The general rule is that someone can put up to £325,000 into a discretionary trust without triggering an immediate inheritance tax ("IHT") charge.
It is quite common to be asked if a client can set up a trust with less than £325,000, with a view to "topping-up" the trust fund at a later date. That might be convenient if, for example, the client comes into some more wealth later, or they can afford to give more wealth away once they start drawing their pension.
However, it is essential to consider the IHT consequences of making additions to a trust. How the addition is taxed depends on who makes the addition.
When a new settlor adds funds
If the funds are added by someone other than the person who set up the trust, then that other person creates a trust (or "settlement") of their own for IHT purposes, which is taxed separately from the original trust. That separate settlement will be subject to the relevant property regime and have 10-year charges in its own right. This can be effective in mitigating IHT. The new settlor might have a free IHT nil rate band for use, meaning there is a separate settlement with its own nil rate band, reducing tax on the overall "pot" in the trust. Care should be taken to clarify whether the proposed new settlor may incur an entry charge when funds are added.
When the original settlor adds funds
If the settlor of the original trust decides to add funds themselves, the additions form part of the original settlement and are liable to 10-year charges on the ten-year anniversaries of the original trust. Because the added funds have not been in the trust for the full 10 years, they will benefit from some time apportionment (similarly to an exit charge), with the IHT charge being reduced to reflect the time for which the added property was not part of the trust fund. The same rules apply even to funds added by way of normal expenditure out of excess income (which is exempt on the transfer into trust, but not exempt from 10-year charges once it is within the trust).
How "baggage" can impact IHT
There is also a critical – and often overlooked – rule around the "baggage" which the trust will carry where there have been additions to it. When a 10-year charge arises after an addition, and the trustees are looking to determine the available nil rate band, the trustees must compare the settlor's cumulative gifting total in the 7 years before the trust was created with the settlor's cumulative gifting total in the 7 years before the addition was made (excluding the initial gift to trust). The greater of the two cumulative totals is the amount by which the nil rate band is reduced in your 10-year charge calculation. This can have a considerable impact on the IHT charge.
If clients or their advisors are considering making additions to trust, then it is essential that the IHT implications of that are considered. It is also important to consider the potential income tax and capital gains tax consequences. If a decision is taken to make additions, then it will become essential to keep records of those additions, and detailed trust accounts recording things like which assets are derived from the added capital, for example.
If you or your clients have any questions on the taxation of additions to trusts, please get in touch.
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Senior Associate
