The tax implications of trusts

Tracy Creed, partner and head of our Private Client team explains the different types of trusts and their tax liabilities.

Note: all tax rates quoted and referenced are effective as of December 2024, and are based on trusts created after 2014.

What is a trust and what types of trust are there?

There are different types of trusts, and these are each taxed differently.

In general, a trust is defined* as a way of managing assets – namely money, investments, land or buildings – for a person or people. Trusts involve the ‘settlor’ – the person who puts assets into a trust – and the ‘trustee’ – the person who manages the trust. In the UK, the majority of Trusts need to be registered with the Trust Registration Service (TRS).

There are many different types of trust including discretionary, life interest, vulnerable persons, accumulation and maintenance, pilot, personal injury, and trusts per autre vie.  Most trusts, including these, are express trusts, which means a trust that is created deliberately by a settlor, usually, but not always, in the form of a document such as a written deed or declaration of trust.

There are also non express trusts such as resulting, implied and constructive trusts. Trusts that are not express trusts are not required to be registered with the TRS as registrable express trusts, but may have to register for taxable purposes if they have a UK tax liability.

What are the most common types of trust?

There are three most common types of trust that are most widely created.

Life interest trusts

Also known as “interest in possession” trusts or where created under the terms of a will “immediate post death interest” trusts.  These involve an individual being given the right to the income or benefit derived from an asset or assets, with the capital of the asset ultimately passing to someone else.  For example, this may be an individual being allowed to occupy a property, or to receive the dividends from a shareholding.

Discretionary trust

A discretionary trust involves trustees being provided with assets which they hold for a defined set or class of beneficiaries.  The trustees can decide which of the beneficiaries, if any, they are going to give the assets to, and whether they will give them income or capital, or a combination of the two. The trustees can choose to divide the assets between the beneficiaries or give all the assets to one of the beneficiaries. What is important with this type of trust is that none of the beneficiaries have an entitlement to anything from the trust until the trustees exercise their discretion and elect to give them something.

Vulnerable persons trust (VPT)

Also known as ‘disabled persons trust’, this is given a particular tax treatment when it is for the primary reason and benefit of someone who is classified as “vulnerable”.  To qualify, the principal beneficiary must be disabled within the meaning set out in Schedule 1a of the Finance Act 2005.

This type of trust is useful as a means of ensuring funds are made available for the lifetime of the vulnerable person, and the funds can be used for various things for example to purchase a property for the vulnerable person to live in, to pay for holidays or respite stays for the vulnerable person, to purchase adapted vehicles and so on.

A VPT is taxed on the same rates applicable to the vulnerable person themself. On the death of the vulnerable person, the value of the trust aggregates with their estate for Inheritance Tax (IHT) purposes. Provided an election is made to HMRC, the trust’s income and capital gains can be assessed at the rates applicable to the vulnerable person.

A VPT often takes the form of either a life interest trust or discretionary trust.  To qualify as a VPT, the trust assets must only (subject to a de minimis) be available for the benefit of the vulnerable person during their lifetime. Therefore, if the discretionary trust is chosen, the discretions only available, (subject to the de minimis) to benefit others after the death of the vulnerable person.

If created in a lifetime, the gift used to create the trust is defined as a potentially exempt transfer for IHT purposes.  If the donor of the gift survives making the gift by seven years, there is no further IHT to pay.  If the donor does not survive the seven years, the value of the gift aggregates with the donor’s estate for IHT purposes, and taper relief may apply. If a gift is made to the value of the nil rate band (or more) and the donor dies within seven years, then the value of the IHT due on the gift will be reduced (tapered) after four years from the date of the gift.

What is the tax regime applicable to trusts?

The tax regime applicable to a trust will depend on how it is created.

A life interest trust created on death will be an “immediate post death interest” (IPDI).  The life tenant, i.e. the person who has the income or benefit will be treated for IHT purposes as if they own the capital of the trust.

In the case of the trust remaining when the life tenant dies, the value of the trust assets will aggregate with their estate for IHT.  For income and capital gains tax (CGT) purposes the trust can be taxed on the life tenant.

However, if a life interest trust that is not for a vulnerable person is created in lifetime, then the trust will form part of the “relevant property regime” (RPR). RPR applies to all trusts that are not an IPDI, VPT, or the very rare “transitional serial interest”.

The creation in lifetime of an RPR trust, is a chargeable lifetime transfer (CLT).  IHT applies if the sum paid into the trust is over and above the available IHT nil rate band that is in force at that time. The current nil rate band is £325,000.  Therefore anything in excess of the nil rate band, will be liable to a 20% IHT charge.  A further 20% IHT liability is due if the settlor (the person giving assets to the trust) dies within seven years of the CLT.

During the lifetime of the trust, IHT is chargeable on distributions of capital to beneficiaries, the tenth anniversary of its creation, and subsequent ten-year anniversaries.

On the tenth anniversary of the trust, there will be an IHT charge if the value of the trust at that time, together with the value of any property distributed in the preceding ten years, exceeds the nil rate band at the anniversary date.

Any income received less than £500 will be free of income tax, provided there are no connected trusts. If the income exceeds £500, income tax will be due on the full amount and at the rate applicable to trusts in the year in which the tax is due.  Currently, the rate of this income tax is 39.35% on dividend income, and 45% on other income.

In the case of trust income being distributed to beneficiaries, the trustees may incur a further tax charge. However, the beneficiary, who will be taxable on the distribution at their marginal rates, will be entitled to a credit for the tax already paid by the trustees.

Trustees have an annual exemption for capital gains tax purposes; currently, this is £1,500 for the 2024/2025 tax year. Thereafter financial gains will be subject to CGT at the rate of 24% on realised gains from 30th October 2024, unless holdover relief is utilised. (Holdover relief will depend on whether it is business assets or shares which are being given away).

Taking account of all of the tax regimes, the tax benefits of a trust may be called into question. However, whether tax benefits can be achieved will depend on the specific and individual circumstances and should be considered as part of a wider estate planning review.

Illustrations

The following fictional scenarios help to explain when trusts might be useful:

• To provide for a disabled or vulnerable child / family member.  David has a son Elliot who has been diagnosed with a disability that he will not recover from.  David wishes to set aside money to look after Elliot in the future.   David has made provision for Elliot and his other children in his will.  David decides to create a VPT in his lifetime and appoints himself, his brother Ian and sister Petronella as trustees.  David is reassured that if he himself becomes incapacitated in future, his brother and sister can make sure that Elliot’s needs continue to be met and supported. David can also take advantage of the beneficial tax treatment afforded to a disabled persons trust.
• To create a family trust fund – for example to pay for grandchildren’s education.  Peter and Mary have two children Jane and Lucy.  Peter and Mary want to set aside money to be used specifically for their grandchildren’s education costs.  Peter and Mary have a combined estate of £1.5m and decide to put £300,000 into a discretionary trust, with the potential beneficiaries of this trust stated as both their current and any future grandchildren.  Peter and Mary appoint themselves, Jane and Lucy as trustees.  Provided Peter and Mary survive the gift by seven years, it will be outside their estates for inheritance tax purposes.
• To mitigate an inheritance tax liability.  Fred and Paul are married and have two children, Sarah and Freya, who are both 18 and have begun their careers. Fred and Paul have a combined estate of £4.0m made up of their home, various investments, and cash in bank accounts of a total £600,000. Fred and Paul decide to each create a discretionary trust, and to gift cash of £250,000 to each trust. The beneficiaries of the trust are stated as their children and grandchildren.  Provided that Fred and Paul survive seven years from making these gifts,and are not  potential beneficiaries of the trusts, the value of their trusts will be outside of their respective estates for IHT purposes.  They can also mandate any income from the trusts to their children so that the income from them is not taxable on Fred and Paul, thereby reducing their own income tax liabilities.
• To prevent an existing IHT liability increasing.  Dave is divorced and has two children.  His estate is worth £3.0m.  Dave’s income is £150,000 per annum and his living costs are c. £50,000. Dave creates a discretionary trust and makes an annual gift of £50,000 into that trust for six years.  Dave is satisfied that giving away this income will not leave him resorting to his own capital to fund his living costs. In funding the trust in this way, Dave is not creating a CLT and therefore does not have to survive any specific length of time. The creation of the trust will not reduce the existing IHT which would fall due on Dave’s estate, but it should help to stop it from increasing.

Trusts and asset protection

Setting up and maintaining trusts isn’t only about tax and tax benefits.  It is not unusual for people to create a trust to protect or ring-fence assets.

For example, a parent could be concerned about a spendthrift child or grandchild and want the trustees to be able to have the option to release funds only when they think it is appropriate to do so, and in a protected and controlled way.

Or a parent could be concerned about a child or grandchild’s addiction, and a trust can provide a safe structure within which the trustees can provide for the beneficiary in a specific way or for a specific purchase. This could perhaps be by buying a property for them to live in, with the property purchased and held in the names of the trustees. In this way, the money isn’t handed over directly to the beneficiary but used for the beneficiary’s benefit.  When, or if, the beneficiary recovers from their addiction, the trustees can consider whether to bring the trust to an end by advancing all of its assets to the beneficiary.

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