Inheritance tax (IHT) is a tax that is levied on the value of a person’s estate upon their death Anyone with assets over a certain threshold is subject to paying this tax, which currently stands at 40% in the UK For individuals who have set up discretionary trusts, there are additional considerations to keep in mind when it comes to IHT.
Discretionary trusts are a common estate planning tool used by individuals to provide financial security for their loved ones beyond their lifetime These trusts give the trustees the discretion to decide how and when the assets held within the trust are distributed to the beneficiaries This flexibility can be advantageous for a variety of reasons, such as providing for minor children or vulnerable beneficiaries, protecting assets from potential creditors, or allowing for tax planning strategies.
However, when it comes to IHT, discretionary trusts are subject to specific rules that can affect the tax liability of the trust and its beneficiaries In order to understand how IHT applies to discretionary trusts, it is important to consider the following factors:
1 Settlor’s position: The settlor is the individual who creates the discretionary trust and transfers assets into it If the settlor retains any interest in the trust or benefits from it in any way, the assets within the trust may still be considered part of the settlor’s estate for IHT purposes This means that the value of the trust assets could be subject to IHT upon the settlor’s death.
2 10-year charge: Discretionary trusts are subject to a 10-yearly charge, which is a tax on the value of the trust assets every 10 years If the value of the trust assets exceeds the IHT threshold, which is currently set at £325,000, the trustees must pay 6% of the value of the assets above this threshold This charge can result in a significant tax liability for discretionary trusts, especially if the value of the assets held within the trust has increased over time.
3 Exit charge: In addition to the 10-yearly charge, discretionary trusts are also subject to an exit charge when assets are distributed out of the trust to the beneficiaries iht on discretionary trusts. The exit charge is calculated based on the value of the assets being distributed and is subject to the same 6% tax rate as the 10-yearly charge This can further impact the tax liability of the trust and its beneficiaries, especially if assets are distributed shortly after the 10-yearly charge has been paid.
4 Gift holdover relief: One way to mitigate the tax liability of discretionary trusts is to take advantage of gift holdover relief, which allows the settlor to defer paying tax on assets transferred into the trust Instead of paying IHT upfront, the settlor can elect to hold over the tax liability to the trustees, who will be responsible for paying the tax when the assets are distributed out of the trust This can be a useful tax planning strategy for individuals who wish to pass on assets to their loved ones without incurring immediate tax liabilities.
5 Taper relief: Taper relief is another tax planning tool that can be used to reduce the tax liability of discretionary trusts Taper relief reduces the tax due on the 10-yearly charge and exit charge based on how long the assets have been held within the trust The longer the assets have been held within the trust, the lower the tax rate will be This can result in significant tax savings for discretionary trusts that have been in existence for a long period of time.
In conclusion, understanding IHT on discretionary trusts is essential for anyone who has set up or is considering setting up this type of trust By being aware of the specific rules and tax implications that apply to discretionary trusts, individuals can make informed decisions about their estate planning and ensure that their loved ones are provided for in the most tax-efficient way possible By taking advantage of tax planning strategies such as gift holdover relief and taper relief, it is possible to mitigate the tax liability of discretionary trusts and protect the assets held within them for future generations.