Discretionary trust tax implications & inheritance tax explained

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".  

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.

Example 1.

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, however she does use her £3,000 annual exemption each year.

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.

Example 2.

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:

Important Information

1. 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.
   
   
2. If the CLT plus any made in the previous 7 years is below the settlor’s NRB there is no entry charge.
   
   
3. 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.
   
   
4. Where a discretionary will trust is created, 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.

Example 1.

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.

Example 2.

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.

Important Information

1. The charge is due 6 months after the month of the event.
   
   
2. 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 –

Example 1.

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 (hypothetical 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.

Example 2.

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.

Important Information

1. The periodic charge is due 6 months after the month of the event.
   
   
2. 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.
   
   
3. 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'.

Example 1.

Let’s reconsider Helen (assume no previous gifts, related settlements or additions)

Initial value of the property comprised in the trust fund £400,000

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 –

1. Work out the quarters – there are 40 in a 10 year period 8x4 is 32. 32/40
   
   
2. Work out the “settlement rate” which is 30% percent of the “effective” rate – 30% x 3.75% = 1.125%
   
   
3. Multiply the amount distributed by the “effective” rate and multiply by the quarters factor. £20,000 x 1.125% x 32/40 = £180

The charge to the trust on the distribution to Connor is £180

Example 2.

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%

Initial value of the property comprised in the trust fund £60,000 (Hypothetical Chargeable Transfer)

There will therefore be no exit charges in the first 10 years

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. 

Important Information

1. The exit charge is due 6 months after the month of the event.
   
   
2. There is no charge if the distribution is made within 3 months of setting up the trust.
   
   
3. Under a discretionary will trust there 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.

Example 1.

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.

Important Information

1. 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.
   
   
2. 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.

Example 1.

Elizabeth makes the following gifts over a period of time –

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.

Example 1.

Elizabeth makes the following gifts over a period of time –