In this article
- When are trusts useful?
- Types of family trusts
- Tax benefits: inheritance tax
- Income tax and trusts
- Capital gains tax and trusts
- Further help
Trusts provide a way of giving away assets, but they give them to trustees to look after on behalf of the beneficiaries – rather than directly to the beneficiaries themselves.
The person creating the trust and providing the assets is the settlor. The trustees (individuals or a trust company) become the legal owners of the assets and look after them, according to the terms of the trust deed and trust law.
The beneficiaries benefit from the trust assets, either by right or at the trustees’ discretion, and from the income the trust produces, the trust capital or both.
When are trusts useful?
Historically, trusts have been created for asset protection – either to protect a potentially spendthrift beneficiary from themselves (with care they may be helpful in divorce or bankruptcy), or to look after the funds for those incapable of doing so because of age or medical reasons.
For example, rather than putting a large sum into a bank for a child to spend on whatever they like at 18, funds can be put into a trust instead. The trust invests and holds those funds until the trustees are happy the beneficiary can manage them.
Trusts can also help with estate planning. For example, grandparents might want to pay their grandchildren’s school fees. One option is to put funds into a trust for their grandchildren now. For inheritance tax (IHT) purposes, this means the gift is today, but the trustees can then use the funds over the following years for school fees.
In this scenario, the grandparents have made a substantial early gift, which is ignored for IHT purposes after seven years – rather than a series of ongoing gifts, each with a seven-year gift period.
Trusts can also be helpful on death as, rather than having to choose to whom to leave a large estate, the assets can be put into a trust. This provides flexibility as to who benefits and when, without adding to anyone’s personal IHT estate.
Types of trust
There are now three main types of ‘family’ trust:
Immediate post-death interest (IPDI) trusts
Created on death, the beneficiary has a lifetime right to the trust income. The capital is often distributable at the trustees’ discretion. An IPDI is different from other trusts because, for IHT purposes, the assets are aggregated with the beneficiary’s estate. IHT is charged on the beneficiary’s personal assets, and the trust assets are added together upon their death.
This type of trust can be useful purely as protection for the beneficiary. Where the beneficiary is a surviving spouse, the spouse exemption for IHT applies as if they had been left the asset outright. They can also ensure that eventually, assets pass to, say, the children of the first deceased rather than any new family a surviving spouse may acquire.
Interest in possession trusts (IIP)
Also known as a life interest trust, an IIP gives a beneficiary a right to the trust income but is created in a lifetime. However, the trust assets are not part of the beneficiary’s estate (unless created before March 2006), and the trustees pay their own IHT charges every 10 years.
While the trustees have no discretion over the trust’s income, they generally have discretion over paying out the capital.
Discretionary trusts
Here, the trustees pay both income and capital entirely at their discretion, providing the most protection. As with a new IIP trust, the trustees pay their own IHT, so the assets are not chargeable on anyone’s death.
Non-family and specialist trusts include employee ownership trusts, pensions, insurance products and IHT planning products like discounted gift trusts – which we cover in other Shipshape articles.
One further non-family trust is a charitable trust. This is another way of setting aside a significant amount now for use in the future, either as an ongoing annuity for specific charities (where funds can be released over time or on certain events), or as a family charity legacy for use in the future.
Tax benefits – inheritance tax
While a trust’s primary use is for asset protection, there are also several tax advantages.
For IHT purposes, creating a trust in one’s lifetime can enable a significant gift to be made and earmarked for beneficiaries now. This, in turn, starts the seven-year clock running.
A lifetime gift into a trust is an immediately chargeable transfer. This means there is a 20% charge to IHT if the gift is above the settlor’s available nil rate band of up to £325,000. It also means that a married couple could settle trusts worth £650,000 every seven years and, over time, put aside a sizeable sum that will escape IHT on their death.
A trust suffers IHT at up to 6% on the value of the assets above the nil rate band every 10 years. However, it should be noted that with no change in the value of the assets, it would take over 60 years for the IHT paid by the trust to be equivalent to the 40% suffered on a death.
Some people are happy to contribute more than £650,000 and suffer the 20% initial charge on that gift, but this should be limited to very high-value estates and those where it is clear the assets will likely rise in value and not be needed by the settlor/s in later life.
It’s also worth noting that assets that qualify for IHT relief do not suffer this entry charge. For example, unquoted company shares that qualify for Business Relief for IHT purposes can be put into a trust at any value without any initial charges.
Some other tax advantages of trusts
We cover the other tax advantages of trusts in more detail in other Shipshape articles, but in summary:
Income tax
Trusts are generally neutral for income tax purposes. An IIP or IPDI trust pays tax on its income at basic rates, and the beneficiary then reports all the income on their return with a credit for the tax paid by the trust.
A discretionary trust pays income tax at the highest rates, but when a distribution is made, it attaches a 45% income tax credit. So if the beneficiary is only a 20% taxpayer, they can recover 25% of the tax. If used for school fees, and the child is a 0% taxpayer, they can recover the whole tax within their personal allowance.
In an attempt to simplify the taxation of trusts (and estates), from 6 April 2024, income of all types up to £500 will not be subject to income tax. Self-assessment tax returns will also not be required. Income over £500 will be taxable in full. This limit is reduced proportionally when a settlor has established more than one trust.
Capital gains tax (CGT)
When a trust is created, provided it is not ‘settlor interested’, any gains on assets added to the trust can be ‘held over’. No gain arises, and the trustees take the asset at the same base cost as the settlor. Therefore, cash is not required to settle a trust. Settling shares or property into a trust under holdover can be beneficial, so no CGT arises – although it is passed on to the trustees to pay in the future.
As with IHT, this enables a gift to be made without incurring a significant upfront tax charge in a protected environment. Trustees pay CGT in the same way as individuals but at the highest rates, currently 20% and 24%.
Can we help?
Trusts come with set-up costs and may require ongoing work to prepare accounts and annual tax returns, but they can be a very powerful and beneficial tool if used correctly.
Be aware that The Chancellor has announced an Autumn Budget for 30 October 2024, and this may include tax changes relating to trusts, inheritance tax and CGT.
At Shipleys, we can provide trust and estate planning advice, arrange for a trust to be created and provide ongoing guidance. For will trusts, we can arrange a suitably worded will to be drawn up to create a trust on death and offer probate services and trust services.
More details on trusts and estates can be found here on the Shipleys website.
Specific advice should be obtained before taking action, or refraining from taking action, in relation to this summary. Please talk with your usual Shipleys contact or get in touch with one of our specialists shown on this page.
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