Taxation of income in discretionary trusts

This article looks at the income tax treatment of income generated from assets held within a discretionary trust.

Rate of Income tax

£500 tax free allowance

Since 6 April 2024 Discretionary trusts may receive up to £500 income each tax year without paying tax. If the total income in the year exceeds this figure, then all income is taxable at the rates shown above.

This £500 band may be reduced where the settlor has created more than one trust. The band is divided by the number of trusts by that settlor. However, the lowest the band can be reduced to is £100. Where the trust has been settled jointly, compare how many trusts each settlor has created and use the highest number.

Prior to 6 April 2024, trusts had a ‘basic rate’ band of up to £1,000. Income falling within this band was taxed at the basic rate of income tax. The £1,000 band would also be reduced if the settlor had created multiple trusts.

The trust’s Tax Pool

The trustees are responsible for reporting and paying income to HMRC using the form SA900, unless total income is less than the trust’s tax free band of up to £500.

Any tax paid by the trustees forms part of the ‘Tax Pool’. This is a record of tax paid by the trust and can be reclaimed if the income is distributed to a beneficiary who pays tax below additional rate (45%) as described below.

Distributing income to beneficiaries

A beneficiary who receives income from a discretionary trust will be required to report it in their tax return. It will be listed simply as trust income, the original source of the income (such as dividends, savings interest, rental income) is not relevant. The beneficiary’s dividend allowance or personal saving allowance cannot be used against trust income.

45% tax credit for beneficiaries

A beneficiary is deemed to have received their payment net of 45% income tax paid by the trust. This is regardless of the rate of tax paid by the trust. For example, where the income fell within the £500 tax free band or where dividend rate was paid.

Trust income distributed to the beneficiary is grossed by 45% and taxed at the beneficiary’s marginal rate, but comes with a tax credit of 45%. Where the trust income falls within the beneficiary’s additional rate band, they’ll have nothing further to pay. Where the income falls within the higher rate band, basic rate band, or the personal allowance, then they can reclaim 5%, 25%, 45% respectively. The reclaim is paid by HMRC from the trust’s Tax Pool.

Topping-up the Tax Pool

As trust income always carries a 45% tax credit, the trustees may find that they have not paid enough tax into the pool to cover the refunds. In this case, the trustees will need to top-up the tax pool using other trust assets. This is done through the trust’s tax return.

Example

Example

Our example discretionary trusts receive £2,000 dividend income, £1,000 interest and £10,000 rental income (after expenses) in the 2024/25 tax year. As total income exceeds £500, there is no tax-free allowance.

The income taxed as follows:

The trustees report the income through their SA900 and pay the tax. £5,737 is credited to the trust’s Tax Pool. The trust now has £13,000 - £5,737 = £7,263 net income which can be distributed to beneficiaries or reinvested in part or in full.

The trustees decide to distribute the full net income (£7,263) to Ben in the same tax year. He is treated as having received grossed up (by 45%) trust income of £13,205 with a tax credit of £5,942 (45%).

The trust income falls within Ben’s basic rate band. His liability to tax is therefore £13,205 @ 20% = £2,641. His tax credit of £5,942 covers this and he is due a refund of £5,942 - £2,641 =  £3,301.

Ben has utilised a £5,942 (45%) tax credit, but the trustees have only paid £5,737 tax. They will therefore need to top-up the tax pool with £205.

In practice, it is unusual for a discretionary trust to pay out all income earned to beneficiaries yearly and therefore the requirement to top-up the tax pool might not arise.

Settlor interested trusts

A trust is treated as ‘settlor interested’ when the settlor (the person who created the trust) or their Spouse / Civil Partner is a potential beneficiary of the trust. This changes the tax reporting processes. These rules are complex, but a summary is provided below.

• The trustees report the income via the SA900 and pay the trust rates of tax, as outlined above.
• The settlor reports the same income in their personal tax return.
  • The income is treated as the highest part of their income, above all other sources.
  • The settlor can use their allowances, including personal savings allowance and dividend allowance
  • The settlor receives a tax credit for the amount of tax paid by the trustees
  • The settlor can reclaim tax paid by the trustees if the credit exceeds their own liability
  • Any reclaimed tax is repaid to the trustees
• If income is paid to a beneficiary (other than the settlor), they report the net income distributed to them
• The beneficiary will not have a tax liability on the income but the additional net income could impact certain reliefs / allowances for example tapering of personal allowance above £100,000.

Last updated: April 2024