Managing trusts and tax

Publish date

4 April 2023

The use of Discretionary Trusts in Deeds of Variation

Are you reluctant to completely give away an inheritance you have received but concerned about your own tax planning and inheritance tax on your death?

By using a Deed of Variation to transfer the inheritance, or part of it, into a Discretionary Trust, you can continue to benefit from the funds you have inherited but they will remain outside of your estate for inheritance tax purposes.

While such an arrangement will certainly be beneficial for those who already have large estates of their own, your estate does not need to be especially large to benefit; so long as your existing estate and the amount you have inherited combined is more than the available nil rate bands, there is likely to be an advantage.

Specific advice should be obtained before action is taken in any particular case.

What is a Deed of Variation?

The term Deed of Variation (which has replaced the expression Deed of Family Arrangement) is normally used to refer to post-death variations or rearrangements of wills, intestacies and certain other dispositions taking effect on death.

A beneficiary who is entitled to part of a deceased person’s estate under a will or intestacy or in other ways (for example, property held in a joint tenancy passes by survivorship) may change the way the inherited assets are owned by means of a Deed of Variation.

We often refer to Deeds of Variation as ‘Deeds of Gift with special tax implications’.

This is because, although the person making the variation is giving away the assets they have inherited, the variation can elect for the gift to be treated as having been made by the deceased person and not by the original beneficiary for all Inheritance Tax purposes and some Capital Gains Tax purposes but not in any other respect.

If the beneficiary chooses to vary their inheritance into a Discretionary Trust, they can still benefit from the inheritance by making themselves a potential beneficiary of the trust. In any other circumstance, it would not be possible to be a beneficiary of a trust you have created without the funds remaining part of your own estate for Inheritance Tax purposes.

In order to be effective for tax purposes, Deeds of Variation must be completed within two years of the death of the deceased person.

But aren’t trusts complicated?

They don’t have to be! A simple way to run such a trust would be for the trustees to give the original beneficiary an interest free loan from the trust. The beneficiary can then treat the funds as their own but on their death, the sum will be owed back to the trust.

However, the trustees may choose to keep the original assets in the trust instead (see real life example below).

A real life example

A client who attended a meeting with one of our solicitors to write her Will happened to mention that her mother had died less than two years ago.

The client had her own property worth £500,000 and had inherited her mother’s property, also worth £500,000. She was divorced with children and so only one nil rate band and one residence nil rate band would be available on her death meaning that she would be able to pass £500,000 to her children free of inheritance tax but the remaining £500,000 would be taxed. She could not afford to give away her mother’s property as she had retired and needed the rental income.

On our advice, she varied her inheritance from her mother into a Discretionary Trust. She was able to continue receiving the rental income but her mother’s property was removed from her estate for inheritance tax purposes, dramatically reducing the inheritance tax bill on her death.

Main tax implications

Inheritance Tax (IHT)

The main effect of a Deed of Variation is that the alterations made by it are treated for all IHT purposes as having been created by the deceased person and not by the original beneficiary.  This means that the settlor of the trust for IHT purposes will be the deceased person, not the person making the Deed of Variation.

Discretionary Trusts are in the relevant property regime for IHT purposes. This means that IHT may arise on each ten year anniversary and on distributions from the trust, depending on the trust’s value. However, a maximum 6% charge would apply (and it is usually far less than this) meaning that it is likely that far less tax would be payable over the lifetime of the trust than if the inheritance had remained in the original beneficiary’s estate on their death. For more information see our information sheet on Discretionary Trusts.

Capital Gains Tax (CGT)

A variation made for CGT purposes does not constitute a disposal by the original beneficiary.  Furthermore, those who take assets under the Deed of Variation will acquire them as at probate value (i.e. the market value at the date of death) for future CGT purposes.

It is possible for a variation to be made for IHT but not CGT purposes, and vice versa.

Income Tax

A Deed of Variation is not generally retrospective to the date of death for Income Tax purposes and is only effective from the date of signature.

Since a Deed of Variation will not be treated as a disposition by the deceased person for Income Tax, a beneficiary who sets up a Discretionary Trust by means of such a deed will be treated as the “settlor” for the purposes of income tax.  This has two important implications:

  • If the person making the variation  (or their spouse) is an actual or potential beneficiary of the trust, all trust income will normally be taxed as their income during their lifetime (whether or not it is distributed)
  • Even if neither the settlor nor their spouse is a beneficiary under the trust, the variation could be in favour of the settlor’s children. If the children receive distributions of income (or of capital to the extent, if any, that income has been accumulated) while they are unmarried and under the age of 18 then those distributions will be taxed in the settlor’s hands.

A Deed of Variation can present a major tax planning opportunity and should be considered in virtually all cases. Using a Discretionary Trust in a Deed of Variation has the added advantage that you can remove inherited assets from your estate for inheritance tax purposes but continue to benefit from them.

If you have received an inheritance and you believe that your estate is likely to be subject to inheritance tax, get in touch to discuss your options.

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