The Pros & Cons of Setting up A Trust for Your Investments
Understanding the Trust Structure
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What is a trust?: A trust is a legal structure by which a person (the settlor) transfers his assets to another person (the trust, managed by trustees) for the benefit of a third person (the beneficiaries)
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Trust Deed: legal contract that creates the trust and spells out how the trust is to be run, including the right of beneficiaries (how income is to be paid out to beneficiaries), the rights, obligations & liabilities of trustees, provisions on how the trust can be ammended and more. It is best to seek professional legal counsel while drafting a trust deed.
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The 3 parties: Settlor (person who transfers the assets), Trustee (person who manages the trust), Beneficiary (person who benefits from the trust)
Main Benefits of setting up a Family Trust
Main benefits of setting up a trust
There are many benefits of setting up a trust structure for succession planning. This includes
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More fool-proof than a will: A trust allows for a smoother transfer of assets to a beneficiary than a will. There are potential legal complications that can arise with a will, especially that of the will being contested. A trust ensures that your assets are smoothly transferred to your beneficiaries, with no complications
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Protection against inheritance taxes/estate duties: While India does not currently have estate duties, there is always the risk of these being introduced in the future. Major developed nations like the US & UK have estate duties of upto 40%. A trust structure can provide protection against such estate duties, helping safeguard your wealth against large taxes.
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Ensuring wealth preservation & trust income being used for specific purposes: Often the 2nd generation can substantially eat away into family assets, reducing the transference of family wealth over multi-generations. Trusts can be structured to ensure that inheritance can be used only for specific purposes as provided in the trust deed.
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Protection & Ring-fencing of assets: ring-fencing of assets against possible losses due to business liabilities, family related liabilities arising from divorce / maintenance claims, tax claims, re-introduction of estate duty in India, and / or actual or potential creditors.
Issues to Consider prior to setting up a Family Trust
Many families under-estimate the legal complexities and other nuances while setting up a family trust. This often leads to the creation of a trust that operates in a manner contrary to it’s intended benefits.
A wide range of potential future circumstances (forseaable & unforseeable) need to be taken into account, to ensure that the trust serves it’s intended purposes. This requires high quality legal and other professional advice, which is not cheap. This is the primary reason why family investment trusts remain the purview of the truly rich.
Remember, while setting up a trust you are effectively losing control over your assets. Before doing so, it is important that you truly understand the various nuances of the different types of trusts. We describe some of the more common problems of a trust structure below:
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Legal nuances: There are many different nuances of what is allowed/not allowed under a trust, the way in which taxes are to be levied, the rights of the beneficiary (and settlor) and the different types of trust structures (specific vs discretionary, revocable vs irrevocable). A lack of appreciation of these nuances can often lead to unintended adverse consequences. This is why it is very important to have quality legal counsel help in the establishment of the trust.
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Loss of control of assets: With the exception of revocable trusts, the settlor legally loses control over the assets of the trust. While this may be done with the best of intentions, there can be unforseen emergencies when not having access to your capital is very damaging.
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Flexibility vs Rigidity: The very aim of creating a trust is often to ensure that the payouts to beneficiaries is only for specific requirements. This leads to families & lawyers often developing a rigid trust structure. However it is not possible to foresee future requirements, and a trust structure’s rigidity can lead to money not being available to beneficiaries when truly required. Creating a trust deed that is too flexible on the other hand, can often defeat the very purpose of creating the trust. It is very important to keep in mind a wide range of potential future circumstances while deciding on the rigidity of your trust deed.
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Power of trustees: The powers and responsibility of the trustees are determined by the trust deed. There have been clear instances where there are disputes between the trustee and the beneficiary or the settlor, and it is possible for a trustee to act in a manner that may not reflect the wishes of the beneficiary/settlor.
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Taxation: Taxation for trusts can be complicated and subject to interpretation. This is especially true if one of the beneficiaries is residing overseas. A trust structure can often lead to unintended tax implications.
Different Types of Family Trusts
Specific vs Discretionary
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Specific/Determinable: The beneficiary shares are clearly defined in the trust deed and cannot be modified by the trustees) OR
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Discretionary: The beneficiary shares are determined by the trustees from time to time)
Revocable vs Irrevocable
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Revocable: The trust can be cancelled or amended during the settlors lifetime. Under a revocable trust, the settlor retains control over the assets. A trust is considered revocable if it contains any provision for the transfer back of any income of the trust assets / power over the trust assets to the settlor.
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Irrevocable: The trust cannot be cancelled or amended. Under an irrevocable trust, the settlor loses control over the assets
Combination
Family trusts are accordingly a combination of the above 2 types. A family trust is therefore either
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Specific Trusts: Specific Revocable OR Specific Irrevocable
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Discretionary Trusts: Discretionary Revocable OR Discretionary Irrevocable
How are family trusts taxed?
For the purpose of India taxes:
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A private family trust is not a separate taxable entity
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A trustee pays the tax in a representative capacity (i.e. the trustee acquires the tax status of the beneficiaries and pays tax accordingly)
Irrevocable Determinate (Specific) Trusts
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Based on beneficiary tax slabs: Under such a trust, the beneficiaries are identifiable and their shares are determinate. Tax rates are based on the beneficiary tax slabs.
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Who pays the taxes: The tax can be paid either by (a) the trustee – in his position as a representative assessee (b) the beneficiary. The tax authorities may choose to tax either the trustee or the beneficiary, but in no case can tax be levied twice.
Irrevocable Discretionary Trusts
- Taxed at the marginal taxation rate: 30%
Revocable Trusts
- Taxed as income for the settlor: in the case of joint settlors, taxes will be charged on the individual settlors to the extent of the assets settled by them in the trust.
Irrevocable Trust
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Conflicting views on taxation on transfer of assets: Technically, a transfer of assets by the settlor into an irrevocable trust, should be considered a gift and not a sale by the settlor (leading to capital gains taxes on the settlor) or as income by the trust (leading to income taxes on the trust). The specific issue relates to an income tax provision that states that any receipt of funds/property without consideration or for a value less than fair market value, is taxable in the hands of the transferee (there is an exception for legal relatives).
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Applicability of stamp duty: stamp duty laws vary from state to state and on the type of assets being transferred. It is best to seek legal opinions on the applicability of stamp duties on specific cases.
