An Introduction to Trusts and Their Tax Implications
What is a Trust?
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A trust is a legal arrangement where one person, known as the settlor, transfers assets to another person or company, called the trustee. The trustee then manages these assets to benefit a third party, the beneficiary. Trusts can be an effective way to manage wealth and are commonly used for inheritance tax planning, among other things.
Types of Trusts and Tax
When discussing trusts, it’s crucial to understand the different types of trust available, as each comes with its tax implications. The most common types include the discretionary trust, the interest in possession trust, and the bare trust.
- Discretionary Trust: In a discretionary trust, the trustees have the discretion to decide how to distribute the income or capital of the trust among the beneficiaries.
- Interest in Possession Trust: Here, the beneficiary has an immediate right to the income generated by the trust as it arises.
- Bare Trust: Assets in a bare trust belong to the beneficiary but are controlled by the trustee until a specified event, like reaching a certain age.
Discretionary Trusts and Taxation
Discretionary trusts are subject to their own tax rules and regulations. Typically, these trusts are charged inheritance tax when assets are transferred to the trust and again if assets leave the trust or the trust is wound up. They may also be liable for income tax and capital gains tax on income and gains generated by the trust assets.
Income Tax and Trusts
Income within the trust is subject to income tax. The tax rate varies depending on the type of income and the kind of trust you have set up. For instance, savings and dividend income within a discretionary trust may be taxed at the basic rate or higher, depending on the circumstances.
Trusts and Inheritance Tax
Trusts are often used as a tool for inheritance tax planning. The tax implications of placing assets in a trust are complex. They can affect the amount of inheritance tax due when a person dies. The creation of the trust, the value of the trust assets, and the terms of the trust deed all play roles in determining the inheritance tax implications.
The Tax Responsibilities of Trusts and Trustees
Trust Tax Return and Responsibilities
Trusts are required to complete a tax return, similar to individuals and businesses. The tax return is used to report details of the income and gains generated by the trust, as well as any tax paid or tax credits overpayment. This is particularly important for discretionary trusts, where the tax rates apply differently depending on how the trustees decide to distribute the trust income.
Who Pays the Tax?
In most cases, the trustees pay the tax on behalf of the trust. The tax paid is often deducted from the trust assets. However, the beneficiary of the trust may also have to pay tax, especially if they receive income from the trust. For example, if a beneficiary receives income, they may need to pay income tax on that amount, depending on their personal tax position.
Special Tax Rules and Trusts for Disabled People
There are special tax rules for trusts set up for the benefit of vulnerable or disabled individuals. These trusts for disabled people often have a more favourable tax treatment to provide additional financial support. It is essential to understand these nuances if you’re considering setting up such a trust.
Capital Gains and Disposal of Trust Assets
When trust assets are sold or disposed of, the trust may incur a capital gains tax charge. The rate of tax and the amount of tax depend on several factors, such as the kind of assets and their value. Capital gains are a critical consideration, especially for trusts holding property or investments.
Accumulate Income Within the Trust
Trustees can choose to accumulate income within the trust rather than distributing it. This can be a strategic decision to minimise tax liabilities, but it comes with its own set of tax implications. Income that is accumulated within the trust may be subject to higher rates of tax, so it is important to be mindful of this when making decisions about the trust income.
Practical Steps to Setting Up a Trust and Understanding Tax Implications
How to Set Up a Trust
Setting up a trust begins with the creation of a legal document known as a trust agreement. This outlines the terms of the trust, specifying the settlor, trustees, beneficiaries, and how the trust assets should be managed or distributed. Once the trust agreement is prepared, assets can be transferred to the trust. It is often advisable to consult tax guides or experts to ensure that you set up a trust that suits your needs and minimises tax liabilities.
Registering the Trust
After the trust is created, you may need to register the trust with the relevant tax authorities. This is particularly important for understanding your tax obligations and preparing for the trust tax return.
Types of Income and Tax Rates
Trusts can generate different types of income, including savings income and dividend income. Depending on the type of trust you’ve established, these will be subject to different tax rates. It’s vital to understand these rates to work out the tax due accurately.
Using a Trust for Inheritance Tax Purposes
Trusts are frequently used to mitigate inheritance tax. By placing assets into a trust, they may no longer be part of the individual’s estate for inheritance tax purposes. However, there are rules and limitations, especially concerning discretionary trusts and their subjectivity to potential inheritance tax charges.
Tax Reliefs and Exemptions
Certain trusts are eligible for tax reliefs or exemptions. For example, trusts for disabled people may qualify for specific exemptions. Understanding these can significantly impact the overall tax bill for the trust.
In some cases, beneficiaries might be able to claim tax back. This is typically possible when the income received by the trust has been taxed at a source, and the beneficiary’s personal tax band allows for a lower rate.
Advanced Considerations in Trusts and Taxes
Trusts for Different Life Stages
As you go through different stages in life, your tax position and financial needs change. Trusts can be adapted to suit these evolving needs. Whether you’re planning for retirement or thinking about your children’s future, trusts offer flexible solutions.
Discretionary Trusts and Settlor-Interested Trusts
Some trusts, like settlor-interested trusts, allow the person who set up the trust to also benefit from it. However, these kinds of trusts come with their own set of tax implications and may be subject to higher rates of tax. It is crucial to understand these nuances to make an informed decision.
Investments and Trusts
The type of investments held in the trust can also affect the tax situation. For example, some investments may offer tax reliefs, while others could trigger a higher tax bill. Understanding the tax implications of different investments can aid in managing the trust more effectively.
End of the Tax Year
As the tax year comes to a close, trustees should review the trust’s financial standing to make any necessary adjustments. This could involve distributing income to beneficiaries or making new investments to minimise the tax liabilities for the upcoming year.
Long-Term Tax Planning
Trusts are not just a short-term solution but can be an integral part of long-term tax planning. Strategies such as accumulating income within the trust or changing the type of investments can have long-term tax benefits or consequences. Therefore, it is advisable to periodically review the trust and consult tax guides or experts for long-term planning.
Expert Help for Complex Trusts
Certain trusts, like those for disabled people or trusts that hold a mix of assets, can be especially complex. In these cases, it might be beneficial to seek professional advice from experienced professionals like Jack Ross Chartered Accountants to navigate the special tax rules and responsibilities that come with these types of trusts.
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It depends on your objectives. Popular types of trusts include Discretionary Trusts, Settlor-Interested Trusts, Bare Trusts and Interest in Possession Trusts.
Depending on which type of trust you use, there can be different tax implications. If you create a trust, you will need to work out your own income tax or inheritance tax liabilities. You may also need to register the trust for Tax and complete an assessment Tax Return. Depending on the assets in the trust and their income stream, it may be necessary to pay income tax, Capital Gains Tax or Council Tax.
Yes, if it is liable for certain taxes such as income tax or inheritance tax then the trustees may need to register it with HMRC.