How to Use Trusts for Tax Efficiency and Estate Planning

Planning for the future, both financially and in terms of securing your legacy, can be a stressful process. Trusts are a powerful tool in estate planning, offering a flexible solution for preserving wealth, minimising tax burdens, and ensuring your assets are distributed according to your wishes. Trusts also address specific family or financial circumstances, such as caring for dependents, safeguarding assets from creditors, or reducing the impact of inheritance tax (IHT).

The common stereotype around trusts like the property protection trust will is that it is only meant for the rich and affluent. However, a trust can easily be taken up by anyone who desires more control over his/her estate.

In this article, we will explore what trusts are, how they work, and how they can be used for tax planning and estate planning purposes.

Types of Trusts

There are several types of trusts, each designed for different purposes and with its own tax implications. Some common types include:

• Bare Trusts: The assets are owned absolutely by the beneficiaries. This is normally a transfer of the assets to minors.
• Discretionary Trusts: The distribution of the assets should be made by the discretion of the trustees amongst beneficiaries.
• Interest in Possession Trusts: The beneficiaries normally have rights to the income produced via assets, not necessarily the assets themselves.
• Settlor-Interested Trusts: A settlor or their spouse could be one of the potential beneficiaries.

There are many other types of trusts, and each type has been developed for a particular purpose. This is why it’s important to decide the type of trust that is most appropriate for your requirements before making a decision.

The Role of Trusts in Estate Planning

Estate planning includes making arrangements concerning the management and distribution of your assets after your death. Trusts provide the versatility and control needed to specify when and to whom your assets should be distributed. Here are a few key benefits:

1. Control Over Asset Distribution: One of the main benefits of a trust is the ability to control how your assets will be distributed. This may be through an outright gift, periodic distributions, or triggered by specific events such as a beneficiary attaining a certain age.
2. Protection of Assets: With an irrevocable trust in place, the trustor’s assets cannot be accessible for claims such as divorce decrees, bankruptcy, or careless consumption by heirs.
3. Avoiding Probate: As the trust property is not subject to probate, the passing of the estate occurs with minimum fuss and much quicker than for the beneficiaries.
4. Provision of Services for Vulnerable Beneficiaries: A trust protects the financial interest of a person who cannot be expected to take care of his or her assets, for example, a child, an aged parent, or a minor.

Using Trusts For Tax Efficiency

One of the strongest benefits of trusts is their ability to minimise tax liabilities, especially inheritance tax (IHT), which is levied at a whopping 40% on estates exceeding £325,000 (as of 2024).

Here’s how trusts can help with tax efficiency:

1. Inheritance Tax Mitigation

• Potential Exemption: Most types of transfers made to trusts for beneficiaries, such as attending to basic expenses for survivors or bare trusts, are treated as gifts. Provided that the settlor makes the transfer and outlives it for the next seven years, such assets may be exempt of IHT.
• Trusts and the Nil-Rate Band: A discretionary trust will be allowed to benefit from a nil-rate band, which will enable the family to pay less inheritance tax on much larger estates.

2. Capital Gains Tax (CGT) Planning

While sending out a trust property unit to a beneficiary trust, capital gains tax (CGT) will be charged. In certain occasions, holdover relief may be claimed, meaning CGT will not be due until the asset is transferred by the trustees for value.

3. Efficient Income Tax Management

Trusts that give interest in possession are designed in such a way that the income is given out to a beneficiary whose income tax rate is less than that of the settlor.

Considerations When Setting Up a Trust

While trusts are beneficial, setting one up involves careful planning and professional advice. Here are some factors to consider: 

• Taxes: While trusts may reduce a donor’s tax liability, they are not entirely tax-free. Depending on the type of trust and the nature of its property, trustees may have an IHT, CGT, or income tax liability.
• Administration: The administration of a trust can be costly in terms of accounting, filing taxes, and upholding legalities. Choose trustees carefully so that they can properly discharge these obligations.
• Fees: Establishing a trust and maintaining one usually incurs legal, administrative, and possibly tax-related fees. Ensure that the advantages always outweigh the costs.
• Legal Advice: The laws of trust can be difficult, and if wrongly done, direct tax disadvantages can appear. A solicitor or tax advisor should investigate the proper formation of the trust with respect to your goals. 

Conclusion

Trusts are still very much central to many forms of tax planning, particularly estate planning. By providing control and flexibility along with possible tax benefits, trusts can help guarantee your legacy and support for generations to come. Keep in mind that trusts are rather complicated tools and should be used with caution and proper expert advice.

When it comes to tax mitigation, asset protection, or securing the well-being of family members, trusts can be useful to attain these goals. Make sure to initiate these processes by talking to a lawyer or an accountant about how you can utilise a trust optimally.

Note: This is a collaborative post