Discretionary Trust Tax implications & Inheritance Tax explained
What is a Discretionary Trust?
A discretionary trust is one where the trustees can accumulate income or pay it at their discretion. Normally the trustees can choose from a wide class of beneficiaries (excluding the settlor) to whom they can distribute the trust funds. The beneficiaries do not have any entitlement to the trust fund thus it does not form part of their estate on divorce, bankruptcy or death. Due to this flexibility the trusts are possibly subject to an entry charge, a ten yearly charge and an exit charge. Sometimes discretionary trusts are referred to as "settlements" or "relevant property trusts".
Most property held in trusts counts as relevant property although there are exceptions to this rule when the asset is:
- in an interest in possession trust and it was put there before 22 March 2006
- subject to a ‘transitional serial interest’ made between 22 March 2006 and 5 October 2008
- put into an interest in possession trust by the terms of a will or the rules of intestacy
- set aside for a disabled person
- set aside for a bereaved minor
- put into an age “18-25” trust
- held in a bare trust
Discretionary Trust entry charge
The entry charge is also known as the lifetime charge or immediate charge and is assessed when the trust is created. Gifts into discretionary trust are classed as chargeable lifetime transfers (CLTs). When setting up a new trust you have to take into consideration any previous CLTs (e.g. gifts into discretionary trusts) made within the last 7 years. Potentially Exempt Transfers (PETs) are not included in this cumulation. As long as this total does not exceed the settlor’s nil rate band (NRB) there will be no entry charge. If it is a couple who are setting up the trust you double up the nil rate band.
If the CLT exceeds the settlor’s available NRB there is an immediate charge of 20% on the amount over. (This is based on half of the death rate of 40%). If the settlor dies within 7 years of making the CLT a further liability to inheritance tax may arise.
Helen makes a gift of £400,000 into a discretionary trust for the benefit of her children and grandchildren when the NRB is £325,000. She has never done trust planning before and this is her first trust,
As the gift exceeds Helen’s available NRB of £325,000, an excess of £75,000 arises and tax due on this amounts to £15,000.
|IHT @20%||£15,000||Tax payable|
As there is an immediate tax charge Helen will have to inform HMRC about the creation of the trust by completing the IHT 100 form and pay the appropriate tax within 6 months after the end of the month in which the transfer was made. Trust Registration aspects are covered here.
When the NRB is £325,000, Graeme makes a gift of £50,000 into a discretionary trust for the benefit of his grandchildren. He has made 3 previous gifts into discretionary trust. His situation is as follows:
|More than 7 years ago||Excluded||£66,000|
|3 to 4 years ago||Included||£156,000|
|1 to 2 years ago||Included||£99,000|
When you add back gifts made in the previous 7 years, Graeme has not exceeded his NRB thus there is no entry charge to pay. The gift made more than 7 years ago is not included in the calculation as it is over the 7 years. As mentioned above, if Graeme had made any PETs, these would not have been included in the cumulation for the purposes of establishing the entry charge.
- If the immediate charge is paid by the settlor rather than from the trust fund, the amount payable will be grossed up by 25% as the tax payment represents a further gift by the settlor. So, in the example of Helen above, tax due would be £18,750. In other words, the loss to her estate would be £400,000 + £18,750 = £418,750. That exceeds the NRB by £93,750 which gives rise to a 20% tax charge of £18,750.
- If the CLT plus any made in the previous 7 years is below the settlor’s NRB there is no entry charge
- If there are joint settlors who set up the trust equally it is effectively treated as 2 trusts settled by each settlor for IHT purposes.
- Where a discretionary trust is created as a result of a will trust there is no entry charge as the IHT will have already been paid on the estate before the asset was placed into the trust.
Settlor’s death within 7 Years
If the settlor dies within 7 years of making the gift into discretionary trust, there may be further tax to pay. The gift is measured against the settlor’s NRB available at death and if this is exceeded a calculation is done based on the full death rate of 40%. Remember any failed PETs are included in the calculation. Gifts eat into the settlor’s NRB in chronological order.
Helen dies between 4 & 5 years after making her gift into discretionary trust, the gift was £400,000 (assume tax was paid from the trust fund) and the NRB available at the date of her death is £325,000. As the gift exceeds the NRB, the tax on the gift is recalculated using the full death rate. Thus the taxable amount is £30,000. As she died 4 to 5 years after making the gift and as tax is due on the gift, taper relief will apply to the tax. HMRC allows a reduction in the tax payable by 40% and therefore the amount due is £18,000. As an entry charge of £15,000 was paid, this is deducted from the tax due, leaving a liability of £3,000.This is primarily a liability of the trustees.
|IHT @40%||£30,000||Taper of 40% tax payable =£18,000|
|Less entry charge paid upfront||£18,000-£15,000||Total tax due £3,000|
Gerry dies 4 years after making a £60,000 gift into a discretionary trust. The pattern of his gifting is shown below. The gift of £60,000 and the gifts made within the 7 years before death do not exceed his available NRB on death. There is no IHT charge on the gifts however they do eat up some of his NRB which reduces what can be used against the rest of his estate.
|12 Years before death – gift||Excluded||£70,000|
|6 Years before death - gift||Included||£140,000|
|5 Years before death - gift||Included||£100,000|
|4 years before death - gift||Included||£60,000|
His executors will only have £25,000 NRB to use against the rest of his estate.
- The charge is due 6 months after the month of the event.
- If the tax due on death is less than the entry charge already paid, there is no reclaim available for the trustees
10 Yearly Charge
This is often referred to as the periodic charge or principal charge and arises when the trust reaches its 10 year anniversary (of the date on which the trust commenced) whereby it has to be assessed to see if any IHT is due. This happens on every 10th anniversary of the trust until all of the assets of the trust have been distributed to the beneficiaries. Business Property Relief (BPR) and Agricultural Property Relief (APR) can be deducted to arrive at the chargeable value.
The detail below reveals that the value of any CLTs made by the settlor in the 7 years before establishing the trust will impact on 10 yearly charges. Beware however the situation where after the trust commences, but before the 10 year anniversary, the settlor makes an addition to the trust. That triggers S67(1) IHTA 1984 (anti-avoidance section). In such cases, the settlor's cumulative total in Step 2 below will be the higher of:
- Total CLTs made in the 7 years prior to commencement, or
- Total CLTs made in the 7 years prior to the date of the addition (but disregarding transfers made on the same day).
This is just an overview as it is a complex area. Full details are available here.
Even ignoring the above, the calculation of the periodic charge can be complex and involves the following steps -
Step 1. Calculate the notional lifetime transfer.
· Value of the trust fund at the 10 year point (net of BPR and APR). Add
· ‘Historic’ value of any related settlements (see below)
Step 2. Calculate the ‘special’ cumulation
· Value of any CLTs made by the settlor in the 7 years before establishing the trust
· Value of property distributed from the trust fund during the previous 10 years
Step 3. Calculate the Aggregate Chargeable Transfer
· Step 1 plus Step 2
Step 4. Deduct the NRB at the 10 year point
If the NRB is greater than the Aggregate Chargeable Transfer then there is no tax due at the 10 year point.
Multiply the Step 4 figure by 20%
If the special cumulation figure in Step 2 exceeds the NRB then Steps 4 & 5 are calculated using the Step 2 figure. This notional tax calculated is then deducted from the tax on the Aggregate Chargeable Transfer. That equals the tax on the hypothetical transfer.
The effective rate can then be calculated – (Step 5 or 6 divided by Step 1) x 100
The actual rate of tax is 30% x Step 7.
This is the tax paid by the trustees which is the actual rate x the value of the trust fund at the 10 year point
Therefore, if the settlor had made no CLTs in the 7 years prior to setting up the trust, and if there was no capital distributed in the first 10 years, then the trustees will have a full NRB for the purposes of the periodic charge.
If however the settlor had made previous CLTs of (say) £300,000 and £30,000 capital had been distributed from the trust in the first 10 years, then if the NRB at the 10 year point is (say) £325,000, then the trustees will have a NRB of £0 (it cannot be negative).
Two settlements are related if, and only if, the settlor is the same in each case and they commenced on the same day. With that in mind, where property is added to a number of related settlements on the same day, the value of the addition to all the settlements concerned and the initial value of relevant property settled in each settlement is taken into account (there are exclusions for charitable funds, lifetime transfers less than £5,000 and additions which are payments of regular life insurance premiums).
Income which has remained undistributed income for more than 5 years at the date of the ten year anniversary is treated as if it were part of the capital for the purposes of the periodic charge (this does not change the identity of the income when it is distributed to beneficiaries for income tax purposes).
Helen’s gift of £400,000 has grown to £650,000 at the 10 year point. She had not made any previous gifts when she set the trust up nor has she made any since. There have been no distributions from the trust fund so far and no related settlements. The periodic charge is calculated as follows –
Step 1. £650,000
Step 2. £0
Step 3. £650,000
Step 4. £650,000 less £387,000 (simple estimated of NRB at 10 year point) = £263,000
Step 5. £263,000 x 20% = £52,600
Step 6. N/A
Step 7. (£52,600 / £650,000) x 100 = 8.0923%
Step 8. 8.0923 x 30% = 2.42769%
Step 9. £650,000 x 2.42769 = £15,780
In simple terms, the trust will be subject to tax of 6% on the £263,000 which is £15,780. The trustees will have to complete an IHT100.
Gerry’s gift has grown to £81,000 at the 10 year point. He has not made any distributions from the trust or added to it. However he did make previous gifts when he was setting this one up which impacts on the calculation. If we again assume a NRB at the 10th anniversary of £387,000 then there is no periodic charge since the NRB of £387,000 is greater than the Aggregate Chargeable Transfer of £81,000 + £240,000 = £321,000..
- The periodic charge is due 6 months after the month of the event.
- The value of the trust fund is subject to a periodic charge even if the settlor is dead, it applies throughout the lifetime of the trust.
- The calculation for a discretionary trust created within a will is similar apart from you add any chargeable transfers made in the last 7 years before death.
Note that if any of the property had not been in trust for the full 10 years (e.g. added funds), then relief is allowed for the number of quarters (40ths) that the property was not ‘relevant property’. For example, in the case of Helen assume that £100,000 of the £650,000 had not been relevant property for 23 of the 40 quarters. In that case relief would be calculated as follows.
- £100,000 x 2.42769% x (23/40) = £1,396
- Ten year anniversary tax would be £15,780 less £1,396 = £14,384
Exit Charge – within first 10 years
An exit charge when capital leaves the trust is also known as a proportionate charge.
When assessing the charge applicable when funds are distributed to a beneficiary, we need to consider 2 scenarios. The first one is distributions out of the trust within the first 10 years and the second is distributions out of the trust after the first anniversary has passed.
When calculating the rate of tax, the value of the property subject to the exit charge is not relevant. Only the historic values (those at the date of set-up or addition) of the trust itself are considered.
Note that the rate calculation is based on lifetime rates (half death rate), even if the trust was set up under the will of the settlor. The rate of tax payable is then 30% of those rates applicable to a 'Hypothetical Chargeable Transfer'.
Let’s reconsider Helen (assume no previous gifts, related settlements or additions)
Lifetime tax paid £15,000
Effective rate = £15,000 / £400,000 = 3.75%
If the trustees of Helen’s trust had distributed £20,000 to her son Connor 2 years before the 10 year anniversary the exit charge would be calculated as follows –
- Work out the quarters – there are 40 in a 10 year period
8x4 is 32.
- Work out the “settlement rate” which is 30% percent of the “effective” rate –
30% x 3.75% = 1.125%
- Multiply the amount distributed by the “effective” rate and multiply by the
£20,000 x 1.125% x 32/40 = £180
The charge to the trust on the distribution to Connor is £180.
Let’s reconsider the example of Gerry (assume no related settlements or additions)
He gifted £60,000 with previous CLTs to be included of £240,000
Lifetime tax paid = £0
Effective rate = 0%
An example of an exit charge in the first 10 years would be as follows
Nigel makes a gift of £300,000 into a discretionary trust. Twelve months previously he had made a PET of £120,000. Assume no other gifts, related settlements or additions to the trust (and ignore exemptions). Assume NRB of £325,000.
Nigel then dies shortly after making his gift into the discretionary trust meaning that his PET fails and becomes chargeable.
Assume there is a £50,000 exit after 26 quarters.
Gift into trust = £300,000
PET becoming chargeable = £120,000
Total = £420,000
(£420,000 - £325,000) x 20% = £19,000
Effective rate = £19,000 / £300,000 x 100 = 6.333%
Settlement rate = 6.333% x 30% = 1.9%
Chargeable transfer = £50,000 x 1.9% = £950
Reduction – relief as property held for 26 quarters but not relevant property for 14 = £332
Tax to pay £618
In summary, note that the settlor’s previous cumulative lifetime total is taken into account when calculating the rate of tax on chargeable events. It is the total value of chargeable transfers made in the seven years before starting the settlement i.e.
- Immediately chargeable transfers, plus
- Any failed PETs if the settlor died within 7 years of starting the trust
Use the chargeable value after annual exemptions, normal expenditure out of income exemption and reliefs.
- The exit charge is due 6 months after the month of the event.
- There is no charge if the distribution is made within 3 months of setting up the trust.
- Under a discretionary will
trustthere is no exit charge if the trust fund is distributed within 2 years of death.
Exit Charge – after the first 10 years
The rate of tax on the exit is a proportion of the rate charged at the previous 10 year anniversary. The proportion depends upon the number of quarters that the property which is exiting has been relevant property since the last 10 year anniversary. If, in the interim, the NRB has increased, we need to recalculate the rate charged at the 10 year anniversary, using the NRB effective at the date of the exit..
Let’s look at Helen again and let’s assume the trustees of her trust gifted £20,000 to Connor 2 years after the 10th anniversary the exit charge would be calculated as follows –
Firstly we need to recalculate the rate charged at the 10 year anniversary, using the current NRB at the date of exit which is assumed as £406,600.
|Value of trust at year 10||£650,000|
|Total||£243,400||X 6% =£14,604|
Recalculated rate = (£14,604 x 100)/£650,000 = 2.247%
- Work out the quarters – there are 40 in a 10 year period
2x4 quarters is 8 quarters
8 quarters /40 quarters
- Multiply the amount distributed by the rate (recalculated where appropriate) and multiply by the quarters factor.
- £20,000 x 2.247% x 8/40 =£90
The charge to the trust on the distribution to Connor is £90
- There is no exit charge if the assets are distributed within 3 months following the date the trust commenced or 3 months following the periodic charge/10 yearly charge.
- Grossing up applies where the trustees pay the tax from funds remaining in trust since the beneficiary is effectively receiving two benefits – the distributed amount plus freedom from paying IHT on it. Grossing up does not apply however on a ten year anniversary or the termination of a trust.
Potential Exempt Transfers and their effect on Chargeable Lifetime Transfers
CLT followed by a PET
It should be noted that if a settlor creates a PET within 7 years of the CLT this can have an impact on the length of time the CLT is part of the settlor’s cumulation.
When a PET fails, from the date of making the PET you look back 7 years and bring any previous CLTs back into the cumulation. This has the effect of using up the NRB of the settlor up to the amount of the CLT. This can cause CLTs to be part of the IHT calculation for up to 14 years.
Elizabeth makes the following gifts over a period of time –
|12 to 13 years before her death||Gift into Discretionary Trust||CLT(1)||£250,000|
|8 to 9 years before her death||Gift into Discretionary Trust||CLT(2)||£325,000|
|3 to 4 years before her death||Gift into Absolute Trust||PET(1)||£200,000|
The position on Elizabeth’s death is as follows. The gifts into discretionary trust would otherwise have dropped out of her IHT calculation as they were made more than 7 years prior to death. However, as she made a PET and died within 7 years of the PET, it becomes chargeable and you now look back from the date of the PET and include any gifts into discretionary trust made within 7 years of the PET. This means that the second CLT is pulled back into her IHT calculation and will use up all of her NRB. This in turn means that the PET now becomes taxable as there is no NRB to set against it. The death estate is taxed as normal, that is, the available NRB for the estate is £325,000 less the £200,000 PET thus £125,000 is available for the remainder of the estate.
PET followed by a CLT
There is also an impact when gifts are made in this order, any failed PETs become chargeable and affect the calculation at the periodic/ 10 yearly charge. They use up some of the NRB that is available to use against the value of the trust fund.
Elizabeth makes the following gifts over a period of time –
|9 to 10 years before her death||Gift into Absolute Trust||PET(1)||£300,000|
|2 to 3 years before her death||Gift into Absolute Trust||PET(2)||£325,000|
|1 to 2 years before her death||Gift into Discretionary Trust||CLT(1)||£150,000|
The position on Elizabeth’s death is as follows. The second PET becomes chargeable as it was made within 7 years of her death. The first PET drops out of her cumulation. As the second PET is chargeable, it uses up the NRB and there will be an IHT charge on the CLT of 40%. The executors will not be able to utilise taper relief as the gift was made within 2 years of death.
When the trustees of the discretionary trust calculate the periodic/10 yearly charge 10 years after set-up of the discretionary trust, the failed PET is now a chargeable transfer and is added into the calculation..
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