Trusts and inheritance tax

October 7th 2024

Trusts can be an extremely useful planning tool for inheritance tax purposes, as well as for family and business succession planning. Partner Christiaan Hansen looks at how trusts and inheritance tax interact as well as outlining the issues and benefits.

Tax is one benefit, but preservation of the family assets is another potential advantage of trusts, however they are not always suitable.

What are trusts
Broadly speaking, a trust exists 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 these beneficiaries as if they owned the asset themselves.

With discretionary trusts, 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 trusts (IIP) exist when, usually, a single beneficiary or 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 these trustees is generally subject to a blanket basic rate of income tax (i.e. 20%, or 8.75% for dividends).

IHT and trusts
IHT is potentially chargeable when assets are placed into trust or 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 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. Instead, 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 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.

IN SUMMARY
As well as providing the benefit of another nil rate band 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 inexperience or family disputes about who gets what. As well as being helpful with estate planning, a trust can provide a secure location for the family assets, ensuring that it stays in the family and survives multiple generations.

Trusts can potentially be very useful but are not always appropriate, so a family’s wishes should be considered carefully. Families should consider what their overall aims are, whether this is asset protection, saving tax, or a combination of both.

If you are considering trusts and have questions on inheritance tax and other related tax implications please do contact us and one of the Team will be happy assist with you further.

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