Trusts and inheritance tax planning

With the inheritance tax (IHT) threshold frozen at £325,000 since 2009 as well as the residence nil-rate band which was introduced in 2020, more estates are falling within the IHT net.

This has sparked renewed interest in using trusts to mitigate exposure.

Trusts and IHT

Trusts can reduce IHT liability by removing assets from your estate. If you survive seven years after transferring assets into a trust, their value and any growth may escape the 40% IHT charge. However, lifetime transfers may trigger a 20% charge, which must be weighed against long-term benefits.

Discretionary trusts are particularly useful for appreciating assets like investments, property, or business interests. They also offer control over how and when beneficiaries receive benefits—ideal for younger heirs or changing family circumstances.

Property and trusts: Special considerations

Placing property into trust requires particularly careful consideration. While the family home might represent a significant portion of your estate, gifting it into trust while continuing to live there can trigger the ‘reservation of benefit’ rules, potentially negating any IHT advantages. To avoid this, you will need to pay a market rent to the trust or vacate the property entirely.

For investment properties, trusts can work more effectively, but practical complications arise. Property requires active management, and trustees become responsible for maintenance, insurance, tenant relationships and compliance with landlord regulations. The trust’s higher tax rates also apply to rental income, making the ongoing tax cost potentially prohibitive compared to personal ownership.

Understanding the obligations

Trusts do create ongoing responsibilities that shouldn’t be underestimated.

Trusts require ongoing compliance: annual tax returns, record-keeping, and professional fees. Discretionary trusts face a 45% income tax rate (reclaimable by beneficiaries), 10-year periodic charges (typically 6%), and exit charges. Trustees must also navigate complex regulations, including anti-money laundering and ownership registration.

These obligations continue for the trust’s entire lifetime, which could span decades. Trustees must also navigate increasingly complex regulations, including anti-money laundering requirements and beneficial ownership registrations.

Integration with other tax planning

Trusts should be integrated with wider financial strategies. They interact with your annual exempt amount (currently £3,000), which can be used to make tax-free gifts whether into trust or to individuals directly.

Individuals need to consider how trust planning affects pension planning, business relief planning, and the use of your residence nil-rate band. Sometimes, maximising these other reliefs might be more beneficial than creating trusts.

Trust planning needs also align with your lifetime cash flow needs. Unlike pensions or other investments you retain, assets in trust generally aren’t available for your use, even in emergencies.

Making informed decisions

Trusts can be powerful tools for IHT planning, but they’re not suitable for everyone. Age, health, family dynamics, income needs, and risk tolerance all play a role. The goal should be to align tax planning with your broader financial objectives.

Professional guidance remains essential to navigate the complexities and determine whether trust planning suits your specific situation.

For further information, please contact us.