Despite reductions in personal taxation over the last two years the tax regime for trusts has remained the same. With an increasing number of people downsizing to release capital and the new pension reforms allowing total access to pension funds it may well be that the use of trusts to benefit children is something being considered. We are therefore reissuing our original article published in August 2103.
This type of trust usually exists where someone holds assets as a nominee for someone else. Formally constituted absolute trusts are not recommended.
Interest in possession trust
Usually set up under a Will where someone is given the right to receive the income of the Trust (or part of it) for life, usually the husband or wife of the person who has died.
Unless a trust deed specifically states otherwise, a trust can invest in anything (which they usually do). Trustees no longer have limits on where they can invest as a result of the Trustee Act 2000. Anything that is authorised by the Financial Services Authority is likely to be OK. However you can restrict which type of investment is used in the trust deed.
Accumulation and maintenance trust
Confusingly an accumulation and maintenance trust is sometimes described as discretionary, because the trustees usually have discretion to decide whether the income from the trust is accumulated or spent for the benefit of the beneficiaries or actually paid to them if they are over age 18.
Since 22 March 2006, new accumulation and maintenance trusts and additions to existing trusts have been treated in the same way as discretionary trusts (see below) unless the assets go to the beneficiary absolutely at the age of 18 (or the Trust was amended to achieve this before 6 April 2008) or the Trust is for a disabled person in which case the age of 25 applies instead of 18 and the new rules don’t apply.
For new accumulation trusts or additions to existing ones where gifts exceed the cumulative inheritance tax exemption limit of the donor, there is a tax charge of 20% inheritance tax when funds are given to the Trust. All such trusts will have to pay a 6% charge of their capital value every 10 years on any value of the Trust in excess of the then inheritance tax limit. In practice existing trusts whose value is below the inheritance tax limit will be unaffected by the new inheritance tax charge.
With an accumulation and maintenance trust a settlor, e.g. a grandparent, gives a sum of money, say £100,000, to a trust for at least one named beneficiary. The trust deed should be drafted by a solicitor with experience in drafting such deeds and might cost you up to £500, maybe more. Once the trust is set up, provided the trust says so, anyone else can add money to it (as well as the original settlor) but this should not be a parent, see Trust income below.
The primary beneficiaries of such a trust are the people named in the trust deed. However they need not yet be born. The deed might specify ‘my grandson Joe Bloggs and any other grandchildren’. While Joe is the only grandson he is entitled to 100% of the income of the trust; but if later four brothers and sisters and cousins arrive, he will only be entitled to a fifth of the trust. Alternatively the trust can be for specified people only. Usually such trusts are more specific and refer to named primary beneficiaries; a new trust can be set up for any further grandchildren who arrive.
With an accumulation and maintenance trust, the trustees have no discretion about who gets income and capital. The share of each beneficiary must be according to the original trust deed. The only discretion is whether to pay out income to a beneficiary. If it is paid out to one beneficiary and not to another, then records have to be kept, showing each beneficiary’s share, so that a beneficiary whose share has been accumulated does not get less.
With a discretionary trust you don’t need to specify who the beneficiaries are. They can be in rather general terms like ‘any of the descendants of John and Jane Bloggs’. The trustees can choose to whom they pay income to, and when; they can decide whether and to whom to advance any capital; when the trust is finally closed down, they can decide to whom the money is given unless this is already specified in the Trust deed. The settlor can leave informal instructions to the trustees on how they should use their discretion (for instance they could be told not to pay any income to anyone who spends it on gambling or illegal drugs).
Discretionary trusts (and now new accumulation and maintenance trusts) have a few snags, however. There can be inheritance tax when money is given to the trust. It comes into effect once cumulative gifts within the previous seven years exceed the inheritance tax threshold (£325,000 up to 5 April 2016). The rate is half the rate paid on death (currently 20% instead of 40%). Discretionary trusts also have to pay inheritance tax once every 10 years on the capital value of their assets if they are worth more than the inheritance tax threshold at the time. Currently that tax is 6% of the capital value of the Trust in excess of the inheritance tax threshold at the time.
If a discretionary trust is set up below the inheritance tax threshold, there is no inheritance tax when it is set up, provided cumulative gifts within the previous seven years including the amount given to the Trust are in total less than the current inheritance tax limit. There is nothing to stop a husband setting one up for £325,000 and his wife setting up a separate trust with identical provisions for a further £325,000. Both would remain below their respective thresholds and no inheritance tax would be payable. However if after 10 years, the value of assets grew above the then inheritance tax threshold, there could be some inheritance tax in the future on the then capital value in excess over the then threshold.
Income from a discretionary trust or an accumulation and maintenance trust is currently taxed at 45% (since 6 April 2013). Income paid by a trustee to a beneficiary is paid with this tax deducted at 45% but the beneficiary (or a beneficiary’s parents in the case of a child beneficiary) can reclaim all (or part) of the tax if he or she is not liable to pay the full amount deducted.
In the case of income received by trustees which comes from UK dividends, the Trustees have to pay 37½% tax to the Inland Revenue on the grossed up amount of the dividend but can set against this the 10% tax credit which is deducted at source and is not reclaimable. This applies where dividend income is accumulated within the trust.
Small trusts with an annual income of £1,000 a year or less since 6 April 2006 pay tax at a rate of 20% for savings income or 10% for dividends. The £1,000 a year applies to all Trusts together of one particular settlor.
Where the beneficiaries are non-taxpayers and income is distributed to them, dividend income from shares or equities, investment trusts and equity unit trusts must be paid after deduction of tax at 35% (not including the 10% tax credit) – and the extra tax has to be paid by the trustee. The beneficiary can then reclaim the full 35%. This makes it less attractive than income from fixed interest stocks or bank and building society deposits if income is to be distributed.
These rules now make a Trust fund which is intended to accumulate money at a date some time in the future less attractive as the income and capital gains will be taxed at the same rate as the donor. The only tax saving will be the avoidance of inheritance tax after 7 years.
But if the Trust is intended to generate an income for a non-tax paying child or young adult, then investment in fixed interest stocks will give a higher income and the whole of the 45% tax deducted by the trust can be reclaimed by the beneficiary or on behalf of the beneficiary. So long as the child only has a modest income from the Trust, then the rise in the trust rate of income has no affect.
Income paid to unmarried children under 18 from a trust set up by a parent usually counts as the parent’s income so no tax rebate is due. It’s not usually worth a parent setting up a such a trust. Such trusts are usually set up by grandparents.
The settlor, the person who gave the money to set up the trust, must not benefit from it; otherwise there are no tax advantages.
The tax repayment claim when the income counts as the child’s is made by the parent on the child’s behalf using Tax Claim Form R232. The trustees must fill in Form R185E giving details of the amount of trust income paid to the parents or spent as well as the tax deducted and give the form to the parent who sends it in with the claim.
If parents are trustees, trust income must be spent on education (e.g. school fees), maintenance (e.g. clothes, food) or benefit (e.g. holidays, presents) to count as having been distributed by the trust and to enable the parent to claim a tax rebate. If the income of the trust is not spent, the 45% tax cannot he reclaimed. But if in a future year the income is spent (in addition to income in that year), the tax can be reclaimed then provided the child (or children) has enough tax allowances in that year.
For more information please contact Graham Clark on 01603 692750 or email Graham.Clark@nwbrown.co.uk