Inheritance Tax and Trusts
A trust or settlement arises when a settlor transfers assets to trustees to hold for the benefit of one or more persons, the beneficiaries. It can be created in lifetime or by Will, or it can arise under the intestacy rules (a ‘statutory trust’).
There are many types of trust and the inheritance tax (IHT) rules apply to them in different ways.
A bare trust is one where the beneficiary has an absolute right to the assets and income, but the trustees hold the assets as nominees. The transfer to a bare trust is a potentially exempt transfer, as explained in one of our earlier articles, if the donor survives for seven years and the assets are treated as part of the beneficiary’s estate for IHT.
An interest in possession trust is one where one or more beneficiaries has a right to the income, and includes a ‘protective trust’ where a beneficiary’s right to income ceases if they become bankrupt. A beneficiary who became entitled to income before 22 March 2006 is treated as entitled to the assets for IHT so the trust capital forms part of their estate on death. This also applies to situations after 22 March 2006 such as immediate post death interests, where a beneficiary becomes entitled to income on the death of an individual, or a disabled person’s trust. Otherwise an interest in possession arising after 22 March 2006 is within the IHT ‘relevant property’ regime.
Relevant Property Trusts
Most trusts nowadays are within the IHT relevant property rules and include discretionary trusts and post 22 March 2006 interest in possession trusts. A discretionary trust is one where the trustees may decide on the distribution of capital and income at their discretion and no beneficiary is automatically entitled to income
The transfer of assets to a relevant property trust, by an individual in their lifetime, is a chargeable lifetime transfer and accordingly the settlor is liable to IHT on the property transferred to the trust at one half of the full rate (20%), except to the extent that the transfer is within the nil rate band, currently £325,000. The transfer has to be grossed up if the settlor also pays the inheritance tax. If the settlor dies within the next seven years, tax on the lifetime transfer is recalculated using the full rate applicable at the date of death (40%), less a credit for tax already charged.
Occasions for charge
Relevant property trusts have their own nil rate band for IHT, based on the settlor’s nil rate band at the time they create the trust, tax is charged every ten years by reference to the value of the trust funds (the ‘periodic charge’) and on distribution of capital to beneficiaries between the ten year anniversaries (‘exit charges’).
Rate of tax
The maximum rate of IHT on a relevant property trust is 6% although the ‘effective rate’ may be less after the nil rate band is taken into account and a reduction applied for the number of quarters in the ten year period when the property has not been relevant property.
The charge on the first ten-year anniversary is found by reference to the settlor’s chargeable transfers before they settled the funds, plus the distributions liable to exit charges and the value of the fund at the anniversary.
Special treatment is available where there is an entitlement to income and capital at any age up to 25. These are referred to as 18 to 25 trusts. The IHT charge applies at age 25 (or earlier) when the beneficiary becomes entitled to the capital, but the charge is based on a maximum of seven years of the normal charge.
A trust created on an individual’s death for a person under the age of 18 where at least one their parents has died, and the funds become payable to that minor on attaining 18, is known as a trust for a bereaved minor, and is not a relevant property trust. These trusts are not subject to IHT on their ten-year anniversaries and there is no IHT exit charge when the beneficiaries become entitled to their funds.
A trust for a disabled person is also not within the relevant property rules and the individual is effectively treated as owning the assets for IHT purposes.
Family Investment Companies
A Family Investment Company (FIC) is often nothing more than a private limited company with a multigenerational share structure. Parents often hold the voting shares with children owning some of the capital via fully participating non-voting shares. In many circumstances there are significant restrictions on the transfer of the children’s shares, particularly when the children are minors or under the age of 25.
Where the capital base of the FIC is small, parents will often make an interest free or low interest loans to the company in order to provide it with more meaningful investment capital. The loans can be repaid to the parents in the future should they wish.
The parents are often the directors of the company too, making the day to day decisions relating to the operation of the company and executing contracts on behalf of the company.
At current tax rates the FIC would pay tax in the UK under the corporation tax regime and adopting corporation tax rates, currently 19%. In the right circumstances several planning opportunities can make a FIC more attractive from a tax perspective when compared with trusts:-
- Dividends received by a UK company from another UK company are generally tax free;
- Other income arising to the company should generally be taxed at 19% as opposed to up to 45% for trust income;
- FIC’s may be able to set costs against taxable income that are not available for
trustees, such as investment management costs;
- Corporate chargeable gains would be chargeable to corporation tax at 19% as opposed to personal capital gains tax rates of 20%. (However, companies do not have annual CGT exemptions which may be available to trustees);
- Where the relevant conditions are met, FIC’s may achieve the Substantial Shareholding Exemption on qualifying disposals, making such disposals exempt from corporation tax.
As a normal limited company the FIC will need to prepare accounts in accordance with UK GAAP and also submit an annual corporation tax return. For private limited companies the accounts will need to be filed at Companies House, although small company disclosure exemptions may be available. If disclosure of the annual accounts at Companies House is of particular concern, and provided there are few, if any, liabilities at the FIC level, an unlimited company may be attractive.
Finally, although the FIC can provide a known structure plus ongoing tax efficiencies compared with trusts, it should be noted that on extraction of funds from the FIC it is likely that both the payment of dividends by the FIC and the payment of capital to the shareholders on a winding up of the FIC is likely to be taxable receipts for the shareholders.
Should you have any queries or questions in respect of the above, please reach out to your usual Arnold Hill & Co contact, call our mainline on 0207 306 9100 or email our general address email@example.com
The information in this article is believed to be factually correct at the time of writing and publication, but is not intended to constitute advice. No liability is accepted for any loss howsoever arising as a result of the contents of this article. Specific advice should be sought before entering into, or refraining from entering into any transaction.