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Absolute Trusts

Introduction

This briefing sets out what an absolute is, why they are used and the different taxes that apply to them.

Core considerations  

  • Once the beneficiary and their entitlement are chosen, they are fixed and cannot be changed. 
  • Absolute trusts are where the beneficiary is absolutely entitled to the trust income and capital.
  • Where the trust is set up by someone other than the beneficiary’s parent, income is taxed on the beneficiary.
  •  Any gains generated within the trust will be taxed on the beneficiary.

Contents

What is an absolute trust?
Why use an absolute trust?
Income Tax
Capital Gains Tax
Inheritance Tax
 

What is an Absolute Trust (Bare trust)?

An absolute trust is an arrangement used by individuals who are certain of their beneficiaries and want a specific person to benefit. They are entitled to income and capital from the trust. Once the beneficiary and their entitlement are chosen, they cannot be changed.  

The beneficiary can benefit at any time, however they become absolutely entitled to receive the trust fund when they reach the age of majority (18 in England and Wales and 16 in Scotland). 

The trust fund belongs to the beneficiary. If the beneficiary dies before they receive all the trust fund, it will form part of their estate and will be distributed in accordance with their Will, or the intestacy rules if there is no Will. Because the beneficiary has an absolute entitlement, the trust fund will also be considered an asset of the beneficiary if they divorce or become bankrupt.
 

Why use an absolute trust?

  • They are commonly used by grandparents to pass funds to their grandchildren either in their lifetime or via their Will.
  • Where they are set up by anyone other than a parent, such as a grandparent, income and gains are assessed on the beneficiary.
  • The creation of an absolute trust is a potentially exempt transfer (PET) and there is no immediate IHT charge to consider.
  • Where an individual receives compensation in respect of an injury where this is placed into trust, it does not count towards the means test for state benefits. These are often called personal injury trusts. 

For example

Donald has 3 grandchildren, however, he only has contact with his grandson Aaron. Donald sets up an Absolute trust with Aaron as the beneficiary. Only Aaron can benefit from the trust fund. The other grandchildren cannot benefit and cannot be added as a beneficiary later. Donald is happy that Aaron will have access to the trust fund when he reaches age 18.

 

Income Tax

Income generated within the trust is assessed on the beneficiary provided the trust wasn’t created by their parent. The parental settlement rules apply where a parent(s) sets up the trust and any income over £100 is assessed on the parent(s). 

If the beneficiary is assessable, they will be able to utilise all allowances such as their personal allowance, the starting rate for savings and the personal savings allowance, in addition to the dividend nil rate. Where the income exceeds their available allowances, it will be subject to the beneficiary’s marginal rates of tax. 

The trustees are obliged to pay all income to the beneficiary unless they are minors in which case they may accumulate the income until the beneficiary reaches age 18 in England and Wales and 16 in Scotland. 

For example

Donald set up a trust for his grandson Aaron and has invested £150,000 into unit trusts. The income generated by the investment will be taxed on Aaron who has a full personal allowance, the starting rate for savings and the personal savings allowance. As the income generated falls within his allowance there is no tax to pay on the income.

 

Capital Gains Tax

Everyone, including children, is entitled to the capital gains tax annual exempt allowance which is currently £3,000. Gains within this allowance are not subject to tax.

Gains above this allowance will be subject to tax. Higher or Additional Rate taxpayers pay 20% on gains from chargeable assets except for gains from residential property, which is taxed at 24%, if the disposal was made from 6 April 2024 to 29 October 2024. Disposals made from 30 October 2024 will be chargeable at 24% on all chargeable assets, including residential property.

Basic Rate taxpayers pay 10% on gains from chargeable assets except for gains from residential property, which is taxed at 18% on disposals made between 6 April 2024 and 29 October 2024.

Disposals made from 30 October 2024 will be chargeable at 24% on all chargeable assets, including residential property. 

Where assets are transferred directly into the Absolute Trust the settlor is making a disposal and will therefore be taxed on any gains. However, if the transfer of assets is made following the death of the settlor there will be no gain realised. The trustees will acquire the assets at the market value at the date of death.

All gains arising on the disposal of assets within the trust will be assessed on the beneficiary, no matter whether the settlor is a parent or someone else.

When assets are transferred to the beneficiary on reaching age 18 there is no disposal, just a change in ownership which does not trigger a gain in this scenario.
 

For example

Donald decides to sell some of the unit trusts in his grandson’s Absolute trust which generates a gain of £3,000. As Aaron has an annual exempt allowance of £3,000 and this is within his allowance there is no capital gains tax to pay.

 

Inheritance Tax

A transfer into an Absolute trust creates a potentially exempt transfer (PET) which drops out of the settlor’s inheritance tax (IHT) cumulation after 7 years. Where there are joint settlors, the gift is deemed to be made half each unless there is evidence to show otherwise.

If the settlor dies within 7 years the transfer becomes chargeable and will use up some or all their nil rate band. The PET is set against the nil rate band of £325,000 (frozen until April 2030).

Where tax is payable on the failed PET, taper relief may apply depending on the timing between the date of the gift and the date of death.

There are no IHT charges when the assets are transferred to the beneficiary.

The value of the trust fund forms part of the beneficiary’s estate for IHT purposes.

For example

When Donald set up his trust for Aaron he created a PET on his estate. The initial transfer was £150,000 and as Donald uses his annual exemption each year, this is the full amount of the PET. If Donald were to die within 7 years the PET fails and becomes chargeable, therefore his nil rate band will be reduced by the £150,000 with the balance available to use against his death estate.

 

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