Could a trust save you inheritance tax and be income tax efficient?

Published by Karen Sadler on 6 February 2023

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Discretionary Trusts can be a useful tool for families for planning asset protection and wealth distribution for future generations and for saving Inheritance Tax (IHT) on estates.

Discretionary trusts are typically used when the settlor (the person setting it up) wants the trustees to have full control over who benefits from the trust and when. This can be set up during someone’s lifetime or when they die.

The beneficiaries do not have an automatic right to the trust’s income or capital and the trustees are there to decide on how much income or capital is paid out, which beneficiaries receive the payment and when and how frequently payments are made.

Discretionary trusts can have both named beneficiaries and/or classes of beneficiaries, so children, grandchildren, nieces, nephews etc. If the settlor isn’t a trustee, then they should provide a letter of wishes to provide the trustees with a framework of how they would like the trust to work.

If you place cash into a trust up to the value of the nil rate band, (currently £325,000 subject to any previous gifts into trust in the last 7 years), then there is no Inheritance Tax (IHT) or Capital Gains Tax (CGT) on entry.  Therefore, over the next 10 years, as there was no entry charge, there will be no IHT to pay on any distribution.  Note there may be a CGT charge if other assets are added to the Trust, but they may be able to be held over and we can advise on this.

Once the settlor survives 7 years, the assets settled falls out of their estate for inheritance tax purposes saving an IHT charge on their estate of £130,000 (on £325,000 assets settled).

Discretionary trusts are classed as ‘relevant property’ trusts because the assets held by the trust are not included in the taxable estate of any of its beneficiaries, so the trust will be assessed for IHT every ten years. The rate of inheritance tax at this anniversary will be no more than 6% of the value of the assets.

Although Discretionary Trusts pay a higher rate of Income Tax, 39.35% for dividends and 45% for interest, this can be worked in a beneficiary’s favour depending on what the funds are intended for.

The higher rates of tax paid by a trust goes into a ‘tax pool’ and when a distribution is made out of income directly to a beneficiary, they would be provided with a ‘statement of income from trusts’, form R185.  This grosses up the income distribution to the beneficiary, meaning that they are given a 45% tax credit, which the beneficiary can claim back, subject to their personal income.

This tax repayment is for the beneficiary and does not get paid back to the trust.  To provide an example, if income distributions were made up to the total of £28,700, this would carry with it a tax credit of £23,481.82.  Therefore, the total which could be received by the beneficiaries would be £52,181.82, subject to their personal circumstances. The tax paid by the Trustees could be claimed back by the beneficiary.

Based on this example, if the distribution from the trust was going to be used to pay school fees and the school fees due for payment were more than £28,700 and you did not want to incur an additional tax pool liability, then the balance of the school fees could be paid out of capital, and if there was no IHT on entry then there would be no IHT payable on the capital distribution.

Caution needs to be taken when calculating the tax credit.  If the tax credit awarded is more than the available tax pool, then the trust will need to pay more tax to bring the tax pool to nil.  This happens because dividends are only taxed at 39.35%, but the tax credit is 45%.

The ideal settlor for a discretionary trust which is used to pay school fees is a grandparent as if an income distribution is made to a child of the settlor, then this would be considered a settlor interested trust and the income would therefore be taxable against the parent.  This is obviously not ideal because not only would the settlor be paying tax on that income, but the child would not be able to reclaim the tax paid by the trust.

One way around this is if the settlor is a parent, is not to pay the school fees from income, but the payment to either be a capital distribution or treated as loans to the child.

This is a complex area and if you would like to discuss setting up or using a Discretionary trust, please get in touch with our team today.

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