Can I use trusts to reduce inheritance tax

Trusts can help you to control what happens to your assets after you pass away. As such, you can also use trusts to reduce inheritance tax.

However, we recommend you seek professional advice to ensure that any trust is set up correctly and meets your requirements.

A trust can also be used to reduce the inheritance tax payable. The trust allows you to retain some control over what happens to your assets.

Furthermore, the trust can specify how the assets are used. The tax treatment of trusts can also be beneficial.

You can use a trust to reduce the inheritance tax payable. However, the rules around inheritance tax and trusts are complicated, and in some scenarios, it might cost you more.

You should seek appropriate advice before setting up a trust to avoid inheritance tax. Also, trusts can be expensive, and taxes should not be the main reason for setting one up.

How a trust works

You are the creator or 'settlor' of the trust. As such, you stipulate how it should be run.

You will also nominate trustees. When you pass away, ownership and control pass to the trustees.

They have a legal obligation to manage the assets on behalf of your beneficiaries. You will create a trust deed that sets out how the trust should operate.

This dictates how the trustees should manage the assets. The trustees legally own the assets, so you must have confidence in them.

Importantly, assets you place in a trust do not form part of your estate for inheritance tax purposes. Consequently, you can use trusts to reduce inheritance tax.

However, this only applies if you live for seven years after placing the assets into trust. There are many forms of trust, and the rules can vary by type.

Are trusts used to reduce inheritance tax subject to tax?

Many people think that trusts are exempt from inheritance tax. However, this is a common misconception.

For example, if the assets in a trust exceed the inheritance tax nil-rate band (currently £325,000), you pay inheritance tax at 20%. This charge applies from the outset, though some exemptions apply, such as if you continue to benefit from the assets.

Broadly speaking, The type of trust determines its tax treatment. A discretionary trust is the most common type of trust used to reduce inheritance tax.

For this type of trust, the following applies:

Work out the value of the assets above the nil rate band. You will pay a 20% tax charge on this amount from the outset.

Furthermore, trustees must revalue the assets in the trust every ten years.HMRC can charge up to 6% tax on any amount above the nil rate band.

If you faced an inheritance tax charge when creating the trust, exit charges can apply before the first tenth anniversary. The rate will match the rate on creation.

For trusts in place for over ten years, the rate will match the rate at the previous tenth anniversary. This can be up to 6%.

Case study

Tom is sixty, single, and intends to leave his estate to his nephew and niece. Concerned about the inheritance tax his nephew and niece may face in the future, Tom has been exploring ways to reduce the potential liability. He has savings of £400,000 in various banks and a personal pension worth £500,000. He also has a further pension in payment that more than meets his income needs. Furthermore, he owns his home outright, which is valued at £500,000. He intends to sell and downsize, releasing a further £200,000. With the changes to the rules on pensions and inheritance tax, he wants to set up a £500,000 trust fund to reduce inheritance tax.

Initial tax

When setting up the trust fund, an initial 20% tax charge applies to the amount above the current nil rate band (£325,000). However, Tom is the settlor and is paying the tax.

Therefore, you pay it at the gross level, which is 25%. Consequently, the initial tax charge is £43,750.

10th anniversary

Further tax may be due on the tenth anniversary of the trust. The value of the assets at the time determines the amount, which can reach 6%.

In Tom's case, if the value of the assets remains unchanged, there will be an additional tax charge of £10,500. In this example, Tom could save his nephew and niece a considerable amount in taxes.

However, it does highlight the misconception that creating a trust prevents inheritance tax entirely.

What types of trust can reduce inheritance tax?

As noted above, a discretionary trust is the most common type of trust used to reduce inheritance tax. However, there are many options available.

The list below is not comprehensive and covers trusts established before you pass away. You can make other arrangements to establish a trust in your will.

Bare trusts

These are simple trusts that hold assets on behalf of somebody else until they take ownership. An example would be holding money for a child until they reach a certain age.

The typical inheritance tax rules do not apply to them. You pay no tax when setting up the trust.

If you survive seven years from setting up the trust, it will not form part of your estate for tax purposes.

Discounted gift trusts

People typically use these trusts to hold insurance bonds. They allow you to receive income as a percentage of the bond value each year.

However, the capital sits outside your estate and transfers to the beneficiaries when you die.

Loan trusts

These are widely available and can limit future growth in your estate's value. You lend your assets to the trust, which means they still form part of your estate.

However, any investment returns remain in the trust and therefore fall outside your estate for tax purposes.

Discretionary gift trusts

This is the most popular type of trust, and many people use it to reduce inheritance tax. You pass your assets to the trust but can stipulate how they are used for the beneficiaries.

Importantly, the trustees can act at their own discretion. Furthermore, Beneficiaries cannot claim the property inheritance tax allowance against property held in a discretionary trust.

If you have already set one up, you should review your arrangements.

Registering a trust to reduce inheritance tax

Trustees must register most trusts with HMRC. If you are a trustee, you can do this online.

You will need to provide various details, including the name of the trust, the trustees, and the beneficiaries. Once the trustee registers the trust, HMRC will issue a UTR number to the lead trustee.

You need this when making tax returns.

Where can I get advice on using trusts to reduce inheritance tax?

A lawyer or accountant with knowledge in this area will be able to help. You can also seek advice from a financial advisor.

STEP, formerly known as the Society of Trust and Estate Practitioners, maintains a database of practitioners who can help. You can find further details on their website.

What will it cost to set up a trust to reduce inheritance tax?

The cost varies depending on your circumstances. In addition to the inheritance tax charge when setting up the trust, the trustees may charge a fee for managing it.

There are also other legal costs to consider. Because of these expenses, you should carefully weigh up whether your estate would benefit from using a trust to reduce inheritance tax.

Concluding thoughts

Setting up a trust is not a straightforward process, so professional advice is always beneficial. Every case is different, and using a trust to reduce inheritance tax is not always the right way forward.

Crucially, setting up a trust does not automatically remove those assets from your estate for inheritance tax purposes — this is a misconception that catches many people out.

If you do create a trust, seek professional advice, review it regularly, register it, and pay any taxes due within the time limit.