Life interest trusts

Life interest trusts remain an important estate planning tool in the UK legal landscape, providing flexibility and protection for both settlors and beneficiaries.

What is a life interest trust?

A life interest trust (also known as an interest in possession trust) grants a beneficiary (the "life tenant") the right to benefit from trust assets during their lifetime, without giving them absolute ownership of the assets themselves. The life tenant typically receives income generated by the trust assets and may have rights to enjoy trust property, while the underlying capital is preserved for eventual distribution to other beneficiaries (the "remaindermen") after the life tenant's death.

These trusts create a split between income and capital interests, providing for immediate beneficiaries while securing assets for future generations.

Reasons to consider

While many clients initially consider life interest trusts primarily for inheritance tax (IHT) planning, there are other reasons which are often more valuable for family protection purposes. Reasons can include :-

• Inheritance Tax Planning - historically, life interest trusts were widely used for IHT mitigation before changes introduced in 2006. While the tax landscape has changed significantly, these trusts still offer important tax planning opportunities when properly structured.

• Second marriages - to balance the needs of a current spouse with inheritance rights of children from previous relationships

• Vulnerable beneficiaries - providing financial support for individuals who may be unable to manage substantial capital

• Concerns about beneficiary immaturity or recklessness - to preserve wealth for beneficiaries who might otherwise deplete capital rapidly

• Protect assets from creditors - assets within properly structured trusts may be protected from creditors of the life tenant

• Care fee planning - potential protection from assessment for long-term care costs

• Divorce protection - safeguarding family wealth from claims in divorce proceedings

Types of life interest trusts

The most common form of life interest trust in the UK, particularly in blended family situations, is created under a will, so comes into effect after death. The typical arrangement provides the surviving spouse with a life interest in the matrimonial home and possibly other assets, with the capital ultimately passing to the children.

The other main type is a Life Interest Trust set up during lifetime, which may be created to provide for a family member with income needs and/or protect assets while allowing specified individuals to benefit and/or to begin estate planning while retaining some indirect control over assets

Key features of life interest trusts

• Two-tier beneficiary system - a "life tenant" with immediate benefit rights and "remaindermen" with deferred capital entitlement.

• Trustee obligations - typically balanced duties to generate reasonable income for the life tenant while preserving capital for remaindermen.

• Right to income - with the life tenant entitled to income generated by trust assets.

• Occupancy rights - potential right to occupy property held in trust.

• Advancement powers - trustees may have limited powers to advance capital to life tenant.

• Appointment powers - trustees or the life tenant may have powers to appoint capital to specified classes of beneficiaries.

Tax issues

Following the changes to the taxation of trusts in March 2006, the IHT advantages of new life interest trusts have been reduced, but they can still be effective in certain circumstances.

It's important to note that the tax efficiency of life interest trusts depends heavily on individual circumstances, timing, and how they're structured. Married couples now benefit from transferable nil-rate bands and the residence nil-rate band, which may reduce the IHT advantages of trust arrangements for some families.

Impact on care costs

One of the most frequently asked questions about life interest trusts concerns their effectiveness in protecting assets from care home fee assessments. The effectiveness of life interest trusts for care fee planning has diminished as local authorities have become more assertive in challenging such arrangements. Courts generally support local authorities in cases where trusts appear to have been established primarily to avoid care costs. Points to note include :-

• Local authority assessment - local authorities assess capital and income when determining liability for care costs.

• Deprivation of assets - transfers made with the intention of avoiding care fees may be challenged as deliberate deprivation of assets. If the primary reason for creating the trust was to avoid care fees, the assessment may be on the basis as if the person still owned the assets.

• Timing considerations - trusts established many years before care is needed, and for reasons other than care fee avoidance, are less likely to be challenged.

• Life tenant's interest - the value of a life interest may be considered in means testing.

• Deliberate deprivation rules -

Potential drawbacks of a life interest trust

• Administrative burden - Ongoing trustee duties, annual tax returns, and record-keeping requirements

• Setup and running costs - Legal fees for establishment, trustee fees, and accounting costs

• Reduced flexibility - Assets locked into a predetermined structure that can be difficult to modify

• Investment constraints - Balancing income production for life tenant against capital growth

• Local authority challenges - Increasing scrutiny of trusts in care fee assessments

• Higher tax rates - Trusts face higher capital gains tax rates than individuals

• Relationship tensions - Potential conflicts between life tenants and remaindermen

• Limited RNRB availability - Restrictions on residence nil-rate band compared to direct gifts

• Complex tax compliance - Specialist advice often required for ongoing tax reporting

Alternative approaches

• Discretionary trusts with letters of wishes - greater flexibility but less certainty

• Family investment companies - alternative asset protection with different tax treatment

• Direct gifts with restrictive covenants - simplified structure while retaining some control

We can help

For clients with complex family structures, vulnerable beneficiaries, or substantial estates, life interest trusts remain an important tool in the estate planning toolkit. Careful drafting, ongoing management, and regular reviews are essential to ensure they meet clients' objectives effectively.

We assist clients in considering all the options and if a life interest trust is attractive, then weighing up e the administrative and tax burdens against the protection and control advantages of setting up a trust.