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Trusts: The tax treatment of discretionary trusts

Fotolia_41561017_S-2These notes apply to trusts where the creator of the trust (the settlor) and his/her spouse cannot benefit from the trust.  If the settlor or his/her spouse can benefit from the trust, special rules apply.

Inheritance tax

Inheritance tax depends very much on the sequence of events which occur after the trust is set up.

If the trust is contained in a will the trustees can, within two years from the date of the testator’s death, distribute the whole of the trust fund to one or more beneficiaries without any liability to inheritance tax.  After the end of this two year period, or in the case of a trust created other than on death, inheritance tax will be due under the “relevant property” regime.

Under the present law this will mean inheritance tax at up to 6% of the value of the trust assets every 10 years, and charges at a proportion of this rate if property leaves the trust between 10-year anniversaries (exit charges).

Exit charges are calculated by reference to the rate of tax applicable when the trust was originally set up or on the last ten year anniversary.  Within the first ten year period the rate of inheritance tax will usually be nil.

On each tenth anniversary of the creation of the trust (the date of death if created by a will) the trust assets are re-valued.  If the total value of

  • the trust assets,
  • any assets transferred out of the trust in the previous ten years, and
  • the value of chargeable lifetime gifts made by the settlor in the 7 years before the creation of the trust (the date of death of created by will)

is still within the nil rate band at whatever level it is then, there will be no inheritance tax to pay.  If the total value exceeds the nil rate band (£325,000 in 2012/13), the excess is liable to a maximum of 6% inheritance tax.

If the trust is brought to an end after the tenth anniversary, the exit charge is reduced according to the time that has elapsed since the ten yearly charge.

Income tax

While the trustees’ discretion over income continues, any income received by the trustees (in excess of £1,000―this first tranche will be taxed at lower rates) will be subject to income tax in the trustees’ hands at the rate applicable to trusts in the year in which it arises. The rate applicable to trusts is currently 50% (or 42.5% on dividend income).

If trust income is distributed to beneficiaries, the trustees may incur a further tax charge but the beneficiary, who will be taxable on that distribution at his or her marginal rates, will be entitled to a credit for the tax already paid by the trustees. Beneficiaries whose marginal rate of tax is less than the rate applicable to trusts will be able to reclaim some or all of the tax previously paid by the trustees.

Capital gains tax

The trustees of a discretionary trust are responsible for capital gains tax at 28% on gains which they realise.  They do, however, enjoy an annual exemption (£5,450 in 2013/14).  This is reduced if the settlor has created more than one trust.

When the trust fund is distributed to the eventual beneficiaries, this counts as a chargeable disposal by the trustees for capital gains tax purposes.

Under present legislation, when a capital gains tax charge arises at the same time as an inheritance tax charge (even one at 0%), it is possible for the trustees and the eventual beneficiaries to elect to hold-over the gain.  This means they postpone the payment of capital gains tax until the beneficiary sells the asset or gives it away.  Taper relief is not available when a hold-over election is made.

These notes are intended only as a guide and are not to be treated as a substitute for professional advice.

By Karen Shakespeare, 5th May 2013

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