Chris Thorpe looks at how trusts and inheritance tax interact and how useful they can potentially be.
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For more tips on this important area of property taxation and plenty more tax tips too, please see our recently released guide, How to Use Trusts to Reduce Property Taxes. Save 40% today.
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Trusts can be a very useful planning tool for inheritance tax (IHT) purposes, as well as family and business succession planning.
Tax is only one factor, as preservation of the family silver is another potential advantage of trusts; but they are not necessarily always suitable.
What are trusts?
A trust exists broadly when the legal and beneficial ownership of an asset lies with different people – one person (or up to four people) can be the legal owner (‘trustee’) who holds the asset for the ‘beneficiaries’, with the ‘settlor’ having placed the asset into trust. However, the settlor (or their spouse or minor unmarried children) should not benefit, ideally.
In its purest form, a bare or nominee trust exists where the beneficiaries have an absolute right to income and capital, so HMRC taxes such beneficiaries as if they owned the asset themselves.
With discretionary trusts, as the name implies, trustees have complete discretion as to what happens to income and capital. Trustees are subject to additional rates of income tax (i.e., 45% or 39.35% for dividends), though distributions to beneficiaries come with a 45% tax credit, which is usually refundable; this essentially recycles the income tax paid by the trustees. The tax pool tracks tax paid by the trustees and that reclaimed by the beneficiaries. Not distributing income will prevent those credits from being refunded and after five years, the undistributed income will count as capital for the trustees’ IHT. If income is to be accumulated, limited companies might be a preferable option.
Interest in possession (IIP) trusts exist when (usually) a single beneficiary (the ‘life tenant’) has a right to enjoy the trust asset(s) for life. This can be in the form of income arising from the asset or a right to reside in a property. Once the life tenant dies, the trust usually dissolves, and the asset moves into the absolute ownership of a ‘remainderman’. Income received by IIP trustees is generally subject to a blanket basic rate of income tax (i.e. 20%, or 8.75% for dividends).
What does IHT have to do with trusts?
IHT is potentially chargeable when assets are placed into trust (or, more precisely, when assets become subject to the ‘relevant property’ regime). Chargeable lifetime transfers and ‘exit charges’ apply when assets go into and out of trusts respectively, and exit charges are at a maximum rate of 6%. Capital gains tax (CGT) need not be paid as ‘holdover relief’ is normally available. These trusts are also subject to IHT charges every ten years.
Relevant property trusts consist of discretionary and those IIP trusts settled in lifetime; IIP trusts set up before 22 March 2006, or in a will, are not subject to these charges; rather, their assets are treated as being owned by the life tenant for IHT purposes, so transfers in are potentially exempt transfers (PETs).
The fact that relevant property trusts have their own nil rate band (NRB) means they are another person as far as IHT is concerned. After seven years, an asset placed into trust is generally outside a settlor’s personal estate for IHT purposes – this means they can gift an asset but (if they are a trustee) not completely lose control of what happens to the assets.
Other benefits of a trust
As well as the benefit of another NRB for IHT and of holdover relief for CGT purposes, insulating the beneficiaries from legal ownership of the asset can potentially provide protection from divorce settlements, care assessments, beneficiaries’ own financial profligacy or inexperience, or family disputes as to who gets what. As well as being another person with an NRB to assist with estate planning, a trust can be a secure ‘cupboard’ for the family silver, ensuring it stays in the family and survives multiple generations.
Practical tip
Families should consider what their overall aims are: asset protection, saving tax, or a bit of both. Trusts can potentially be very useful but are not always appropriate, so the family’s wishes would need to be considered carefully.
