However, in the UK, the rates of tax applying to trustees have steadily increased over the past few years, perhaps discouraging the use of these structures despite their numerous other benefits. Here we look at the position of UK resident trusts and some of the main benefits that trusts offer.
Firstly, what is the tax position for someone looking to set up a trust? Any individual establishing a UK resident trust with chargeable funds in excess of the nil rate band (£325,000 currently, and frozen for the next four tax years) will attract an immediate lifetime inheritance tax (IHT) charge at 20% on the amount exceeding the nil rate band.
There is also potentially a charge to IHT every ten years from the date the trust was created and when capital leaves the trust. However, this charge is capped at a maximum of 6% of the value of the funds. In practice the rate applying is often lower, particularly where trusts are initially funded to the level of the nil rate band – in which case the charge is likely to be minimal if not nil. Compared to a potential 40% IHT charge in an individual’s estate, this rate offers a substantial tax saving.
A well-advised client will be aware that there are a variety of ways of funding trusts in excess of the nil rate band, without incurring the immediate 20% IHT charge. This includes making use of the gifts out of excess income exemption, by the donor loaning funds to trustees rather than making gifts outright or by utilising property that qualifies for business or agricultural property relief.
Income and Capital Gains Tax
Turning to the other tax rates applying to trustees of discretionary trusts, those generating more than £1,000 income per annum, the tax rate applying is 50% (42.5% on dividend income) and any capital gains generated are taxed at 28%. Clearly, the headline income tax position is disadvantageous as the 50% rate applying above £1,000 for trustees applies to individuals only once £150,000 of income has arisen.
Again, this tax rate can be planned around with some consideration by the trustees. The rate itself applies to net income and unlike individuals, trustees are able to claim deductions for expenses incurred against gross income. In addition, the trustees may choose to pay out income to their beneficiaries during the tax year. If the income is paid out to a beneficiary who pays a marginal tax rate at anything below 50%, a tax repayment claim can be made, meaning that whilst there is a timing/cash flow issue, the actual income tax rate applying to the trust income is determined by the beneficiary’s tax rate.
Even if income is not paid out various strategies can be employed to make this rate less onerous. Gearing a portfolio towards generating capital growth, or using a structure such as an offshore life assurance bond within the trust, are just two examples of how the ongoing income tax suffered can be minimised. It may even be appropriate, given the requirements of the beneficiaries for trustees to appoint a life interest, to sidestep the 50% rate of income tax.
From a capital gains tax perspective, the rate applying for trustees is the same rate for individuals, so there is no tax “leakage” on capital gains made within a trust. Care should be taken if a trust is being funded by assets that could qualify for Entreprenuer’s Relief, as this is unlikely to apply to funds held in trust. However, beyond that, it is arguable that it is better to have assets expected to appreciate in value within a trust because the capital gains tax position is neutral. However, for IHT purposes, any future growth on the asset falls immediately outside the individual’s estate.
Succession planning and asset protection
Setting the tax position to one side, succession planning and asset protection are two of the main purposes for using a trust. The ability to hold family money in a manner that allows for peace of mind that assets will be secure, that beneficiaries will be protected from external parties (and themselves) and assets will be distributed in the correct manner at the right time is appealing for a variety of different reasons.
Consider the father on his second marriage, with children from each marriage; the elderly matriarch wanting to benefit her grandchildren in the future; the anxious parents who watch as their children embark on relationships with unsuitable suitors or who acquire friends with dubious habits; the retiring founder of a family business. In each case, a trust could be of benefit in different ways. Simply put, a trust can provide reassurance that family money will be protected in the future, regardless of changes in family, social or economic dynamics.
A trust can be useful in respect of the maintenance and education of children – school fees planning for instance. Whilst only sums that can be demonstrably used for the child’s maintenance and education can enter the trust free from IHT (compared to the old rules, which were far more generous), moving this money into a protected environment ensures that whatever happens to the parents in the future, the money in the trust can only be used to provide for their children.
Charitable trusts
Charitable trusts are a planning area gaining traction amongst the wealthy. A charitable trust suffers no income or capital gains tax on an ongoing basis and can provide a focal point for a client’s lifetime philanthropic work as well as a legacy after their death. There are no perpetuity rules applying to charitable trusts so the charity can in theory last forever and often provides a focus for the family in the future. Funding the trust initially can offer income tax and capital gains tax relief and any transfer into a charitable trust is exempt from inheritance tax immediately.
The last point to make is that the use of trusts can be helpful to protect family assets earmarked for your children in the event of the breakdown of one of the children’s marriage. The law in this area is complex and ever-evolving, the Radmacher case decided last week adding greatly to our understanding of pre-nuptial agreements. However, if funds are in trust already for the benefit of your children, it is fair to say that there is a greater chance of them being excluded from the divorce proceedings than if the funds are owned outright.
In summary, the painting of a trust solely as a tax avoidance vehicle is erroneous and old-fashioned. In a world where asset protection from even your nearest and dearest is prized amongst the wealthy, trusts will always serve a purpose and structured correctly will still offer the well-advised client many benefits.
