How is an Interest in Possession Trust Taxed?

Interest in possession trusts can be very useful when a settlor (that is, the individual establishing a trust) wishes to provide a beneficiary with a regular income. If the settlor has an income-generating asset, they can place this into trust and name one or several beneficiaries that should derive the income from that asset. The assigned trustee is obliged to pass all of the income, less their reasonable costs, directly to the beneficiaries for the lifetime of the trust.

The only exception is when the terms of the trust state that the trustees may alter the beneficiaries at a later date. Frequently, the asset itself (known as the capital) will ultimately pass to a beneficiary once they attain a certain age. If, for example, the asset is a property that is being let, the beneficiary may receive the income generated by the property until they reach 25 and the property itself is transferred to them.

Income Tax

As the beneficiary is entitled to the income generated by the trust, they will also be liable for any income tax that is levied. Importantly, however, there are circumstances in which this is not the case. If either the settlor or their spouse can benefit in any way from the assets that are held in trust, then any income generated will be treated as if it were the settlor's for tax purposes.

As a result, there may well be no change in the settlor's situation with regard to income tax. It should also be noted that, in cases where the beneficiary is liable for the tax, this may be absorbed into the annual exemptions. This is particularly the case for minors, who are unlikely to earn enough in a year to push them over the threshold.

Inheritance Tax

Transfers of assets into discretionary or interest in possession trusts are chargeable under the post-2006 inheritance tax (IHT) schedule. This means that, if the value of the transfer is greater than the settlor's remaining Nil-Rate Band allowance, a flat charge of 20% will be levied on it. Furthermore, assets held in trust are subject to a regular charge once every ten years.

The maximum rate at which this charge can be levied is 6% of the total value of the assets; this charge may, however, be lower as it is worked out at 30% of the average IHT charges levied throughout the lifetime of the trust. In many cases, however, particularly if assets are distributed amongst a number of smaller trusts, these charges will be absorbed by the Nil-Rate Band and no tax will actually be paid.

Capital Gains Tax

For the purposes of Capital Gains Tax (CGT) trusts are allowed an annual exemption, set at £4,600 for the last tax year. As this exemption is renewed annually, it is often advisable to realise assets on a regular basis rather than in one go at the end of the lifetime of the trust. If capital gains exceed the annual allowance (which tends to rise year on year in line with inflation), they will be charged at a flat rate of 40%.

The tax treatment of interest in possession trusts is complex, particularly in situations where the settlor stands to benefit from the assets placed in trust. As such, specialist advice should always be sought in order to mitigate a tax liability.