Tax Planning Using Discretionary Trusts
- July 2021
- 4 minutes
Trusts and the law surrounding them require careful consideration alongside other personal and business circumstances.
The use of trust:
- Should I make a one-time contribution or consider establishing a trust?
- What are the tax implications of creating a trust?
- Can I be a trustee?
- What are the types of trust?
- Is it possible to reduce the IHT on my estate by using a trust?
- What type of property can I transfer to a trust?
- Can the use of trusts help with succession planning?
What is a trust?
When the following conditions are met, a trust is formed:
- A person referred to as “the Settlor”
- Transfers assets to trustees (appointed by the Settlor)
- For the benefit of others called ‘’beneficiaries’’
- For a certain period of time (The trust Period)
Why do people use trusts?
As part of their estate tax (IHT) preparation, an individual with assets may be willing to make absolute transfers of their assets to family or friends. While a direct gift has the advantage of simplicity, there are several reasons why someone might not want to make forthright donations, including loss of control and the donee’s age or personal/financial circumstances.
A donor can remove assets from his estate by gifting them to a trust rather than giving them to an individual outright, triggering the “seven-year clock” for IHT purposes (the value of a gift will become exempt from IHT if the donor survives for seven years from the date of the gift), while avoiding some of the disadvantages of an outright gift.
People have traditionally used trusts to secure their assets and oversee their management, as well as to govern how and when such assets are handed to others.
Flexibility and tax considerations are also major variables that impact a person’s decision to use a trust.
The settlor establishes his motives at the outset and determines the scope of the beneficiaries’ interests and the trustees’ powers, as specified in the Trust Deed’s conditions. Acting as a trustee by a settlor is perfectly permissible.
Using trusts allows you to keep control over the management and ultimate destination of your assets. Although the settlor can quickly sell an item, the existence of a trust prohibits ownership from flowing directly to the beneficiaries. The settlor/trustees select the date and extent of the beneficiaries’ claim by keeping some control. As a result, ownership of trust property can be transferred to the next generation overtime at the settlor’s/trustees’ discretion.
The assets do not become the beneficiaries’ property; instead, they are kept by the trustees on behalf of the beneficiaries. The trustees are in charge of administering the assets as well as protecting and preserving trust property.
A trust is a suitable vehicle for someone who wants to remove assets from their estate without giving the intended beneficiary complete authority and ownership. This can be useful if a donor is concerned about the recipients’ age, potential financial troubles, divorce procedures, or the vulnerability of a beneficiary.
Trusts are frequently created with the intention of lasting a long time. When the settlor is unsure about the exact scope of each beneficiary’s rights at the time of the gift, flexibility can be advantageous. Trusts are sufficiently adaptable to accommodate ever-changing conditions, which is critical when the beneficiaries’ future demands and circumstances are unknown at the outset. Such flexibility is not available with an outright donation.
- Tax Consideration
Trusts are a vehicle for passing on money and, as a result, are an excellent instrument for IHT planning. IHT mitigation can be performed through the use of trusts with careful planning, but with the extra benefits stated above. The direct tax consequences of establishing a trust are covered further down.
Types of Trust:
- Bare Trust
- Interest in possession
- Discretionary trusts
- Accumulation and maintenance trusts
- Mixed Trusts
- Settlor-interested trusts
- Vulnerable beneficiary trusts/disabled trusts
- Charitable trusts
- Non-resident trusts
The focus of this tutorial is on discretionary trusts, which are more widely utilised due to the freedom they provide. A discretionary trust is the most flexible type of trust and is frequently suggested for tax planning purposes.
The settlor will name a list of possible beneficiaries or classes of beneficiaries who may benefit from the trust assets, but the trustees will decide on the specific interests of each beneficiary, including any future beneficiaries. The settlor can include future generations by specifying a broad class of beneficiaries, such as grandchildren born during the trust period.
The beneficiaries of a discretionary trust do not have an automatic right to any of the trust’s income or capital. The trustees will have complete discretion over which beneficiaries will receive benefits, when they will receive benefits, and how much they will receive. The trustees will be free to utilise and distribute the trust’s income and capital as they see fit, thanks to their discretionary powers. The trustees may, for example, choose to distribute only a portion of the revenue to one or more classes of beneficiaries or to keep and accumulate the entire income. Likewise, a decision could be made to advance or appoint all or part of the capital to a beneficiary, or indirectly by funding a beneficiary’s education. The settlor can provide the trustees instructions in the form of a Letter of Wishes, specifying how he wants the discretion to be exercised, but this is not binding on the trustees. However, in practice, the settlor may appoint himself as a trustee in order to maintain control and be actively involved in the decision-making process.
Before creating a discretionary trust, it is advisable to consider tax implications. These are discussed below.
Inheritance tax (IHT)
Taxable lifetime transfers are lifetime transfers of value, such as gifts, that are immediately chargeable to IHT. Chargeable lifetime transfers include gifts to discretionary trusts.
IHT is now levied at a rate of 40% on any chargeable transfer made after a person’s death, and at a lower rate of 20% on charged lifetime transfers. As a result, giving assets to discretionary trusts has IHT implications to consider.
If the chargeable value of the assets transferred into the trust, combined with the value of any other chargeable lifetime transfers made in the preceding seven years, does not exceed the settlor’s nil rate band for IHT purposes (the nil rate band for 2019/20 is £325,000), the settlor has no IHT liability on the trust’s creation. If the chargeable value transferred into the trust exceeds the nil rate band, the excess is immediately chargeable on the settlor at 20%. Should the settlor pass away within seven years of the gift, then a further IHT charge arises of 20%, which will be payable by the trustees on the excess.
Generally speaking, HMRC is not able to impose an IHT charge on a beneficiary of a discretionary trust, and therefore, such IHT charges will be levied on the trustees instead during the trust period. This can arise when assets are transferred out of a trust (exit charge) and at each ten year anniversary of the trust (principal charge).
Each ten-year period, the principal charge is determined as a percentage of the trust’s value. This IHT fee cannot be more than 6% of the trust fund’s value. When trustees make a capital distribution to a beneficiary, the exit charge applies. The IHT exit charge is a proportion of the value of the assets that are leaving the trust.
Capital gains tax (CGT)
A settlor establishes trust by transferring property to it. Assuming the assets settled aren’t cash (cash isn’t a chargeable asset for CGT purposes), the settlor is regarded to have made disposal at market value for CGT purposes (the settlor and trustees are related individuals, therefore all transactions are treated as market value). Under the gifts relief provisions, a claim to defer a capital gain can be made, where the gift is a chargeable transfer for IHT purposes. If a settlor transfers assets to a discretionary trust, this is a chargeable transfer for these purposes. Therefore, capital gains arising on the gift of any asset to a discretionary trust will qualify for gift relief, and thus the gain can be deferred. Effectively, this means that the settlor can postpone paying CGT until the asset is sold or distributed by the trustees at a later period, at which point the trustees will be responsible for any CGT due. When it comes to succession planning, this is a helpful relief because it permits the settlor to avoid an immediate CGT tax when gifting an asset. Gift relief does not apply to an outright gift to an individual.
A charge to CGT may also arise during the trust period if the trustees either sell trust assets or appoint assets out of the trust to a beneficiary (a deemed disposal – see below). A discretionary trust is a separate entity for CGT purposes and has its own exemptions and reliefs. The annual exemption for CGT purposes is one half of the exemption generally available to individuals (£6,000 for 2019/20).
As a result, if the trustees make a capital gain on the settled property, they will be subject to CGT as a chargeable person in their own right. CGT is applied to realised gains at a rate of 20%. (28 per cent applies to the sale of the residential property). A deemed disposal occurs when the trustees take the decision to transfer assets out of the trust to a beneficiary. Such a transfer is deemed to take place at the market value of the asset as at the effective transfer date for CGT purposes. This type of transaction is also a taxable transfer for IHT reasons. As a result, when an asset is transferred to a beneficiary, the trustees will be eligible for gift relief in the same way that a settlor is (upon creating a trust). As a result, a gift relief election would defer any gain that would otherwise be charged to the trustees until the beneficiary personally disposes of the asset. As can be seen, gift relief allows a donor to convey an asset tax efficiently to a donee over a period of time via a discretionary trust without paying immediate CGT costs.
Income tax (IT)
Any income generated by trust assets is subject to taxation and must be paid by the trustees. The trustees are in charge of filing annual trust tax returns and registering the trust with HMRC. Depending on the type of income, the ‘trust rate’ of 45 per cent or the ‘dividend trust rate’ of 38.1 per cent is applied within the trust.
As mentioned above, the trustees have the power to accumulate or distribute the net income of the trust as they see fit. When a beneficiary receives trust income, it carries a tax credit at the trust rate of 45%, regardless of the nature of the income. As a tax planning point, it should be noted that if income is distributed to a beneficiary whose rate of tax is lower than that of the trustees, then that beneficiary is entitled to make a repayment claim from HMRC for the additional tax paid by the trustees. If the beneficiary pays income tax at the basic rate of 20%, for example, the beneficiary may be able to reclaim the excess tax paid by the trustees on any trust fund income delivered to the beneficiary. This can be used as a tool to claw back some of the tax paid by the trustees at the higher trust rates of income tax with appropriate preparation.
The assets transferred to the trust would cease to be those of the settlor for IT purposes and as mentioned, the higher trust income tax rates will apply. The exception to this is where the discretionary trust might have a class of beneficiaries who constitute the minor children of the settlor. r. Any income paid to, or applied for, the benefit of those children while they are both unmarried and under the age of 18, will be treated as taxable income of the settlor and not the trustees.
Summary- Tax Consequences
- On the creation of a trust, the settlor transfers assets to the trustees
- The transfer of assets into a discretionary trust has IHT and CGT implications on the settlor
- If the trust assets generate income, or the trustees dispose of assets, during the trust period, the trustees will be subject to trust IT and CGT
- If income is distributed to a beneficiary by the trustees of the trust fund, that beneficiary may be in a position to recover the additional trust tax from HMRC.
- If the trustees appoint an asset to a beneficiary, there are IHT (exit charge) and CGT implications on the trustees
- IHT principal charges arise on the trustees on each ten-year anniversary of the trust.
A trust is perfect for an individual who wishes to remove assets from their estate in a tax-efficient manner, without passing absolute control and ownership to a beneficiary.