Can a Trust Avoid Inheritance Tax?
Can a trust avoid inheritance tax? In the UK, trusts are a powerful estate planning tool—but whether they can help you avoid inheritance tax (IHT) depends on the type of trust, how it’s structured, and how it’s used. In this comprehensive guide, we explore how trusts interact with HMRC’s inheritance tax rules, which trusts can offer tax advantages, and how to use them effectively.
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What Is a Trust and Why Use One?
A trust is a legal arrangement where a person (the settlor) places assets under the control of trustees for the benefit of beneficiaries. While trusts are often used for asset protection and family planning, they also play a role in inheritance tax planning.
Common reasons people use trusts include:
- Protecting assets from care fees or divorce settlements
- Controlling how and when beneficiaries inherit
- Minimising inheritance tax liability
But the key question remains—can a trust avoid inheritance tax? Let’s break it down.
How Inheritance Tax Works in the UK
Inheritance tax in the UK is charged at 40% on estates above the £325,000 nil-rate band. There’s also a £175,000 residence nil-rate band if you’re passing your main home to direct descendants. Any estate over these thresholds is subject to tax unless exemptions or reliefs apply.
This is where trusts come into play. Some trusts are treated differently for IHT purposes—but not all trusts avoid inheritance tax completely.
Which Trusts Can Reduce Inheritance Tax?
1. Bare Trusts
A bare trust names the beneficiary outright and gives them access to the assets when they turn 18 (or 16 in Scotland). These are not effective for avoiding IHT as the assets are treated as part of the beneficiary’s estate.
2. Discretionary Trusts
Discretionary trusts give trustees the power to decide how the assets are distributed among beneficiaries. Can a trust avoid inheritance tax using this structure? Not entirely—but discretionary trusts do remove assets from the settlor’s estate if they live for seven years after the gift is made.
3. Interest in Possession Trusts
These allow a named beneficiary to benefit from the income of the trust during their lifetime. The capital may pass to another beneficiary later. These trusts are generally included in the beneficiary’s estate for IHT purposes, so they offer limited inheritance tax mitigation.
4. Trusts for Vulnerable Beneficiaries
Special rules apply to trusts for people with disabilities or learning difficulties. These may benefit from IHT exemptions and income tax advantages. For more on this, see the UK Government guidance.
When Can a Trust Avoid Inheritance Tax?
Can a trust avoid inheritance tax altogether? In very specific cases, yes—but usually, it’s more accurate to say that trusts can reduce or delay inheritance tax.
Gifts into Trust (and the 7-Year Rule)
When you place assets into a discretionary trust, it may be treated as a potentially exempt transfer (PET). If the settlor survives for seven years after making the gift, the assets are excluded from their estate for IHT purposes.
Nil Rate Band Trust Planning
Couples sometimes set up trusts that take advantage of the nil-rate band upon the first death, preserving that allowance and reducing the second estate’s tax bill.
Using Trusts for Life Insurance Policies
Placing a life insurance policy in trust can ensure the payout doesn’t form part of your taxable estate, effectively avoiding IHT on that amount. This is one of the most effective ways a trust can legally avoid inheritance tax.
Tax Rules You Must Understand
While trusts can reduce IHT, they come with tax responsibilities. Key taxes to understand include:
- Initial charge: 20% for transfers into some discretionary trusts above the nil-rate band
- Periodic charge: Up to 6% every 10 years on trust assets above the nil-rate band
- Exit charge: Charged when assets leave the trust
These taxes apply depending on the type of trust, the size of the trust, and when the transfer was made. It’s essential to get legal advice before setting up a trust.
How to Set Up a Trust That Minimises IHT
If you’re considering a trust to reduce or avoid inheritance tax, you should follow these steps:
- Determine your goals—protection, tax planning, control, etc.
- Choose the correct type of trust for your needs
- Work with a qualified estate planner or solicitor
- Consider the 7-year rule and potential charges
- Ensure trustees understand their legal responsibilities
Setting up the wrong kind of trust or doing it without proper advice could result in unexpected tax bills or legal issues. Our team at MP Estate Planning is here to help you do it right.
Book a free consultation to see how a trust might fit into your inheritance tax planning.
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Conclusion: Can a Trust Avoid Inheritance Tax?
Can a trust avoid inheritance tax? Yes—if used strategically and legally. While not all trusts eliminate IHT, certain types like discretionary trusts and trusts for life insurance policies can significantly reduce your tax bill. The key is setting up the right structure and understanding how HMRC treats different trusts.
Trust planning should never be a DIY task. One error can cost your family thousands. That’s why we’re here to help. Book your free consultation or view our fixed-fee pricing today.