is complex and involves multiple tax considerations. For inheritance tax the value of an IIP trust becomes part of the deceased life tenant’s estate. This means the trust assets are included in the life tenant’s estate for inheritance tax purposes. Income tax applies to trusts, detailing the obligations of trustees versus beneficiaries and how income is assessed and taxed based on distributions and mandates.
Gifts into IIP trusts created after 22 March 2006 are immediately subject to inheritance tax. IIP trusts created at death are exempt from periodic or exit charges so there is a tax advantage for those setting up these trusts through their wills. Lifelong trusts created after this date are treated similarly to discretionary trusts for inheritance tax purposes, with some exceptions for disabled persons’ trusts.
The income from the trust is taxed at the beneficiary’s personal tax rate if it is paid to them directly. Dividend income from the trust is taxed at a specific rate of 8.75%. The income retains its source nature and the tax implications are tied to the beneficiary’s financial situation. If the income is not paid to beneficiaries, the trustees are taxed at the basic rate.
For capital gains tax the trustees are taxed at a specific rate when trust assets are sold and are entitled to half of the individual annual capital gains tax exempt amount. Beneficiaries can also use their personal allowances and various savings allowances to reduce their effective tax liability on trust income.
Inheritance Tax and the Relevant Property Regime
The Inheritance Tax (IHT) treatment of an IIP trust depends on whether it is created during a lifetime or on death. For lifetime trusts, the main issue is whether the trust was created before or after 22 March 2006. If it was created before 22 March 2006, the trust is not subject to the relevant property regime, and there are no periodic or exit charges. However, if it was created after 22 March 2006, the trust is subject to the relevant property regime, and there are periodic and exit charges.
Pre-2006 Rules and Transitional Serial Interest
Interest in Possession Trusts created before 22 March 2006 are exempt from periodic and exit charges for inheritance tax. This means the life tenant’s interest in such trusts is not subject to the relevant property regime, so there’s a big tax advantage. Also these trusts get a tax free uplift on death of the life tenant.
Gifts into IIP trusts created before this date were Potentially Exempt Transfers (PETs) and were not subject to immediate inheritance tax charges. This background is important to understand the current tax treatment and benefits of older IIP trusts.
Transitional Serial Interest (TSI) allows certain life insurance trusts to retain pre-2006 rules. This applies to IIP trusts created before 22 March 2006 and means the tax treatment remains favourable even if a new beneficiary is appointed after the death of the previous one.
Post-2006 Changes and Immediate Post Death Interest
From 22 March 2006 new Interest in Possession Trusts are classified under the relevant property regime and this changes the tax treatment. This has big implications for how these trusts are managed and taxed, especially for inheritance tax.
An Immediate Post Death Interest (IPDI) arises when someone gets a life interest on death of the previous owner under a will or intestacy. This type of interest doesn’t require the beneficiary to be a surviving spouse or civil partner, so it’s not limited to just them.
These changes mean IIP trusts remain a flexible tool in estate planning, for various beneficiaries and situations, and within the new tax rules.
Income and Capital Gains Tax
Income and capital gains tax for Interest in Possession Trusts needs to be managed carefully. Trust income is taxed at the beneficiary’s personal tax rate if it’s paid to them directly so they can use their personal allowances and savings allowances to reduce their tax liability. Trustees are responsible for ensuring that income tax is properly assessed and paid based on the nature of the income and the beneficiary’s tax status.
Trustees are responsible for paying capital gains tax on disposal of trust assets. 20% or 24% for gains on residential properties not eligible for private residence relief. Trustees can defer capital gains tax on asset disposals under certain circumstances, e.g. using hold-over relief.
When trust assets are transferred to a beneficiary, trustees are treated as making a chargeable disposal for capital gains tax purposes. So any capital gains arising from the disposal are taxable and trustees need to manage these transactions carefully to minimise tax liabilities.
Investment Strategies for IIP Trusts
Investment strategies are key to IIP trusts. Trustees need to balance income for the life tenant with capital growth for the remaindermen. This means a considered approach to choosing investment vehicles that can provide both income and growth.
A balanced investment strategy will often include a mix of income and growth investments. OEICs are commonly used for trustees of IIP trusts with income beneficiaries as they can provide a regular income and growth. Investment bonds should be avoided for income for life tenants as any payments are treated as capital.
Trustees need to consider the suitability, tax efficiency and administrative costs of their investments. By choosing and managing their investments carefully they can ensure the trust meets the needs of the life tenants and the remaindermen.
Life Insurance Trusts
Life insurance trusts within the IIP framework have special considerations. The Transitional Serial Interest (TSI) rules apply to life insurance trusts set up before 22 March 2006 so they can retain the old tax treatment. This is important to keep the trust pre-2006 even if premiums are paid after 2006.
If an income beneficiary dies before the life insured, a new beneficiary can take a present interest in the trust. This means the income will continue to be paid according to the original trust terms so the beneficiaries have continuity and stability.
There are also special rules for life policy trusts so the income beneficiary is treated as having an earlier interest if they predecease the life insured. Trustees of IIP trusts need to understand these rules to comply and get the best tax treatment.
Trustee Duties
Trustees of IIP trusts have many administrative responsibilities. As the legal owners of the trust assets, trustees must act in the best interests of the beneficiaries and manage the assets wisely. This means making investment decisions that balance the life tenants and the remaindermen.
The trust deed sets out the rules for the distribution of capital and income to the beneficiaries. Trustees must follow these rules and keep precise records of trust income and expenditure to discharge their fiduciary duties. Good record keeping is important for transparency and accountability of the trust.
Proper management of the trust assets and following the trust deed means the trust will run smoothly and meet the needs of all beneficiaries.
Trust Maintenance and Compliance
Trust Registration Service and Compliance
Once the trust is created, the trustees will be the legal owners of any trust assets and investments. They will have wide investment powers, but these must be used in the best interests of the beneficiaries. The trustees will need to act fairly between different classes of beneficiaries, balancing a reasonable yield for the life tenant with capital growth for the remaindermen. The trust must also be registered with the Trust Registration Service (TRS) if it has an income that is not mandated directly to the life tenant, or where capital gains from disposals are created.
Conclusion
IIP trusts are a useful estate planning tool to provide income for life tenants and preserve capital for future beneficiaries. You need to know the key features, tax and administrative responsibilities of these trusts to get the best out of them.
Whether you are setting up an IIP trust or managing one, this will help you understand the IIP trusts. By balancing the life tenants and remaindermen and the tax rules, trustees can get the trust to work.
Frequently Asked Questions
What is a life tenant in an Interest in Possession Trust?
A life tenant in an Interest in Possession Trust is a beneficiary entitled to receive income generated from the trust assets without owning the assets themselves. This entitlement lasts until their death or a significant life change, such as remarriage or entering a civil partnership.
How are Interest in Possession Trusts taxed?
Interest in Possession Trusts are taxed by including the trust’s value in the life tenant’s estate for inheritance tax purposes. The income is subject to the beneficiary’s personal tax rate, while capital gains tax applies to the disposal of trust assets.
What is the role of trustees in an Interest in Possession Trust?
Trustees in an Interest in Possession Trust play a crucial role in managing the trust assets, distributing income to the life tenant, and ensuring compliance with the trust’s terms. They must effectively balance the need to generate income for the life tenant while preserving the capital for the remaindermen.
When should one consider setting up an Interest in Possession Trust?
One should consider setting up an Interest in Possession Trust when aiming to provide for a surviving spouse while preserving capital for children, especially in blended families. This type of trust ensures that significant assets are managed in accordance with specific wishes.
What changes occurred to Interest in Possession Trusts after 2006?
After 2006, new interest in possession trusts is subject to the relevant property regime, which altered their tax implications. This includes the ability to create immediate post-death interests, enabling life interests to be established upon the death of the previous owner.
