Inheritance tax (IHT)
Other than for some limited exceptions, if you transfer an asset into a trust during your lifetime, it will be immediately subject to inheritance tax at 20% to the extent that the value of the asset being transferred (when added to any similar transfers made in the previous seven years) is more than £325,000 (the nil-rate band). There will be no further IHT to pay from your estate as long as you survive 7 years from the date of the gift and providing that you are not a possible beneficiary of the trust.
If the value of the assets held within the trust increases and/or they produce income which accumulates within the trust over a period, the value of the growth and/or income will immediately fall outside of your estate, again so long as you are not a potential beneficiary.
Once every ten years the trust is in existence, there is an anniversary charge to IHT at a maximum rate of 6%. This is charged on the total value of the trust to the extent that it exceeds the then nil-rate band reduced by any gifts chargeable to IHT made by the donor in the seven years prior to transferring the assets to the trust and by any capital distributions made from the trust in the past ten years.
When assets are distributed from the trust, there is an exit charge on the value of the assets transferred based on the previous ten-year anniversary rate but recalculated taking into account the nil-rate band at the date of the distribution and reduced proportionately to reflect the time passed from the last ten-year anniversary.
Generally, a transfer of an asset into a trust on death will be chargeable to IHT. If the combined total of the non-relieved assets of the estate passing to non-exempt beneficiaries and any lifetime gifts made within the 7 years before death is less than £325,000 (up to £650,000 for a married couple or civil partners), no IHT will be payable.
For wills incorporating a life interest trust, the position is the same unless the beneficiary entitled to the income (known as the life tenant) is a surviving spouse or civil partner in which case there is no IHT due. During the lifetime of the trust, the life tenant is treated as being entitled to the underlying capital for IHT purposes and is therefore treated as making a transfer of that capital on his or her death or on a transfer out of the trust to other beneficiaries during lifetime.
Discretionary will trusts have the same tax regime of ten-year anniversary and exit charges as lifetime trusts.
Capital gains tax (CGT)
When assets are placed into trust in lifetime, they are treated as though they have been disposed of at market value, but any gain can be deferred so that no CGT arises until the asset is eventually disposed of in the future. The deferral is only possible provided that the person who set up the trust, their spouse/civil partner and minor children are not potential beneficiaries.
Any gains arising on trust assets are reduced by an annual exemption of £6,150 (2020/21) divided equally by the number of trusts set up by the same individual in existence in the relevant tax year. The remaining gains are taxed at 20%, unless the gain is on a residential property interest (where the rate would be 28%).
Life interest trusts
The trustees of a life interest trust are taxed at 7.5% on dividend income and at the basic rate (20%) on other income received prior to paying it to the life tenant. The trustees are not liable to tax at higher rates.
The life tenant can reclaim the tax paid if they are personally not liable to tax. If they are a basic rate taxpayer, they will have no further liability. If the life tenant is a higher or additional rate tax payer, they will have an additional liability up to their own marginal tax rates.
If income is paid direct to the life tenant they pay tax at their own marginal rate and the trustees have no tax liability.
Income generated by assets held within a discretionary trust is chargeable to income tax at 45% on non-dividend income. Dividend income is charged at the dividend trust rate of 38.1%. The first £1,000 of trust income is taxable at 20% or the dividend rate of 7.5%, although the 45% rate will still apply to any distribution of the income out of the trust.
On income being distributed from the trust by the trustees, the tax paid is potentially reclaimable by the beneficiaries.
‘Tax privileged’ trusts
Assets which are held within a charitable trust do not attract any IHT, CGT or income tax liability. Some trusts set up for disabled beneficiaries benefit from a favourable tax regime if the necessary requirements are met.
It may be that setting up a certain type of trust would be suitable in light of your own personal and financial circumstances. For instance you may wish to protect any assets you give your children in the event they go through a divorce or bankruptcy. You may simply want to withhold certain assets until you feel your children are at an age to deal with such assets responsibly. A trust can also provide flexibility, which in turn opens up a number of useful tax planning opportunities.