People plan their succession to ensure their wealth is passed on smoothly and according to their wishes. Estate or succession planning is a part of financial planning that concerns this transfer of wealth. It ensures one’s wealth is protected and distributed with minimal legal hassle and tax burden.
Generally, there are four ways to go about estate planning: wills, gifts, nominations, and trusts. Among them, a popular option especially among HNIs is trusts, as they offer a structured approach to not just managing and distributing assets but also wealth management and asset protection.
Here, we’ll explore trusts, their types, and trust fund tax benefits to understand how they can be an effective estate planning tool.
What is a Trust Fund?
The specific definition of a trust can be found in the Indian Trusts Act of 1882, which in simple words, describes it as a legal arrangement where the creator of the trust transfers property to a trustee, who holds and manages it for the benefit of beneficiaries.
Here, property can mean a number of things, like cash, land, stocks, bonds, mutual funds, gold, or any other valuable asset. Essentially all that can be legally owned and transferred can be included in a trust. There are three parties involved in this arrangement:
- The settlor or author – This is the creator of the trust. It can be an individual or entity like an AOP, HUF, or a company.
- The trustee – Appointed by the settlor, the trustee bears the responsibility of managing the trust.
- The beneficiary – This is the person or entity that will benefit from the trust.
The settlor decides on the terms of the trust, such as its purpose and how the wealth will be distributed. Everything happens as per the wishes of the settlor. The trustee then acts according to the set terms. The trustee’s job is to comply with legal authorities, manage the assets ethically and responsibly, and always make decisions that are in the best interest of the beneficiaries.
How Trust Funds Work
A trust deed is created which clearly outlines the terms, aims, and conditions of the trust. For example, if Raj wants to pass on his wealth to his minor son when he turns 25, he can set up a trust and appoint a trustee. Raj can then transfer his assets to the trust, which will be managed by the trustee until Raj’s son completes 25 years.
Until then, the trustee will work according to the terms specified in the deed, like providing for the child’s education, healthcare, and other essential needs. Over the years, the wealth will grow and once the son turns 25, the assets will be handed over to him in a way that minimises any court troubles or any other financial complications.
The above is a general example of a private trust, where the goal is to protect an individual’s wealth so that it may be passed down to future generations. There are other purposes for which a trust can be created, as well. Wealth can be passed down to promote the welfare of a larger section of society (like members of a particular religion or community) and other philanthropic causes.
Before we go any further, let’s have a look at the different types of trusts one can create in India. It’s important to understand them as they have specific taxation rules.
1. Private Trusts
Private trusts are governed by the Indian Trusts Act and are created for the benefit of specific individuals or groups rather than the general public. If an individual wants to pass on their assets to their heir, they can set up a private trust so that the wealth is managed responsibly by a trustee who can distribute it according to the settlor’s wishes. These trusts are used quite commonly in estate planning.
The settlor can give special right to the trustee to act at his own discretion and create a discretionary trust. This means that in the event of the settlor’s death, the trustee has the right to use his own judgment to manage and distribute assets to the beneficiaries that require it most. There are other benefits of a private trust which we’ll get into later.
2. Public Trusts
On the other hand, a public trust is created for a charitable or social purpose to benefit a group of people. They can belong to a certain community, which means they are not required to be specifically named in the trust deed. This type of trust is designed to serve the public interest. By making one, a settlor can make sure that their assets are used for the intended cause of promoting welfare or a religion.
Public trusts are managed for a large number of people and not just the heirs of the settlor. That’s why they are subject to more regulations to prevent misuse of funds. Information about their trustees, objectives, and management is open to public inspection which increases transparency and accountability.
An example of a public trust is a religious trust, such as religious endowments and wakfs. These are special types of public trusts that manage temples, mosques, churches, religious charities, and associated properties.
Unlike private trusts, public trusts are not governed by a single law that can be applied nationwide. Rather, they are governed by laws made and administered by states, like the Bombay Public Trusts Act of 1950, which specifically governs public and charitable trusts in Maharashtra. Similarly, other laws apply to religious trusts, like the Hindu Religious and Charitable Endowments Act and the Muslim Wakf Act. However, to qualify for tax benefits under the Income Tax Act, a public trust must register itself under the respective State Trusts Act.
3. Other Types
While these trusts are not exactly distinct categories, they are classified based on their structure and function.
- Testamentary and Non-Testamentary trusts
These are classifications based on when a trust is created. A testamentary trust is created through a will and takes effect after the death of the settlor. Non-testamentary trusts, on the other hand, are created while the settlor is alive and take immediate effect. This is why the latter is also known as a living trust.
- Revocable and Irrevocable Trusts
Revocable trusts are flexible as they allow the settlor to change (or revoke) the trust deed at any time during their lifetime. Irrevocable trusts cannot be altered once the assets are transferred, but they do provide other advantages like better asset protection and tax benefits.
- Discretionary and Specific Trusts
These classifications are used for taxation purposes. In a discretionary trust, the settlor does not specify the share of each beneficiary. Instead, the trustees are given the discretion to decide how to distribute assets among the beneficiaries, which can change over time. In a specific trust, the trust deed clearly identifies the beneficiaries and specifies their share in the trust.
Tax Benefits of Trust Funds
There are several trust fund tax benefits which make them an attractive estate planning option.
- Benefits of an Irrevocable Trust Fund
Irrevocable trusts are beneficial for HNIs who want to reduce tax liabilities on their assets. When assets are transferred into an irrevocable trust, they are no longer considered part of the settlor’s taxable estate. On top of that, the trust itself does not have to pay taxes after the owner dies. This makes irrevocable trusts particularly useful for individuals with large real estate holdings.
- Charitable Public Trust Exemptions
Under sections 11, 12, and 13 of the Income Tax Act, public charitable trusts enjoy several exemptions from tax. For example, the income generated by a religious or charitable trust, which if used for such purposes, is exempt from income tax. There are certain requirements to this rule, like using 85% of the income for charitable purposes.
There are also exemptions on income from donations received by the trust, as long as they are applied towards the charitable goals. An exemption of 100% is applicable in such a case, but the trust must be registered under Section 12AA for this benefit to take effect.
- Exemptions on Buying Capital Assets (For Religious Trusts)
If a religious trust uses income to invest in capital assets, repay loans for capital assets, revenue expenditure, or donations to other trusts registered under Section 12AB or 10(23C), it can also qualify for tax exemption.
- Section 80G Benefits
Section 80G of the Income Tax Act allows taxpayers who donate to charitable trusts to deduct a certain percentage of the donated amount from their taxable income. This can help individuals reduce the tax burden. The exact amount that can be deducted depends on the type of charity and other rules listed under 80G. Some charitable organisations qualify for a 100% deduction, while some for a 50% deduction.
Other than these tax benefits, there are many other advantages of setting up a trust, such as:
- Philanthropy
Public trusts can be used to support charitable causes. If a settlor believes in a cause, wants to make the situation of marginalised communities better, or desires to do something valuable for religious purposes, they can create a charitable trust to donate assets to those specific causes or NGOs that promote them. Doing so ensures that their wealth is used to benefit society even after their death. This can include donating to help with the medical treatment of disabled individuals, basic education for orphans, and promoting women’s empowerment.
- Protecting Assets
A huge benefit of trusts, especially private ones, is wealth protection. Let’s understand this with an example. Imagine a medium-sized business owner who creates a trust and gradually transfers assets into it. As time goes forward, the owner makes significant losses due to various risks like market fluctuations, lawsuits, and other financial setbacks.
Eventually, the business takes a downturn, and the owner loses a substantial amount of money. Since the assets are now held in the trust, they are protected from creditors, banks, and other legal claims against the business. The portion of wealth held by the trust is safe.
- Preserving Family’s Wealth
A trust helps preserve the value of assets for future generations. Some assets like land may not be practical for a settlor to divide among individuals. If such assets are put into a trust, the settlor can make sure that the beneficiaries can enjoy them without actually owning them.
- Cannot Be Challenged
A trust cannot be easily challenged in the same way a will can be. Wills can be contested in lengthy and costly court battles. However, once a trust is established and assets are transferred to it, it is much harder to challenge.
- Privacy
Another major distinction from wills is that a will becomes a public record when probated, while a trust remains private. The distribution of assets and personal matters related to the settlor’s estate thus stay out of the public eye.
Taxation Rules for Trust Funds
Private Trusts – Discretionary vs Specific Trusts
As stated before, the shares of the beneficiaries of a specific trust are fixed. If a specific trust has a business income, it is taxed at a 30% maximum marginal rate (plus cess) unless it is created for the benefit of a dependent. If it does not earn its money from a business, the income is taxed in the hands of the beneficiaries according to their tax slabs.
In discretionary trusts, the trust is taxed at the 30% maximum marginal rate (plus cess) and this rate applies to the trust’s income, not the beneficiaries. This is because the share of the beneficiaries is decided by the trustee later.
Public Trusts – Sections 11 to 13 and Section 80G
Public charitable trusts enjoy many tax benefits under Sections 11 to 13 of the Income Tax Act. Section 11 grants exemptions on income received by charitable or religious trusts, or trusts promoting international welfare which interests India. Section 12 deals with donations received by the trusts. It states that all donations can be fully exempt if they are used for religious or charitable purposes.
Again, these exemptions can only be claimed if the trust is registered under Section 12AA. Section 13 prevents exemptions in certain cases, as it deals with forfeiture of exemption. For example, if the trust is not registered, it can lose the exemptions it would otherwise have been eligible for.
To claim tax exemption on income from assets held for charitable or religious purposes, a trust has to use at least 85% of its income towards such purposes in India. These can include promoting yoga, education, providing medical relief, relief to the poor, and other public welfare acts. If this requirement is not met, the trust can be taxed at 30% MMR under certain conditions.
Under Section 115BBC, anonymous donations to charitable trusts can be taxed at a 30% maximum marginal rate if they exceed Rs. 1 lakh or 5% of the total donations, whichever is higher.
The donations made to charitable trusts can also be exempt from tax, as per the conditions under Section 80G. Taxpayers can claim deductions of 50% or 100% of the amount they donate, the exact percentage depends on the type of trust.
How to Maximize the Tax Benefits of Trust Funds
If you want to make the most of the trust fund tax benefits, you should meet with a tax consultant as the rules governing trusts can be quite complex. A tax advisor can help you understand how you can create and register trusts, and their tax implications, ensure compliance with the relevant laws.
You’ll also receive expert advice about how you can maximise your tax benefits, as these professionals walk you through various tax-saving investments that offer deductions and exemptions under the Income Tax Act.
Conclusion
Trust funds are gaining more and more popularity among HNIs as they offer many advantages like trust fund tax benefits, easier wealth management, and asset protection. They can be an excellent way to go about estate planning, so consult with an investment planner to protect your wealth and ensure it is distributed according to your wishes.
