Excess Income Trusts

Excess Income Trusts (EITs) are a useful tool when carrying out inheritance tax planning. They offer an opportunity for individuals who earn more income than they need to pass wealth to future generations by placing their excess income into trust.

EITs can be considered in relation to estate planning, tax efficiency, and long term family wealth preservation. They have become increasingly relevant as more families look for ways to reduce their inheritance tax liability.

What is an EIT?

An EIT is a trust which is funded from an individual’s surplus income rather than their capital, and is usually a discretionary trust.

What is a discretionary trust?

A discretionary trust is a trust under which the trustees have complete discretion regarding what benefits each beneficiary should receive and when. No beneficiary has any entitlement to trust assets and they may receive nothing from the trust.

The person creating the trust, known as the settlor, decides who will be potential beneficiaries of the trust. The settlor gives the trustees powers to distribute both capital and income to one or more beneficiaries.

The settlor can be one of the trustees which allows for a certain amount of control of the assets in the trust during their lifetime.

Potential beneficiaries can be either named persons and/or a class of people, for example, the settlor’s children, grandchildren, future descendants, siblings etc.

However it is extremely important that neither the settlor nor the settlor’s spouse or civil partner is a beneficiary as this can have negative tax implications and frustrate the estate planning. This means this type of planning is potentially unsuitable for individuals who may need the funds they are considering settling in trust.

It is also important for the trustees not to make distributions to a child or stepchild of the settlor while they are a minor, as this can have negative income tax implications for the settlor. However, distributions can be made to the settlor’s children or stepchildren once they are adults and to minor grandchildren of the settlor.

Why are EITs different to other discretionary trusts?

Generally discretionary trusts created in lifetime are funded using capital rather than income. If the assets transferred by the settlor into trust exceed £325,000 in value in any seven year period, there will be an immediate charge to inheritance tax on the excess at a rate of 20%, unless those assets qualify for a relief from inheritance tax such as business relief (also known as business property relief/BPR) or agricultural relief (also known as agricultural property relief/APR).

By comparison, if the settlor transfers their excess income into trust rather than capital, there will be no immediate charge to inheritance tax as long as the payments meet the conditions required for the “normal expenditure out of income” exemption to apply. This is the case no matter how much is transferred into trust which makes this a very attractive planning opportunity for settlors who receive a large amount of income each year.

What is the normal expenditure out of income exemption?

Gifts out of excess income, or normal expenditure out of income, is an exemption from inheritance tax which is available when an individual regularly gives away all or part of their surplus income.

To qualify for the exemption the following conditions must be met:
• the gift must be made from income, not capital;
• the gifting must form part of a regular pattern; and
• after the gift, the individual must still have enough income to maintain their usual lifestyle.

When applied to gifts to individuals, this exemption means that the gifts are immediately exempt from inheritance tax and there is no need to survive the seven years which is usually required.

As stated above, when applied to gifts into trust, it means that no lifetime inheritance tax charge applies even if more than £325,000 is transferred to trust during a seven year period. It also means the settlor’s nil rate band (the amount that everybody may leave free of inheritance tax) is not reduced by the transfer into trust and will still be available to use if the settlor dies within seven years of making the transfer to the trust.

However, once the cumulative total of the gifts into trust exceeds the settlor’s available nil-rate band, an inheritance tax account will need to be completed, so that the availability of the exemption can be agreed with HM Revenue & Customs.

For more detail on the exemption including the record keeping required please see here.

What are the benefits of an EIT?

The normal expenditure out of income exemption can be used to make outright gifts, but the benefit of using a trust is it allows wealth to be passed down while maintaining control over timing and distribution. The trustees can also protect assets for beneficiaries who may not yet be financially mature, or who do not have capacity.

A trust also allows for flexibility across the generations. The class of beneficiaries can be very wide, enabling the trust to adapt to changing family circumstances, including future children or grandchildren.

This planning best suits individuals with high levels of income as compared to their outgoings. It is less likely to suit individuals whose income varies significantly year to year, making regular gifting from income harder to demonstrate, or individuals with only a small amount of surplus income as the administrative work and costs of running a trust may outweigh the benefits.

It is also important to note there will be a potential charge to inheritance tax on the assets in the trust every ten years. There will also be an exit charge when distributions of capital are made. The maximum rate of inheritance tax on each occasion is currently 6%, which is low compared to the 40% rate and, these charges can generally be mitigated using multiple trusts if needed.

Overall, EITs are becoming more popular as inheritance tax receipts rise and families look for ways to pass on wealth efficiently without triggering immediate tax charges. They offer a powerful combination of tax efficiency, control and long term planning flexibility, especially for individuals with consistent surplus income and a desire to support future generations.

If you are considering using an EIT as part of your estate planning, we recommend taking professional advice to ensure the trust is set up correctly, all the conditions for the normal expenditure out of income exemption are met, and you have records of all the information you or your executors will need in order to claim the exemption