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The consequences of the death of the settlor

Financial advisers, whether or not they have been involved in the setting up of an earlier trust, are frequently called upon to assist with financial matters after a client or a relative of a client has died.  Frequently there are questions with regard to the administration of a trust that the deceased had set up during lifetime or there may be questions in relation to a trust that has been created under the deceased's will. Judging from our experience at Technical Connection particular problems often arise in connection with loan trusts and other inheritance tax (IHT) mitigation schemes.  This month we will consider the consequences of the death of a settlor under the different trust arrangements.

Who is the settlor?

For tax purposes the settlor is the person who has provided funds to the settlement. In most cases this will be the person named as the settlor in the trust deed but it is important to remember that this will not always be the case. The first thing for an adviser to establish in relation to any existing trust is who the settlor is.  A part of this exercise will be establishing what assets were transferred to the trust and when.  This is especially relevant where a trust has been created with a nominal sum so it will not be apparent from the trust deed what assets have been transferred and when.

Remember also that if two persons jointly create a trust or the funds come from a joint account, they are both settlors and, for IHT purposes, the trust is treated as two separate settlements even if for income tax and CGT purposes there is only one.

It is also important to remember that where a trust is created under a deed of variation within two years of death of the testator, the settlor for IHT purposes is the deceased but for income tax and CGT purposes the settlor is the original beneficiary who varies their legacy.

Regardless of the tax position, for the purposes of trust administration and any powers reserved to the settlor, the settlor will be the person defined as such in the trust document.

Impact of the death of the settlor on trust administration

This will depend on the extent of any powers reserved to the settlor.  In many lifetime trusts the settlor will be one of the trustees and, frequently, especially under the "standard" discretionary or flexible trusts provided by life offices, the settlor will also be the appointor under the trust, i.e. have the power to appoint benefits under the trust during lifetime.  Obviously in such cases these powers, after the settlor's death, will vest in the trustees.

The first job of an adviser will be to establish who the surviving trustees are and whether there is a sufficient quorum for them to make decisions.

If the settlor at the time of his death was the sole trustee (either because  no additional trustees have been appointed  - which is possible in England and Wales - or because the trustees previously appointed have died  or retired and no replacement has been appointed -  then who can act will depend on the jurisdiction governing the trust. In England and Wales and in Northern Ireland the legal personal representatives of the last trustee (here the settlor) will act as the new trustee. Therefore, probate will be necessary to establish who these people are. These people will be able to act as new trustees or will need to appoint new trustees to carry on the trust administration.

In Scotland if the sole or last remaining trustee dies, the executors of the last trustee must obtain a separate confirmation (equivalent of probate) in respect of the trust assets. The confirmation on the estate of the deceased is not sufficient, as would be the case in England and Wales. Furthermore, once they have obtained the separate confirmation on the trust assets, this will only enable them to recover and deal with the trust assets as an interim measure - effectively they are placed in the same position in relation to the trust assets as they are in relation to the deceased's estate. They can, for example, distribute the assets to the beneficiaries who are absolutely entitled and can give a valid receipt (i.e. over the age of 16) but where the trust is to continue they must appoint new trustees - the confirmation does not give them the title to act as trustees as such.

Many trusts will require a minimum number of trustees, usually two, and many also include a 'no conflict of interest' clause requiring an "independent " trustee if the existing trustees are also trust beneficiaries and wish to exercise their power to appoint benefits in their own favour. The word "independent" does not mean "professional", so it should not normally be necessary to appoint a solicitor or accountant unless this is desired. It is important to remember that professional trustees will charge fees for acting.

Death of a settlor of a trust holding a protection policy

In this case the settlor will normally also be the life assured and so their death will result in a  claim under the policy and the payment of the death benefit to the trustees. The trustees' proof of title will be the deed evidencing their appointment, which may be a separate deed or incorporated in the trust deed. Once the trustees receive the policy proceeds they may well need advice on how to deal with the funds. If it is not intended to distribute the funds immediately, usually because the intended beneficiaries are minor children, the trustees will need to obtain proper advice on where to invest the funds.

If the trust is a discretionary or flexible trust, ideally the settlor would have left a letter of wishes with the trustees.  But this will not absolve the trustees from properly exercising their discretion. With protection policies, it is only when the sum assured is paid on death that the trustees will begin to appreciate the scale of their task.

Death of a settlor under a trust holding investments.

In this case the trustees' functions are not likely to be affected by the death of the settlor unless either the settlor had retained some dispositive powers under the trust (see section above about the settlor's power to make appointments) or the settlor had reserved some beneficial rights under the trust for himself. Typically there are two types of IHT scheme where the settlor may reserve certain rights. These are loan plans and discounted gift trusts (DGTs).

Death of a settlor under a DGT

Under a typical DGT the settlor carves out a series of capital payments for himself, usually for life, while the rest of the trust fund is held either for a named beneficiary under a bare trust or for a class of beneficiaries under a flexible or discretionary trust.

The death of the settlor will mean that the settlor's rights terminate and the trust fund is available to the other beneficiaries. Remember that the settlor's rights under a DGT have no value in the event of his death. The only IHT implications will be if the death occurs within 7 years of the original gift. The trustees need to ensure that the life office is informed immediately so that any payments made directly to the settlor's bank account stop. If any payments are inadvertently made after the date of the settlor's death, these should be refunded to the trustees.

If the settlor was the sole life assured under the bond held by the trustees, the settlor's death will also give rise to a chargeable event for income tax purposes as the bond will terminate (assuming it was a life policy and not a capital redemption plan). If the bond was effected on multiple lives and the settlor is not last to die, the bond can continue and the trustees will need to carefully consider the most tax-efficient way to surrender it if they want to pay the benefits out to the trust beneficiaries.

Death of a settlor under a Loan trust

Under a Loan trust, the settlor lends a sum of money to the trustees who invest it in a bond. The settlor remains entitled to the repayment of his loan on demand whilst any growth is held for the benefit of the beneficiaries, again under either a bare trust, flexible trust or a discretionary trust.

When a settlor/lender under a Loan trust dies, the outstanding loan forms part of their estate. Ideally there should be something in the settlor's will (or a codicil) dealing with the loan entitlement. For example, it is often recommended that the settlor makes a provision in his will or a codicil that the entitlement to the outstanding loan under the  Loan trust should pass to his spouse (if it is desired to take advantage of the spouse exemption for IHT purposes) or to another individual, perhaps an adult child. If there is such a provision then, as long as the outstanding loan is not needed by the executors to, say, settle the estate debts, it will pass to the named beneficiary who will effectively step into the lender's shoes and be able to demand repayment by the trustees on demand or leave the loan outstanding so that there will be no need for the trustees to encash the bond

In the absence of a specific will /codicil provision, the loan entitlement will pass into the residue of the estate. However, in practice this will only happen if the funds are not needed by the executors for anything else, e.g. to cover the estate liabilities, specific legacies etc. Remember that the executors' primary duty is to realise all assets of the estate, administer the estate and distribute it to the beneficiaries named in the will.

Obviously, if the executors demand repayment of  the loan to the estate then the trustees will have to surrender the bond and repay the loan. Often, for various reasons, it is not convenient to surrender the bond and one of the questions we often get asked at Technical Connection is whether the loan can be written off or waived, or whether a deed of variation can be made so that the bond does not need to be surrendered.

Here it is important to remember some fundamental facts. First, the executors cannot write off or waive  anything, it is simply not in their power, and so what can happen in practice will depend on  whether the entire outstanding loan passes into  the residue (assuming there is no specific legacy of the loan entitlement) and, if so, who inherits it.

If the money is not needed for any other purpose and the outstanding loan has indeed passed into the residue of the estate, the executors could, with the agreement of the beneficiary entitled to the residue, assent the benefit of the outstanding loan to him or her (or the trustees if the residue is left to trustees). It would then be up to the beneficiary / trustees to decide if they are happy to receive periodic repayments of the loan or call in the outstanding loan, or indeed vary their legacy in favour of the Loan trust or another beneficiary.

Another important point to remember is that a deed of variation can only vary a disposition, i.e. a will provision, so the beneficiary of the residue may make a variation in favour of another beneficiary. That other beneficiary could be a trust, including the Loan trust, that owes the money to the estate so that the loan merges with the fund held for the beneficiaries of the trust which will have the same result as being written off. However, a deed of variation itself cannot "write off" or "waive" the loan.

Conclusion

Clearly it is the Loan trusts that cause most headaches for advisers and trustees. In most cases problems will be avoided if the settlor/lender leaves a specific legacy of their outstanding loan to a named individual. So it is important that advisers give advice on this when a Loan trust is being set up. Of course, it is also important to remember that such a legacy will fail if the funds are needed in the estate to repay the estate debts so nothing can be guaranteed, but at least in most cases the problems involved in dealing with outstanding loans will be avoided.