Heather Rogers is the founder and owner of Aston Accountancy and This is Money’s resident tax expert.
One of the most common misconceptions I come across in my professional life concerns trusts. There is plenty of misunderstanding regarding how they work and the tax implications.
There seems to be a widely-held belief that if you move assets into trust there will be no tax to pay at all. Unfortunately, this is rarely the case.
Here I will run through the main types of trusts, how they work, what they are used for, and the ways they can be beneficial, to dispel some of the myths.
Can you avoid tax with a trust? There is a lot of misunderstanding regarding how they work and the tax implications, says our tax expert
What is a trust?
In a trust, assets are managed by a person or persons called trustees, for the benefit of another called the beneficiary or beneficiaries.
The person who puts the assets into the trust is called the settlor. When a trust is created, there is usually a trust deed or a will which will determine how the assets are managed.
The trustees are responsible for the assets in the trust. They manage the trust, prepare the tax returns, pay the tax liabilities, and decide how best to invest or use the trust’s assets.
Assets can be land and property, shares and cash.
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Why put assets into trust?
The typical reasons for setting up a trust are as follows:
– Protection of family assets;
– Someone is too young to manage their affairs;
– A person is incapacitated and likewise cannot manage their affairs;
– The settlor wants to pass on assets during life or after death in a way they can control.
Assets can be passed into trust either while someone is alive in a lifetime trust, or after their death using a will trust.
Nearly all trusts have to be registered with the trust registration service.
Let’s look at a few of the most commonly used trusts.
This is the simplest form of trust. The trustees look after the assets until the beneficiary reaches legal adulthood.
The beneficiary has the right to all the income and capital once they are 18 (16 in Scotland).
A transfer of assets into a bare trust does not give rise to an inheritance tax charge on the settlor and the assets in the trust will form part of the beneficiary’s estate, not the settlor’s.
Therefore, the settlor’s estate doesn’t have to pay any inheritance tax on them.
Income and gains are taxable on the beneficiary regardless of their age unless:
– A parent of the beneficiary is the settlor and the income is more than £100 per year in which case it is taxed on the parent;
– The settlor or their spouse retains an interest, for example by receiving income from the property held in the bare trust.
Interest in possession trusts
These are usually created on death. The beneficiary receives any income from the trust immediately directly from the trustees, or the use of the assets held in trust, but cannot control the assets themselves.
The income they receive could be income from a rental property or dividends from shares in a company, but the beneficiary has no rights over the property or shares which will pass to a third party, for example the children of the settlor.
If the income is mandated to the beneficiary (meaning it goes directly to them) then the income will be taxed on the beneficiary.
If not, then the trustees will pay tax – 8.75 per cent for dividend income and 20 per cent on anything else.
Sometimes there is no income but the right of use of the asset, for example the family home for a surviving spouse during their lifetime, but the home passes to the children on the spouse’s death.
This is often used to protect children from disinheritance, should the surviving spouse remarry.
The assets would still be in the settlor’s estate for inheritance tax purposes.
A discretionary trust is exactly that. The trustees have complete control over the assets and the income generated from them and they decide how and when to give the income and assets to the beneficiaries.
Depending on the trust deed, trustees can decide:
– What gets paid out to the beneficiaries – this could be income or capital;
– Which beneficiary or beneficiaries to make payments to;
– How often payments are made to the beneficiaries;
– Any conditions to impose on the beneficiaries.
One use of this trust could be for a grandchild who may need more financial help than other beneficiaries at some point in their life, and also for beneficiaries who are not capable or perhaps responsible enough to deal with money themselves.
Often the grandparents set up the trust with the parents as trustees.
Sometimes they are used to protect family assets.
The trustees pay tax on the income, the first £1,000 being taxed at the same rates as interest in possession trusts and the rest of the income being taxed at 39.35 per cent on dividend income and 45 per cent on all other income.
For inheritance tax purposes, things are more complex. Because the beneficiaries do not by the very nature of the trust have any entitlement to the trust fund itself, it does not usually form part of their estate on divorce, bankruptcy or death.
Due to these advantages, depending on the amount put into trust, there is often a tax charge on assets put in, 10-yearly charges and exit charges when assets come out.
However, a settlor can transfer in up to the nil rate band of £325,000 (£650,000 for a couple) every seven years without an entry charge providing they have not used any of their nil rate band previously within the last seven years in similar transfers.
If the settlor puts more than this into the trust, then the settlor will pay tax at 20 per cent on the excess. If the settlor dies within seven years then there may be more tax to pay.
If the discretionary trust is created in a will, then all the assets will be taxed in the normal manner for inheritance tax. There is no inheritance tax saving. However, no further charge will apply to the assets entering trust.
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