Trusts and Income Tax

Trusts are separate legal arrangements that can own assets and receive income, and they face different tax rules depending on their type. If you're a trustee or beneficiary, understanding how trust income is taxed, what expenses can be claimed, and what reporting is required will help you meet your...

What types of trust exist for tax purposes

The tax treatment of a trust depends on its type. The main categories are:

Interest in possession trusts give a named beneficiary the automatic right to receive trust income as it arises. The beneficiary pays Income Tax on this income at their own rates.

Discretionary trusts allow trustees to decide which beneficiaries receive income and how much. The trustees pay tax on the income at special rates before distributing it.

Accumulation trusts allow income to be retained and added to the trust capital rather than paid out. These follow similar tax rules to discretionary trusts.

Some trusts combine features of these types and are taxed accordingly on different portions of their income.

How trust income is taxed

Trusts pay Income Tax on various types of income they receive, including rental income, trading profits, interest, and dividends.

Certain items are treated as income for tax purposes even though they might not seem like regular income. These 'deemed income' items include:

Gains on life insurance policies
Accrued income scheme profits
Lease premiums (lump sum payments received instead of rent)

The tax rates that apply depend on the trust type. Accumulation and discretionary trusts pay at special rates on income above the tax-free amount. From 6 April 2024, these rates vary between 39.35% and 45%. Interest in possession trusts have the income taxed on the beneficiary rather than at trust level.

Trust management expenses

Trustees incur costs when carrying out their duties, known as trust management expenses. These expenses have strict rules about what qualifies and how they affect tax.

What expenses qualify

Only expenses that relate directly to trust income count as trust management expenses. Qualifying costs include:

Preparing the income sections of a tax return (but not the capital gains pages)
Deciding which beneficiaries to pay and how much
Paying income to beneficiaries

What expenses don't qualify

Expenses that benefit the whole trust rather than just income cannot be claimed as trust management expenses. Examples include:

Most legal expenses
Investment advice costs
Costs of changing trust investments

These relate to trust capital under trust law, not income. Similarly, business expenses for trusts that trade are deducted from trading profits in the normal way, not as trust management expenses. Payments to beneficiaries also don't count as management expenses.

How expenses reduce tax

For accumulation or discretionary trusts, trust management expenses are deducted from income that would otherwise be taxed at the special trust rates. The amount covered by expenses is instead taxed at the lower rates for that income type. This provides tax relief.

For interest in possession trusts, trust management expenses reduce the amount of income the beneficiaries receive and must pay tax on.

Expenses are deducted in a specific order: first from dividend-type income (such as from stocks and shares), then from non-dividend income (such as rent or savings interest). They're taken into account in the tax year they occur.

Tax pools for discretionary trusts

Discretionary trusts use a system called a 'tax pool' to track Income Tax paid by trustees. When trustees make a discretionary payment to a beneficiary, that payment is treated as having 45% tax already deducted. The beneficiary can reclaim some or all of this if they pay tax at 0%, 20% or 40%.

The trustees must have paid enough Income Tax (in current or previous years) to cover these 45% tax credits. The tax pool is the record that tracks this.

How it works

The tax pool increases when trustees pay tax at the special trust rates. It decreases when trustees make payments to beneficiaries, reduced by the 45% tax credit attached to each payment. Any balance carries forward to the next tax year.

A shortfall arises when tax credits on payments exceed the tax pool balance. This happens when trust income falls within the tax-free amount, is taxed below 45%, or certain other circumstances apply. Trustees must pay the shortfall through their Trust and Estate Tax Return, even in years when the trust receives no income.

Reliefs and allowances

Trustees can claim various reliefs and allowances on trust income from:

A trade or partnership run by the trustees
UK land and buildings owned by the trust
Foreign assets

The specific reliefs available depend on the income type and are detailed in the guidance for the relevant supplementary pages of the Trust and Estate Tax Return.

Trusts for vulnerable beneficiaries

Some trusts established for vulnerable beneficiaries qualify for special tax treatment. A vulnerable beneficiary is either:

A person with a mental or physical disability
A child under 18 whose parent has died (known as a 'relevant minor')

These trusts can benefit from more favourable tax rates designed to protect vulnerable people's interests.

Trustee responsibilities

Trustees must complete a Trust and Estate Tax Return (form SA900) to report trust income and pay any tax due. This includes:

Calculating tax on different types of income at the correct rates
Claiming allowable trust management expenses
Maintaining tax pool records for discretionary trusts
Providing tax credit information to beneficiaries who receive payments
Paying any shortfalls in tax pools

Trustees should keep detailed records of all income received, expenses incurred, and payments made to beneficiaries to support their tax return.

Sources

This article provides general guidance based on current HMRC rules. For advice specific to your situation, speak to your accountant.