How different types of trust income are taxed, what management expenses and reliefs can be deducted, and understanding the tax pool.
Items taxed as income on trusts
Find the tax rates that apply to trusts in the Trusts and taxes guidance.
Some items that may not appear to be income in the hands of the trustees are taxed as income at the rates for accumulation, discretionary or interest in possession trusts. The items are known as ‘deemed income’ and include:
- gains on life insurance policies
- accrued income scheme profits
- lease premiums (lump sum payments received instead of rent)
Trust management expenses
The costs incurred by trustees as part of their duties are called ‘trust management expenses’. These expenses may reduce the amount:
- that is taxed at the special trusts rates for accumulation and discretionary trusts
- of tax due on a beneficiary’s income from an interest in possession trust
Only trustee expenses that relate directly to trust income are allowed as trust management expenses. These may include the costs of:
- preparing a tax return for income received (this does not cover the cost of preparing capital gains pages - which must be excluded from the expenses claimed)
- deciding which beneficiaries to pay and how much
- paying income to beneficiaries
Expenses not allowed
Examples of expenses that are not allowed include:
- expenses incurred for the benefit of the whole trust - such as most legal expenses
- the cost of investment advice or of changing trust investments
Under trust law, the above expenses relate to trust capital not trust income.
Expenses for things like trading or running a business do not count as trust management expenses. A trust’s business expenses are deducted from its trading profits just as they are with any other business.
Trust payments to beneficiaries also do not count as management expenses. Helpsheet 392 Trust Management Expenses explains the expenses that do and do not qualify.
Deducting expenses for accumulation or discretionary trusts
Expenses cannot be deducted from the income of any part of the trust that is treated differently for tax purposes. For example, in a mixed trust where part of the trust is treated as an interest in possession trust.
Income that has been used to pay trust management expenses is not chargeable at special trust rates. Instead it’s taxed at the lower rates for that type of income, for example the basic rate of Income Tax.
Trusts management expenses for accumulation or discretionary trusts are taken into account in the tax year in which they occur.
Trust management expenses are taken into account before applying the rate for trust income up to £1,000 (also known as ‘standard rate’).
Deducting expenses for interest in possession trusts
With interest in possession trusts, trust expenses cannot be used to reduce the trustees’ taxable income. The trustees take them into account when calculating the income due to beneficiaries.
The expenses are taken into account in the tax year in which they occur.
Order for deducting expenses
Trust management expenses are deducted in the following order: 1. From dividend-type income, eg income from stocks and shares. 2. From from non-dividend-type income, eg rent, trade, savings.
Find more information about dealing with trust management expenses in the Trust and Estate Tax Return guide.
Reliefs and allowances
Trustees may be able to claim reliefs and allowances on a trust’s income from:
- a trade or partnership carried on by the trustees
- UK land and buildings that the trust owns
- foreign assets
You can get more information about these reliefs and allowances in the guidance notes for the relevant supplementary pages of the Trust and Estate Tax Return.
Trusts with vulnerable beneficiaries
Some trusts set up to help ‘vulnerable beneficiaries’ may qualify for special tax treatment. In this context, a vulnerable beneficiary is:
- a person with a mental or physical disability
- a child below the age of 18 - a ‘relevant minor’ - whose parent has died
You can find out more about these types of trust and how they’re taxed in the guide on trusts for vulnerable people.
Tax pools apply to discretionary trusts. When trustees make a discretionary payment of income it’s treated by the beneficiary as if Income Tax has already been paid at the trust rate (currently 45%). This means the beneficiary could claim some or all of the tax back if they’re a non-taxpayer or pay tax at 20% or 40%.
When trustees make a payment, they must have paid enough Income Tax (in the current or previous years) to cover the 45% ‘tax credit’ (tax treated as deducted).
The tax pool keeps track of Income Tax the trustees pay. If the tax credit on payments to beneficiaries cannot be covered by the amount of tax recorded in the tax pool, the trustees must pay the difference. They do this through the Trust and Estate Tax Return.
How the tax pool works
The tax pool is a record that the trustees need to keep to show, at the end of a given tax year, the difference between:
- the total Income Tax entering the tax pool that year, plus the amount carried over in the tax pool from earlier years
- the total value of the 45% tax credits attached to income payments to beneficiaries that year
When the trustees pay tax at the special trust rates, the tax pool increases by the amount of tax paid. This can vary between 7.5% and 45%.
When the trustees pay income to beneficiaries, the amount in the tax pool is reduced by the value of the 45% tax credit for each payment.
The ‘tax pool’ itself is what’s left at the end of the tax year of the tax paid by the trustees. This is after the 45% tax credits on any payments to beneficiaries have been deducted.
Any balance is carried forward to the next tax year and can be offset against payments then.
How tax shortfalls can arise
A shortfall can arise where the amount of tax credits on payments to beneficiaries exceeds the amount available in the tax pool.
This can happen when:
- some of the income received falls within the ‘standard rate band’ and is taxed at the lower rates of 7.5% for dividends and 20% for other income
- some of the income received is from chargeable event gains from certain life insurance policies taxed at 45%, but what enters the tax pool is the difference between the trust rate and basic rate 20%, so only 25% enters the tax pool
How to prevent a tax shortfall
Use the HMRC tax pool calculator to:
- check for (and prevent) a potential tax pool shortfall when planning a distribution of income
- enter estimates to work out the maximum income you can distribute to beneficiaries over the tax year without incurring a tax shortfall
- work out how to maximise use of the tax pool if a trust is being wound up mid year
When HMRC will work out your tax pool calculation
If you file your SA900 Trust and Estate Tax Return by 31 October you can ask HMRC to work out your tax. When they do this they’ll also work out your tax pool surplus or shortfall for the following year based on:
- the information provided at question 14 of the return (a list of income payments made to beneficiaries during the tax year)
- the amount of unused tax pool brought forward from the previous tax year
HMRC includes the tax pool surplus or shortfall amount for the next tax year in your tax calculation.
If you choose to work out your own tax HMRC will check the tax pool only if they’re reviewing your tax return for accuracy. It’s therefore important to understand and get your tax pool figures right, so that you do not accidentally overpay or underpay tax.