How are trusts taxed for inheritance tax?

Discretionary trusts are subject to three IHT charges: a 20% entry charge on transfers above the nil-rate band, a periodic charge of up to 6% every 10 years, and an exit charge of up to 6% on distributions. Bare trusts generally have no IHT charges. The IHT treatment of trusts depends on the trust type. Discretionary trusts (also called 'relevant property trusts') are subject to three charges: (1) Entry charge — when assets are transferred to the trust, a 20% charge applies to the value above the nil-rate band (£325,000). This is a lifetime charge, and the nil-rate band is shared with other lifetime gifts in the preceding 7 years. (2) Ten-year periodic charge — every 10 years, a charge of up to 6% applies to the value of the trust assets above the nil-rate band. The exact rate depends on the value of the trust and the available nil-rate band. (3) Exit charge — when assets are distributed from the trust to beneficiaries, a charge of up to 6% applies, calculated based on the time since the last 10-year anniversary. Bare trusts have no IHT charges — the beneficiary is treated as the owner, and the assets are in the beneficiary's estate. Interest in possession trusts have the trust assets treated as part of the life tenant's estate. Relevant legislation: Inheritance Tax Act 1984, Sections 58-69 (chargeable transfers to trusts); Sections 71-79 (relevant property regime — periodic and exit charges). Example: A grandparent transfers £500,000 to a discretionary trust. The entry charge is 20% of (£500,000 - £325,000 nil-rate band) = 20% of £175,000 = £35,000. Every 10 years, a periodic charge of up to 6% of the trust value above the nil-rate band applies. If the trust is worth £600,000 at the 10-year anniversary, the periodic charge could be up to 6% of £275,000 = £16,500. Common mistake: Underestimating the ongoing IHT charges on discretionary trusts. The entry charge, 10-year periodic charges, and exit charges can accumulate over the life of the trust.

What is the 20% entry charge on discretionary trusts?

When assets are transferred to a discretionary trust, a 20% IHT charge applies to the value above the nil-rate band (£325,000). The first £325,000 is free from the entry charge, subject to the 7-year rule for prior lifetime gifts. The entry charge (also called the 'lifetime rate') applies when assets are transferred to a discretionary trust. The charge is 20% of the value of the transfer above the nil-rate band. The nil-rate band for trust transfers is the same as the standard nil-rate band (£325,000), but it is shared with other chargeable lifetime transfers made in the preceding 7 years. This means that if the settlor has made other transfers to trusts in the last 7 years, the available nil-rate band is reduced. If the settlor dies within 7 years of making the transfer, the entry charge may be recalculated at the death rate of 40% (with a credit for the 20% already paid). The entry charge is payable by the trustees (not the settlor) and must be paid by the end of the tax year following the year in which the transfer was made. Relevant legislation: Inheritance Tax Act 1984, Section 66 (chargeable transfers to trusts); Section 7 (rate of tax). Example: A settlor transfers £500,000 to a discretionary trust. If no other chargeable transfers have been made in the preceding 7 years, the nil-rate band of £325,000 is fully available. The entry charge is 20% of (£500,000 - £325,000) = 20% of £175,000 = £35,000. The trustees must pay £35,000 by the end of the following tax year. Common mistake: Forgetting that the nil-rate band is shared with other chargeable lifetime transfers in the preceding 7 years. Previous trust transfers can reduce the available nil-rate band, increasing the entry charge.

What is the 10-year periodic charge on trusts?

Every 10 years, discretionary trusts are subject to a periodic charge of up to 6% of the trust's value above the nil-rate band. The exact rate depends on the trust's value and the available nil-rate band. The 10-year periodic charge (also called the 'principal charge') applies to discretionary trusts (relevant property trusts). Every 10 years from the date the trust was established, a charge of up to 6% is applied to the value of the trust assets above the nil-rate band. The calculation is complex: (1) The trust's value at the 10-year anniversary is determined. (2) The nil-rate band available to the trust is calculated (based on the settlor's nil-rate band, reduced by any chargeable transfers in the 7 years before the trust was set up). (3) The effective rate is calculated as a percentage of the trust's value above the nil-rate band, up to a maximum of 6%. (4) The charge is the effective rate multiplied by the trust's value above the nil-rate band. The charge is payable by the trustees. For most trusts, the periodic charge is relatively modest (often 4-6% of the excess above the nil-rate band). Relevant legislation: Inheritance Tax Act 1984, Section 71 (ten-year periodic charge). Example: A trust was established with £500,000 and is worth £700,000 at the 10-year anniversary. The nil-rate band available is £325,000. The value above the nil-rate band is £375,000. The effective rate (depending on the calculation) might be 4.5%. The periodic charge is 4.5% of £375,000 = £16,875. Common mistake: Forgetting to file the 10-year periodic charge return and pay the charge. Missing the deadline can result in penalties and interest.

What is the exit charge on trusts?

When assets are distributed from a discretionary trust to beneficiaries, an exit charge of up to 6% may apply. The charge is based on the value of the distribution and the time since the last 10-year anniversary. The exit charge applies when assets are distributed from a discretionary trust to a beneficiary. The charge is calculated based on: (1) The value of the distribution. (2) The effective rate at the last 10-year anniversary (or the date of the transfer, if before the first 10-year anniversary). (3) The proportion of the 10-year period that has elapsed since the last anniversary. The exit charge is designed to ensure that assets do not escape the trust regime without a charge. The rate is pro-rated based on the time since the last 10-year anniversary — if the distribution is made immediately after a 10-year anniversary, the exit charge is low; if made just before the next 10-year anniversary, the exit charge is close to the full periodic rate. The exit charge is payable by the trustees. Relevant legislation: Inheritance Tax Act 1984, Section 72 (exit charge). Example: A trust has an effective rate of 4.5% at the last 10-year anniversary. Five years later (halfway through the 10-year period), the trustees distribute £100,000 to a beneficiary. The exit charge is 4.5% × 50% (proportion of the period elapsed) × £100,000 = £2,250. The beneficiary receives £97,750 (or the trust pays the charge from remaining assets). Common mistake: Assuming that distributions from trusts are always tax-free. The exit charge can apply, reducing the amount received by the beneficiary.

Should I use a trust or make outright gifts for IHT planning?

It depends on your objectives. Outright gifts are simpler but give up all control. Trusts provide control and asset protection but involve IHT charges and complexity. Specialist advice is needed to determine the right approach. The choice between outright gifts and trusts depends on several factors: (1) Control — if you want to retain control over how assets are used, a trust is preferable. Outright gifts give the beneficiary full control. (2) Asset protection — trusts can protect assets from a beneficiary's divorce, bankruptcy, or poor financial decisions. Outright gifts offer no protection. (3) IHT efficiency — outright gifts (PETs) become exempt after 7 years. Trusts have entry charges (20% above the nil-rate band), periodic charges, and exit charges. (4) Simplicity — outright gifts are simple and low-cost. Trusts are complex and require ongoing management. (5) Beneficiary circumstances — trusts are useful where beneficiaries are young, vulnerable, or financially irresponsible. (6) Flexibility — discretionary trusts allow trustees to adapt distributions to changing circumstances. The right approach depends on the settlor's objectives, the family circumstances, and the assets involved. Specialist advice is essential. Relevant legislation: Inheritance Tax Act 1984 (various provisions on gifts and trusts). Example: A grandparent wants to gift £200,000 to their grandchild. If they make an outright gift, it is a PET — if they survive 7 years, it is exempt, and there are no IHT charges. If they set up a discretionary trust, the entry charge is £0 (within the nil-rate band), but there will be periodic charges and exit charges. The trust provides control and asset protection, but at a cost. Common mistake: Setting up a trust without considering whether an outright gift would achieve the same IHT outcome more simply and cheaply.

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Trusts are a powerful estate planning tool that can help reduce inheritance tax while retaining some control over how assets are distributed. However, the IHT treatment of trusts is complex, with charges on entry, every 10 years, and on exit. Understanding the different trust types and their IHT implications is essential for effective trust-based estate planning.

Types of Trusts

The main types of trusts for IHT purposes are: (1) Discretionary trusts — the trustees have discretion over how to distribute income and capital among the beneficiaries. (2) Interest in possession trusts — a beneficiary has a right to the income from the trust. (3) Bare trusts — the beneficiary has an absolute right to both income and capital. (4) Mixed trusts — a combination of different trust types. Each type has different IHT treatment, and the choice depends on the objectives of the trust.

IHT Charges on Trusts

Discretionary trusts are subject to three main IHT charges: (1) Entry charge — when assets are transferred to the trust, a 20% charge applies to the value above the nil-rate band. (2) Periodic charge — every 10 years, a charge of up to 6% applies to the value of the trust assets above the nil-rate band. (3) Exit charge — when assets are distributed from the trust, a charge of up to 6% applies. Interest in possession trusts and bare trusts have different IHT treatment, with bare trusts generally having no ongoing IHT charges.

Discretionary Trusts

Discretionary trusts are the most flexible trust type, giving trustees discretion over distributions. They are commonly used for family wealth planning, asset protection, and IHT planning. The main IHT charge on setting up a discretionary trust is 20% on the value above the nil-rate band. The trust is then subject to 10-year periodic charges (up to 6%) and exit charges. Despite the charges, discretionary trusts can be effective for IHT planning because the assets are removed from the settlor's estate and the trust can hold assets for multiple generations.

Bare Trusts

Bare trusts are the simplest trust type, where the beneficiary has an absolute right to both income and capital. For IHT purposes, the beneficiary is treated as the owner of the trust assets. This means there are no entry charges, periodic charges, or exit charges on bare trusts. However, the assets are treated as part of the beneficiary's estate for IHT purposes, so they may be subject to IHT on the beneficiary's death. Bare trusts are often used for gifts to children, where the trustee holds the assets until the child reaches 18.

Key Points

What You Need to Know

Discretionary trusts have entry charges (20%), periodic charges (up to 6% every 10 years), and exit charges
Bare trusts generally have no IHT charges but the assets are in the beneficiary's estate
Interest in possession trusts give a beneficiary the right to income
Trusts can remove assets from the estate while retaining some control
Trust planning requires specialist advice to navigate the complex IHT rules

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