Written by Ray Coman
Despite recent legal changes which have removed many of the tax benefits of trusts, they are still an effective way to protect and control family wealth. The typical purpose of a trust is to allow someone to enjoy financial security provided by an income without giving that person any right over the asset which produces the income.
A trust is an arrangement in which one person (the trustee) manages property for the benefit of another person (the beneficiary.) Trustees must act according to the wishes of a third person (the settlor) who gives property to the trust.
There are two main forms of trust, a life interest and related property trust.
Life interest trusts
Generally in a life interest trust, a beneficiary has the benefit of income from the trust for life (or for a specific period), but the capital passes to a different beneficiary. A common example is a trust that forwards income to a widow for the rest of her life, and passes capital to the children on her death.
Related property trust
In a related property trust, it is common for the trustees to have greater control over who will receive income and capital. Trustees are directed by the wishes of the settlor which are normally set out in a trust deed.
For life interest trusts created up to 22 March 2006, the creation of a trust did not give rise to an inheritance tax charge. The creation of the trust would also be created as a potentially exempt transfer so that no further inheritance tax would be paid if the donor survived for seven years. There were no periodic or exit charges, although there was a charge when the life interest ended. This is commonly where the interest would be included the deceased's estate.
Life interest trusts created after 22 March 2006 will be treated as related property trusts, unless:
- The trust is created under a will and meets certain conditions such as giving total interest in the income to a beneficiary; or
- The trust is created for the benefit of a vulnerable person, such as disabled person
Inheritance tax on trusts
Related property trusts set up during the life of the settlor will potentially attract an inheritance tax liability. There is no tax to pay where the gift (and certain previous gifts) is below the nil rate band. Any amount of property over the nil rate band is subject to tax at 20%. Related property trusts set up by a will, are paid out of the estate. The balance of the taxable estate over the nil rate band is taxed at 40%.
Although the lifetime tax at say 20% is lower that tax at 40%, there is additional tax to pay on a related property trust. There is a charge to inheritance tax every ten years, which is a maximum of 6% of the value of the trust property. There is also a tax when assets are distributed from the estate.
Income tax and capital gains tax
Assets are transferred from the trust will be subject to capital gains tax. The annual exemption is half that for individuals. It may be possible to defer gains.
In an interest in possession trust, income is taxed at 10% on dividend income and 20% on all other income. Income from a related property trust is taxed at 32.5% on dividends and 40% on all other income. Beneficiaries will receive a credit for income taxed, so that they will effectively pay the same tax as if they had received the income directly.
Once a trust is set up, there are a number of legal requirements to satisfy. These include the completion of an annual Trust Return and inclusion of trust income in the personal tax return and calculations.
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