A Guide to: Trusts
Although the tax efficiencies of trusts have been squeezed in the last 14 years, the overarching advantage of control and protection offered by trusts is invaluable.
There are still big tax benefits available, but these tend to be when advance planning is done and expert advice sought.
Trusts have been around for centuries and arguably have a reputation for being tax avoidance vehicles used by the wealthy.
In 2006 HMRC clamped down on what were previously very generous opportunities for tax planning when it came to trusts. Having said that, with careful consideration and good advice, trusts still prove to be tax efficient tools for a number for circumstances, that are not limited to the wealthy.
There are many individuals and families in varying circumstances that could benefit from using trusts. Sure, tax planning is often a key consideration, but it should be far from the only motive.
Other important factors, such as control and protection of assets have always been near the top of the list of considerations; but perhaps now more than ever following the 2006 restrictions.
Trusts embody the idea of the separation of the legal and beneficial ownership of assets, and this is what makes them such bespoke arrangements.
This separation allows control over how assets are used and managed due to the fact that control sits with the legal owners (Trustees). This separation can be a useful tool when passing assets down generations to minimise inheritance tax (IHT) exposure; talk about having your cake and eating it.
Trusts are often subject to IHT in their own right, but with careful planning, the level of exposure can be far less than that of an individual.
Circumstances in which Trusts might be beneficial:
- Managing the IHT exposure of an individual by moving family assets into trusts, all the while maintaining control and protection of the assets;
- Ensuring a surviving spouse continues to live in the family home for their lifetime, whilst ensuring the ultimate beneficiaries are the children;
- Providing for a vulnerable person who is perhaps not able to manage their own affairs;
- Making use of the IHT nil rate band (currently £325,000) during lifetime. Assets transferred into trust during lifetime might only be subject to IHT if the value transferred exceeds £325,000. Subject to 7 years passing before death following the transfer, the value of the assets transferred should fall outside the estate of the settlor.
There is the potential to avoid wasting generous business property relief (BPR), when an estate passes to a surviving spouse on death. There is often no IHT due given the spousal exemption. Given two reliefs are available, why not double dip? This is a lucrative tax planning tool for owners of business assets.
‘Double dipping’ wills can prove to be very effective estate planning vehicles for entrepreneurs.
Business property relief (BPR) of 50% or 100% may available to entrepreneurs. There are specific requirements for assets to qualify for BPR, but assets used in the course of business will likely attract BPR which is a very generous inheritance tax (IHT) relief.
If these assets are left to a surviving spouse on death, there will likely be no IHT due. However, in the hands of the surviving spouse BPR may be lost, therefore these assets may then become fully liable to IHT.
Through careful estate planning, a will can be structured so the business assets can take advantage of BPR…twice, before settling in the hands of the surviving spouse. This is known as a “double dipping” will and can help achieve significant IHT savings.
The will could be structured such that on the first death the whole estate will be left to a trust fund, which will subsequently have two sub-funds; a BPR fund and a residuary fund.
The BPR fund will receive any assets that attract BPR and will be held on discretionary trust for the benefit of the surviving spouse and various family members. If 100% BPR is achieved, there will be no IHT on the transfer of these assets into trust.
The residuary fund will receive the residual estate and this could be held in a life interest trust for the surviving spouse, thus achieving the spousal exemption; again, there would be no IHT on the death of the first spouse.
That’s the first dip at BPR…
Later down the line the BPR assets can be transferred into the residuary fund, in exchange for assets of equal value. On the basis that there has been no reduction in value in either of the trusts, no IHT is due.
What is achieved here, is a second dip at BPR relief on the assets swapped.
When the assets switch place, the non-BPR assets are now held on trust for family members including the surviving spouse. These assets were originally exempt from IHT due to the spousal exemption, but can now benefit individuals other than the surviving spouse.
The non-BPR assets will now be subject to 10-year charges and exit charges – but these rates are capped at 6%, which is much more manageable than 40% that would have otherwise been charged to get these assets in the hands of family members other than the surviving spouse.
The structure will only work if the spouse holding the BPR assets dies first.
A similar mechanism can be used for agricultural assets and agricultural property relief (APR), although the benefits are potentially more limited than where BPR is at play, given BPR is often more generous than APR.
A consideration for the entrepreneur considering cashing out of their business, is the chance to maximise entrepreneur’s relief (ER) by sharing the gain with the next generation and using their lifetime limits; especially given the reduction of the lifetime limit from £10m, to £1m in March 2020. This would also ensure an element of the proceeds have already been shared with the next generation, without having to make a separate lifetime transfer.
Normally, assets in a trading businesses are exempt from inheritance (IHT), due to the availability of business property relief (BPR). However, when these assets are sold and converted to cash, BPR is automatically lost. For business owners selling business assets for substantial amounts, IHT exposure should be considered.
Following the recent reduction in the entrepreneurs lifetime limit from £10M, to £1m, there could be capital gains tax (CGT) payable at up to 20% on the gain. Depending on the size of the gain, the tax payable could be substantial.
Given that it is often the intention to at some point share some of the proceeds from the sale of their business with the next generation, it makes sense to consider the big picture before a sale actually goes ahead. Simply transferring funds to children, even on trust, would likely give rise to an IHT charge. This seems hard to swallow alongside the CGT payable, and considering the original assets may have been exempt from IHT due to the availability of BPR.
One option would be to transfer a portion of the business into trust before the terms of sale are agreed. This would be an event subject to IHT, but one where BPR can be claimed to potentially avoid any actual IHT being payable.
When the cash eventually comes in for the sale of the whole business, an element will come into the trust. This would be subject to CGT, but more about managing that later. The end result is that you have a portion of cash in a trust fund for your family without having incurred any IHT to get it there.
The big advantage here is that if the sale doesn’t go ahead, you have still retained control of the assets, but have created a very tax efficient platform should the sale go ahead.
These trusts will be subject to 10-year charges, but at a maximum rate of 6% every 10 years. This is far more appetising than the 20% IHT that would occur if the proceeds were transferred into trust after a sale went ahead, or the 40% IHT exposure if the proceeds are held on to.
Often BPR and entrepreneur’s relief (ER) come hand in hand, and with at least 2 years planning ahead of a potential sale of a business, it may be possible to tap into the next generation’s £1m lifetime allowances on the sale of business assets. Essentially this is just an extension of the above mechanism, whereby an interest in possession (IIP) trust is used. Providing the life tenant (beneficiary) of the IIP trust meets certain criteria, the trust too can claim ER providing the life tenant’s lifetime allowance is available.
General Tax Implications:
Trusts are often subject to income tax, capital gains tax, and inheritance tax. The intricacies of the tax treatments are far spread, but please see below for an overview:
I would suggest that the income tax position is more straight forward than the other taxes. Broadly, there are two types of income tax positions for trusts:
Interest in possession or sometimes known as life interest – so called because the beneficiary has the right to benefit from an asset for a certain length of time, quite often, their lifetime.
Discretionary – so called because the trust may have a class of beneficiaries, or potential beneficiaries, that have the right to benefit from the trust assets at the Trustees’ discretion.
Interest in possession trusts are subject to basic rate tax on their income (20% for non-savings and savings income, 7.5% on dividend income). The beneficiary then includes the gross income on their tax return, and takes advantage of the a tax credit equal to the tax the Trustees have already paid on this income.
Mandating income directly to the beneficiary can cut out the potentially unnecessary admin of preparing a trust tax return.
Discretionary trusts are subject to the additional rate tax on their income (45% for non-savings and savings income, 38.1% on dividend income)
There are some limited opportunities to access the basic rates bands on an element of the income.
The beneficiaries will only be subject to income tax on actual income distributions paid to them, or paid out of the trust, for their benefit.
The income distributions are always considered to have been paid net of 45% tax, regardless of what income was actually generated in the trust.
HMRC have been careful to ensure they are not out of pocket, when providing tax credits. The trustees must track the tax credits given to the beneficiaries against that tax that the trust has paid to HMRC, on an accumulative basis. If at any point the tax credits exceed the tax paid by the trust, the trust must make up the difference.
Any distributions are taxable in the beneficiaries’ hands as ‘Trust income’ subject to either 20/40/45% depending on their other income.
In some instances where the beneficiary has no other income, a straight reclaim for the tax the trust paid can be made, by way of a form R40, avoiding the need to prepare a tax return for the beneficiaries.
As I mentioned above, trusts are often subject to IHT. Creating a trust in lifetime, essentially creates a quasi-person, who takes on the available nil rate band of the settlor, at the time of the transfer. Upon creation, the value of the assets transferred into trust are subject to 20% IHT, on the value in excess of the available nil rate band at the time, after taking into account any reliefs available such as business, or agricultural property relief.
The trust then carries its NRB with it for the duration of its lifetime. These types of trust are known as relevant property trusts. These trusts will be subject to charges every 10 years, and when assets exit the trust. The prevailing maximum tax rate is 6% for these events. Often these IHT charges over a trusts lifetime, are less than the 40% on death should the assets remain in the settlor’s estate.
There are trusts that are not relevant property, and these types of trust are not subject to the same IHT charges as described above. Instead, the trust fund attaches itself to the beneficiary and forms part of their estate. Should they die whilst being a beneficiary, the value of the trust fund is brought into their estate and will be subject to IHT on their death. Discretionary trusts will always be relevant property trusts, with interest in possession falling in or out of this category depending on the circumstances surrounding their creation.
Trusts are often subject to CGT, which seems a little unfair given that they are also subject to IHT. Therefore, various CGT reliefs are available, the most notable being holdover relief.
When assets are transferred into a trust in lifetime, this event triggers CGT. However, it is often the case that where that event is also subject to IHT, holdover relief can be claimed. This means that should the trust subsequently dispose of this asset, it is the settlor’s base cost that is used, rather than the value at the time of the transfer. If the trust does dispose of these assets, holdover relief may be able to be claimed again.