Introduction

There are various types of trust which may be suitable when establishing a trust for the benefit of grandchildren during lifetime. The choice of trust will depend on the circumstances and amounts involved. 

The main types of trust that can be created to benefit children during a grandparent’s lifetime are: 

• Discretionary trusts 
• Interest in possession trusts 
• Bare trusts

In all of the situations described below it has been assumed that the settlor and the settlor’s spouse or civil partner (where relevant) cannot benefit in any way under the terms of the trusts concerned. For these purposes we have assumed that if the settlor has minor dependent children as well as grandchildren, the settlor’s minor children cannot benefit under the terms of the trusts. Where this is not the case, the tax position may be radically different from that set out.

It has also been assumed that all the individuals who may add property to or benefit from a trust will be UK resident and domiciled, and that the trust will be UK resident. The tax position may differ significantly if any or all of the individuals are non UK resident or non-UK domiciled, or if the trust is non-UK resident. 

Discretionary trusts

Under a discretionary trust no beneficiary has any right to income or capital. A discretionary beneficiary merely has a right to be considered by the trustees as a potential object of their discretionary powers. The trustees have considerable flexibility as to whom amongst the class of beneficiaries they decide to confer any benefit, as to either income or capital, or both. Normally the settlor of such a trust will send a letter of wishes to the trustees providing guidance to them as to how he or she would wish them to exercise their discretion. Such an expression of wishes cannot be binding on the trustees, as otherwise the status of the trust as discretionary would be compromised. 

Inheritance Tax (IHT)

As beneficiaries have no right to income or capital, there is no charge to IHT on the value of the trust fund on the death of beneficiaries of a discretionary trust. 

A gift into a discretionary trust is a chargeable lifetime transfer for IHT purposes, but to the extent that the value being gifted into trust does not exceed the amount of the nil rate band available to the donor, no IHT will be payable. Any excess value over the nil rate band will be taxed immediately at the lifetime rate of 20%, unless a relief or exemption applies. 

The nil rate band is £325,000, frozen until 5 April 2028. If a couple are considering settling assets on trust, the combined available nil rate band between them would therefore be £650,000. Gifts within any unused annual exemptions from the current and previous year, some business property (e.g. shares in an unquoted trading company) and certain agricultural property may also be transferred free of an immediate IHT charge.

A charge to tax on the trustees arises on every tenth anniversary of the making of the settlement and when assets leave the trust. The applicable IHT rates can be low when compared with tax rates that apply to some individuals on death. The maximum ten-year charge is 6% of the value of the trust fund at the ten-year anniversary date, with IHT charges on interim trust distributions calculated as a proportion of the 6% rate.  

Income tax

For UK resident discretionary trusts in 2023/24, the first £1,000 of income received is taxable at the basic rate of 20% or dividend rate of 8.75%. Income over this amount is taxed at the rate applicable to trusts, which is 39.35% on dividends and 45% on all other income. The £1,000 standard rate band will be abolished with effect from the 2024/25 tax year and so all trust income will be taxable at the rate applicable to trusts. The dividend and savings nil rate bands do not apply.  

Trust beneficiaries receive income distributions net of a 45% tax credit. If the beneficiary pays tax at a rate lower than 45%, or if the income distribution is within the beneficiary’s personal allowance, the beneficiary can claim a repayment of tax. The trustees must pay sufficient tax to cover the 45% tax credit that attaches to any income distribution they make. This can mean the trustees must pay additional tax when they make distributions.  

Capital Gains Tax (CGT)

CGT will usually arise when assets standing at a gain are settled on trust, unless the asset is an exempt asset such as cash. These gains can be heldover so that the trustees would acquire the asset at the donor’s base cost for CGT purposes. 

To the extent that trustees realise capital gains in excess of the annual exemption, trustees pay CGT at a rate of 20% on most gains and 28% on residential property and carried interest gains (the latter point relates to private equity). The annual exemption for trusts is currently £3,000 for 2023/24 reducing to £1,500 for 2024/25. However, this is subject to anti avoidance provisions to prevent multiple settlements being created in order to benefit from multiple annual exemptions.

Interest In Possession (IIP) trusts

This type of trust is usually used to benefit adult children or grandchildren. It is common for the beneficiary(ies) to be entitled to receive income for life as of right and for the trustees to have discretion to appoint capital to a beneficiary who is entitled to receive trust income. IIP trusts may also be used for the benefit of a surviving spouse/civil partner and children. 

More flexible IIPs often contain an overriding power for the trustees to make appointments to a wider class of beneficiaries.

Inheritance Tax (IHT) 

Lifetime gifts into IIP trusts follow the same IHT treatment as applies to gifts into discretionary trusts. Therefore, depending on the value transferred into a settlement, the type of assets settled and previous gifts made, there is an IHT charge on creation and further charges every ten years and on distribution of assets from the trust.

Income tax

IIP trusts are transparent for income tax purposes, which means that the beneficiary with a right to receive income will be taxable on trust income at their marginal tax rate (i.e. the tax rate depends on the beneficiary’s income level, which will determine the tax rate applicable to the trust income). Notably this means that dividend income will be taxable at dividend rates, and that, unlike for discretionary trusts, no further tax will be payable on a distribution of the income by the trustees. 

Capital Gains Tax (CGT)

As with discretionary trusts, any capital gains made on gifting assets to IIP trusts can be heldover, provided the trust is not settlor-interested. Gains made by trustees are taxable on them, as outlined for discretionary trusts above.

Bare trusts

A bare trust is a trust where the beneficiary has an absolute right to the trust’s income and capital. The beneficiary is usually a minor or a person with a disability who requires support in managing their assets. Whilst the trust remains in existence, the trustees can pay out capital and apply income for the maintenance, education and benefit of the beneficiary.

Minor beneficiaries become absolutely entitled to the trust capital and any accrued (and arising) income on attaining the age of 18 years. For this reason, this type of trust may not always be appropriate. 

Inheritance Tax (IHT)

Gifts into a bare trust qualify as Potentially Exempt Transfers (PETs), so that no IHT is due where the donor survives making the gift by seven years. 

On the death of a beneficiary under a bare trust, the value of the beneficiary’s interest under the trust comprises part of their estate for IHT purposes. 

Income tax

Any income arising under a bare trust is taxable on the beneficiary, whose own personal allowance and tax rate(s) will apply.

Capital Gains Tax (CGT)

Gifts into bare trusts are disposals by the donor and, unless the gift is cash, the amount of any inherent gain on the asset gifted into trust will need to be reviewed as a CGT charge may arise. 

If the asset is a business asset, any capital gain can be heldover provided the statutory rules are met in full. The trustees would then acquire the asset at the donor’s base cost for CGT purposes.

HMRC registration 

Most UK trusts and certain non-UK trusts with a UK connection must register with HMRC and provide required information, including details of settlors, beneficiaries and anyone with control over the trust. The public can access this information in some circumstances. Deadlines for provision and updating of information apply. 

There are limited exemptions from registration, including an exemption for children’s bank accounts held in a parent’s name because the child is a minor (which is a type of bare trust). A separate briefing note on the trust register is available.