How to avoid the 50% income tax rate for trusts

From 6 April this year, many family trusts will have to pay tax on their income at 50% whatever the level of income. The 50% rate applies to all trust income and is not restricted to income over £150,000. Fortunately there are ways to reduce the effective rate.

1. If you earn less than £150,000

If you created the trust, you are known as the settlor. If you are the settlor and you anticipate earning less than £150,000 from April 2010, there are three methods for reducing the 50% tax rate on trust income. These depend on whether you are married or in a civil partnership, or whether you have children under 18. They all involve making the trust “settlor-interested” for income tax purposes.

(a) How to avoid the 50% income tax rate for trusts if you are married or in a civil partnership

If you are the settlor of a trust but also a beneficiary, this can cause inheritance tax problems. However, if your spouse or civil partner (but not you) is a beneficiary, this avoids the inheritance tax problems and yet the trust is still treated for income tax purposes as being “settlor-interested”.

What is the advantage of a trust being settlor-interested? Put simply, the trust’s income is treated as yours and taxed accordingly. This means the rate of tax on trust income will be reduced to 40% or even 20% depending on your marginal rate of tax, rather than at the trust rate of 50%.

This significant tax saving can be achieved by including your spouse or civil partner as a beneficiary of the trust. In all other respects, the trust will stay the same, still allowing income to be paid out to any of the beneficiaries at the trustees’ discretion. Whether the trustees can add your spouse or civil partner as a beneficiary of the trust will depend on the specific wording of the trust deed.

(b) How to avoid the 50% income tax rate for trusts if you have children under 18

If you are the settlor of the trust and you are not married or in a civil partnership, or if the trustees do not have the power to add your spouse or civil partner as a beneficiary, the trust’s income can still be taxed at a lower rate if you have children under 18 and they are beneficiaries of the trust.

This is because trust income paid to your minor children will be treated as yours and taxed at your own marginal rate rather than at the trust’s 50% rate.

(c) How to avoid the 50% income tax rate for trusts in other circumstances

Even if neither of the above applies, there are still other steps the trustees can take to reduce the effective tax rate on trust income. These include investing in ways which mean the investment return is taxed as if the trust is settlor-interested for income tax purposes.

2. If you earn more than £150,000

If you are the settlor and are likely to be a 50% taxpayer from April 2010, there is nothing to be gained by making the trust settlor-interested, as your personal tax rate will be the same as the trust’s.

However, if the beneficiaries of the trust are not 50% tax payers, and if the trust deed allows, the trust could be varied so that one or more of the beneficiaries receives a right to the income from the trust. In that case the trust income is taxed at the beneficiary’s own lower rate of tax.

All of these planning ideas could result in a significant tax saving although they generally require a change to the terms of the trust. We would be happy to review the trust deed, advise on the tax saving opportunities and prepare the necessary documentation.

For further information, please contact Andrew Goldstone on +44 (0)20 7440 7205 or by e-mail.