Inheritance Tax (IHT) poses a significant concern for many people across the UK, especially those with property or other high-value assets. Trust funds have become an increasingly popular method to limit or even sidestep this tax altogether, but many people are unaware of this option, or believe it to be illegal due to misconceptions about how trusts work.
This guide aims to clarify the legalities and intricacies of trust funds in the context of IHT, explaining how you can set up a trust and potentially reduce your IHT liability within the bounds of the law.
Understanding the Basics of Inheritance Tax
Inheritance Tax usually comes into effect when an individual passes away. It applies to the cumulative worth of their estate, which is a comprehensive term including all the forms of property (real estate, vehicles, etc.), financial assets (bank accounts, investments), and personal possessions (jewellery, artwork, etc) they owned when they died.
The tax liability is determined based on the total estate value and kicks in if this surpasses the existing nil-rate band – essentially, the tax-free allowance. This currently stands at £325,000. If your estate’s value exceeds these figures, then the amount over the threshold is subject to a 40% rate of IHT.
As an example, let’s assume the total value of your estate is £600,000. If you qualify for the basic nil-rate band of £325,000, then your estate would pay 40% tax on the remaining £275,000 (£600,000 minus £325,000), amounting to a tax bill of £110,000.
In certain circumstances, such as where a property that is the person’s main residence is passed directly to their descendants, this threshold can be up to £500,000.
It’s worth noting that married couples and civil partners can transfer any unused portion of their nil-rate band to their surviving partner. This effectively doubles the nil-rate band for the survivor, potentially reaching up to £650,000 or even £1 million in certain circumstances. This can significantly reduce or even eliminate IHT liability for their estate.
The Fundamentals of Trust Funds
A trust fund is a legally binding arrangement designed to give one party – one or more trustees – the responsibility to manage and oversee assets for the benefit of another party or parties, known as beneficiaries. In essence, the trust safeguards assets until specific conditions are met. These conditions should usually be detailed in a trust deed.
Trusts are a versatile estate-planning tool, because they come in various forms, each tailored to specific needs and circumstances. Below are some common types of trusts:
- Bare trusts are straightforward trusts where the beneficiary has an immediate and absolute right to both the income and capital held within the trust. They are often used for minors, with the understanding that the assets will become fully accessible when the beneficiary reaches the age of 18.
- Discretionary trusts offer the trustee the discretion to decide how, when, and to which beneficiaries the trust income or capital will be distributed. This offers a higher degree of flexibility and is useful when you wish to make provisions for future needs that are not yet clear.
- Interest in Possession trusts give the beneficiaries the right to the income generated from the trust, but not necessarily the capital. This type of trust is often set up to provide for a spouse during their lifetime, with the trust assets going to children or other beneficiaries after the spouse’s death.
- Family or accumulation trusts allow trustees to accumulate income within the trust and add it to the trust’s capital. They can then decide to distribute income later.
- Mixed trusts are hybrid trusts incorporating features of more than one type of trust. They offer flexibility but are complex and need expert structuring.
Trusts often have their own tax obligations, separate from the individuals who created or benefit from them. For instance, trusts may be subject to income tax on generated revenue, Capital Gains Tax on asset disposal, and in some cases IHT, depending on how the trust is structured.
Trusts offer a mechanism to retain a degree of control over how assets are utilised and distributed after you’re gone. They can be designed to disburse assets when beneficiaries reach a certain age or milestone, or for specific purposes like education or home ownership. This ensures that your wishes for the wealth you have accumulated are respected and executed in the manner you envisage.
The Legal Standing of Trust Funds in Reducing Inheritance Tax
Trusts have long been recognised in the UK as a lawful and effective method to lessen the financial impact of Inheritance Tax.
The process of setting up a trust is formalised through a legal document known as a ‘trust deed’. This deed outlines the rules, responsibilities and parameters governing the trust, including how assets will be managed and distributed. Due diligence is imperative at this stage; failure to comply with the intricacies of the law can result in a void trust or unintended tax consequences.
It is also crucial to understand that trusts are not designed to hide assets from tax authorities. UK tax law requires full disclosure of trust income, gains and distributions. The trustees are legally obliged to report these to HM Revenue & Customs (HMRC) and may need to complete a Trust and Estate Tax return annually.
While trusts are a valid means of minimising IHT, there are limitations imposed by anti-avoidance laws. For example, the ‘seven-year rule’ states that assets transferred into a trust will only be entirely free of IHT if the person who transferred them survives for at least seven years after the transaction. Failing this, the asset could be subject to IHT as if it were still part of the original estate.
The Advantages of Utilising Trust Funds to Limit Inheritance Tax
Placing assets in a trust remove them from your rightful ownership, reducing the taxable value of your estate. Furthermore, you can add other gifts and even life insurance policies to a trust post-establishment, effectively reducing your tax liability.
What you may not know is that trusts can also provide additional benefits like:
- Flexible asset distribution
- Greater control of assets
- Protection from creditors and legal actions
- Strategic gifting and lifetime transfers
- Family financial security
- Privacy in certain circumstances
Considering the multifaceted benefits, trusts can serve as an invaluable tool in estate planning, especially when minimising IHT is a priority. However, trusts are complex legal entities with their own tax implications, so you will need to craft a trust that is both compliant and optimally effective.
Creating a Trust to Safeguard Your Legacy
Trusts have been, and continue to be, an efficient way to shield assets from high IHT bills, thus securing the future financial well-being of your beneficiaries. However, trusts also entail their own complexities and challenges.
Therefore, expert legal guidance is essential for making well-informed decisions in your estate planning and ensuring that your financial aims are met in a way that aligns with your beneficiaries’ best interests.