Inheritance Tax (IHT) is a significant concern for many families when planning to pass on their wealth to future generations. Rising property values, particularly in London and the surrounding counties, combined with a freeze on the inheritance tax threshold since 2007, mean many estates are now subject to IHT charges.
The most recent statistics from HMRC showed that around 4% of estates paid inheritance tax in 2020/21. According to the Institute of Fiscal Studies (IFS), the proportion of estates liable for inheritance tax is set to rise to over 7% by 2032/33, with around 23% of estates in London expected to be impacted, five times higher than those in regions such as the North East.
Without effective estate planning, the tax burden generated from inheritance tax charges can significantly diminish the wealth passed to future generations. Trusts have long been used to manage IHT liabilities effectively, offering a range of potential tax benefits while protecting assets.
This article will explore how trusts work, the various types of trusts available, and how they can help mitigate inheritance tax. We will also examine the key considerations when establishing a trust for estate planning purposes and their potential limitations.
Table of Contents
What is Inheritance Tax?
Inheritance Tax is a charge paid on the value of someone’s net estate upon their death. After applying available tax reliefs, this is calculated as the total value of their assets, minus any outstanding debts. In the UK, IHT is levied at 40% on the portion of the estate that exceeds the nil-rate band of £325,000. This threshold applies to everyone, meaning married couples can benefit from a combined £650,000 allowance. Note that there is no inheritance tax to pay on transfers between married couples.
In addition to the standard nil-rate band, the residence nil-rate band (RNRB) offers an extra allowance for individuals who pass on their primary residence to direct descendants, such as children or grandchildren. As of 2024, the residence nil-rate band is £175,000, which can increase the total IHT-free allowance to £500,000 for individuals or up to £1 million for couples if both allowances are fully utilised. For up-to-date information on Inheritance Tax allowances, please see our UK Tax Rates and Allowances page.
What is a Trust?
A trust is a legal arrangement that allows a person (the settlor) to transfer assets to trustees, who manage them for the benefit of specified individuals (the beneficiaries). Trusts can be used to hold various assets, such as property, shares, and cash, and are commonly used in estate planning to control how and when beneficiaries receive their inheritance.
How do Trusts Work in the UK?
In the UK, trusts operate by distinguishing legal and beneficial ownership. The trustees legally own the assets within the trust and are responsible for managing them in accordance with the instructions laid out in the trust deed. On the other hand, beneficiaries have the right to benefit from those assets, whether in the form of income, capital, or both, depending on the terms of the trust.
By separating the ownership of assets, trusts provide a protective framework to shield the assets from immediate taxation and protect them from creditors or potential legal claims. Trusts can, therefore, be a particularly useful mechanism in safeguarding family wealth, ensuring that assets are distributed according to the settlor’s wishes and potentially reducing inheritance tax liabilities.
Roles and Responsibilities in a Trust
- Trustees: Responsible for managing the trust assets and adhering to the terms of the trust deed.
- Beneficiaries: Individuals or organisations who will benefit from the trust’s assets.
- Settlors: The person who establishes the trust and transfers assets into it.
Types of Trusts
Discretionary Trusts
In a discretionary trust, the trustees have discretion over how and when to distribute assets or income to the beneficiaries. This allows flexibility in managing the trust and can be useful in cases where beneficiaries have varying financial needs, such as multigenerational wealth.
Bare Trusts
A bare trust, also known as a simple trust, gives the beneficiaries absolute entitlement to the assets within the trust. The trustees hold the assets in their name, but the beneficiaries have full rights to access them once they reach a certain age, typically 18. The trustees have no discretion, and the assets must be passed directly to the beneficiaries.
Trusts with Interest in Possession (Life Interest Trusts)
A trust with an interest in possession, also known as a Life Interest Trust, gives a beneficiary the right to receive income from the trust’s assets (such as rent from property) while the capital is preserved for future beneficiaries. For example, a spouse may receive income from a property in the trust, but the property itself is passed to children after the spouse’s death.
18-25 Trusts
These trusts are designed for younger beneficiaries, with assets held until the beneficiary reaches the age of 18 to 25. This type of trust is particularly beneficial for safeguarding assets until the beneficiary is more financially mature, ensuring they receive support at a stage in life when they may be better equipped to responsibly manage their inheritance.
Can you Avoid Inheritance Tax with a Trust?
Trusts can be a highly effective tool for mitigating inheritance tax, even though their primary purpose is often to help protect assets and help manage family interests across generations.
It is important to understand and consider the rules governing the tax treatment of trusts. Below are key areas in which trusts can reduce IHT liabilities:
Removal of Assets from the Taxable Estate
When assets are transferred into certain types of trusts, they are typically considered outside the settlor’s estate for inheritance tax purposes. This reduction in the estate’s value can significantly lower the IHT liability, especially for estates that exceed the IHT threshold. By strategically using trusts, high-value estates can avoid being heavily taxed upon the settlor’s death.
For example, if the trust’s value falls below the nil-rate band, it can be free from IHT entirely, as long as the settlor survives for seven years after the transfer. However, for larger estates or trusts where the assets exceed the nil-rate band, any amount above the threshold may still be subject to tax, such as the 10-year anniversary charge on discretionary trusts (detailed under ‘Considerations for Setting up a Trust’ below).
The Seven-Year Rule
The seven-year rule states that the trust must be established for at least seven years before the settlor’s death to remove assets from the taxable estate entirely.
Assets placed into trusts are treated as potentially exempt transfers (PETs), meaning they will only be exempt from IHT if the settlor survives for seven years after making the transfer. If the settlor passes away within the seven-year window, the value of the assets is added back into their estate for IHT purposes. In such cases, the IHT due on these assets is tapered based on how long the settlor survived after making the transfer.
This taper relief can still reduce the IHT owed, but the full exemption is only available after the seven-year mark. Additionally, if a settlor gifts assets into a trust within seven years of their death, other lifetime gifts might also be drawn back from the estate, potentially increasing the IHT burden.
Annual Exemptions
Certain trusts enable individuals to take advantage of the annual gift exemption, which allows up to £3,000 of gifts per year without incurring IHT. If unused, this exemption can be carried over for one additional tax year, permitting up to £6,000 in tax-free gifts in a single year. This is a useful way to gradually reduce the value of an estate, particularly when used in conjunction with other estate planning strategies.
Considerations for Setting Up a Trust
While trusts offer significant tax advantages, they may not be suitable for everyone. Several factors, including costs and trustee responsibilities, must be considered before establishing a trust to determine if a trust is the right solution for your estate planning. We explain these considerations below.
Costs and Tax Implications
Setting up a trust can be a complex and costly process. Professional advice, both legal and tax, is usually required to ensure the trust is structured correctly, and some trusts may involve ongoing administrative fees. The initial costs might include solicitor or legal fees for drafting the trust deed, as well as accountant fees.
Transfer of Assets
When assets are transferred into a trust, it’s important to consider whether an immediate IHT charge will be applied. For example, when transferring assets into a discretionary trust, if the value of assets exceeds the nil-rate band of £325,000, the excess amount may be subject to an immediate IHT charge of 20%. This charge is applied at the time of transfer and is considered a chargeable lifetime transfer (CLT).
For example, if £500,000 worth of assets are placed into a discretionary trust, the £175,000 that exceeds the nil-rate band would be taxed at 20%, resulting in a £35,000 tax charge.
It is important to note that transferring assets that have depreciated in value, such as property or shares, may also incur Capital Gains Tax (CGT)
What is the 10-Year Rule for Trusts?
The 10-year rule applies to certain types of trust, primarily discretionary trusts, where the trust’s assets are reviewed for Inheritance Tax every ten years. On each 10-year anniversary, trustees are required to pay up to 6% of the trust’s value as IHT. This is designed to prevent trusts from being used to shelter assets from IHT indefinitely. Suppose assets are distributed to beneficiaries before this anniversary. In that case, an exit charge may apply, which is a proportionate portion of the 10-year charge based on how long the assets have been held in the trust.
Exit Charge
An exit charge may apply when assets are distributed from a trust to beneficiaries. This is a partial inheritance tax charge based on how long the assets have been held in the trust before being transferred out. If assets are removed from the trust before the 10th anniversary, the exit charge is proportionate to the time the assets were held.
For example, if assets are distributed five years after being placed into the trust, the exit charge might be 3% of their total value.
Choosing the Right Trustees
Choosing the right trustees is one of the most important decisions when setting up a trust. Trustees are responsible for managing the assets within the trust, complying with legal requirements, and ensuring that beneficiaries receive their intended benefits.
Since trustees have legal responsibilities, it’s important to select individuals who are reliable, financially knowledgeable, and willing to take on the long-term commitment and responsibility of trust management.
Ongoing Administrative Responsibilities
Trustees have ongoing administrative responsibilities. These include maintaining detailed records, filing annual tax returns, and ensuring compliance with trust law and tax regulations.
These administrative responsibilities are ongoing for the life of the trust and can be time-consuming and costly. Given the complexity of these responsibilities, many trusts are managed by professional trustee companies to alleviate burdens and avoid penalties.
Loss of Control Over Assets
Once assets are placed in a trust, the settlor (the person creating the trust) no longer has direct control over them. This means that the settlor must be comfortable with relinquishing control. This is often a key consideration for individuals when deciding whether to establish a trust.
- Trustee Control: Once assets are transferred into a trust, the trustees have full legal control over how the assets are managed and distributed, subject to the terms of the trust deed. In discretionary trusts, trustees have greater control over when and how beneficiaries receive their share of the assets.
- Irrevocability: Many trusts are irrevocable, meaning that once assets are transferred into the trust, they cannot be removed by the settlor. This is an important consideration, as the settlor will no longer have direct access to or control over the assets.
- Emotional Considerations: Relinquishing control over assets can be emotionally challenging, mainly if the trust involves family businesses, properties, or other significant assets. It is important for the settlor to be fully aware of this before deciding to establish the trust.
Advantages of Setting Up a Trust
Trusts offer a variety of benefits beyond helping reduce IHT liability. They provide a secure way to manage and protect assets while giving flexibility over how and when these are distributed. Below are some of the key advantages of setting up a trust:
Protection of Assets
Trusts provide a protective legal structure that shields family wealth from unforeseen circumstances. For example, assets held within a trust can be safeguarded against claims from creditors, which can be crucial in cases of bankruptcy.
Trusts can also offer protection in situations of divorce or marital disputes, helping to prevent family wealth from being divided or depleted as part of a divorce settlement.
See our article on Capital Gains Tax for Divorcing and Separating Couples
Trusts can help business owners protect family businesses from external claims and ensure the business remains within the family.
Delaying Decisions
Trusts allow individuals to delay decisions about the final distribution of assets, which is useful when beneficiaries are young or their financial needs are uncertain.
This flexibility is also beneficial when future circumstances are unpredictable. If beneficiaries’ personal or financial situations change, the trust can be managed to meet their evolving needs, such as covering the cost of a first home purchase or educational costs.
Flexibility
Trusts can offer flexibility in the ongoing management of assets, enabling trustees to respond to beneficiaries’ changing needs over time. Trustees have the discretion to adapt how assets are allocated, distributed, or reinvested based on beneficiaries’ current needs and prevailing financial conditions.
This flexibility is particularly valuable for managing long-term family wealth, as trustees can ensure that assets are distributed responsibly and in accordance with the settlor’s wishes.
Maximising Tax Efficiency with Trusts in Estate Planning
Utilise the Nil-Rate Band and Residence Nil-Rate Band
As mentioned, the nil-rate band allows up to £325,000 of an estate to be passed on free from IHT. You can reduce or eliminate your liability by placing assets into a trust that falls within this threshold. Additionally, married couples or civil partners can transfer any unused NRB to the surviving spouse or partner, effectively doubling the IHT-free threshold to £650,000.
In addition, the residence nil-rate band (RNRB) offers an extra allowance of £175,000 when passing on the family home to direct descendants, bringing the total IHT-free threshold to £500,000 for individuals or up to £1 million for couples.
Early Transfers into Trusts
Establish trusts early to maximise your tax efficiency. This will mean you can benefit from the seven-year rule. By making early transfers into trusts, you can gradually remove significant portions of wealth from your estate, thereby reducing the overall IHT liability. This is particularly beneficial for individuals with high-value estates who wish to pass on wealth to future generations without incurring a heavy IHT charge.
Working with professional advisers, such as solicitors, accountants, and tax specialists, is advised to ensure that your trust is set up and managed correctly. A professional will help you choose the right type of trust to suit your estate planning goals.
What is the Process of Setting Up a Trust?
Establishing a trust involves careful planning, and the process typically includes the following steps:
- Choose the type of trust: Decide which type of trust suits your estate planning needs.
- Select trustees: Appoint individuals who are responsible and capable of managing the trust.
- Draft a trust deed: This legal document sets out the terms of the trust, including how the assets should be managed, who the beneficiaries are, and any specific instructions for distributing the assets.
- Transfer assets: Transfer the chosen assets into the trust. Remember, depending on their value, this may have tax implications.
- Get professional advice: Trusts can be complex, so it’s very important to seek advice from legal and tax professionals to ensure the trust is set up correctly.
Conclusion
Trusts are valuable in inheritance tax planning, offering flexibility and opportunities for potential inheritance tax savings. They allow individuals to manage their assets during their lifetime and ensure a smooth transfer of wealth to their beneficiaries after death. However, trusts are not universally applicable; each individual’s financial situation and goals are unique.
Therefore, careful consideration must be given to the type of trust that best meets your needs, the responsibilities of the appointed trustees, and the potential tax implications involved.
At DS Burge & Co, we offer comprehensive personal tax advice on trust arrangements, estate planning and inheritance tax mitigation. Whether you’re concerned about how your assets might be taxed or looking for ways to safeguard your wealth, we offer personalised advice tailored to your circumstances.
Contact our experts today to see how we can support you.