A Simple Guide to Trusts

Background

A Trust offers a flexible way of passing property to others without giving them full access to all the capital, and possibly all the income. The assets in a Trust are owned and controlled by Trustees, whereas the benefit of the assets is enjoyed by beneficiaries.

A Trust is often created for Inheritance Tax or wealth planning reasons.

A Trust can be created by an individual either during their lifetime or on death via their Will.

Trustees would be appointed to manage the Trust. With regards to lifetime Trusts, the individual creating the Trust (the “Settlor”) can be a Trustee, if they wish.

The Trustees control what happens to the Trust’s assets and income on a day-to-day basis. This means that if the Settlor is a Trustee, they can retain some control over the Trust assets during their lifetime.

The beneficiaries are typically the Settlors’ family, being adult children and grandchildren and their remoter issue. However, the categories of beneficiary can be extended beyond these groups. In some circumstances the spouses and partners of these individuals are excluded. The purpose of this is to ensure the assets within the Trust are protected as far as possible from any relationship breakdowns allowing the assets to benefit the immediate family.

A Trust structure can also protect assets from bankruptcy which is another reason why individuals like to put potentially valuable assets into a Trust.

There are many different types of Trust. This note focuses on the two main types of Trust, an Interest in Possession Trust (“IIP”) and a Discretionary Trust. You will need to seek professional advice prior to creating a Trust to confirm which type of Trust is most suited to your objectives.

With an IIP one or more beneficiaries are entitled to the income of the Trust or they may have an entitlement to reside in the property owned by the Trust for their lifetime.

With a Discretionary Trust, none of the beneficiaries are entitled to anything. Any benefit is granted at the discretion of the Trustees, although the Settlor can leave a Letter of Wishes giving notice of how they would like the Trust assets to be used after their death.

Tax implications

A Trust is a separate structure for the purposes of taxation. A special tax regime applies to Relevant Property Trusts which would typically include IIP Trusts created by an individual during their lifetime and Discretionary Trusts. The following comments assume that the Settlor or their spouse or civil partner cannot benefit from the Trust during their lifetime. There are also special rules where a Trust is created by a parent for a minor child which are not considered in this note.

Inheritance Tax

For lifetime gifts into Trust, the maximum value which can be transferred into a Trust without incurring a lifetime Inheritance Tax charge is £325,000 per individual Settlor. Value transferred in excess of £325,000 will result in a lifetime Inheritance Tax charge at a rate of 20% unless specific Inheritance Tax reliefs are available. Relief would normally only apply to certain qualifying business property or agricultural property.

A gift into Trust will not form part of an individual’s Inheritance Tax estate if they survive the gift by more than 7 years, potentially removing considerable value from their Inheritance Tax estate which would otherwise be taxed at a rate of 40% on their death.

Any increase in value to the asset given away after the transfer will be outside of the individual’s estate from the date of the gift. This means there can be considerable savings where an asset is transferred into a Trust which later increases significantly in value (for example, with land or buildings because planning permission is granted).

Ordinarily the value of the assets held within the Trust are not subject to Inheritance Tax on anyone’s death, but instead a small Inheritance Tax charge arises every 10 years (a maximum of 6%) on the value of the Trust assets over and above the Inheritance Tax Nil Rate Band at that time. There are also “exit charges” on capital distributions made from the Trust.

Where the Trust created confers an Immediate Post Death Interest (“IPDI”) on the beneficiary the value of the Trust property is not subject to the Inheritance Tax charges mentioned above. Instead, the value of the assets comprised in the IPDI will be included in the beneficiary’s estate for IHT purposes. The Trustees will be responsible for the proportion of any resultant IHT that relates to the Trust’s assets. This type of Trust is typically created under an individual’s Will.

Income Tax

Typically, the types of income generated by a Trust would be property income, interest, dividends from UK resident companies, and dividends and interest from overseas sources.

With an IIP Trust, ultimately the income is charged on the beneficiary at his personal rates, regardless of when and whether the income is paid over to him. Income Tax is currently charged at rates up to 45%. Typically, the Trust income is “mandated” to the beneficiary whereby the income is treated as arising directly to the beneficiary which reduces the tax compliance burden for the Trustees.

A Discretionary Trust is subject to the highest rates of Income Tax. Based on current rates, property and interest income received by this type of Trust would be taxed at a rate of 45%. Dividend income would be taxed at a rate of 38.1%.

However, where income generated from the Trust’s assets is distributed to the beneficiaries then a tax credit can be claimed back by them for the tax paid by the Trustees. A beneficiary who has little, or no, other income could therefore potentially claim back the tax credit in full resulting in no overall Income Tax being payable. This can therefore be extremely tax efficient.

Capital Gains Tax

A gift into a Trust during an individual’s lifetime is a disposal at market value for Capital Gains Tax purposes. A benefit of transferring an asset into a Trust rather than making an outright gift is that Holdover Relief can be claimed on gifts into Trust to defer the capital gains arising.

There are no immediate Capital Gains Tax consequences when assets are left to a Trust on death.

A Trust will also pay the highest rate of CGT being 20% on non-residential property or 28% on residential property, depending upon the asset being disposed of. A Trust has half of the CGT Annual Exemption, currently £6,150 for 2020/21. The Annual Exemption available to a Trust is restricted where the Settlor makes multiple settlements on the same day.