UK Trust Taxation

Understanding UK trust taxation

Trusts remain a cornerstone of estate and succession planning, offering control, flexibility and protection of assets. Yet their tax treatment is far from straightforward. UK rules vary not only by trust type but also by when and how assets move in and out of the structure. For advisers, understanding these nuances is essential, in order to help clients make informed decisions.

The role of trusts in planning

Bare trusts, discretionary trusts and interest in possession trusts are among the most common structures. Each offers different benefits – and different tax implications.

A bare (or absolute) trust is the simplest form. The beneficiary has an immediate right to both capital and income, and trustees simply manage the assets until the beneficiary reaches adulthood (18 in England and Wales, 16 in Scotland). These trusts are often used to hold assets for minors.

Discretionary trusts provide maximum flexibility. Trustees decide how and when to distribute income and capital, and beneficiaries have no automatic entitlement. This control comes at a cost: more complex tax treatment.

Interest in possession trusts, often called life interest trusts, require trustees to pay income to a named beneficiary – the life tenant – who may also have the right to occupy property. After the life tenant’s interest ends, capital passes to another beneficiary. Since 2006, new interest in possession trusts have been subject to the same inheritance tax (IHT) regime as discretionary trusts, reducing their popularity.

When a trust is created during a settlor’s lifetime, IHT treatment depends on the structure. Transfers into a bare trust are treated as gifts and classed as potentially exempt transfers (PETs). There’s no immediate IHT charge, but if the settlor dies within seven years, the gift may become taxable.

For discretionary and interest in possession trusts, transfers are chargeable lifetime transfers (CLTs). If the amount exceeds the nil-rate band, an immediate 20% IHT charge applies, with a further charge if the settlor dies within seven years.

Capital gains tax (CGT) also applies when assets move into a trust, as this counts as a disposal at market value. Gains are taxed at 18% or 24% after allowances. Hold-over relief is generally available for discretionary and interest in possession trusts (if not settlor-interested), but not for bare trusts unless assets qualify.

Tax during the trust period

Tax treatment continues once the trust is in place. In a bare trust, the beneficiary is the legal owner for tax purposes, so income and gains are taxed as theirs. An exception applies if a parent creates the trust: if income exceeds £100 a year, it’s taxed as the parent’s income.

Interest in possession trusts typically see trustees pay tax at 20% on most income and 8.75% on dividends, unless income is paid directly to the beneficiary, who is then taxed at their marginal rate with credit for tax already paid.

Discretionary trusts face the highest rates: 45% on income and 39.35% on dividends. The first £500 of income is tax-free, but above that, all income is taxed. Distributions carry a 45% tax credit, and beneficiaries who are not additional rate taxpayers may reclaim some or all of this. Trustees also pay CGT at 24% on gains above the annual exemption, currently £1,500, shared if multiple trusts exist.

Exit and periodic charges

Discretionary trusts may incur periodic charges every ten years, based on the value of trust assets above the nil-rate band. The maximum effective rate is 6%, though often lower. Exit charges apply when assets leave the trust and depend on timing and previous periodic charge calculations. Bare trusts are exempt from these charges because the beneficiary is the legal owner.

Will trusts, created on death, are treated differently. IHT applies to the estate before assets enter the trust, often keeping transfers within the nil-rate band. Discretionary will trusts may face periodic and exit charges if their value exceeds the nil-rate band, while interest in possession trusts can also have IHT implications depending on their structure.

Why this matters

Trusts can deliver significant value for clients seeking to protect and pass on wealth – but their tax treatment is complex. For advisers, the key is planning: understanding how different trust structures are taxed at creation, during their lifetime and on exit. With the right approach, trusts remain a powerful tool in estate planning.