Reducing Inheritance Tax with Trusts

Inheritance tax (IHT) is charged at 40% on the value of your estate (above certain thresholds) when you die. For many families, a combination of property, savings and investments can create a significant liability even after deduction of available allowances. With careful planning using trusts, it is possible to reduce or eliminate that liability while keeping control of what happens to your assets.

IHT: An Example in Practice

Consider a retired married couple with two adult children and several grandchildren. Their estate is worth £1,300,000:

Asset	Value
Main Residence	£600,000
Two Rental Properties (£200k each)	£400,000
Shares	£100,000
Cash	£200,000
Total Estate	£1,300,000

As a married couple, their combined allowances on the second death are £1,000,000 (two Nil Rate Bands of £325,000 each plus two Residence Nil Rate Bands of £175,000 each (assuming the main residence is left to the children or grandchildren). This leaves £300,000 taxable and an IHT bill of £120,000.

Why Use a Trust Rather Than a Direct Gift?

Gifting assets directly to your children can work for IHT as gifts fall outside your estate after seven years. However, direct gifts have two drawbacks that a couple (like the above example) might want to avoid:

• Divorce risk: an outright gift becomes part of your child’s assets and could be split in a divorce.
• No guarantee for grandchildren: gifting to a child does not ensure grandchildren will ultimately benefit.

A discretionary trust solves both problems, with the trustees controlling how and when assets are distributed:

• Neither the children nor grandchildren have an automatic right to the assets, which protects from divorce claims.
• The children and grandchildren can be named as beneficiaries from the outset, ensuring that the grandchildren will benefit as well.

How the Trust Works for IHT

The key tax features of a discretionary trust are:

• No entry charge: a couple can transfer up to £650,000 (£325,000 each) into trust with no immediate IHT, provided no other similar transfers have been made in the previous seven years.
• Periodic charge: every ten years, trust assets above the Nil Rate Band face a charge of up to 6%. Where values stay below the band, the charge is nil.
• Seven-year rule: if you die within seven years of making the transfer, the value may be brought back into your estate (with some relief in years three to seven). After seven years it is fully outside.

The Plan in Practice

The couple transfer one rental property (£200,000) and £100,000 in cash into a discretionary trust (total £300,000 and treated as a joint transfer of £150,000 each).  Neither spouse exceeds their individual £325,000 limit so there is no IHT entry charge with scope to add to the trust in future if needed.

Tax points to be aware of:

• Stamp Duty Land Tax: no SDLT is payable when a mortgage-free property is transferred into trust so no SDLT in this case.
• Capital Gains Tax: transferring a rental property into trust triggers a CGT disposal but holdover relief is available for discretionary trusts, deferring any gain until the trustees sell.  If there is a CGT liability on the transfer, this can be deferred.
• Income tax: rental income inside the trust is taxed at 45% however distributions to beneficiaries may allow some of that tax to be reclaimed.

The Result

After seven years, assuming the couple survive the transfer, the retained estate on the second death looks like this:

Retained Estate	Amount
Main Residence	£600,000
Rental Property 2	£200,000
Shares	£100,000
Remaining Cash	£100,000
Total Retained Estate	£1,000,000
Less: Combined Nil Rate Bands	(£1,000,000)
Taxable Estate	NIL
IHT Saving	£120,000

Practical Points to Consider

• Trustees: the couple can act as trustees themselves alongside their children or a professional trustee.
• Letter of wishes: a non-binding guide to the trustees on how you would like assets to be used (for example, to fund grandchildren’s education or to avoid distributions during a divorce).
• Administration: most trusts must be registered with HMRC and will require annual tax returns.
• Timing: the seven-year clock starts on the date of transfer, so acting early while both settlors are in good health maximises the benefit.
• Asset values: it is worth noting that the assets remaining in the estate, including the main residence, may grow in value, potentially creating a future IHT liability even where none exists today.

In Summary

By placing one rental property and £100,000 in cash into a discretionary trust, this couple could eliminate a £120,000 IHT liability entirely. The trust also protects family assets from the risk of divorce and ensures grandchildren are provided for, which is something a simple gift cannot guarantee.

Professional advice from a specialist solicitor or tax adviser is essential before taking any steps.

Wilson Nesbitt’s Private Client team advises on the full range of IHT planning options, from discretionary trusts and deeds of variation, to will drafting and powers of attorney. To find out more, please get in touch.