Chapter 3: Legal concepts and considerations relevant to financial advice Flashcards
Chapter 3: Legal concepts and considerations relevant to financial advice
NUMBER OF QUESTIONS 9
Main areas covered are the legal aspects of contract, agency and owner ship.
Legal status
KEY FACTS
With a sole trader, the law does not distinguish between the individual running the business and the business itself. As far as HMRC are concerned, they are one and the same.
Sole traders pay income tax on their profits, plus potentially both Class 2 and Class 4 NICs.
They are one man/woman bands, responsible for all areas of their business, but they may also have employees.
Partnerships pay income tax on their profits, plus potentially both Class 2 and Class 4 NICs. In the traditional model, each partner is ‘jointly and severally liable’ for any partnership debts.
There are countless examples of partners absconding abroad and leaving remaining partners to pay off any outstanding debts!
Companies pay corporation tax on their profits, including gains, plus NICs.
NICs are broken down into employer and employee Class 1 contributions.
Summary of legal concepts
- There are three generic types of legal person, from a business perspective: sole-trader, partnership, and limited company
- A sole-trader is responsible for income tax on profits, and Class 2 and 4 NICs
- Partnerships can be traditional or limited liability
- Each partner is responsible for income tax and NICs on their profit share
- An LLP limits liability to partnership assets, much like a limited company
- A limited company has its own legal status. It is registered at Companies House and must have documents such as Articles and a Memorandum of Association
- Business Relief could be available to protect shares in a private company from inheritance tax
- A public limited company is one that has been floated on the stock exchange, and has offered at least 25% of its ordinary share capital for sale to the general public
- Both private and public limited companies pay corporation tax on their profits, including gains
Insolvency and Bankruptcy
KEY FACT
An individual
can declare themselves, or be declared, bankrupt.
Companies
become insolvent, go bust, or are in default.
The relevant parties are a debtor, who owes monies and a creditor, to whom monies are owed.
Debt procedures
2 key pieces of legislation are the Insolvency Act 1986 and Enterprise Act 2002.
Together they provide criteria for when bankruptcy can be initiated and the structure that debt procedures followed on next card.
Debt procedures Cont…
- Petition to the court
• A creditor (or group of creditors) can ‘present a petition’ to the courts, as long as:
• The creditor is owed at least £5,000
• A ‘demand for payment’ has not been met within three weeks (21 days) - Official reciever
• Once the courts accept the petition, an official receiver is initially appointed
• The official receiver:
- Takes control of the debtor’s property
- Gathers details of all the debtor’s assets and liabilities
- Sends a report to creditors if required
- Decides whether a creditors’ meeting should be called, so that they can appoint an
insolvency practitioner to act as the ‘trustee in bankruptcy’ - Trustee in Bankruptcy
• All assets owned by the debtor, at the time of bankruptcy, pass to the trustee, with
the exception of:
• Tools of the trade, a vehicle if required for business, clothing, bedding etc
• Pensions could also be used. This depends if they are in payment or not
•The main function is to sell the debtor’s assets and distribute the money to creditors,
using a set order (as per the Insolvency Act 1986)
•the debtor’s financial situation will be reviewed annually
The order in which creditors are paid is:
- Bankruptcy costs - all the fees of the official receiver, trustee in bankruptcy, the courts
- All preferential creditors – such as missed wages, accrued holiday pay, pension contributions and
any secured borrowing i.e. mortgages - Unsecured creditors -all other creditors not classed as preferential
KEY FACT
At this point it’s worth pointing out that, a when a court is considering a creditor’s petition, they will look at how many assets the potential bankrupt has.
If there is enough money to pay everyone, the court would usually refuse the petition, as more ‘normal’ debt-recovery processes would be more appropriate.
This means that, in most bankruptcy cases, funds are tight and not much cash filters down to unsecured creditors.
This is another reason why unsecured debt is more expensive for the borrower.
In Summary
• Bankruptcy relates to individuals and insolvency relates to companies
• An individual must owe at least £5,000 to creditors to be declared bankrupt
• There are set procedures that must be followed for both
• Creditors are unlikely to receive all monies owed to them
• Bankruptcy will have serious credit consequences for an individual
Laws of contract, capacity and agency
Contract Law
Key legal concepts in relation to any contract that must be adhered to, for the contract to be valid.
For a contract to be legally binding, some of the main conditions:
Offer - An Offer must be exist
Acceptance - The offer must be accepted
Intention - There must be an intention to contract
Offer and acceptance
There are three parties to a life insurance contract:
- The proposer- The individual(s)/company applying for cover
- The life assured- the person(s) on whose death the policy will pay out
- the life office- the insurance company.
KEY FACTS
The legal offer is completion and submission of the proposal or application form.
Legal acceptance is when the applicant agrees to be bound by the contract terms and conditions by giving consideration, so by payment of a premium.
Payment of policy premiums is consideration on behalf of the applicant/proposer.
Payment of benefits is consideration on behalf of the policy provider.
Who automatically has insurable interest?
There are 6 situations where insurable interest is automatic
- On your own life
- On your spouse or registered civil partner (RCP)
- An employer on their employee
- A mortgagee on a mortgagor (lender and borrower)
- A creditor on a debtor
- Between business partners
Capacity to contract
Some people do not have the capacity to contract such as minors, low mental capacity and drunks
Any contracts taken out by minors will be one of the following:
Binding:
These are enforceable if they are to benefit the minor, such as a contract of employment/apprenticeship
Binding unless repudiated:
These are contracts that the minor can effectively back-out of prior to, or within ‘a reasonable time up to and after their 18th birthday (this is known as ‘during minority)’. Rent agreements are one such contract.
Non-Binding:
This is effectively all other contracts.
Laws of contract, capacity and agency Summary
- There must be an offer, acceptance and intention to contract for a contract to be legally binding
- An individual must have the capacity to contract
- This is not present if the individual is under age 18, or mentally incapacitated (including being drunk)
- All material facts must be disclosed
- This applies to both applicant and provider
- Insurable interest means the assured has a financial • • interest in the life assured
- The law of agency applies to advisers and their clients
- An IFA is an agent of the client
- Single and multi-tied advisers are agents of their providers
- This can lead to some interesting situations in relation to non-disclosure
3.3 Property ownership
3 ways to hold a property under UK law, Freehold, Leasehold and Commonhold
Freehold
• The building and the land are owned by the individual(s) ‘in perpetuity’, until they either sell on or die
• This is common on residential houses in England, Wales and Northern Ireland
Leasehold
- The land is owned separately, and not by the owner of the property ‘bricks and mortar’
- The purchaser buys the property and ‘leases’ the land, often on a long-term lease such as 999 years, from another individual who owns the freehold (freeholder)
- Shorter-term leases could be in place, especially on London leasehold properties
- The property owner pays a rent to the freeholder
- At the end of the lease, both the land and property on it revert to the freeholder unless the leaseholder(s) purchases the freehold
- If leaseholders wish to purchase the freehold, at least 50% of the leaseholders must agree.
Commonhold
- Introduced by the Commonhold and Leasehold Reform • Act 2002
- This came about due to city centre flats becoming more common in cities such as Manchester, Leeds and London
- The flats are owned by the purchaser in perpetuity (like freehold) and the owners are members of a Commonhold Association
- This association owns the land, the building and the common parts (gardens, entrance halls, staircases or lifts) and each member has a vote
- A management company often provides maintenance for these common areas, and is paid for by the association’s members
3.3.2 Mortgage finance decisions
KEY FACT
A minimum of 50% of leaseholders must be agreement to be able to jointly purchase a property freehold.
They must have lived in the property for a minimum of two years and there must be at least 21 years left on the lease.
3.3.3 Joint Ownership
Can be done in 1 of 2 ways: Joint tenants or Tenants in common
Joint Tenancy
It means that each tenant has an equal share of the
property and when one dies, the survivor(s) inherit the deceased owner’s share.
ALSO
no one tenant can sell without the agreement of the other(s).
Tenancy in common
Each party owns a separate share. When one party dies, their share forms part of the deceased individuals estate. They can also share their share at any point.
Property ownership Summary
- There are three forms of property ownership; freehold, leasehold and commonhold
- Leaseholders can buy a freehold if at least 50% of them are in agreement
- Under a commonhold basis, a Commonhold Association exists, and all unit-holders are members
- A property can be held either as joint tenants or tenants in common
- On death, a joint tenancy is not dependent on wills and probate, and it will solely pass to the survivor
- On death under tenants in common, the deceased’s share will pass into their estate and be distributed according to their will or the laws of intestacy
- Government assistance is /was available in two ways: equity loans or a mortgage guarantee scheme
- 4 Financial agreements
- 4.1 Powers of attorney
A power of attorney is a legal document, drawn up and agreed between 2 individuals:
The donor; who creates the power (remember ‘or’ usually relates to the ‘doer’)
The attorney; who is granted powers by the donor, such as the ability to make financial and/or welfare
decisions on their behalf
They provide powers either generally or specific to different areas. Examples include:
General Power of Attorney
• Ability to transact as if you were the donor, used for general banking, buying and selling investments, or
paying bills
Enduring Power of Attorney (EPA)
• Largely replaced by the Lasting Power of Attorney, but any arranged before their introduction are still
valid
Lasting Power of Attorney (LPA)
• Introduced by the Mental Capacity Act 2005. These widened the scope of the Enduring Power and cover
either health and welfare, property and financial affairs or both
KEY FACT
There can only ever be one donor, but it is common to have more than one attorney.
For example, a parent may create a power as the donor, appointing both their children as
attorneys.
A Lasting Power of Attorney is registered with the Office of Public Guardian (not the Court of Protection) immediately, i.e. not at the point of mental incapacity.
This helps to remove some of the challenges that EPAs often encounter.
There are two elements that can be included in an LPA:
• Health and welfare: covering long-term care wishes and extending to giving or refusing consent for medical treatment
• Property and financial affairs: largely the same as those carried out under an EPA
If covering both elements, separate documents are required.
Financial agreements Summary
• There are three powers: general, enduring and lasting
- There are two parties to a power: donor and lasting
- An LPA is revoked:
- on the donor death, bankruptcy or if they change their mind
- on the attorney’s death, bankruptcy or incapacity
- if the marriage or civil partnership of the two parties ends
3.4.2 Wills & Intestacy
When an individual dies, they do so either testate or intestate.
Testate means they have died with a valid will.
Intestate means they have died with no will, or it was
invalid.
When a beneficiary becomes the new owner
of an asset, they are deemed to have ‘succeeded to the asset.
If a will is in place, the main steps to be carried out on death of the individual are:
1) Prove the Will
The executors ‘prove the will. The death is registered (in England with the Probate Registry, in Scotland with the Local Sheriff’s Court). You will be tested on English law.
2) Complete HMRC accounts
The executors complete an HMRC return, highlighting all assets plus any gifts in the past seven years. HMRC will calculate any inheritance tax due. This is usually where the estate, plus any gifts in the previous seven years, exceed the nil rate band of, currently, £325,000.
Any tax due must be paid before probate will be granted.
3) Receive probate
Once any outstanding tax is paid (if applicable), a Grant of Probate (England) or Grant of Confirmation (Scotland) is issued.
The Grant is the licence for personal representatives to deal with the deceased’s affairs and estate.
4) Distribute the estate
When the grant has been received, the estate can be distributed in line with the deceased’s will and their legally documented wishes.
Will Validity
There are strict rules in relation to a will and its validity. It will only be valid if:
• It is in writing. This can be printed, typed or personally handwritten
• It is signed by the testator (initials or an ‘X’ are fine)
• A person acting in the testator’s presence, acting under instruction, can sign if the testator is not able to write, because of illness for example
• The signature must be witnessed by two or more people, who are present when the will is signed
• This is known as attestation and must also be witnessed by the testator
Changing a will
Often, an individual testator may wish to change the provisions in their will or cancel it altogether. This is
known as revocation of a will.
Actions that revoke a will are:
Writing a new will
• The act of writing a new will shows a clear intent that any previous wills should be revoked
• The new will often include a statement to the effect that it replaces any previously made wills
Deliberately destroying a will.
• If a will is deliberately destroyed and no new one is drawn up, then the individual will die intestate (without a will)
Marriage or civil partnership
• Entering into a marriage or civil partnership will revoke a will
• Unless the will states that it was made in anticipation of the marriage
• Divorce does not completely revoke a will
-Any bequests to the former spouse will lapse (unless it states otherwise in the will)
- The remainder of the will remains valid
- The appointment of the estranged spouse as an executor will be cancelled
- Best practice, however, would be to write a new will
3.4.3 Personal representatives and the administration of estates
Wills often name executors who are the people empowered with dealing with the deceased’s estate
KEY FACT
There are two grants of representation:
Grant of Probate where there is a valid will
Letters of Administration where the deceased has died intestate
Summary
• An individual can die testate or intestate
• Testate means they died with a valid will:
- The estate will be distributed by executors they appointed
- According to their personal wishes
- Once a Grant of Probate is obtained
• Intestate means the individual died without a will or with one that was invalid:
- Administrators are appointed by the court
- Who then distribute the estate according to the laws of intestacy
- Once a Grant of Letters of Administration is obtained
3.4.4 Trusts
A trust is a means of arranging property for the benefit of other persons without giving them full control over it.
Trust law
The basic rules of trusts are required for your RO1 exam and will be tested.
This means understanding:
• Who the three parties to a trust are
These are the settlor, trustees and beneficiaries. A trust separates out legal ownership from beneficial/equitable ownership. Trustees are the legal owners with beneficiaries being the beneficial or equitable owners of trust assets.
• The fundamentals relating to the most common types of trusts
• How trusts are arranged and amended
3 Parties to a Trust
Settlor
• This is the original owner of the asset, i.e. the person giving up the asset as a gift
• A settlor can also be named as a trustee, to retain an element of control over the asset
• This is very common, and good practice
• A settlor can also be a beneficiary in some cases, however this is unusual
• It is also unwise in tax planning cases, as it will negate any tax advantages of the trust
Trustees
- These are the legal owners of the asset held in trust
- They own the asset temporarily and control the asset for the term of the trust
- They have instruction to pass the asset to the beneficiary in the future
- They must look after it in the interests of the beneficiary
- Trustees must be aged at least 18, of sound mind and not bankrupt, as they are in control of trust assets on behalf of beneficiaries
- There are professional and non-professional trustees
- Non-professional trustees have up to six months to get ‘up to speed’
Beneficiaries
- These are the long-term intended recipients of the asset
- They have beneficial or equitable ownership of the asset
- They can ‘act’ against trustees who do not act in their best interests
- There are many cases where beneficiaries have sued trustees through the courts
- As above, the settlor should not be a beneficiary, as this negates any trust tax advantages
Trust types
The main trusts that tend to be examined in the R01 exam are bare/absolute, interest in possession and discretionary/flexible.
Express
This is generally created by signing a trust deed. It is ‘expressly set out in that someone ‘expresses their wishes’ rather than ‘express’ in the speedy sense.
Implied
The trust is not created expressly but implied as a result of the actions or words of individuals.
Resulting
Comes into existence when another trust fails or can no longer be fulfilled.
Bare or Absolute
This type of trust has a fixed and unchangeable beneficiary. The main trustee duty is to
transfer the property to the beneficiary at a stated age, usually 18.
Technically, a ‘Bare’ trust becomes an ‘Absolute’ trust when the beneficiaries reach age 18.
Another version is a trust based on the Married Woman’s Property Act 1882 where beneficiaries are limited to the settlor’s spouse/children.
Transfers into this trust type are classed as potentially exempt. No inheritance tax (IHT) is due up front, however large the transfer value is. If the settler/donor survives for seven years, the transfer is then exempt from IHT.
Settlements
This is a trust with successive interests e.g. ‘to my wife for life then my children for life then their children’. These are used in order to give a beneficiary an interest in the property whilst alive but not the ability to pass it to someone of their choice This is termed a ‘life interest’.
Successive This is similar to settlements, but different, in that the asset is used for the benefit of several beneficiaries, each with a life interest, until finally passing to a class of beneficiaries in ultimate trust. They are often used for gifts in relation to marriage.
For example, a cautious father may wish to pass an asset to his daughter on marriage. He is quite happy for his new son in law to have a life interest if his daughter dies but ultimately wants to keep the asset in the family so that only his grandchildren inherit the asset, rather
than children from any union that the new son-in-law may enter into.
Power of appointment
The trustees have powers to vary or appoint beneficiaries within a class of beneficiaries stated in the trust. These are very flexible and provide many powers to the trustees. The trust will have a 'gift over' beneficiary who is the person to benefit in situations where no actual appointments of assets are made. This is important as the 'gift over' beneficiary is the one who has an interest in possession' for IHT purposes. A Power of Appointment trust is the standard trust used by many life companies for insurance policies.
Interest in possession
The beneficiary has a present right to income and possibly capital.
The terms ‘life tenant’, ‘remaindermen’ and ‘default beneficiary’ are often used in relation
to an IIP trust.
Trust types CONT…
Discretionary/ flexible
There is no named beneficiary. Appointment of assets is at the discretion of the trustees. No one beneficiary has an interest in possession. This makes it an even better idea for the settlor to also be one of the trustees.
This type of trust, as per its title, gives absolute flexibility as to which beneficiary gets what in terms of the trust’s assets. Transfers are classed as chargeable so there may be some upfront IHT due at a 20% rate if the transfer is above the current nil rate band.
Will
Created by a will and comes into effect at death, a will trust acts on the wishes of the deceased. The key point is that the trust only comes into effect after death, so any assets are still part of the deceased person’s estate at date of death.
It is often used when a will bequest of money/assets is made to a minor so that they can access the funds at age 18.
Statutory
Created by law e.g. to comply with intestacy rules.
Intestacy
Very similar to a statutory trust, but created due to intestacy. For example, an intestacy trust will be created to administer any life interests created by the intestacy rules.
If part of the estate is to go to a child, who has not yet reached age 18, then an intestacy trust will be created. No one can inherit without capacity, so they must be at least age 18.
Pension scheme
The assets of a pension scheme are there for the benefit of their members, so pension scheme trusts are common. Occupational pensions are set up subject to an irrevocable trust, whereas personal pension schemes will use irrevocable or scheme-specific trusts.
