In this month’s article in his ‘Keep It Simple’ series, Neil Da Costa tackles a topic that examiners always say students struggle with.
An individual called a settlor transfers assets into a trust (which is a separate legal entity) run by trustees who are the legal owners of the trust assets. The income and capital from the trust assets go to beneficiaries.
Trusts are set up to protect assets from bankruptcy, divorce, protect younger beneficiaries and to guarantee wealth goes to specific people.
Interest In Possession Trusts (IIP)
With an IIP, the trustees must pay out income to a life tenant. The life tenant benefits from the income throughout their life so is called the beneficial owner. On death of the life tenant, the trust assets are included in the life tenant’s death estate although the inheritance tax is payable by the trustees.
When the life tenant dies, the assets of the trust go to the remainderman free of tax.
Simple example: Ming
Ming is a wealthy 75-year-old widow with three grown up children. She has recently met Guy who is 79 and wants to marry him, but is keen to protect the control and capital value of some of her assets and pass them on to her children.
Explain the benefits of setting up an IIP trust for Ming.
Solution to Ming
Ming can transfer her assets into a IIP trust before marrying Guy. The transfer will be treated as a chargeable lifetime transfer for inheritance tax and will be taxed immediately at 20%.
Guy could be the designated life tenant and will benefit from the income from the trust throughout his life. When Guy dies, the IIP trust assets will be included in his death estate although the tax will be payable by the trustees.
Ming’s three children would be classed as the remainderman. They would inherit the capital assets of the IIP trust upon Guy’s death free of tax.
IIP Trust Income Tax
IIP trust income retains its original identity and is taxed at the basic rate. (20% for non-savings and savings income, 7.5% for dividends). There are no personal allowances or nil rate bands available. HMRC do not allow any tax deduction for trust administration expenses.
The trustees must compute the income available to the beneficiary net of tax and after deducting the trust administration expenses.
The trust administration expenses are deducted from the dividend income first, then savings and finally the non-savings income.
After finding the distributable income, the trustees issue a form called a R185 to the beneficiary showing the net income and tax credit which can be claimed.
Simple example: Guy
Guy is the life tenant of an IIP trust.
The IIP trust has non-savings income of £1,500 (20% tax = £300), savings income of £2,750 (20% tax = £550) and dividend income of £4,000 (7.5% tax = £300). The trust administration expenses are £500.
What would the net income and tax credit figures be in Guy’s R185?
Solution to Guy
The net income is computed based on the income less tax.
Non savings £1,200 Savings £ 2,200
The trust expenses of £500 are deducted from the dividends to reduce the dividend income to £3,200.
The tax credit amounts are computed based on the net income. Non savings £300. Savings £550 Dividends £3,200 x 7.5/92.5 = £259.
Discretionary Trusts (DT)
With a DT, the trustees may pay out income or capital at their discretion to a class of beneficiaries e.g., family members. No single beneficiary is entitled to the income.
For inheritance tax purposes, a discretionary trust is called a relevant property trust. Once the property is in the trust, there are two possible charges to inheritance tax. An exit charge is imposed when assets leave the trust, and a principal charge is imposed every 10-year anniversary.
The rate of inheritance tax for lifetime gifts is 20%. The principal charge is 20% x 30% = 6% based on the value of trust assets at each 10th anniversary.
Discretionary Trust Income Tax
Discretionary trusts are treated as tax shelters and are taxed just like additional rate taxpayers. Non savings and savings income is taxed at 45% while dividends are taxed at 38.1%.
Discretionary trusts are not entitled to any personal allowances or nil rate bands.
However, discretionary trusts are entitled to a basic rate band of £1,000. This is applied to non-savings income first, then savings and finally dividends.
HMRC do give discretionary trusts tax relief for trust administration expenses. However, tax relief is only available at the basic rate.
We must assume the expenses are paid from dividends, savings, and finally non-savings income.
The beneficiaries of a discretionary trust are not entitled to any income so are only taxed on what they actually receive. The DT income is treated as non-savings income and is treated as being net of 45% income tax.
Simple example: Fola
Fola is a beneficiary of a discretionary trust.
She is a basic rate taxpayer. She received £55,000 from the discretionary trust.
What would the net income and tax credit figures be in Fola’s R185?
Solution to Fola
Fola’s R185 would show net income of £55,000
The tax credit is £55,000 x 45/55 = £45,000.
You have now understood trusts and can easily earn marks on this popular exam topic.
• Neil Da Costa is a Senior Tax Lecturer with Kaplan in London. He is the author of Advanced Tax Condensed and Tax Condensed which summarise the entire syllabus using accelerated learning memory joggers.