Inheritance Tax (Part 3) – Trusts Products through your Financial Adviser

The previous articles in the inheritance tax series have looked at what inheritance tax is, the rate at which it is chargeable, available exemptions and allowances, and ways to reduce or mitigate the tax liability. This final article will look at some of the most popular trust-based products available, usually through a financial adviser. These trust-based products will all use either an absolute (bare) trust, a discretionary trust or a combination of the two.

Gift Trust

A Gift Trust has the same principle as an outright girt to a beneficiary with regards to how the assets are removed from your estate. The difference with placing the assets into a Gift Trust is that you can become a trustee and retain an element of control over the assets. You do however, not retain any access to them.

The Gift Trust can be written as either an absolute trust or a discretionary trust. With an Absolute Trust, neither the beneficiaries nor their share of the trust can be changed once the trust has been set up, but the proceeds will be completely free of IHT if the client survives for seven years. With a Discretionary Trust, the trustees can pay the benefits to anyone, but there may be immediate, periodic and exit tax charges and there are also reporting requirements.

Taxation of a Gift Trust

The taxation of a gift trust will be as per the previous article detail the taxation of an Absolute (Bare) Trust or Discretionary Trust dependent upon which basis it is written on.

Advantages of a Gift Trust

• Assets gifted can be removed from the estate after seven years
• Any growth is immediately outside of the estate
• An element of control can be retained especially if a Discretionary Trust it utilised as the settlor could be named as protector trustee

Disadvantages of Gift Trust

• If the gift is within the inheritance tax nil rate band, you would not benefit from any reduction in the taxable estate until after 7 years
• For any amount over the nil rate band, If you were to die within 3 years you would not have mitigated any Inheritance Tax
• If you were to die 3-7 years after making the gift whilst some of the Inheritance Tax would have been mitigated there would still be some liability to tax, only if the gift into the trust is above your nil rate band
• You lose access to the assets you have gifted
• If you retain any access to the assets or continue to enjoy the use of the asset this could be classed by HMRC as a gift with reservation, which means that they are could still be liable to tax
• If an Absolute Trust is utilised the settlor will not be able to alter the beneficiaries in the future

If a discretionary trust, an entry charge, a periodic tax charge and an exit charge may apply

Discounted Gift Trust

The Discounted Gift Trust allows the settlor to make a gift of the capital but retain the right to receive a regular fixed sum for the rest of their lives, from the trust fund.  In order to establish a DGT, the individual (the settlor) makes a gift to a trust.  The value of the gift is invested within the trust into a single premium investment bond. The arrangement will stay in place throughout the settlor’s lifetime.

The settlor can decide who they then wish to benefit from the capital within the DGT upon their death (the beneficiaries). The investment bond within the trust is set up in such a way to ensure that a regular ‘income’ is paid to the settlor at pre-agreed dates and in pre-agreed amounts. For tax purposes, this ‘income’ is actually deemed to be a return of a portion of the capital that was used by the settlor to make the gift. The proportion of the capital gift that will be required to maintain these ‘income’ payments throughout the settlor’s life are calculated when the bond is established, based upon the settlor’s health and expected lifespan.

The proportion of the value of the gift that is expected to eventually be returned to the settlor as an ‘income’ during their lifespan is called the ‘discount’. The value of the ‘discount’ is calculated at the outset and immediately falls out of the settlor’s estate for IHT purposes.  An immediate IHT saving is therefore made, of 40% of the value of the discounted sum.

The remaining value of the gift will fall out of the settlor’s estate gradually over the next few years, with the gift falling out of the estate entirely if the settlor survives for seven years after making a gift.

Taxation of a Discounted Gift Trust

• The value of the chargeable lifetime transfer is the value of the investment less the value of the settlor’s retained right to income (i.e. the discount). This is actuarially calculated at outset, provided full in advance underwriting or concurrent underwriting is requested. If a discount is available, this normally provides an immediate saving in IHT if your client dies within 7 years of establishing the trust
• If the value of the transfer after applying the discount is in excess of the settlor’s available nil-rate band, IHT will be payable on the excess at the lifetime rate. Given the structure of the plan, IHT must be paid by the settlor at an effective rate of 25%
• assets held within the Discounted Gift and Income Trust is relevant property for IHT purposes
• IHT charges may apply if assets are transferred out of the trust to a beneficiary.

Advantages of a Discounted Gift Trust

• Investing in a Discounted Gift Trust can be an effective way to reduce an individual’s estate immediately, with the possibility of further reducing the value of the estate over the following seven years.
• Utilising a Discounted Gift Trust allows the settlor to take an ‘income’ from the investment, whilst still reducing the estate for IHT purposes.        
• Any growth in the value of the investment belongs to the Discounted Gift Trust, and therefore will not form part of the estate for IHT purposes, giving rise to further IHT savings.
• As the Discounted Gift Trust is already established under trust, probate will not be required following death to release the funds. The investment can be retained in the trust, to be dealt with in line with the trustees’ instructions.

Disadvantages of Discounted Gift Trust

• The ‘income’ payments may fall back into the settlor’s estate for inheritance tax purposes if it is not spent.
• Whilst HMRC have confirmed that DGTs will not fall under the Gift With Reservation rules at present, legislation may change.
• The settlor must undergo underwriting before establishing the Discounted Gift Trust arrangement, and medical problems may be discovered at this stage. Not only will this reduce the value of the ‘discount’, therefore reducing the immediate inheritance tax saving, but the discovery of medical problems can be unwelcome and worrying.
• The investment growth may not be sufficient to sustain large income payments without capital erosion.  This would reduce the value of the fund eventually available to pass to the chosen beneficiaries.
• The investment bond itself will contain one or more underlying funds.  These funds may be subject to stock market movements and may fall in value as well as rise.
• Once the level of withdrawals and the period of deferral have been established, these cannot subsequently be changed.
• A periodic tax charge on all assets in trust above the inheritance tax threshold would be payable on the every 10^th anniversary if the discretionary trust is utilised

Loan Trusts

Rather than gift the money into trust the Loan Trust allows the settlor to loan capital to a trust. The loan must be documented as being both interest free and repayable on demand. The trustees invest the money aiming to achieve income or capital growth as appropriate. Growth on the funds held within the trust is immediately outside of the estate.

The settlor may demand repayments of the loan (this should be on an irregular basis) as required.  If this money is used as “income” it will cease to be part of your estate for inheritance tax purposes as it is spent.

On the death of the settlor, any outstanding loan would be repaid to your estate and the balance held in the trust would be distributed to the beneficiaries, free of Inheritance Tax.

Taxation of the Loan Trust

• Income Tax: Provided repayments back to the settlor do not exceed the cumulative allowance (5% of the amount invested each year) and a maximum of the amount invested, there will be no immediate liability to income tax on the amounts withdrawn. Where amounts withdrawn exceed the allowable amount in any tax year, a liability to income tax may arise.
• Inheritance Tax whilst settlor is alive: There are no inheritance tax consequences of setting up the Loan Trust. As you are not making a gift there will be no reduction in your estate unless and until loan repayments are made to you and either spent as income or gifted elsewhere.
• Any loan balance outstanding at the date of your death will form part of your taxable estate for inheritance tax purposes. Any investment growth will be outside your taxable estate from day one and can pass to the trust beneficiaries free of any immediate liability to inheritance tax.

Advantages of a Loan Trust

• Any growth on the funds held within the trust is immediately outside of the estate
• The settlor is able to recall part or all of the loan at their discretion.
• An Absolute or a Discretionary Trust can be utilised to suit the needs of the settlor
• A Discretionary Trust will allow the settlor to retain an element of control over the beneficiaries of the trust
• The settlor can take advantage of Potentially Exempt Transfer regime by waiving part or all of the loan at any point

Disadvantages of a Loan Trust

• The capital investment will remain in the settlors estate and will be included in the Inheritance Tax calculation
• The settlor has no access to the growth on the investment
• Once the loan is repaid, you have no further possibility of benefiting from the trust fund (in the form of income or otherwise).
• Poor investment performance may leave the trustees unable to repay the loan
• If an absolute trust is used, an adult beneficiary may call for their share of the trust growth to be paid at any time. The trustees will first repay the outstanding loan to the settlor. This may not be the most opportune time from an investment point of view to cash in the bond
• A periodic tax charge on all assets in trust (less the loan owed to the settlor) above the inheritance tax threshold would be payable on the every 10^th anniversary if the discretionary trust is utilised

Flexible Reversionary Trusts

A Flexible Reversionary Trust allows the settlor to make a gift, to be held in trust for a wide range of potential beneficiaries. At the same time the settlor carves out a revisionary interest in the trust in the form of a series of policy maturities, to which they will become entitled to at a specific dates which will be set at outset.

On these dates the settlor will have the option to receive the funds or roll them over to the next anniversary date.

After seven years the initial gift will fall outside of the estate for Inheritance Tax purposes and the growth will be immediately outside of the estate.

Whilst it is possible for the settlor to receive maturities from the trust, if you will require these maturities on an annual basis to cover day to day expenses then other options should be utilised.

Taxation of a Flexible Reversionary Trust

• Income tax treatment:  The implementation of the arrangements at outset should not give rise to a chargeable event. Furthermore, the exercise of the right to defer the maturity date should not give rise to a chargeable event. A chargeable event will occur when each policy matures, is surrendered or the last life assured dies. On each of the above chargeable events, the chargeable gain will be subject to income tax.
• Capital gains tax treatment:  A gain arising on the disposal of any interest in the policies under the arrangements is not a chargeable gain for capital gains tax purposes. No other charge to capital gains tax should arise under the arrangements in relation to the settlor or the trustees of the Initial Trust or Settlement, in particular when the settlor receives any maturity benefit.
• Inheritance tax treatment:  The creation of the Initial Trust will not give rise to a transfer of value or a settlement for inheritance tax (IHT) purposes. Any growth in the value of the policies is immediately outside the settlor’s estate for IHT purposes. Naturally, if the settlor receives the maturity proceeds of any policy, that money will be within their estate for IHT purposes.
• Chargeable transfer: No charge to Inheritance tax will arise if the gift is within the settlor’s available inheritance tax nil rate band. A gift over the inheritance tax nil rate band will attract a charge to IHT at 20% on the excess. If the settlor dies within seven years of making the chargeable transfer, further IHT may become due.
• Periodic charges and Exit charges may also apply if the value is outside of the nil rate band.

Advantages of a Flexible Reversionary Trust

• Capital gifted into the trust will be out of the estate for IHT after 7 years
• Any growth is immediately outside of the estate
• The settlor retains access to a proportion of the funds on an annual basis
• A range of beneficiaries can be named
• The investment will be held offshore meaning any gains within the fund will not be taxed until the money is repatriated back to the UK
• Money can be assigned or appointed to a wide range of beneficiaries and the gains taxed on the beneficiary rather than the settlor or the trust

Disadvantages of a Flexible Reversionary Trust

• The fees applied by the providers to utilise the trusts are generally higher than utilising Discounted Gift Trusts, Gift Trusts and Loan Trusts. This would need to be considered on a case by case basis for individual clients
• The settlor is unable to access the funds except for maturities on policy anniversaries
• If the settlor receives a policy maturity and does not dispose of the capital out of the estate there will be an increase in the estate for IHT purposes. The maturity if taken is not added back to the Nil Rate Band.  As you do not require the capital from your investment, due to the amount of capital you also hold in cash, the maturity of the investments would fall into your estate.
• There are two statutory anti-avoidance provisions these are the gift with reservation provisions introduced in 1986 and a pre-owned asset tax introduced by Finance Act 2004.  At present a Flexible Reversionary Trust is not caught by either of these provisions, however should HMRC feel that the trust is not in keeping with these provisions they may unwind the trust which could lead to the IHT relief being loss and the charges paid over the length of the contract lost.

Disclaimer

This article contains information from sources believed to be reliable but no guarantee, warranty, or representation, express or implied, is given as to its accuracy or completeness.  Howard Wright Ltd does not undertake any obligation to update or revise any future statements.  Past performance is not a reliable indicator of future results. Investments can go down as well as up and actual results could differ materially from those anticipated. This article is for information purposes only and has no regard to the specific investment objectives, financial situation or particular needs of any person as such, the information contained in this article is not intended to constitute, and should not be construed as, investment or financial advice.  Appropriate personalised advice should be taken before entering into any transactions.  No responsibility can be accepted for any loss arising from action taken or refrained from based on this publication.  Howard Wright Ltd is Authorised and regulated by the Financial Conduct Authority.