Inheritance tax and trusts

Using trusts to avoid inheritance tax

Trusts offer a way to manage your estate when you pass away, keeping an element of control over what happens to your assets and how they can be used.

The tax treatment of trusts can also mean they're useful for reducing the amount of inheritance tax (IHT) that will be paid. However, the rules around inheritance tax and trusts are complicated, and it might cost you more.

As such, you should think carefully before setting up a trust to avoid inheritance tax, and seek appropriate advice. Trusts can be expensive, and tax shouldn't be the main reason for setting one up.

• Are you making a will? If you want support, you can make your will and have it reviewed by Which? Wills

How do trusts work?

As the creator or 'settlor' of the trust, you stipulate how it ought to be run. After you pass away, the ownership and control will shift to your nominated trustees, who are legally obliged to manage the assets on behalf of your beneficiaries.

You'll agree a trust deed, which dictates how the trustees should manage the assets. You must have confidence in the trustees, as they'll legally own the assets. Note that settlors can be trustees, too.

Assets in trust don't form part of your estate, meaning they won't be included when working out how much inheritance tax is due, provided you live for seven years after placing the assets into trust.

Trusts come in many forms, and the rules can vary depending on the type.

How are trusts taxed?

It's a common misconception that assets in trust are exempt from inheritance tax.

You'll normally pay it at 20% when setting up a trust if it's in excess of the nil-rate band. There are some exceptions, such as if you continue to benefit from the assets.

The way a trust is taxed depends on what sort of trust it is.

For a discretionary trust (the most commonly used for inheritance tax planning), the rules are as follows:

1. Pay 20% IHT when setting the trust up

Start by working out the value of the asset that's not covered by your personal allowance. You'll pay a 20% tax charge on this amount when the trust is set up.

2. Pay 6% IHT each 10 year anniversary

Any assets in the trust need to be re-valued each decade. After that, a 6% charge is levied on the value of the total assets, less the £325,000 IHT allowance.

3. Up to 6% tax on exit

Finally, IHT will need to be paid again when the trust is closed, or if assets are removed. Tax is based on the most recent 10-year anniversary valuation, up to 6%, charged on a pro-rata basis.

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How do the tax charges work?

The 20% charge applies to the value of assets you put in the trust, less any inheritance tax allowance you haven't used in the past seven years. So, if you placed assets worth £400,000 into trust and hadn't used your allowance elsewhere, you would pay £15,000 (20% of the £75,000 in excess of the £325,000 allowance).

If you set up multiple trusts, this will be factored in when you pay tax establishing the trust. So if the second trust is established within seven years of the first, you can't claim the £325,000 allowance - only any amount you hadn't already used.

On top of the tax paid when setting up the trust, there's also a tax charge on assets in trust every 10 years afterwards. This is levied on the current value of the assets, after deducting the £325,000 inheritance tax allowance.

So if that £400,000 investment increased in value to £500,000, IHT would be due on £175,000. This is charged at 6% (over the £325,000), so in this example there would be a £10,500 bill.

Finally, an exit charge is levied if or when assets are removed from the trust, or the trust is closed. The tax is charged at the most recent 10-year valuation. Again, the £325,000 IHT allowance is deducted, so if the estate is worth £500,000, then £175,000 would be subject to IHT.

The same 6% applies, although it's charged on a pro-rata basis, since the last 10-year charge. So if five years have passed, you'll pay 3%, and if only one year has passed, you'll pay 0.6%.

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Example: tax on discretionary trusts

Say Carla is transferring her £500,000 property into a trust.

She hasn't used any of her £325,000 personal allowance in the past seven years. So £175,000 of her property's value is subject to 20% tax on setting up the trust, resulting in a £35,000 bill in the first year.

The assets are revalued every decade. The property value increases to £750,000 in the first 10 years - this is subject to a 6% tax, less the £325,000 allowance. So the tax bill would be 6% of £425,000, for a total of £25,500 after 10 years.

Five years later, the trust is closed. In that time, the property value has risen to £800,000 - however, the rules allow the initial value of the property at the start of the 10-year period to be used. So, it would be £750,000 minus the allowance, which again comes to £425,000. It's only been five years, so the 10-year tax rate of 6% is halved to 3%.

This means 3% tax is payable on £425,000, for a total of £12,750 as an exit charge.

• Find out more: Inheritance tax: thresholds, rates and who pays

What sort of trusts can be set up?

There are many options available to people setting up trusts, and this list is not comprehensive.

This list covers trusts you set up before passing away, although other arrangements exist to establish trusts in your will.

Bare trusts

Bare trusts are simple trusts used to hold assets on another person's behalf until they choose to take ownership.

For example, bare trusts are used to hold assets for a child to ensure they don't use them until they're grown up. This type of trust doesn't follow these inheritance tax rules.

Instead, assets placed in a bare trust are treated as potentially exempt transfers.

You'll pay no IHT when establishing the trust, but if you die within seven years of creating it, it will be taxed as part of your estate.

Discretionary gift trusts

The most popular type of trust. You hand over the assets to the trust and stipulate how you would like them to be used for the beneficiaries. Crucially, the trustees are free to act at their own discretion. The property IHT allowance can't be claimed against property in a discretionary trust, so if you've already set one up you should review your arrangements with an adviser.

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Loan trusts

Available 'over the counter', these can be used to limit future gains in the value of your estate. You lend your assets to the trust, meaning they still form part of your estate. However, any investment returns from your assets remain in the trust, and fall outside your estate for tax purposes.

Discounted gift trusts

These are typically used to hold insurance bonds and allow you to receive income for up to 5% of the bond each year. The capital sits outside your estate and transfers to the beneficiaries when you die.

• Find out more: will trusts and lifetime trusts

Registering a trust with HMRC

You might be required to register your trust in order to comply with anti-money-laundering requirements, or if you need to get a UTR number to complete a self-assessment tax return for the trust.

Registering taxable trusts

You need to register your trust with HMRC if it becomes, or is already, liable for the following taxes:

• capital gains tax
• income tax
• inheritance tax
• stamp duty in England, LBTT in Scotland and LTT in Wales
• stamp duty reserve tax.

Registering non-taxable trusts

Non-taxable trusts in existence on or after 6 October 2020 must have been registered with the Trust Registration Service (TRS) by 1 September 2022.

The TRS was first set up in 2017, and only required trustees to register if the trust incurred income tax, CGT, IHT, stamp duty or stamp duty reserve tax. The information held about the trusts was only to be accessible by HMRC and other law enforcement agencies.

However, the scope of the TRS was extended in October 2020, meaning non-taxable trusts and even some trusts held outside the UK must also be registered - and this must be done by the 1 September deadline.

From later in 2022, the information held about the people associated with a trust may be shared with organisations and individuals involved in preventative work around anti-money laundering, counter-terrorist financing and associated offences.

How to register a trust

If you're a trustee, you can register a trust online - but you'll need an organisation government gateway user ID and password.

You'll need information such as the name of the trust, the date it was created, and personal details of the lead trustees and beneficiaries - there's a more extensive list on the government's website.

Once the trust is registered, HMRC will usually issue the lead trustee with a UTR number for making self-assessment tax returns.

Trusts that don't need to be registered by the deadline

• Trusts for bereaved children under the age of 18,or adults aged 18 to 25, set up under the will (or intestacy) of a deceased parent or the Criminal Injuries Compensation Scheme.
• Will trusts, created by a person's will that's come into effect on their death. In this case, the trust can remain unregistered for up to two years. If it still exists once those two years are up, it must be registered with the TRS.

Example

Alice and Bob own a property as tenants in common. Alice dies, and by the terms of her will leaves her share of the property on trust to Bob to occupy for the remainder of his life. As a trust created by will, the trustees are not required to register the trust immediately on Alice's death.

If the trust is still in existence two years after Alice's death, the trust is required to be registered from that point.

For more information, there are several trust and estates guides on gov.uk.

Where can I get advice on trusts?

You'll want to seek the advice of a lawyer or accountant with knowledge in this area.

STEP (formerly known as the Society of Trust and Estate Practitioners) manages a database of people who can help with this. Visit its website for more information.

What will a trust cost?

It really depends on your circumstances.

In addition to the inheritance tax charge when setting up the trust, the trustees will likely charge a fee for managing the trust, and there are other legal costs to setting one up.

Because of these expenses, you should carefully weigh up whether your estate would benefit from a trust.