Understanding Inheritance Tax Trusts: A Financial Adviser is Essential

Wednesday 16 October, 2024

Inheritance tax (IHT) can be a substantial concern for many individuals as they plan their estates. One effective strategy to mitigate this tax burden is the establishment of inheritance tax trusts.

In this article, Conor Muldoon, our Independent Financial Adviser based in St Albans, explains the different types of trusts available, how they function, and why consulting with a financial adviser is important to ensure proper planning.

Types of Inheritance Tax Trusts

Inheritance tax trusts have the potential to be powerful financial tools designed to manage asset distribution while potentially reduce inheritance tax liabilities. The primary types of trusts often recommended include discretionary trusts, interest in possession trusts and bare trusts.

Discretionary trusts* allow trustees the flexibility to decide how the trust’s assets and income are distributed among beneficiaries. This flexibility can be particularly advantageous for managing inheritance tax by effectively shifting assets out of the settlor’s estate.
Interest in possession trusts, in contrast, can provide beneficiaries with the right to receive income generated by the trust assets for a specified period or for their lifetime, while the capital remains within the trust.
Bare trusts, or simple trusts, enable beneficiaries to directly receive both income and capital from the trust. Although these assets are considered part of the beneficiaries' estate for inheritance tax purposes, bare trusts offer straightforward administration.
Accumulation and maintenance trusts* accumulate income generated from trust assets and distribute it to beneficiaries only when they reach a certain age or meet specific conditions, often used to provide for minors or dependents until they are mature enough to handle their inheritance.

*Note: Whilst these trusts can remove the IHT liability from an individual’s estate, they have their own inheritance tax implications.

How Inheritance Tax Trusts Work

When setting up an inheritance tax trust, assets are transferred into the trust, which then becomes the legal owner. The term "settlor" refers to the individual who creates and establishes the trust. The settlor transfers their assets into the trust, thereby making the trust the legal owner of those assets.

The settlor's role involves defining the terms of the trust, including how the assets are to be managed and distributed to the beneficiaries. Essentially, the settlor sets the parameters for the trust's operation and outlines the conditions under which the assets will be handled and passed on.

By placing assets into a trust, their value is typically excluded from your estate, potentially reducing your inheritance tax liability. Trusts also offer various degrees of control over the timing and manner of asset distribution to beneficiaries and can provide protection from creditors, ensuring that assets are used in accordance with your wishes.

When transferring assets into an inheritance tax trust, it’s important to consider the potential tax implications. Under the UK's "7-year rule", gifts made into a trust are considered potentially exempt transfers (PETs) and may not incur inheritance tax if the settlor survives for seven years after the transfer. However, if the settlor passes away within that period, the value of the assets may be subject to inheritance tax.

Additionally, some trusts may be subject to entry, periodic, and exit charges. An entry charge can arise if the value of the transfer exceeds the available nil-rate band, while periodic charges may be levied every ten years on the value of the trust’s assets. Exit charges may also apply when assets are distributed to beneficiaries. It’s advisable to consult a financial adviser to fully understand these rules and ensure efficient estate planning.

Complexity and Compliance

The establishment of an inheritance tax trust is a complex process that involves careful consideration of legal and tax issues; therefore, establishing a trust may not be the most suitable course of action for everyone.

Drafting trust deeds, the legal documents that create the trust, requires meticulous attention to ensure they accurately reflect your intentions and adhere to the most current regulations at that time.

Accurate valuation of the assets being placed into the trust is crucial for tax purposes and to avoid future disputes. Additionally, trustees bear a fiduciary responsibility to manage the trust assets in accordance with the trust deed, which necessitates ongoing oversight and management.

Why Professional Financial Advice is Crucial

Given the intricate nature of setting up inheritance tax trusts, a financial adviser can be a valuable resource. A qualified Financial Adviser will bring extensive knowledge of various trust structures and can guide you in selecting the most appropriate type of trust based on your unique circumstances and objectives. If a trust is not appropriate for your situation, then they will also inform you and explain the reasons why.

In addition to financial advice, it is also important to seek legal advice when establishing a trust to ensure compliance with all relevant laws and regulations.

The financial adviser will ensure that the trust is established in full compliance with the current tax laws and regulations, thereby minimising the risk of legal and tax complications.

Moreover, the adviser will offer personalised strategies that align with your overall financial planning goals, integrating trust planning into your broader estate management strategy.

In Summary

By working with a professional financial adviser, you can navigate the complexities of trust establishment and management effectively, ensuring that your estate planning is both efficient and compliant with regulatory standards.

"Inheritance tax trusts are valuable tools for managing and potentially reducing tax liabilities, but their complexity makes professional guidance essential. With the right advice, you can ensure efficient estate planning that complies with the latest regulations."

Conor Muldoon, Independent Financial Adviser in St Albans

The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. This is for information only and does not constitute advice. The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts.

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