The tax implications of Trusts
What is a Trust and why would you have one?
A Trust is a legal arrangement between a ‘Settlor’ and ‘Trustees’. Trustees hold certain assets which previously belonged to the Settlor and use those assets to benefit one or more of the ‘Beneficiaries’.
The details of the arrangement are contained in a legal ‘Trust deed’ document which names the people involved and sets out the terms of the Trust. Trusts may be established while the Settlor is alive but can also be created through a Will.
There are a number of reasons to set up a Trust. It can provide flexible, financial protection for those important to you, making sure that value passes to the people you want it to. It can also benefit future generations in a tax efficient way.
Tax benefits of a Trust
Although some of the tax benefits of Trusts have been reduced in recent years, they are still a useful vehicle for protecting value for the family.
Commonly, Trustees are trusted family members or friends of the Settlor but they can also be professionals such as solicitors or accountants to ensure all decisions are made in the best interests of the Beneficiaries.
A Trust can have a maximum of four Trustees and a minimum of two. It is possible to run a Trust with only one Trustee, but usually they can only carry out administrative duties such as day to day management. If distributions of income or capital are going to be made then there should always be two Trustees capable of acting together.
Normally, the Trustees will act unanimously.
Trustees are the legal owners of the Trust assets. Their role is to:
- deal with the assets according to the Settlor’s wishes, as set out in the Trust deed, Will or letter of wishes
- manage the Trust on a day-to-day basis and pay any tax due
- decide how to invest or use the Trust’s assets.
If the Trustees change, the Trust will still continue. However, there always has to be at least one Trustee. If the Trust has no living Trustees the Beneficiaries may have to resort to the court to get a new Trustee appointed.
But, if a sole Trustee dies without appointing a successor it will not be possible to manage the Trust fund until the executor of the Trustee obtains a grant of probate and is able to take over the Trusteeship. For this reason we always recommend that at least two Trustees are appointed at any given time.
A Beneficiary is anyone who benefits from the assets held in the Trust.
The beneficiaries are defined in the Trust deed and can be named individuals or classes of beneficiaries such as my children and grandchildren. The beneficiaries can include a spouse or a whole family.
Each Beneficiary may benefit from the Trust in a different way. For example, a Beneficiary may benefit from the income or the capital, or both.
In some cases, the Settlor may also be a Beneficiary of the Trust. These are known as 'Settlor Interested Trusts'.
ExampleGrandparents set up a Trust for their grandchild. They contribute £312,500 cash into the Trust and it is invested into a property producing rental income of £12,500 a year (a 4% return). The Trust would pay tax of: £12,500 at a rate of 45% = £5,625 The Trustees (the grandparents) agree to make a distribution of income of £6,250 to the grandchild to help pay school fees. The Trust is treated as paying out £6,250 net of 45% tax: Gross distribution = £11,364 Refundable tax credit at 45% = £5,114 Net distribution = £6,250 Assuming there is no other income, the tax on the grandchild is nil, based on the distribution of £11,364 as it is less than the personal allowance. In addition the grandchild is entitled to an income tax repayment of £5,114 In total, the grandchild will receive £11,364. |
Types of Trust
There are several different types of Trust and they each have their own tax implications. The most common types are Bare Trusts, Discretionary Trusts and Interest in Possession Trusts.
A Bare Trust gives the Beneficiary an immediate and absolute right to both the capital and the income.
Although the assets are held in the name of a Trustee, they have no discretion over what income to pay the Beneficiary. Essentially, the Trustee is a nominee in whose name the assets are held, with no active duties to perform.
This Trust exists when a Beneficiary has a current legal right to any income from the Trust as it arises. Often these Trusts are set up in a Will, to benefit a surviving spouse.
The Trustees must pass all of the income received, less any Trustees’ expenses and tax, to the Beneficiary.
The capital will usually pass to a different Beneficiary, or Beneficiaries, at a specific time in the future or after a specific event.
This Trust is effective where couples are concerned about protecting assets for their children. This could be in cases of remarriage, where there are children from an earlier relationship or where there are concerns over the ability of the surviving spouse to handle the assets.
The surviving spouse is able to benefit from the income arising from the assets allowing them to enjoy the same standard of living during their lifetime, without access to the capital of the Trust fund. This is protected for the Residuary Beneficiaries (usually the children) who will become entitled on the death of the second spouse.
The settlement of the assets on first death does not trigger a charge to IHT. This can also mean that the ‘nil rate band’ is preserved and therefore able to be passed to the surviving spouse. Although the assets then form part of the estate on second death, this is only for the purpose of calculating IHT. The Trust assets pass in accordance with the terms of the Trust, not the will of the surviving spouse.
Inheritance Tax
There are a number of circumstances in which IHT may become due for a Trust.
Setting up the Trust
If a Settlor transfers assets worth more than the ‘nil rate band’ (currently £325,000) into a Trust, the excess above the limit can be charged to IHT at 20%.
Ten year anniversary
A Trust has a charge to IHT every 10 years on the anniversary of its creation. A 10 year anniversary charge will be applicable if the value of the Trust is in excess of the nil rate band available at the date of the charge.
The value of the Trust is calculated on the day before the 10 year charge and is the market value of any Trust assets less any debts and reliefs such as Business Relief or Agricultural Property Relief. It also includes the initial value of any other Trusts created by the Settlor on the same day.
Interest in Possession Trusts set up before 22 March 2006 are not subject to these 10 year anniversary charges unless assets have been added to the Trust after this date.
Exit charges
IHT may be due when assets are transferred out of a Trust (known as 'exit charges') or when the Trust ends.
Income Tax
Trusts are subject to different rates of income tax depending on the type of Trust.
Discretionary Trusts
From 6 April 2024, where a Discretionary Trust receives income of £500 or less, it may be treated as a ‘Low Income Trust’. The rules deem these trusts to have net income of £nil and therefore the Trustees may not be required to submit a self-assessment tax return to HMRC.
Where more than one trust created by the same Settlor exists in a tax year, the £500 limit is split equally amongst the trusts, subject to a minimum of £100 per trust.
Where a Discretionary Trust receives income over £500, the income will be taxable at the additional rate of tax being 39.35% for dividend income and 45% for savings and non-savings income.
When income is paid out to a Beneficiary, there is a 45% tax credit attached to it. If the Beneficiary only pays tax at the basic rate, they can claim a refund of any excess tax on their Self- Assessment tax return for the year.
Interest in Possession Trusts
Interest in Possession Trusts may also be treated as ‘Low Income Trusts’, where they receive income below £500, subject to the number of trusts in existence that were created by the same settlor.
Where an Interest in Possession Trust receives income over £500, the income is taxed at the basic rate of tax, i.e. 8.75% on dividend income and 20% on all other income. If the Beneficiary pays tax at the higher rate, there will be additional tax to pay through their Self-Assessment tax return.
Sometimes the Trustees mandate income to the Beneficiary. This means it goes to them directly instead of being passed through the Trustees. If this happens, the Beneficiary will include this income directly on their Self-Assessment tax return.
