Tax Implications for Discretionary Trusts
Many people think about setting up a trust for their family, as it can be a useful vehicle for tax planning and providing for future generations. One type of trust is a 'discretionary trust' and we will take a deeper look at its benefits and implications.
What Is a Discretionary Trust?
A discretionary trust is a very flexible trust that usually grants trustees discretion to make decisions about how to use the trust assets for the potential beneficiaries of the trust. A beneficiary of a discretionary trust is referred to as a 'potential beneficiary', because they would only receive assets from the trust if the trustees decide to exercise their discretion in favour of one or more of the beneficiaries. The trust document will set out who the trustees and potential beneficiaries are, as well as setting out what powers and discretions the trustees have.
As with all types of trust, there are income tax, capital gains tax and inheritance tax implications to consider. A broad overview of the tax implications of creating a discretionary trust is given below.
Dr Otto wishes to make provision for his three children during his lifetime, but does not want them to have access to too much money while they are still young. He has some shares worth £20,000 and a second property worth £480,000 which he would like to put into trust for them, and would like to appoint his wife, Rebecca, and his sister, Amelia, as the trustees. To make sure they have as much flexibility as possible, he thinks a discretionary trust would be the best option, but what are the tax implications?
Income Tax Implications
Once the trust has been set up, the trustees will need to make annual returns to the Revenue to declare any income received by the trust in each tax year. The trustees will not benefit from any allowances for income tax, and so all income received by the trust will be subject to income tax.
- Trust income up to £1,000 is taxed at 8.75% for dividends and at 20% for all other income.
- Any income over £1,000 is taxed at 39.75% for dividends and at 45% for all other income.
If the trustees pay out income to a beneficiary, they should provide a tax certificate at the end of the tax year so that if the beneficiary is a lower rate tax payer the tax paid at the higher rates can be reclaimed.
Capital Gains Tax Implications for Dr Otto
When Dr Otto transfers the shares and the property into the trust, the transfers will be treated by the Revenue as 'disposals' by Dr Otto, for capital gains tax purposes. However, a claim can be made to HMRC to 'hold over' any gain if the shares and/or the property are worth more when they are transferred into the trust than they were when Dr Otto acquired them.
Capital Gains Tax Implications for the Trustees
As the trustees, Rebecca and Amelia will be liable for capital gains tax on gains made as a result of disposing of assets. If they dispose of the shares and property originally transferred to the trust, the gain will be calculated on the basis of the value when Dr Otto first acquired them. Any gain realised on the disposal of trust assets will be subject to assessment for capital gains tax, and the trustees will need to account to HMRC for any gains and pay the tax out of trust assets. The trust can benefit from an annual allowance for capital gains tax, currently £6,150 (or £12,300 if the beneficiary is considered vulnerable). Certain reliefs might be available to trustees who transfer assets out of a trust to a beneficiary, which would need to be considered on a case by case basis.
Inheritance Tax Implications for the Settlor
When Dr Otto creates the trust, the transfers of the shares and the property will be treated by the Revenue as being lifetime gifts to the trust. This is known as a 'chargeable transfer' and is subject to an immediate assessment to inheritance tax. As the value of the assets to be transferred to the trust will exceed Dr Otto's allowance for inheritance tax (currently £325,000) there will be an immediate charge to inheritance tax, at 20% (even though Dr Otto is still living). The tax charge will be on the value of the assets in excess of Dr Otto's allowance - subject to any available reliefs being claimed. To avoid an immediate charge to inheritance tax, the value of the assets being transferred should be within the allowance.
Inheritance Tax Implications for the Trustees
Discretionary trusts are subject to a periodic charge to inheritance tax, (even in the lifetime of the settlor). The charge arises on the tenth anniversary of the creation of the trust, and at the end of each subsequent ten-year period during the life of the trust. The tax is charged on the value of the assets in the trust immediately before the anniversary, but the trustees might be able to claim certain reliefs on eligible assets. If no relief applies, the tax charge is a 6% charge on the value of assets in excess of the trustees' allowance for inheritance tax (currently £325,000).
In addition to the ten yearly periodic charge, there will be a separate charge to inheritance tax when distributions are made from the trust within each ten-year period (known as 'exit charges'). Depending on when in the ten-year cycle the exit charge arises, it is charged as a percentage of the 6% ten-yearly charge.
Is a Discretionary Trust Right for You?
Discretionary trusts can be a useful way of providing for beneficiaries and protecting assets, but they need careful consideration because of the tax consequences and ongoing trust administration responsibilities while the trust is in existence. They are flexible instruments that ensure the protection of the assets that are transferred into the trust and of the beneficiaries (who will only receive assets from the trust if the trustees decide his should be the case).