Tax planning with trusts

2 May 2018

Trusts continue to be a useful way to plan individual’s estates and to save tax for the family.

How is a trust created?

Every person who can hold and dispose of property, or an interest in property, can create a trust in respect of it.  The person creating the trust is called the settlor. A trust is usually created by the settlor with a trust deed but may also arise from a will.

Does the settlor have to pay tax?

Assets transferred into a trust during an individual's lifetime may result in a chargeable gain arising on that individual, with any Capital Gains Tax (CGT) payable by 31 January after the tax year of transfer.

There are important CGT reliefs available, such as on the transfer of business assets or where a transfer is subject to an immediate Inheritance Tax (IHT) charge (which is the case for most transfers into trust), even if the IHT rate on that transfer is nil.  Transfers of assets to trust on death will not result in a CGT charge, as on death all assets receive a tax-free uplift to the market value at this date.

If the value of the transfer (reduced for reliefs for agricultural or business property) exceeds the settlor's nil rate band for IHT purposes, either in the lifetime for a transfer to a trust within the relevant property regime or on death, an IHT charge arises.

Where the value of the assets transferred to a trust during the settlor's lifetime exceeds the available nil rate band at that time, a charge of 20% of the excess will be incurred.  This liability can either be paid by the settlor (in which case the amount must be grossed-up to an effective 25% rate) or by the trustees.

Transfers on death are generally liable to IHT at 40% on the excess of the so-called “nil rate band” (currently £325,000) on the value of assets owned by an individual at the date of their death.  This nil rate band can also be enhanced by claiming any nil rate band unused on a previous spouse’s death.  Furthermore, additional relief may be available by claiming the “residential nil rate band” that increased to £125,000 per individual from 6 April 2018.

Can settlors benefit from the assets?

Although it is possible to retain an interest in assets gifted into trust, normally by the settlor or his spouse/civil partner being capable of benefiting from the assets, this will affect the tax treatment of the trust.  Such settlor-interested trusts are taxed in a slightly different way to other trusts.  In such cases, the income realised by the trust will be treated as the settlor's own and taxed in accordance with their own personal circumstances.  Also, there is no relief from CGT on transferring assets into settlor-interested trusts.

Do trusts have to pay Income Tax?

Any income received by a trust will be subject to Income Tax.

Where the trust income belongs to the beneficiary, the trustees have to account for the tax.  The trustees account for the tax on this income at the basic rates applicable to that income (20% or 7.5% for dividends), taking into account any trust management expenses.

Broadly, discretionary trusts are currently taxed at 45%, except for 38.1% on dividend income. 

Do trusts have to pay Capital Gains Tax?

Capital Gains realised by a trust are currently charged to tax at a rate of 20% (except for the sale of residential properties that are liable at 28%).  A trust has an annual exemption (currently a maximum of £5,850).

A CGT charge may also arise when assets are appointed from trusts, however, where there is also an immediate charge to IHT; an election can usually be made to holdover the gain and transfer the gain to the recipient so they are liable to CGT on a future disposal.

How are the IHT charges payable by trusts calculated?

Under the so-called ‘relevant property regime’, many trusts will also be subject to IHT charges every ten years.  The maximum rate of IHT that can apply at this time is 6%.  If a trust ceases before the ‘ten-year charge’, an apportioned charge may be incurred.

IHT may also be due when assets are appointed from a trust, known as an ‘exit charge’.  In this case, the charge to IHT is based on:

  • the value of the property leaving the trust
  • the proportion of the period of ten years for which the assets have been held on trust since the last ten-year charge
  • the rate of tax at the last ten-yearly charge, subject to any IHT reliefs available at the time.

Do beneficiaries have to pay tax on trust income?

As mentioned above, beneficiaries with an IIP are taxable on all of the income available to them.  As the trustees have already accounted for tax at the basic rate, the beneficiaries receive the income with a tax credit.  This means that they should only have an additional liability if they are a higher rate taxpayer.

Where income payments are made from a discretionary trust to the beneficiaries, the payments are treated as having had tax deducted at a rate of 45%.  Generally, the beneficiary will receive a tax credit for the tax deemed to have been deducted and it may be possible to claim a tax refund.

Do trusts have to submit tax returns?

Yes, all active trusts need to complete an annual tax return.  Such tax returns need to be submitted to HM Revenue & Customs (HMRC) before 31 October (for paper returns) or 31 January (for electronic returns) following the end of each tax year.  Any tax due in relation to that return will be due on 31 January following the year-end.  Penalties may be due if returns are submitted late.

Trusts are also now required to be notified to HMRC using the online trust registration system.