Tax efficiency of a trust

mr_gnat

Hello,

I've been advised to setup a trust by my solicitors in order to minimise my inheritance liability when I pop my clogs.

Someone else (non professional) has questioned the wisdom of this, saying that trusts in general aren't a good way to minimise tax liability and actually may well increase the total tax liability to my estate and benefactors, and I'd be better off, keeping it simple.

Its early days, and it seems a complex area, but broadly it seems that my estate would be subject to 20% inheritance tax rather than 40% (above the threshold), sounds good, but my friend says I need to factor in the fact that any income derived from this trust to my benefactors would almost certainly be at basic rate of tax, so 20%....so actually I've got nowhere, except for the added costs of trustees, and additional taxes every 10 years and on winding up.

I must admit, I can't now see how a trust can ever reduce the tax liability, except for edge cases, where beneficiaries pay no income tax.

My head hurts.

Malthusian

Its early days, and it seems a complex area, but broadly it seems that my estate would be subject to 20% inheritance tax rather than 40% (above the threshold)

That's not how it works.

It sounds like there has been some confusion as to how the rules on chargeable lifetime transfers work. Those are subject to an immediate 20% tax charge on money above the nil rate band. If you die within 7 years your estate then pays another 20%. So the rate of IHT is still 40%.

sounds good, but my friend says I need to factor in the fact that any income derived from this trust to my benefactors would almost certainly be at basic rate of tax, so 20%

You are the benefactor (settlor is the more commonly used term for trusts). From the mention of "additional taxes every 10 years and on winding up" it sounds like the kind of trust where income would be subject to the trust rates of tax, whcih are 45% on interest and 38.1% on dividends. If income is distributed to beneficiaries they may be able to claim some of that tax back.

You haven't mentioned any reasons to set up a trust in your post. Have you considered simply giving your beneficiaries the money?

mr_gnat

Well, I have one child to whom it wouldn't be sensible to give lots of inheritance to as a lump sum, so I think a trust is probably best in this scenario in order to oversee it.
I have two more direct beneficiaries (sorry if my jargon is wrong) to whom it seemed to make sense to minimise inheritance tax, but I'm starting to doubt the sense of this, and it all seems quite a complex area.

xylophone

to my estate and benefactors, 

Do not confuse "benefactor"  (one who gives) and "beneficiary" (one who receives).

Keep_pedalling

Trusts do not magically reduce IHT, simpler method such as gifting are often better options.

How big is your state and how much of that is made up of your home? What is your marital status?

mr_gnat

I think I'm sort of trying to work out the sense of it based on this which page
"inheritance tax and trusts - which?" (it wont let me paste the link)

lets take a worked example from the which page

Say Carla is transferring her £500,000 property into a trust. She hasn't used any of her £325,000 personal allowance in the last seven years. So £175,000 of her property's value is subject to 20% tax on setting up the trust, resulting in a £35,000 bill in the first year. The assets are re-valued every decade. The property value increases to £750,000 in the first ten years - this is subject to a 6% tax, less than £325,000 allowance. So the tax bill would be 6% of £425,000, for a total of £25,500 after 10 years. Five years later, the trust is closed. In that time, the property value has risen to £800,000 - however the rules allow the initial value of the property at the start of the 10-year period to be used. So, it would be £750,000 minus the allowance, which again comes to £425,000. It's only been five years, so the 10-year tax rate of 6% is halved to 3%. This means 3% tax is payable on £425,000, for a total of £12,750 as an exit charge.

so I understand this above, but for the full picture you need to factor in any subsequence tax consequnces on the beneficiaries.

so for trusts how does this work? 20% is paid up front, 6% paid per 10 years (pro ratad) and 6% on exit, unlike a pension, there seems little incentive to earn interest/dividends inside a trust rather than outside.

A simplistically scenario is what happens if a trust is setup as above, and then it immediately closed, then the liability would appear to be 26% (20 initial + 6 closing) on (above) £175,000, rather than 40%?...that surely can't be right? (in more than 1 way).

my instinct is now that its probably a bad idea, but I can't see how the maths work (I can see it for pensions for example, where it only actually makes full sense when you look at the liability at the point of drawing the pension, not just the saving on the way in).

mr_gnat

Keep_pedalling said:

Trusts do not magically reduce IHT, simpler method such as gifting are often better options.

How big is your state and how much of that is made up of your home? What is your marital status?

lets say divorced, 350k home, 800k in total.

Keep_pedalling

Is Carla going to carry on living in this property? If so is she also going to pay full market rent into the trust?

if the answers are yes and no then the property never leaves her estate.

Malthusian

mr_gnat said:

Well, I have one child to whom it wouldn't be sensible to give lots of inheritance to as a lump sum, so I think a trust is probably best in this scenario in order to oversee it.

Then that turns the scenario on its head compared to the original post, where the driver behind setting up a trust was to reduce the inheritance tax bill.

Trusts pay penal rates of tax compared to individuals so the starting point is that putting money in a trust = more tax, even if it's possible to limit the impact with proper planning.

Giving money away (whether to a trust or directly to a beneficiary) may be more tax efficient than hanging onto it until you die, but it's the giving away part that reduces the IHT bill, not the trust part.

So you may need to decide which is more important, simplicity and lower costs and taxes, or preventing the child from accessing all of their share of your estate at once.

Who do you plan on appointing as trustees, who would have the job of deciding who gets what from the trust and when? If all three potential beneficiaries are compos mentis adults they would be able to wind the trust up and share out the proceeds. Preventing that would typically mean including other potential beneficiaries you haven't mentioned yet. These seem more important considerations to discuss with a solicitor than non-existent inheritance tax savings.

mr_gnat

Can Carla simply set the trust up when she dies as part of her will? whats the 'normal' arrangement?

theoretica

mr_gnat said:

Well, I have one child to whom it wouldn't be sensible to give lots of inheritance to as a lump sum,

I believe there are specific trusts which may be more favourable available for some disabled people - but of course many people just handle money poorly without qualifying for that protection.