Inheritance tax – Setting up a trust
Archived article: please remember tax and investment rules and circumstances can change over time. This article reflects our views at the time of publication.
This article is an extract from Octopus Investments' publication "A guide to untangling inheritance tax" and it is reproduced with its permission. Read more about Octopus Investments.
The article has been written in accordance with Octopus Investments’ understanding of the law and interpretation of it at the time of publication: remember tax rules can change and benefits depend on circumstances.
Trusts can be used to make sure that assets are given to beneficiaries in a timely and controlled manner, without incurring an inheritance tax bill.
People usually set up trusts as a way to make sure assets are kept in the family over generations. The biggest advantage of trusts is that they can be set up exactly to your own personal wishes.
There are several different types of trusts to meet different needs. For example:
- If you want to leave assets to children or grandchildren, but you don’t want them to have access to the assets until they’re a certain age.
- If you want to impose certain restrictions on how your estate is allocated to beneficiaries.
- If you want someone to receive an income from your assets during their life, but ultimately want the assets to be passed to someone else.
Understanding the limitations of trusts
Trusts offer much greater control as to where your money will go, but they can be complicated to set up.
Additionally, since 2006, inheritance tax charges have applied when certain trusts are set up, and when assets are transferred out of the trust to the trust beneficiaries. This can make settling a significant amount into trusts less attractive. Assets settled into some kinds of trusts that are set up during your lifetime also take seven years before becoming exempt from inheritance tax, similar to making a gift directly to a beneficiary. If you die before then, the amounts settled into trust will be included in your estate, and inheritance tax will be payable if the estate is valued at more than the nil-rate band.
Types of trust and how they work
Usually set up to provide money for a group of beneficiaries – for example, children or grandchildren – but responsibility for managing the assets in the trust is given to someone else: the trustee. For the purposes of inheritance tax, the assets in a discretionary trust are outside of the estate, provided the person who set up the trust lives more than seven years. However, inheritance tax can be payable (1) at the outset, (2) every ten years (known as ‘periodic’ charges) or (3) when trust assets are paid out to beneficiaries.
Discounted gift trusts
These involve a person making a gift to a trust while retaining the right to pre-agreed payments of capital from the trust during their lifetime. For inheritance tax purposes, the gift is valued after applying a ‘discount’ based on the person’s age, sex and health. The effect is that they can immediately reduce the value of their taxable estate by the amount of the ‘discount’ applied to their gift to the trust, while retaining the benefit of the regular payments from the trust during their lifetime. The discount is given because the trust will be paying amounts out to the owner for the rest of their life. But if these amounts are not spent, they will again be subject to inheritance tax when the owner dies.
Immediate Post Death Interest trusts
These ensure that one beneficiary receives a ‘life interest’ in the assets in the trust. A life interest could be the right to live in a house, or the right to receive rent from that property throughout the rest of their lifetime. The capital held in the trust has to be passed to different beneficiaries in the future. Here’s an example: a husband has children from a first marriage but has since remarried. He can set up a trust in his will, naming his second wife as the lifetime beneficiary (also known as the ‘life tenant’). His wife can then receive an income from the trust for the rest of her life. When she dies, the capital in the trust will pass to her husband’s children from the first marriage. When it comes to inheritance tax, the assets in the trust, not just any unspent income from it, are classed as part of the lifetime beneficiary’s estate. When they die, the value of the trust is part of their ‘death estate’, so it may use up some or all of their nil-rate band and inheritance tax may be payable.
Typically, a person sets up a loan trust with themselves as the trustee, for the benefit of someone else. The trustee makes a loan to the trust which is often repayable on demand. They are able to invest the loan capital in order to generate growth for the trust, and ultimately the beneficiaries, over the long term. The growth within the trust is immediately exempt from inheritance tax.
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