Trusts are a cornerstone of estate planning in England and Wales, offering both tax efficiency and asset protection. However, the tax treatment of trusts is far from straightforward. Many people set up trusts without fully appreciating the ongoing tax implications, which can lead to unexpected costs or compliance issues. If you’re considering a trust, it’s vital to understand the different types, how they are taxed, and the common pitfalls that can arise.

Types of Trusts and Their Uses

Trusts come in several forms, each with distinct features and tax consequences:

• Interest in Possession Trusts: These give a named beneficiary the right to trust income as it arises. The capital may pass to another beneficiary later. This structure is often used to provide for a spouse during their lifetime, with the remainder going to children.

• Discretionary Trusts: Trustees have the power to decide how and when to distribute income or capital among a class of beneficiaries. This flexibility is useful for families with young or vulnerable members, but it comes with higher tax rates and more complex reporting.

• Accumulation Trusts: Here, income is retained and added to the trust capital rather than paid out. These are less common but can be useful for building up assets for future beneficiaries.

• Bare Trusts: The beneficiary has an absolute right to the trust assets and income. For tax purposes, the assets are treated as belonging to the beneficiary, which can be advantageous for children or young adults.

A common source of confusion is the distinction between these trust types, especially when family circumstances change. For example, a discretionary trust can sometimes be treated as an interest in possession trust if the trustees act in a certain way, so it’s important to keep trust deeds and trustee decisions clear and up to date.

Inheritance Tax: The Relevant Property Regime and Its Traps

Most trusts (except bare trusts and some special trusts for disabled persons or bereaved minors) fall under the “relevant property regime” for Inheritance Tax (IHT). This regime brings several potential charges:

• Entry Charge: When assets are transferred into a trust during your lifetime, there may be a 20% IHT charge on amounts above the nil rate band (currently £325,000). Many people overlook this, assuming gifts into trust are always tax-free.

• Ten-Year (Periodic) Charge: Every ten years, the trust may face a charge of up to 6% on the value of assets above the nil rate band. This can erode the value of the trust over time, especially if not planned for.

• Exit Charge: When assets leave the trust (for example, when distributed to a beneficiary), a proportionate IHT charge may apply.

It’s easy to underestimate the impact of these charges, particularly if the trust holds assets that appreciate in value. Regular valuations and careful record-keeping are essential to avoid unexpected tax bills.

Income Tax: Rates, Distributions, and Beneficiary Implications

Trusts are subject to income tax at rates that depend on the type of trust:

• Discretionary Trusts: Income is taxed at the “trust rate” (currently 45% for most income, 39.35% for dividends), which is higher than most individuals’ rates. Trustees must provide beneficiaries with tax vouchers so they can claim back any overpaid tax, but this process can be administratively burdensome.

• Interest in Possession Trusts: The beneficiary is taxed on the income as if they received it directly, but trustees may still have to deduct basic rate tax before payment.

• Bare Trusts: Income is taxed as if it belongs to the beneficiary, which can be tax-efficient for minors with little other income.

A common pitfall is failing to consider the beneficiary’s own tax position. For example, if a beneficiary is a non-taxpayer, they may be able to reclaim tax paid by the trust, but only if the correct paperwork is completed.

Capital Gains Tax: Reliefs and Traps

Trusts pay Capital Gains Tax (CGT) at 20% (or 24% for residential property), with a lower annual exemption than individuals. Key points include:

• Holdover Relief: When assets are transferred into or out of a trust, gains can sometimes be deferred, but only if the right elections are made. Missing deadlines for these elections is a common and costly mistake.

• Business Asset Disposal Relief: This may reduce CGT on qualifying business assets, but only if strict conditions are met.

• Principal Private Residence Relief: This can apply to residential property held in trust, but only if a beneficiary occupies the property as their main home. The rules are strict and often misunderstood.

Planning Strategies and Regular Reviews

Effective trust planning often involves:

• Making full use of the nil rate band for lifetime transfers.

• Considering alternatives such as family investment companies, which may offer more flexibility and lower tax rates.

• Using insurance bonds within trusts to defer or reduce income tax.

• Weighing up the risks and benefits of offshore trusts, which have their own complex rules for UK residents and can attract anti-avoidance legislation.

Trust tax rules change frequently, and HMRC’s approach can be strict. Regular reviews of your trust arrangements are essential to ensure they remain effective and compliant. Failing to keep up with changes can result in unexpected tax bills or penalties.

Final Thoughts

Trusts are powerful tools, but their tax treatment is intricate and can catch out even the well-prepared. Take time to understand the rules, keep clear records, and review your arrangements regularly to avoid common pitfalls.

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Disclaimer: This blog post provides general information for educational purposes only. It is not legal advice. Outcomes can vary based on your personal circumstances.