Trusts

Trusts are highly effective inheritance tax planning tools. They can...

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...whilst preserving the IHT savings afforded by the trust arrangement.

Inheritance tax planning is all about avoiding or reducing the amount of tax that is incurred when an individual’s assets are given or transferred from their estate to another individual, a trust or somewhere else. Most IHT planning decisions hinge on whether to make gifts during an individual’s lifetime, on their death, or both.

Making lifetime gift...

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...,000), the surviving spouse’s nil rate band – whatever it is at the time of their death - will be increased by 80%. The residence nil rate band (RNRB) can also be inherited in the same way.

The executors or administrators of the survivor’s estate must claim the unused transferable nil rate band within two years of the death of the first to die.

A transfer to a bare trust is a Potentially Exempt Transfer (PET). The main advantage of a PET is that there is no limit on the amount or size of gifts that can be made, and there is no lifetime IHT tax to pay. If the donor survives seven years from the date of the gift, its value is excluded from the donor’s estate and there is no IHT to pay (the ‘potentially exemp...

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...quences (holdover relief is not available with transfers to absolute trusts).

Donors can provide for any IHT that may fall due on a PET if they do not survive seven years using life assurance with a seven-year term. The policy is set up with a sum assured to match the potential IHT charge, and must be written in trust so that the death benefit falls outside of the estate.

Transfers to discretionary trusts are chargeable lifetime transfers, which will fall outside of the settlor’s estate after 7 years. There may be lifetime tax to pay if the size of the transfer exceeds the nil rate band, taking account of any other CLTs in the preceding 7 years.

Under current legislation, a nil rate band discretionary trust could be created every seven years with no immediate charges to IHT, and the possibility of no subsequent charges.

However, a charge to IHT arises on the value of the settlor’s property in a discretionary trust on every 10-year anniversary and a pro-rata exit charge arises whenever trust property ceases to be classed as ‘relevant property’.

Discretionary trusts are considered to be ‘related settlements’ if they have the same settlor and are created on the same day.

When calculating the settlor’s cumulative total for IHT purposes, transfers made on the day on which a discretionary trust is created are disregarded. The ‘related settlements rule’ ensures that the initial value of any related settlements is included for calculating the tax due for both the ten-year anniversary charge and the exit charge. Without this rule, a settlor could create several small discretionary trusts on the same day to produce a lower overall tax charge, as was the case until a few years ago.

Until 6 June 2014, the ‘related settlements rules’ could be circumvent...

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...r anniversary charges and exit charges. So, although each trust continues to have its own nil rate band, the value of property that has to be taken into account for each of the trusts is increased to include other added property in other trusts, so a higher tax charge arises as a result.

The Chancellor announced the changes in March 2015 but said that the rules would not apply where the valued added was less than £5,000. He also announced that, for existing pilot trusts, the new rules will not take effect until 6 April 2017.

There is a liability to IHT when a settlor transfers assets into a discretionary trust and this can either be paid by the settlor themselves or be paid by the trustees from the trust fund. If the settlor pays the tax, this payment is itself considered a ‘gift’ for IHT purposes and may incur an IHT charge of its own.

Discretionary trusts are useful when there is a clear need to remove asset value from an estate, but where the ultimate beneficiary has not been chosen at the time the transfer is made. This is a tax-efficient way to transfer assets that are most likely to appreciate in value, because any capital appreciation does not increase the donor’s estate – any growth belongs to the trust. However, when appreciating assets are placed in a trust, the trust will need to be monitored closely to take advantage of any opportunities to avoid or reduce ten-year anniversary charges and exit charges.

The order in which PETs and CLTs are made can affect the amount of IHT payable. Annual exemptions are used on a strict chron...

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...e more than seven years prior to the donor’s death (making the potential cumulation period 14 years instead of seven).

There is an annual IHT exemption of £3,000, which is especially useful for individuals who do not have, or cannot afford to...

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...fit of the arrangement may be lost if the policy has to be cancelled due to a change in the insured person’s circumstances.

There are several issues to consider when deciding on the most appropriate tax wrapper for trust investments in the context of IHT planning. The CGT regime is generally more advantageous where the trust assets are growth-oriented, e.g. shares.

Most taxpayers avoid CGT because their gains are either within their  CGT annual exempt amount, or are eliminated on d...

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...ustees have the power to advance capital to the beneficiaries, which would be classed as income in the hands of the recipient beneficiary (this was decided in the case of Brodie’s Will Trustees (1933), but in a later case, the court decided to treat a capital advancement as just that – capital. So, it appears that each case would be decided on its merits).

A loan trust allows investors access to their capital while achieving gradual IHT benefits. They are suitable for those who are not willing or able to make significant lifetime gifts.

This is how a loan trust works:

The settlor sets up a discretionary trust and makes an interest-free, repayable on demand, loan to the trustees, who then invest this into an investment bond

No transfer occurs for IHT purposes because the settlor has not made a gift

Any investment growth is hel...

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...for IHT purposes if it does not fall within one of the IHT exemptions

The settlor needs to make provision for what should happen to any outstanding loan amount on their death. If they do not, their personal representatives are under a duty to call in any outstanding amounts and distribute them to beneficiaries. The settlor might not want this

Trustees are liable for any shortfall if, at the time of the final loan repayment, the value of the bond has fallen below the amount due

A DGT allows an investor to make a lifetime gift that may be discounted for IHT purposes and to take a fixed regular income for life.

They are suitable for individuals who are under the age of 90 at the outset, are reasonably healthy, need a regular income, and who wish to make a gift with immediate IHT.

The investor must accept that the income payments are fixed and that, once a DGT is set up, they lose access to the capital.

This is how a discounted gift trust works:

The settlor makes a cash gift or assigns a bond into a discretionary trust or an absolute (bare) trust, under which the settlor has reserved the right to receive fixed capital sums on pre-selected dates

This provides the settlor with regular income until their death, or the bond becomes exhausted, whichever occurs first

The ‘income’ is produced from the 5% capital...

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...e

The settlor must spend the income from the plan; otherwise it will accumulate and increase the size of their estate, negating the purpose of the plan

If the settlor no longer requires income from the plan, they can waive future rights by deed in favour of the beneficiaries, although the value of the waived rights will be classed as a CLT in the case of a discretionary trust or a PET in the case of a bare trust

Capital cannot be distributed to beneficiaries during the settlor’s lifetime

Trustees can make appointments of capital or loans to the settlor’s surviving spouse or civil partner, provided that person is not also a settlor

Trustees can make loans to beneficiaries, rather than distributing capital, and such loans create debts against the recipient beneficiary’s estate for IHT if they are still outstanding on their death

A flexible reversionary trust (FRT) allows an individual to make a lifetime gift for IHT purposes, while retaining the option to receive a flexible payment each year. An FRT is a revert-to-settlor trust, meaning that the settlor’s carved out interest can be defeated by the trustees. This type of ar...

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...

If the settlor dies within 7 years, the whole gift is included in the estate

No established discount at the outset – the settlor is limited to investing up the available NRB to avoid lifetime tax at 20%

There is no 5% tax-deferred withdrawals facility during the settlor’s lifetime

Back-to-back arrangements allow an individual to purchase an annuity on their own life and take out a life policy on their own life under trust. On their death, the annuity has no value for IHT purposes and the life policy will be outside of their estate because it is in trust. ...

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...p>The main advantage of back-to-back arrangements is that they facilitate moving large amounts of capital out of the individual’s estate for IHT purposes. One major disadvantage is that the individual has to been in reasonable health to be underwritten for the life policy.

The main IHT liability for married couples and those in a civil partnership arises on second death when the joint estate is left to their offspring or other beneficiaries.

Life assurance policies can be used to cover the potential IHT lia...

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...ematurely, but the premiums can add up to a substantial amount if they survive to an old age, and may even exceed the sum assured that the policy is due to produce on death

The trust itself might be subject to periodic and exit charges

Trusts need to be reviewed on a regular basis to ensure that they are still achieving their original aims. It is impossible to say how regularly these reviews should take place other than that they should be carried out in accordance with each customer’s individual circumstances.

In addition, when there are significant changes to tax law or other relevant legislation, it will be appropriate to carry out an immediate review to make sure that such changes do not adversely affect the trust arrangement, either in respect of its aims or the tax treatment of the assets held within it.

Trustees have a legal duty to regularly review the trust they manage. Reviews by settlers and/or beneficiaries will be done less frequently and usually following a financial review with their adviser.

Death

A trust can continue in the event of the death of a trustee, either because there are other trustees already in place, or because new trustees are appointed under the terms of the Trustee Act 1925 s.36.

The death of a beneficiary could result in other beneficiaries being entitled to a new or larger share of the trust property. There may be instances where, on the death of a beneficiary, their share passes to the beneficiaries of their estate, rather than passing to the remaining beneficiaries of the trust.

In the case of a life policy under trust, if a life assured dies and a claim arises under the terms of the trust policy, the trustees will receive policy proceeds. Before distributing proceeds of such a policy to the beneficiaries of a trust, the trustees should check the legal and taxation consequences of such pay-outs.

Where a beneficiary with an interest in possession under a pre-22 March 2006 trust dies, the value of that interest forms part of their estate for IHT purposes. The policy is valued on a market value basis and tax is based on rates applicable to the relevant beneficiary. However, it will be paid by th...

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...rustees and the beneficiaries.

Changes that have taken place in recent years include anti-avoidance measures, trusts for the vulnerable, a new trustee basic rate income tax band and a new pre-owned assets tax regime.

The Pre-owned asset tax (POAT) regime introduced an annual income tax charge on certain assets which a taxpayer attempts to transfer out of their estate whilst at the same time retaining a right to enjoy those assets.

Most life assurance based IHT planning schemes, such as discounted gift trusts and loan trusts, appear to have been accepted by HMRC as outside the scope of the regime. However, such arrangements should be reviewed in case this ever changes.

Economic changes

Economic changes or changes in the market may affect the investments held within a trust to the extent that it may become difficult to fulfil the objectives of that trust. Trustees must keep investments under review to ensure they are fulfilling their duty of care.

Trust review checklist

Have there been any taxation changes that may require the investments to be altered or amended swapped?

Has the settlor or any of the beneficiaries died?

Do any of the beneficiaries have special needs?

Are the present trustees still the appropriate people for the role?

Are there any periodic or exit charges due?

Are the terms of the trust still valid and appropriate?

Are the trust investments in the name of all the trustees?

Are the trust investments still appropriate?

Have there been any economic changes since the last review?

Have any of the beneficiaries changed since the last review?

What authority do trustees have to distribute income or capital?

How much flexibility is built into the trust?

Is the trust deed/Trustee Act 2000 being adhered to?

Any changes to the beneficiary’s attitude to risk or capacity for loss

Any changed to beneficiaries since last review/need to apportion capital