Navigating Taxation in Trusts: What You Need to Know

Trusts are a useful way to manage assets, protect wealth, and ensure that your wishes are carried out for the benefit of family members or charities. However, taxation in trusts can be complex, and it is essential to understand the rules to avoid unexpected tax liabilities. This article outlines the key points you need to know about the taxation of trusts in Scotland.

What Is a Trust?

A trust is a legal arrangement where one or more people (the trustees) manage assets for the benefit of others (the beneficiaries). Trusts can be set up for various reasons, such as:

– Protecting assets for young or vulnerable beneficiaries.

– Passing on wealth while managing tax liabilities.

– Supporting charitable causes.

Trusts are established using a document called a trust deed, which sets out the terms of the trust.

 

Types of Trusts and Their Tax Treatment

The tax treatment of a trust depends on its type. The main types of trusts are:

Bare Trusts

A bare trust is the simplest type of trust, where the assets are held in the name of the trustee, but the beneficiary has the absolute right to them. The beneficiary is responsible for paying tax on income or gains as if they owned the assets directly.

Discretionary Trusts

In a discretionary trust, trustees have control over how and when the trust assets are distributed to beneficiaries. This type of trust is often used to provide flexibility in managing assets.

Interest in Possession Trusts

Here, a beneficiary has the right to receive income from the trust, but they do not own the capital. For example, a trust might allow a surviving spouse to receive income from assets, with the capital passing to children later.

Each type of trust has different tax rules for income, capital gains, and inheritance tax.

 

Income Tax

Income tax on trust income depends on the type of trust:

Bare Trusts:

The beneficiary pays tax on income as though it were their own.

Discretionary Trusts:

Trustees pay income tax at the rate of 45% on most income. Beneficiaries may reclaim some tax if their personal tax rate is lower.

Interest in Possession Trusts:

Income is taxed at the beneficiary’s rate, but trustees may deduct tax at the basic rate (20%) before passing it on.

 

Capital Gains Tax

Capital gains tax (CGT) applies when trust assets are sold or disposed of at a profit. Trustees have an annual tax-free allowance, which is lower than the personal allowance for individuals. The rate of CGT depends on the type of trust and the nature of the asset sold.

For discretionary and interest in possession trusts, gains above the allowance are taxed at 20% or 28% for residential property.

 

Inheritance Tax

Inheritance tax (IHT) can apply when assets are transferred into a trust, every ten years during the life of the trust, and when assets are distributed out of the trust. The current rules include:

– A 20% charge on assets transferred into a trust above the IHT threshold (£325,000 for most individuals).

– A ten-year anniversary charge, which may apply to trusts holding significant assets.

– An exit charge when assets are distributed to beneficiaries.

 

Practical Steps for Managing Trust Taxes

Understand the Tax Rules:

– Work with a solicitor or tax adviser to ensure the trust complies with tax laws.

– Keep Detailed Records:

– Accurate records of income, expenses, and distributions are essential for tax reporting.

File Tax Returns on Time:

– Trustees must file annual tax returns and pay any taxes due.

Seek Professional Advice:

– Trust taxation is complex, and expert advice can help you avoid mistakes and reduce tax liabilities.

 

Conclusion

Trusts are a valuable tool for managing assets, but understanding the tax implications is crucial. Each type of trust has its own tax rules, and trustees have important responsibilities to ensure compliance. By seeking professional advice and staying informed, you can manage your trust effectively while minimising tax liabilities.

If you are considering setting up a trust or need help managing an existing one, then please contact our experienced Private Client Team on 01324 622 888 or contact help@randa-fa.co.uk and we would be delighted to assist. We can guide you through the process and help you navigate the complexities of trust taxation in Scotland.