You’ve had a discretionary trust for your children for many years. They are now adults, and following a ten-year charge you want to end the trust and distribute the assets to each of them. How can this be done without triggering a tax trap?
IHT and trusts
In 2006 the government significantly tightened the tax rules for trusts, primarily to close a perceived inheritance tax (IHT) loophole. This brought most trusts within range of the periodic ten-year charge. As the name suggests, the rule requires trusts to be assessed for IHT every decade. Broadly, IHT is payable on the value of trust funds if they exceed the nil rate band (NRB) (£325,000 for 2024/25).
The ten-year charge on winding up
The tax can’t be avoided by simply winding up a trust before the ten-year charge is triggered. It accrues every three months (quarter) which means if you wholly or partly wind up a trust between ten-year charges there’s a proportionate charge (assuming the funds exceed the NRB) for each full quarter that has elapsed since the last tax charge. This is called an exit charge.
Pro advice. If you wind up the trust within three months following a ten-year charge there’s no exit charge. This might sound like a good thing but it can lead to a little-known capital gains tax (CGT) trap.
CGT on trust assets
When assets to which CGT apply, e.g. shares, unit trusts, property, are passed from the trust to the beneficiaries, e.g. upon the wind up of a trust, the transfer counts as if the assets had been sold for their market value (MV), i.e. the amount they could expect to fetch if sold on the open market. If the trust acquired the assets for less than the MV, the difference is taxable. When calculating this CGT trusts can knock their annual CGT exemption (£1,500 for 2024/25) off the gains to reduce the amount on which tax is payable.
Example. The Billy Mill Roundabout Trust owns one asset, worth £200,000 when it was acquired. 15 years later, when the property was worth £375,000, the trust is wound up and the property transferred to its beneficiaries. The trust is deemed to have made a taxable capital gain of £175,000.
Pro advice. CGT can be deferred if the trustees and the beneficiaries make a joint holdover election. The gain then only becomes taxable when the beneficiaries sell or transfer the property.
Holdover election condition
An election is only allowed if the transfer of assets is chargeable to IHT. There doesn’t have to be IHT payable, say because the transfer value is below the NRB. It only needs to be within the scope of IHT. This condition can catch trustees out. If assets are transferred from a trust within three months of an IHT ten-year charge, a holdover election isn’t allowed because the transfer isn’t chargeable to IHT. As we’ve already mentioned, the IHT charge accrues quarterly, so a transfer within three months of a ten-year charge isn’t IHT chargeable and the holdover election condition isn’t met. To avoid the trap simply make sure you allow three months from a ten-year charge to elapse before making a transfer.
If assets are transferred from a trust to a beneficiary it can result in a capital gains tax charge. This can be deferred indefinitely where the trustees and the beneficiary make a holdover election. However, an election is not allowed if the transfer is made within three months following a trust’s ten-year charge. Your client can avoid this trap by delaying the transfer.
The next step
This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.