The use of trusts (particularly a discretionary trust) could be regarded as a more advanced estate planning tool. A discretionary trust is a form of living trust (inter vivos trust) set up while you’re alive. In South Africa we also often refer to them as family trusts because they tend to house inter-generational family assets and form a great vehicle for succession and legacy planning.
Discretionary trusts are mostly used by people who have built up a sizeable asset base who want to protect assets in the event of insolvency, reduce their estate duty obligation and want succession planning to be smooth and seamless. But there are many forms of trusts and not all of them are only useful for rich people.
What is a Trust?
A trust is a legal relationship in which the holder of a right gives it to another person or entity who must keep and use it solely for another’s benefit. There are 3 parties to a trust. The founder or settlor who establishes the trust. The trustees who become owners of the trust property or assets. And the beneficiaries who may benefit from the assets held in the trust. While the terms used around the world might vary slightly, and the tax treatment and legalities depend on a jurisdiction, the diagram below provides a simple, visual framework to understand.
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Different Types of Trust
While the focus on this piece is around discretionary trusts and the value they provide from an estate planning perspective, in South Africa we have a number of different trust structures that serve various purposes.
Inter Vivos or Living Trust
Established by the founder while they’re still alive and governed by the trust deed that defines who the trustees, founder and beneficiaries are, the powers and duties of the trustees, if and when the trust can be wound up, how the assets should be managed etc. Simply put the trust deed acts as the ‘Bible’ that governs how that trust structure can operate and be managed.
From an estate planning context, the most common form of living or inter vivos trust used is a discretionary trust (often called a family trust.) If you’re the founder – you donate or ‘sell’ assets to the trust via a loan account and those assets are then administered by the trustees on behalf of the beneficiaries, who can be named (your wife, children, yourself etc.) – or be a class of beneficiaries (e.g., grandchildren) because they are not yet known.
The founder can also be a trustee and beneficiary but will need at least one independent trustee to be a part of the board of trustees to demonstrate independence and that in fact the trust is not simply an alter-ego of the founder (which means they retain effective control of the trust assets).
A discretionary trust provides the trustees with absolute discretion as to how and when to allocate income and/or capital to the beneficiaries of the trust. As the founder, you can however provide a letter of wishes to the trustees to ask them to use their discretion and consider distributing assets/income in a certain manner at a certain time. This discretion and the fact that beneficiaries do not have a vested right to income or capital from the trust – means all assets in the trust are not subject to estate duty. Because beneficiaries have no rights it also means all assets in the trust are protected from creditors.
Vesting Trust
A vesting trust on the other hand provides trustees no discretion and beneficiaries rights are fixed and predetermined in the trust deed. Because a beneficiary has a vested right to income or capital from the trust, on death assets are subject to estate duty and no creditor protection is enjoyed. So, their use from an estate planning purpose is more limited. While the benefits of a vesting trust relative to a discretionary trust might be more limited, controlling how and when a beneficiary has access to income or capital might be a good thing, e.g. they might not be responsible enough or of an age to deal with a large amount of money.
Testamentary Trust
Is created via your Last Will and Testament and only comes into effect on death. If your Will is invalid for any reason, the testamentary trust won’t be established. It is usually established to provide for minor beneficiaries and their needs to avoid assets intended for your minor children being administered by the Guardians Fund.
That Guardians Fund is in control of the State via the Master of the High Court, which inevitably involves a lot of bureaucracy and inefficiency, and just as importantly means that the trust assets may not be invested in a way that is of optimal benefit to the beneficiaries.
Deciding who you want to appoint as trustees is also important – they should have the knowledge and skills to fulfil your intentions adequately and means it may be a good idea for the guardian of minor beneficiaries to perhaps not also serve as a trustee. Their views can be considered but it avoids possible conflicts of interest.
Other uses of a testamentary trust may be to make financial provision for your spouse or to manage assets that may be wasted by an irresponsible beneficiary.
A testamentary trust will also qualify as a special trust if the youngest minor beneficiary is under the age of 18, which provides certain tax advantages, more on that below.
Special Trusts
Are typically established for the maintenance of a person with a mental illness or any serious physical disability that prevents them from earning an income or managing their own affairs. Special Trusts are taxed at individual rates rather than trust rates.
Benefits of a Discretionary Trust
- Protection of minor beneficiaries, anyone suffering from a mental illness, or physical disability. Using a testamentary trust or special trust where appropriate can assist in this regard and you don’t need a proper discretionary trust for this. (because its a lot more expensive and complex to set up and manage.)
- Protection against creditors in the case of a discretionary (living) trust should the founder or a beneficiary go insolvent on the condition that no vested interest exists.
- Estate duty saving because once assets are transferred to the trust, all future growth of those assets remain outside of the estate. Assuming assets were sold to the trust via a loan account, only the loan account remains in the settlor’s estate for estate duty purposes. That loan can however be repaid using the annual R100,000 donations tax allowance thereby reducing its value over time.
- Once assets are in the trusts it allows for intergenerational wealth planning because the trust doesn’t die and beneficiaries and future generations can continue to benefit from capital and income the trust generates, as provided for in the trust deed. In other words, the Family Trust arrangement we often think of when talking about trusts in South Africa to house family wealth across generations.
It is important to note that assets sold to a discretionary trust via a loan account need to be done on an arms length basis and that interest-free loans will now trigger various anti-avoidance regulations. That means loans should be made at commercial terms which is now widely accepted as being the REPO Rate + 1%.
Taxation of Discretionary Trusts and the Conduit Principle
All trusts (unless they are deemed as a special trust), pay income tax at a flat rate of 45% and CGT at an effective rate of 36%, in other words much higher than you would as an individual taxpayer.
However, to provide for a more efficient tax treatment of income or gains a trust generates, there is a mechanism used known as the conduit principle. Without going into the technicalities of it, in summary it works as follows:
If income or gains are distributed to beneficiaries of a trust in the same tax year as which they accrue (at the trustee’s discretion of course), the income or gains are deemed to have been accrued to the beneficiary (instead of the trust) and the beneficiary therefore pays the tax according to their own tax rates.
Therefore, managing trust assets diligently, retaining proper records and minutes, deciding on how to effectively distribute income etc. to beneficiaries, is an important function of the ongoing administration of trustees both from a tax planning perspective, but also to ensure ongoing compliance. Therefore, if the authorities ever scrutinise the management of a trust – everything has been done correctly.
Divorce and Trusts
When calculating the value of the respective estates in cases of divorce and any settlement negotiations, a correctly structured and managed discretionary trust will not form part of the founder’s estate. Because if done properly, you no longer own or have any right to those assets, as they are now owned and controlled by the trustees for the benefit of the beneficiaries.
Having said that, there is case law and precedent that shows that if the settlor retains effective control of the trust assets (alter ego concept), in other words manages or runs the trust assets as if it were their own – the Courts can decide that those assets should in effect be regarded as part of their personal estate and subject to any divorce claims.
Therefore the devil is always in the detail and how a particular trust is established and managed will determine its effectiveness. SARS and tax authorities around the world are starting to scrutinise the operation, management and structure of trusts more closely to determine if there are shortcomings – which can not only create unwanted tax implications – but can mean the trust does not actually serve the purpose for which it was designed, e.g., asset protection in the case of divorce or insolvency.
Discretionary Trust Cost
The establishment costs and ongoing administration costs of running a trust will always form part of deciding whether it makes sense. And that will be different for everyone depending on the size and complexity of the assets a trust will administer.
Domestic trusts are certainly easier and cheaper to set up and administer than offshore trusts, because for offshore trusts you will ordinarily appoint offshore corporate trustees to manage the trust, and their services do not come cheap. As a very rough guideline or ballpark figure, expect to pay anything between USD 15,000 – 20,000 to set up and administer an offshore trust from one of the more reputable ‘offshore jurisdictions’ like Guernsey and Jersey, so unless you have USD 2 million plus to invest, we generally don’t think it’s viable.
It’s probably easier to save on fees with a domestic trust because you don’t have to appoint corporate trustees and as your independent trustee (s) you could appoint your accountant or someone else you trust who won’t necessarily charge you an arm and a leg.
Having said that though, it is important to do things properly and not to cut corners to demonstrate that the trust is in fact a proper separate legal entity and is managed accordingly. If not and SARS deems the trust simply as an alter ego to yourself (that you retained effective control of the trust assets), the whole thing falls flat.
Spending money on having a proper trust deed drafted, appointing an independent trustee (s) and the ongoing costs relating to administration so things are done properly could cost anything between R5,000 – R20,000. Again, the more complex and sizeable your assets, the more you should expect to pay.
The other costs to bear in mind are the costs incurred to transfer assets to the trust, which may include things like transfer duty, capital gains tax, donations tax etc. Any change of ownership (e.g., from your name to that of the trust) is a deemed disposal from a CGT perspective.
Donating the assets to the trust (which will incur donations tax) or selling assets via a loan account are other factors to consider when setting up a trust.
Setting up a discretionary trust
Setting up a discretionary trust is not something you should do lightly. It requires careful thought and planning and should be done for the right reasons. If avoiding tax is your primary objective, chance are that SARS – as they become more sophisticated and increasingly target trust structures – will find you out.
If however within the broader context of your estate planning – wanting to leave a legacy, protect your assets etc. – setting up a discretionary trust makes sense, then do it properly.
Get professional advice, make sure you’re prepared to give up control of the assets you want to hold in the trust, consider the cost and ongoing admin/compliance obligations and make sure you’re working with the right people to ensure your trust structure is managed correctly.
Conclusion
Discretionary trusts are not for everyone but are probably the ultimate advanced estate planning tool in the right circumstances. But it’s more important than ever to utilise them correctly if it’s an option you are considering. Taking professional advice and working with corporate trustees means you are more likely to do everything properly. But that comes at a cost. At Henceforward we work with various specialists who can help set up and manage domestic and offshore trusts. Get in touch if you would like to know more.
Read Next: Check out our Estate Planning 101 the Ultimate Guide which is a comprehensive resource on all things estate planning.
Carl-Peter Lehmann
Carl-Peter is a CERTIFIED FINANCIAL PLANNER and investment professional with more than 20 years experience, including having worked in offshore locations like the Channel Islands and Hong Kong. He is a Director and Partner at Henceforward. Henceforward facilitate and enable the use of intervivos discretionary trusts for their clients under the right circumstances, particularly to preserve and transfer family wealth to future generations.
