Inheritance tax (IHT) is a complex and often misunderstood area of estate planning, particularly when it comes to discretionary trusts Discretionary trusts can be a valuable tool for passing on wealth to future generations, but they also come with their own set of tax implications Understanding how IHT applies to discretionary trusts is essential for anyone looking to establish one as part of their estate planning strategy.
What is a discretionary trust?
A discretionary trust is a legal arrangement where the settlor transfers assets to trustees, who are then given discretion over how and when to distribute those assets to beneficiaries Unlike a bare trust, where the beneficiaries are named and have a fixed entitlement to the trust assets, discretionary trusts give trustees more flexibility in deciding who should benefit from the trust and when.
One of the key benefits of a discretionary trust is that it allows the settlor to provide for a wide range of beneficiaries, including future generations who may not yet have been born However, this flexibility can also complicate the tax treatment of the trust, particularly when it comes to IHT.
How does IHT apply to discretionary trusts?
IHT is a tax that is payable on the value of a person’s estate when they die, as well as on certain lifetime transfers of assets The current rate of IHT is 40% on the value of an estate above the nil-rate band, which is currently set at £325,000 per person.
When it comes to discretionary trusts, the trustees are responsible for paying any IHT that is due on the trust assets This can be a significant expense, particularly if the trust holds valuable assets or if there have been multiple transfers into the trust during the settlor’s lifetime.
One key consideration when it comes to IHT on discretionary trusts is the concept of relevant property Relevant property is any property that is held in a discretionary trust and is subject to the ten-yearly charge and exit charge regime for IHT purposes This means that the trustees must pay IHT on the value of the trust assets every ten years, as well as when assets are distributed out of the trust.
The rate of IHT that is payable on relevant property depends on the value of the assets in the trust and the length of time that they have been held in the trust iht on discretionary trusts. The current rate for the ten-yearly charge is 6% on the value of the trust assets above the nil-rate band, while the rate for the exit charge is 6% on the value of assets that are distributed out of the trust.
In addition to the ten-yearly charge and exit charge, discretionary trusts are also subject to the usual IHT rules that apply to all estates, such as the nil-rate band and the residence nil-rate band This means that the trustees must take into account any other assets that the settlor has, as well as any previous gifts that have been made, when calculating the amount of IHT that is due on the trust.
How can IHT on discretionary trusts be mitigated?
There are a number of strategies that can be used to mitigate the impact of IHT on discretionary trusts One common approach is to use the settlor’s nil-rate band and any available exemptions to reduce the amount of IHT that is payable on the trust assets.
For example, the settlor could make gifts of up to £3,000 per year, as well as gifts for special occasions such as weddings or birthdays, which would be exempt from IHT They could also use their annual exemption to make gifts of up to £250 to any number of people each year without incurring IHT.
Another strategy is to make use of the settlor’s spouse or civil partner’s nil-rate band, as well as any unused nil-rate band from a deceased spouse or civil partner This can effectively double the amount of assets that can be passed on free of IHT to the trust beneficiaries.
In some cases, it may also be possible to restructure the trust in order to take advantage of the lower rates of IHT that apply to certain types of property For example, assets that qualify for business property relief or agricultural property relief may be subject to a reduced rate of IHT, which could result in significant tax savings for the trust.
Conclusion
IHT on discretionary trusts is a complex area of estate planning, but with careful consideration and expert advice, it is possible to minimize the tax liabilities that can arise By understanding the rules and regulations that apply to discretionary trusts, as well as implementing effective tax planning strategies, it is possible to ensure that the wealth passed on to future generations is protected from unnecessary tax burdens.
In summary, navigating IHT on discretionary trusts requires careful planning and a full understanding of the tax implications Seek advice from a qualified professional to ensure that your estate planning strategy is as tax-efficient as possible.