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September 29th 2020

The role of trusts in tax planning: an example

Trusts can be very useful in tax planning, however there is no “one size fits all” when it comes to using trusts for planning purposes. The effectiveness of this type of planning will be determined by the individual’s wishes and their own circumstances. Scholes Chartered Accountants provides small business owners with tailored advice on these matters.

I have provided an example below to illustrate how a trust can be used in the right circumstances:

Passing assets to your children - Example

John has a residential investment property which he purchased some years ago for £120,000. There is no mortgage on the property. The property is valued at £320,000 on 30 September 2020.

John has made no gifts or lifetime transfers to any trust in the prior seven years.

John wishes to pass the property to his adult son, Alan. If John gifted the property there would be two tax consequences:

1) Inheritance Tax (IHT) – the gift would be a potentially exempt transfer (PET) and would fall out of John’s estate if he survives seven years from making the gift to Alan.

2) Capital Gains Tax (CGT) – John and Alan would be deemed as connected parties which results in the market value of the property (£320,000) being treated as a disposal value for CGT purposes. John would be liable to tax on the gain of £170,000 (£320,000 less £120,000) at a rate of 18% or 28%! Even worse, as it is a gift, John does not receive any actual cash to cover the tax bill!

Solution?

John could create an Interest In Possession (IIP) Trust with Alan as the beneficiary of the trust.

John gifts the property to the trust and elects to claim hold-over relief which means that there will be no CGT payable.

The value of the property at the date of the transfer (£320,000) is below the nil rate band available to the trust (see above) so there will be no IHT payable.

The property had no existing mortgage and the gift of the property will not be subject to Stamp Duty Land Tax (or the Scottish or Welsh equivalents).

After a few years (ideally more than two but less than 10) when the property is worth £350,000 the property is transferred from the trust to Alan.

Alan and the trustees make a joint election to claim hold-over relief so again there will be no CGT payable when the asset is transferred to Alan.

IHT is payable when assets leave the trust, however because the property is not been held for 10 years, the calculation is based on the value when the assets were originally placed in the trust, namely £320,000. This value will be fully covered by the trust’s nil rate band which means that no IHT will be payable.

Result

Alan has received an investment property which is worth £350,000 and there was no CGT or IHT paid.

The assets will also be out of John’s estate for IHT purposes if he survives for seven years from the initial gift to the trust.

Tax warnings

a) Alan will be entitled to any rental income. The trustees and Alan will also be liable to income tax on any rental income received.

b) If the property is transferred out of the trust too quickly, HMRC could apply anti-avoidance procedures which will basically treat the whole transaction as a gift from John to Alan and ignore the trust. The longer the property stays in the trust, the better.

c) Alan's base cost of the property for CGT purposes will be the original purchase price of £120,000.

If you'd like to discuss any of the points in the article, please feel welcome to contact us today.

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