Trust Tax 101: Inheritance Tax on Trusts

Curious about the tax regimes on different trusts? Unsure which planning solutions are the most tax-efficient for your clients? CTT’s Technical Director Spencer Tattam has the answers.

IHT: life and death

Most clients think of IHT as the tax that’s paid when we die; but that’s not the only time IHT comes into play. It’s something that needs to be considered when putting lifetime planning in place for clients, especially when the aim is to mitigate IHT risks.

There are three occasions when a client’s IHT liabilities need to be considered:

• On the client’s death
• When a client makes a gift in their lifetime
• By the trustees when a Trust forms part of the client’s planning – this depends on the type of trust

There are two IHT charges that might arise on death. The first is the Estate Charge that’s billed at 40% on assets owned by the client immediately before their death.

The second is a supplementary charge due on any failed lifetime gifts that have not exceeded the 7 years necessary to exclude them from the client’s estate.

IHT is payable in a client’s lifetime whenever there is a transfer of value. A transfer of value is established when assets leave the transferor’s estate, effectively decreasing its value, and enter the recipient’s estate, immediately increasing its value. This could be in the form of a Potentially Exempt Transfer (PET) or a Chargeable Lifetime Transfers (CLT).

PETs and Inheritance Tax

Most lifetime gifts are exempt from tax at the time of gifting. These are known as PETs; they have the potential to be exempt from IHT on death, but only if certain criteria are fulfilled.

PETs are subject to the ‘wait and see rule’:

Gifts become fully tax exempt once they have been outside the client’s estate for at least 7 years prior to death. Should the client die within three years of making the gift, the gift is taxed at 40%. If they die after three years but before the required 7-year period is up, a tapered rate of tax is applied.

PETs can also be created in the settling of certain types of trust. Trusts are more commonly associated with Chargeable Lifetime Transfers, though this is not always the case.

In some instances, such as with Bare (Absolute) Trusts or a Disabled Person’s Trust, IHT is calculated on the value of the recipient’s estate. This is because, for tax purposes, assets in these trusts pass wholly into the beneficiary’s estate as soon as the trust is settled and responsibility for any tax due lies with the recipient.

A cumulation of failed PETs can greatly increase the client’s Inheritance Tax liabilities. For this reason, it’s essential to assess the value of any PETs, and the order in which they are gifted, when using them to reduce a client’s estate for IHT purposes.

Chargeable Lifetime Transfers and Inheritance Tax

Chargeable Lifetime Transfers (CLT) give rise to an immediate Inheritance Tax charge. These include transfers into discretionary trusts. Most client wealth transfers will fall under the category of PETs; however, if the transfer does not result in either of the following conditions:

• The property being transferred is considered part of the recipient’s (donee’s) estate, or
• The recipient’s estate increases in value by an equivalent amount,
  then the gift will be classed as a CLT. This means it will be subject to immediate Inheritance Tax at 20% on any excess over the available Nil Rate Band (NRB) when it enters the Discretionary Trust.

Further trust charges to be aware of when creating IHT mitigation plans for clients include:

• Those on Relevant Property Trusts, which are subject to their own special rates in accordance with relevant Property Regime.
• Anniversary charges – commonly known as the ‘10-year-charge’ at a maximum of 6% over the available Nil Rate Band.
• Exit Charges – payable when assets leave the trust. This also has a maximum rate of 6% and is calculated in regard to the rate of tax paid at the last 10-year anniversary.

Client circumstances dictate whether paying these 6% charges is more tax beneficial than paying the 40% IHT on death on a lump sum held in trust.

Types of trust

Having an understanding of the various types of trust and how they are taxed is vital to creating a tax-efficient strategy for your clients. Some of the most common types of trust used in planning are:

Bare Trusts

Also known as ‘Absolute Trusts’, Bare Trusts are the most common types of trust; in fact, they are so common, it’s possible for testators to create a Bare Trust within their will without even realising that’s what they’re doing.

A Bare Trust is created when the settlor leaves assets in trust to a minor beneficiary absolutely. The trust can be created during the settlor’s lifetime; in their will, or intestacy. Assets remain in a Bare Trust until such a time as the beneficiary comes of age (18 years).

Trustees only have statutory discrepancy dispositive powers while the beneficiary is a minor. They can advance income and capital from the trust for use by minor beneficiaries in certain circumstances.

They also have some discretion regarding investments, though it’s wise to consult the beneficiary before acting on any investment decisions.

Inheritance Tax on a client’s Bare Trust

When created during the settlor’s lifetime, any assets placed into a Bare Trust are PETs. They could also be Gifts with Reservation of Benefit (or GROBs) where the doner gifts an asset to a beneficiary but retains some of the benefit of that gift for themselves.

PETs that exceed the available NRB and Resident’s Nil Rate Band (RNRB) where applicable are chargeable for IHT at 40% if the settlor dies within 7 years of creating the trust.

If a beneficiary dies, the value of their share in the trust is added to the value of their estate for IHT.

Tax on Children’s trusts

Children’s trusts can be used to protect assets up to the age vested; after this time, assets are inherited absolutely and there is no further protection from future threats such as bankruptcy or divorce.

Children’s trusts settled by a parent and that vest when the child reaches 18 are known as Bereaved Minors Trusts (BMTs); those that vest between 18-25 are 18-25 Trusts. Both qualify for RNRB.

While there are no exit charges on BMTs and 18-25 Trusts that vest at 18; those that vest later have an exit charge to a maximum of 4.2%.

If not settled by a parent, these types of trust are known as Relevant Property Trusts and are subject to their own IHT charges. They do not qualify for RNRB.

Both BMTs and 18-25 Trusts can only be created by a parent, not a grandparent. Therefore, care must be taken when leaving contingent gifts to a grandchild as it would then become a Relevant Property Trust for tax purposes, making it ineligible for RNRB.

While BMTs and 18-25s have their place, they offer less flexibility than your typical Discretionary Trust, provide limited protection for assets, and can trigger additional tax implications in certain circumstances.

Flexible Life Interest Trusts and taxation

Also known as an Interest in Possession Trust (IIP), this trust structure lets the ‘life tenant’ use income from the trust or make use of its assets, such as a property, during the trust’s lifetime while ‘remaindermen’ have an absolute entitlement to the capital once the trust comes to an end.

IIP trusts are popular in second marriages and only provide asset protection for a limited time. Care needs to be taken when selecting beneficiaries as not making use of spousal exemptions can subject assets to multiple IHT charges when moving them between estates.

They do not suffer periodic, entry, or exit charges but they are also ineligible for NRB or RNRB of the deceased; plus, there is also a likelihood of any potential RNRB being subject to tapering.

If a remainder survives the life tenant of an IIP trust, assets vest in their estate absolutely. If the life tenant survives the remaindermen, the reversionary interest is part of the deceased’s estate for IHT purposes but is relievable.

IIPs settled within the settlor’s lifetime are classed as Relevant Property Trusts and taxed under the Relevant Property regime; those settled on death or intestacy are classed as Qualifying Interest in Possession Trusts and form part of the beneficiary’s estate for IHT purposes.

Discretionary Trusts

Discretionary trusts can be created during the settlor’s lifetime or upon death via the will or through a deed of variation.

Assets placed in a discretionary trust do not form part of any beneficiary’s estate; if the settlor is a beneficiary, assets remain part of their estate. All assets are distributed to beneficiaries at the discretion of the trustees, though the settlor can specify their wishes for distribution in a memorandum.

Creation and settlement of a Discretionary Trust during the settlor’s lifetime is a CLT. Discretionary Trusts are subject to periodic (anniversary), entry, and exit charges, but do also benefit from the NRB. If a potential beneficiary dies, no value held within the trust forms part of their estate.

Tax on your client’s Discretionary Trusts

There’s no question Discretionary Trusts provide the most effective long-term protection, owing to the way assets are owned by the trust and distributed at the discretion of its trustees. However, care must be taken when calculating the various charges on Discretionary Trusts as these can quickly add up.

Depending on how the settlor uses the trust, the number of CLTs and distributions made, and the value of the assets held in trust, careful planning is needed to ensure any actions are carried out at the right time to maximise their benefit and offset the payment of any charges.

Even in the event that no tax is due, this will still need reporting to ensure compliance with HMRC.
To mitigate any trust management risks for clients and ensure the trust continues to achieve tax-effective planning during its lifetime, we recommend using our Professional Trustee Services.