Many believe that trusts are just used to avoid paying tax, but this is not the case. Simply by putting money or assets in a trust does not stop the tax man from paying attention. Indeed, using a device like a trust solely to reduce the tax you owe may be risky, since HMRC might consider such acts ‘aggressive tax avoidance’. However, when set up properly, trusts can have the benefit of reducing your tax bill, and the tax bills of those you love.
A brief, and simple, history of tax and trusts
The history of taxes, and trusts, are intertwined. Although devices similar to trusts have existed since Roman times, the modern trust is more usually traced back to a dispute between Henry VIII and landowners.
Medieval monarchs relied on income they could generate over their feudal rights to land, like the money they could demand when land changed ownership, especially through inheritance. Landowners avoided this by transferring ‘uses’ rather than the land itself. They created the earliest trusts, separating ownership and use of their land, avoiding the taxes that came with ownership changes.
Unsurprisingly, these prompted conflict between the monarch and the landowner. This started a process that continues to this day, with the tax collector and the taxpayer constantly vying to collect as much or pay as little as possible.
The taxes you pay, and how trusts can help
Taxation is incredibly complicated, but that also means there are many ways that trusts can help you reduce your tax bill. Here are just a few examples.
Spreading trust payments to minimise income tax
Most people are familiar with income tax because they see it deducted from their pay. However, income tax covers more than just salary income. Income from pensions, interest, rental, dividend payments, and even from a trust are also liable for income tax.
Because trusts can be set up to give the trustees discretion, they can use that discretion to favour beneficiaries that pay no or basic rate tax. An example might be for trustees to spread payments to younger members of the family, helping them to establish themselves in life, without dramatically increasing their tax liability.
Using a trust to defer capital gains tax payments
Capital Gains Tax (CGT) is paid on the ‘profit’ made when assets are sold or transferred. There are some exemptions, such as family homes or vehicles. However, this is even applied when an asset is gifted. Giving a property to a child, for example, can still incur capital gains tax as if it had been sold.
A trust can help avoid capital gains by using ‘holdover relief’. In effect, this means that if the property is later sold, the trust becomes liable for CGT based on the original purchase price. However, if the trust retains ownership, it can continue to provide a property or income for the beneficiary, rather than attracting a hefty CGT bill.
Putting assets into a trust to reduce inheritance tax
Depending on who benefits from your estate, inheritance tax can be payable on estates with as little as £325,000, a threshold that most home-owners easily exceed. Because of the instinct to want to protect an inheritance for family members, trusts are most often associated with estate planning.
By putting your property or assets into a trust, you no longer own them, and they cannot form part of your estate. This means that there will be no inheritance tax payable. However, the trust needs to be correctly structured to ensure that it doesn’t end up losing just as much in other taxes.
Trusts cannot just be about tax
You cannot create a trust solely to avoid tax. However, reducing the overall tax paid can be a legitimate outcome of other purposes. For example, if you set up a trust to handle some of your estate, then setting it up to maximise the amount your family receive — in part by reducing the tax they pay — is legitimate.
You also need to ensure it is established carefully. You are giving away your property and assets, so you must make sure the trust structure protects your interests as well as the beneficiaries.
Ultimately, trusts can be tax-efficient ways to ensure that you and your loved ones get the most out of your assets, before and after your death. However, trusts, like taxes, are complicated and getting it wrong can see the costs far outweigh the benefits a trust brings.
Always take expert advice from professionals when you are setting up your trusts, then you’ll know that you are doing the best you can to protect your estate and your family.