What are trusts?
A trust is an arrangement where PROPERTY is transferred by an individual (SETTLOR) to the TRUSTEES, to be held for the benefit of one or more specified persons (BENEFICIARIES). The specific terms of the arrangement are contained in the TRUST DEED which outlines the trustee’s powers & duties.
The Trustees are the LEGAL OWNERS of the property after the transfer from the SETTLOR and they act in a representative capacity in the best interests of the BENEFICIARIES.
The separation of the LEGAL OWNERS from the BENEFICIAL OWNERS allows the TRUST to provide INCOME from the assets to one group of BENEFICIARIES while preserving the CAPITAL for another group of BENEFICIARIES.
What types of trusts are there?
There are many different types of TRUSTS. But two main types are:
- DISCRETIONARY TRUSTS (DT)
- INTEREST IN POSSESSION (IIP) TRUSTS
Discretionary Trusts (DT)
As the name implies, discretionary trusts are operated at the DISCRETION of the TRUSTEES.
The BENEFICIARIES have NO LEGAL RIGHT to benefit from the INCOME or CAPITAL of the TRUST.
Any distribution of INCOME or CAPITAL is at the sole discretion of the trustees.
When INCOME is distributed to the BENEFICIARIES it is deemed to be distributed NET OF 45% TAX and is always taxed as NON-SAVINGS INCOME. On the INCOME TAX COMPUTATION the amount received must be grossed up by 100/55 and is taxed in the year RECEIVED.
The BENEFICIARY will then receive a TAX CREDIT of 45% which then acts as a TAX REDUCER on the INCOME TAX LIABILITY.
Interest In Possession (IIP) Trust
As the name implies, with an Interest In Possession, the BENEFICIARY has a LEGAL RIGHT to receive income generated by the trust assets OR to USE a trust asset e.g live in a property.
This BENEFICIARY is known as a LIFE TENANT as they have a LIFE INTEREST in the trust.
Once the LIFE INTEREST comes to an end the CAPITAL will be distributed to the BENEFICIARY of the CAPITAL assets. This BENEFICIARY is known as the REMAINDERMAN.
The LIFE TENANT is legally required to receive income from the trust assets. This is why the BENEFICIARY must account for the trust income each tax year.
When INCOME is distributed from an IIP trust it is received NET OF 20% TAX and NET OF 7.5% TAX for DIVIDENDS.
On the INCOME TAX COMPUTATION the INCOME amount must be grossed up by 100/80 and the DIVIDEND amount must be grossed up 100/92.5.
The BENEFICIARY will then receive a TAX CREDIT of 20% for INCOME and a TAX CREDIT of 7.5% for DIVIDENDS which acts as a TAX REDUCER on the INCOME TAX LIABILITY.
CGT while assets are in the TRUST and on transfer OUT of trust.
While assets are in the trust, the trust is still subject to CGT each tax year but at a higher rate of 20% and 28% on residential property.
The trust receives an ANNUAL EXEMPT AMOUNT of £6,150 (half the amount available to an individual).
When assets are transferred out of trust to a BENEFICIARY it is a GIFT OUT OF A TRUST and a CHARGEABLE DISPOSAL at MARKET VALUE. In most cases, since there is a charge to IHT (EXIT CHARGE) then GIFT relief is available to defer the gain and lower the base costs of the asset for the BENEFICIARY.
IHT while assets are in the TRUST and on transfer OUT of trust.
While assets are in the trust there is a PRINCIPAL CHARGE to IHT every 10 years. The maximum rate of IHT payable on the PRINCIPAL CHARGE is 6%.
IHT is payable on transfer of the assets out of trust. This is known as an EXIT CHARGE. The maximum rate of IHT payable on the EXIT CHARGE is 6%.