For individuals planning their estates, understanding trusts and inheritance tax is vital because, without the right knowledge, significant portions of your estate could be lost to taxes, reducing the wealth passed on to your loved ones.
Trustees and beneficiaries also need to be aware of the obligations and potential tax charges that come with managing or receiving assets from a trust. The 10-year charge, in particular, can be a significant consideration in the long-term planning and administration of a trust.
Whether you're setting up a trust for the first time or managing an existing one, it's crucial to understand how these financial mechanisms work and how they can impact your estate planning.
In this article, we'll explain the fundamental concept of a trust and how inheritance tax applies to trusts and estates. We'll also break down the 10-year charge that applies to certain trusts, how it's calculated, and what it means for your trust's assets.
Table of Contents
- What is a trust and how does it differ from a will in estate planning?
- What is inheritance tax and when does it apply to trusts?
- What is the 10-year charge?
- How is the 10-year charge calculated?
- What are exit charges?
- How are exit charges calculated?
- What are Chargeable Lifetime Transfers?
- What are the reporting requirements for trustees in relation to the 10-year charge?
- Are there any exemptions or reliefs available to mitigate the impact of the 10-year charge?
- Planning strategies to mitigate the 10-year charge
- Methods to amend trust terms
- How can Lawhive help?
What is a trust and how does it differ from a will in estate planning?
There can be some confusion over wills and trusts because they share some similarities.
A trust is a legal arrangement where one party (the settlor) transfers assets to another party (the trustee) to hold and manage for the benefit of a third party (the beneficiary).
The most common types of trust include:
Discretionary Trusts: Decide how to use trust income and capital for the beneficiaries’ benefit.
Life Interest Trusts: Written into someone’s will to protect their assets for the beneficiaries.
Bare Trusts: The simplest form of trust, trustees hold a specific asset for beneficiaries.
Both trusts and wills are critical tools in estate planning, but there are key differences between the two.
Function and timing
As you know, a will only takes effect upon the death of the person who makes it and outlines how assets should be distributed after death.
On the other hand, trusts can provide ongoing management and distribution of assets according to the trust's terms, however, they can be established during the settlor's lifetime (living trust) or created upon their death (testamentary trust).
Control and flexibility
While a will provides clear instructions for the distribution of assets after death, they don't offer the same control over how assets are managed and distributed over time as trusts do.
For example, with a trust, you can set conditions for distributions or provide ongoing support to beneficiaries over time. They can also be tailored to the specific needs of beneficiaries, like providing for dependents, individuals with special needs, or charitable purposes.
Privacy and probate
Wills must go through probate and become accessible to the public after probate is granted.
Trusts, however, bypass the probate process, allowing for a private transfer of assets directly to beneficiaries.
Asset protection and tax planning
Wills don't offer asset protection from creditors or legal claims against the estate, while trusts can (particularly irrevocable trusts).
What is inheritance tax and when does it apply to trusts?
Inheritance Tax is a tax on the property, money, and possessions of someone who has died. It's typically charged on estates above a certain threshold, known as the nil-rate band, although there are certain exemptions and reliefs on transfers between spouses or civil partners and gifts to charities.
Trusts can be subject to Inheritance Tax at different stages, depending on the type of trust and the nature of the assets held.
Type of Trust | Inheritance Tax Implications |
|---|---|
Bare Trusts | Assets in a bare trust are subject to Inheritance Tax as part of the beneficiary’s estate upon their death. |
Interest in Possession Trusts | Upon the death of the life tenant, the value of the trust assets may be included in their estate for Inheritance Tax purposes. Additionally, periodic charges (such as the 10-year charge) may apply. |
Discretionary Trusts | Discretionary trusts are subject to periodic Inheritance Tax charges, including the 10-year charge and exit charges when assets are distributed to beneficiaries. |
Accumulation and Maintenance Trusts | May incur periodic IHT charges and exit charges. |
What is the 10-year charge?
The 10-year charge, also known as the 'principal charge' is a periodic Inheritance Tax charge that applies to the value of the trust's assets every 10 years.
How is the 10-year charge calculated?
The 10-year charge is typically up to 6% of the value of the trust assets that exceed the available nil-rate band.
The value is assessed on each 10th anniversary of the trust's creation.
What are exit charges?
Exit charges are fees that apply when assets are distributed from the trust to beneficiaries.
How are exit charges calculated?
Exit fees are calculated on the value of the assets leaving the trust, usually based on the period since the last 10-year charge or the establishment of the trust.
What are Chargeable Lifetime Transfers?
When assets are transferred into certain types of trusts, such as discretionary trusts, the transfer is considered a Chargeable Lifetime Transfer and may incur an immediate Inheritance Tax charge at 20% if the value exceeds the available nil-rate band, payable by the settlor.
What are the reporting requirements for trustees in relation to the 10-year charge?
Trustees have specific responsibilities when it comes to managing trusts and complying with tax regulations, including the 10-year charge.
Here's what they must do:
1. Calculate the trust's value
On the 10th anniversary of the trust, trustees need to calculate the net value of the trust by determining the market value of all trust assets and subtracting any allowable debts or liabilities.
2. Determine the available nil-rate band
Trustees must then calculate the proportion of the nil-rate band available to the trust. If there are other trusts created by the same settlor, the nil-rate band may need to be apportioned between them.
3. Calculate the 10-year charge
If the net value of the trust’s assets exceeds the available nil-rate band, the excess is subject to the 10-year charge.
Trustees should apply the periodic charge rate to the excess value to calculate the tax due.
4. Report the charge to HMRC
Trustees must complete and submit the Inheritance Tax Account (IHT100) form to HMRC.
The IHT100 form must be submitted within six months of the 10th anniversary. Missing this deadline can result in penalties and interest charges.
5. Pay the 10-year charge
Trustees must pay the calculated 10-year charge to HMRC by the due date.
Are there any exemptions or reliefs available to mitigate the impact of the 10-year charge?
The 10-year charge, or periodic charge, can significantly impact the value of assets held within a trust. However, there are various exemptions and reliefs available that trustees can use to mitigate the financial impact of this charge, including:
Nil-rate band
Each trust is entitled to a nil-rate band, which is a threshold below which no inheritance tax is payable.
This amount is applied every ten years to offset the value of the trust assets subject to the 10-year charge.
However, if the settlor has created multiple trusts, the nil-rate band may need to be apportioned among them, reducing the available exemption for each trust.
Business Property Relief
Business Property Relief provides significant tax relief for qualifying business assets held within a trust. BPR can reduce the value of these assets to calculate the 10-year charge by up to 100%.
To qualify, the business must generally have been held for at least two years before the charge.
Agricultural Property Relief
Agricultural Property Relief offers relief from the 10-year charge for qualifying agricultural property. APR can reduce the value of these assets for tax purposes by up to 100%, depending on the type of property and its use.
This relief typically applies to land or pasture used for agricultural purposes, buildings used for agricultural activities, and farmhouses. The property must generally have been owned and used for agricultural purposes for at least two years before the charge.
Heritage Assets Relief
Trusts holding heritage assets, such as land, buildings, or objects of historic or national interest, may qualify for special relief. These assets can be exempted from the 10-year charge if certain conditions are met.
The asset must be accessible to the public for a specified number of days per year, or there must be agreed-upon preservation undertakings.
Annual exemptions and small gifts
Trustees can use annual exemptions, such as the annual gift exemption, to reduce the value of assets subject to the 10-year charge. For example, small gifts up to a certain value can be excluded from the trust’s value.
Regular use of these exemptions can gradually reduce the trust’s asset base, minimising the impact of the 10-year charge over time.
Excluded property trusts
Trusts holding non-UK assets may benefit from excluded property status, meaning these assets aren't subject to the 10-year charge if they meet specific criteria.
Planning strategies to mitigate the 10-year charge
Utilise the nil-rate band effectively
Creating separate trusts for different assets or beneficiaries can spread the nil-rate band and reduce the taxable value in each trust. This strategy, known as the “Rysaffe principle,” involves setting up multiple trusts on different days to maximize the use of the nil-rate band.
Leverage business and relief
Assets such as shares in unlisted companies, interests in partnerships, and certain business properties may qualify for BPR, which can provide up to 100% relief from the 10-year charge.
To effectively leverage these reliefs, make sure the trust’s business assets meet the qualifying conditions, such as being held for at least two years and being used in a trading business rather than an investment business.
Regularly review and value trust assets
Regularly review the value of trust assets to stay informed about potential 10-year charge liabilities. This proactive approach allows trustees to plan and make strategic decisions before the charge is due.
It is also advisable to schedule periodic valuations for high-value or complex assets, especially close to the 10th anniversary, to make sure the trust's asset values are current and compliant with HMRC requirements.
Plan for asset distributions
Distributing assets to beneficiaries before the 10-year charge date can reduce the value of the trust subject to the charge. This can be particularly effective if beneficiaries can receive assets without immediate tax consequences.
You should plan the timing of asset distributions carefully, as distributing assets shortly before the 10th anniversary can minimise the taxable value of the trust at the charge date.
Exit charges are also typically lower than the 10-year charge and can be part of an effective mitigation strategy.
Seek professional advice
Tax advisors, financial advisors, and wills, trust, and probate solicitors can provide tailored advice and strategies relating to trusts, inheritance tax, and the 10-year charge.
At Lawhive, our network of experienced solicitors is on hand to support in all elements of estate planning, from setting up a trust to making a will.
Contact us today for a free case evaluation and discover how we can help you.
Can trustees change the terms of a trust to reduce the 10-year charge?
Amending the terms of a trust to reduce the impact of the 10-year charge can be a complex process, as trusts are typically governed by strict legal rules and the original intentions set out in the trust deed.
However, there are certain circumstances and methods under which trustees may be able to adjust the terms of a trust to mitigate the periodic charge.
Discretionary trusts
Trustees of a discretionary trust might change the timing or manner of distributions to reduce the value of assets held in the trust at the 10th anniversary.
However, these decisions must be made in line with the trust deed and the best interests of the beneficiaries.
Fixed trusts
Fixed trusts, where beneficiaries have a fixed right to trust income or capital, typically offer less flexibility for trustees to make amendments. The terms are more rigid, limiting the scope for strategic adjustments to reduce the 10-year charge.
In cases where the terms are restrictive, trustees should seek legal advice to explore any potential options for amendments within the constraints of the trust deed.
Amendment clauses
Some trust deeds include specific clauses that allow for amendments under certain conditions. These clauses may provide trustees with the ability to adjust the terms or restructure the trust to adapt to changing circumstances or tax regulations.
Trustees should review the trust deed carefully to identify any such provisions and consult with a solicitor to understand how they can be exercised.
Methods to amend trust terms
The terms of a trust can be amended by:
A Deed of Variation
Court approval
Appointment and re-settlement
Exercise of discretion
How can Lawhive help?
At Lawhive, we provide expert guidance and support to help trustees manage and optimise trust arrangements effectively.
Contact us today for a free case evaluation and no-obligation quote for the services of a specialist lawyer.