There are actually many ways that you can reduce inheritance tax payable when you pass on wealth.
However, some of the people that are extremely wealthy might find that this is not enough. The control that trusts give you over who receives your wealth, and how it happens is critical to allow proper planning.
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What is a trust?
Legal constructs, where the settlor transfers assets to be managed by a trustee, for the benefit of another person, known as the beneficiary.
For inheritance tax planning purposes, the settlor must not also be a beneficiary of the trust.
The settlor is the one who creates the trust, and transfers their assets into it. They then choose trustees and beneficiaries, meanwhile setting the rules that allow the trustee to manage the trust.
The trustee then manages the assets, acting in accordance to the trust deed and in the best interests of the beneficiary.
What are the main types of trust?
There are two main types: bare trusts and discretionary trusts.
There are variations on discretionary trusts that allow the achievement of specific goals. Examples are: interest-in-possession trusts, loan trusts and discounted gift trusts.
What are some tax-planning scenarios?
One way to reduce liability is to gift assets to beneficiaries before you die.
If you give all ownership and associated rights up, the gift becomes exempt from inheritance tax after seven years, with the liability reducing on a sliding scale during the seven years.
Depending on the circumstances of you family, gifting might expose your assets to unintended, perhaps unwanted consequences, as you need to accept the loss of control over the asset that has been gifted.
Some scenarios include:
- You gift cash to your adult son who, unbeknown to you, has debts. His creditors claim all the money.
- You gift a house to your married daughter who goes on to separate from her husband. He gets half the house’s value in the divorce proceedings.
- You want to pass money directly to your grandchildren, but they access it during their adolescence and fritter it away.
In all of these unfortunate circumstances, trusts offer you protection.
What are bare trusts?
The simplest of trusts.
Beneficiaries are chosen at the outset and can’t be changed. These trusts are mostly used when money is passed from parent to children, with the parents acting as trustees.
The assets that have been put into a trust will be treated as a gift for inheritance tax purposes, so after seven years there’s no tax that will need to be paid.
When children turn 18, or 16 in Scotland, a bare trust does not exist any more, with the assets belonging solely to the beneficiaries. B
If a bare trust is used, and it produces more than £100 in income per annum, be way that the income would be taxed as it if were parents’.
What are some examples?
Mike and Sarah are in their late 60s and have five young grandchildren. They all live in England.
They would like to give them money when they reach adulthood, either for a house deposit or some other purpose, and they have faith they will be brought up not to squander it.
Mike and Sarah are aware that gifting money now, rather than when they are in their 80s, gives them a better chance of surviving seven years and removing assets from the scope of inheritance tax.
They gift £10,000 each into five bare trusts with the five grandchildren as beneficiaries. Their parents are trustees and are responsible for saving or investing the money. When the children turn 18, the money is available to them.
What are discretionary trusts?
These are classic trusts, where the settlor sets the rules that trustees must follow. There has to be at least two trustees, and there can be multiple beneficiaries
This kind of trust allows you to retain a level of control over how assets are used.
You can specify rules for your assets within these trusts, rather than them merely being accessible when the beneficiary turns 18. You can specify how they can be drawn, such as beneficiaries drawing an annual income.
This can help protect the underlying assets from a wide range of risks such as divorce, bankruptcy, or impulsive spending.
How are discretionary trusts taxed?
Despite a high level of control, discretionary trusts do have some downsides.
Complicated trusts result in more adviser fees. Discretionary trusts also have their own tax rules, which assets are exposed to, such as capital gains tax, income tax and inheritance tax.
Likewise with individual inheritance tax, there are rates and allowances.
£325,000 can be transferred into a discretionary trust in a seven-year period and benefit from the nil-rate band.
Anything above this is chargeable at 20% on entry into the trust, while a 10-year charge of up to 6% on any excess of the nil-rate band can apply as well, plus an exit charge of up to 6%.
Taxation of trusts has become more aggressive in recent years, and the rates of capital gains, income and dividend tax are generally not favourable.
Whilst taxation on trusts has become more aggressive, planning and timing into the right investment mix can help to manage tax liabilities.
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