Paul Wright goes through the different roles trusts can play in inheritance tax planning
'In this world nothing can be said to be certain, except death and taxes'. Benjamin Franklin's immortal words date from 1789, but continue to resonate today as more and more people find themselves falling within the spectre of inheritance tax (IHT). It is no surprise then that IHT sits high on the political agenda and perhaps the only certainty today is that IHT will continue to evolve.
The 2006 Budget has already demonstrated that wide spread changes to the IHT rules can and do happen. The changes to the rules surrounding the treatment of 'interest in possession' trusts, by far the most popular trust used for IHT planning, led many to suggest that IHT planning itself was dead. Indeed, with providers' suspending many of their trust schemes at the time, it's easy to see why many reached this conclusion.
The reality however, was that as an industry we simply needed to take stock of what the impact meant. After all, the treatment being applied to interest in possession trusts was one advisers were already familiar with and therefore these trusts could still be used to mitigate IHT, provided the gift made was within the current nil rate band. Advisers had to re-visit existing, established processes and take steps to adjust the recommendations being made to meet the specific needs of their customers. The changes simply required time to reflect on the changes being made to the treatment of the trust as well as time to sit down and consider the right solution for the customer.
The need for advice
Indeed, today advisers admit that they are now spending more of their time dealing with customer's IHT needs. Equally, the time advisers are spending on education and training, specifically in the field of IHT planning is increasing, with extra time being committed to understanding the complexities of the ever changing environment. One simply need consider the changes in the 2007 budget and the introduction of the transferable nil rate band to realise just how quickly things can change in this area and the need for adviser to keep on top of the changes.
There is no set answer and it remains the job of the adviser to work with the customer to understand what they wish to achieve by placing their assets within a trust and in particular what control, if any, they wish to maintain of those assets. Knowing these elements will help the adviser shape the best solution for their customer.
The table below summarises the features of the three main types of trust. As can be seen, the three types of trust all have different characteristics.
Interest in possession trusts
'Interest in possession' trusts have been by far the most popular of the three trusts for IHT planning purposes, principally due to the flexibility regarding beneficiaries and its previous tax treatment as a potentially exempt transfer.
However, interest in possession trusts are now subject to the same IHT regime as discretionary trusts, that is they are treated as relevant property and therefore create a chargeable lifetime transfer at the outset. This has increasingly made discretionary trusts the preferable option.
If total gifts made to a discretionary trust are below the nil rate band and made only every seven years, they will avoid IHT at the time the trust is established. While this is an option it does mean that IHT planning needs to start much earlier than it does for most.
However, gifts into discretionary trusts that are above the prevailing nil rate band - taking account of any other chargeable lifetime transfers made by the settlor in the past seven years - are taxed on the excess at half the death rate, currently 20%, when they are established.
The trust also pays a periodic charge every ten years, on any assets valued above, the then nil rate band. This tax charge is a maximum of 30% of the lifetime rate, currently 6%. In addition, there is also a potential exit charge when capital is distributed to a beneficiary of the trust. This is also a maximum of 6%.
'Discretionary' trusts have typically been used for generation jumping. For example, if a third generation of potential beneficiaries inherit the trust's assets, IHT is saved on the estate of the previous two. The difference in taxation lies in the fact that there is no interest in possession at outset and neither is one imposed by a certain age. In a nutshell, the trust can run for its full perpetuity period, usually 80 years, without its assets being attributable to an individual's estate for IHT purposes.
If the customer does not want to face the possibility of these tax charges, he or she could consider bare trusts.
'Bare' (or absolute) trusts are also a viable option for IHT planning. The treatment of these trusts is so far unchanged and gifts into them are classed as potentially exempt transfers. As a result, where it is necessary to create a potentially exempt transfer a bare trust is the best solution, however, advisers will need to take full consideration of the fact that beneficiaries, and their share of the trust, must be specified at the outset and this cannot then be changed. It is normally possible for the beneficiary to demand their share of the trust fund any time after the age of 18.
However, some Discounted Gift Bare Trusts are written to protect the assets while the donor is still alive. In other words, the beneficiaries cannot force the trustees to make payments to them while the donor is still alive.
Flexibility and choice
The result of all this is that if a settlor/donor requires flexibility in the choice of their beneficiaries, either now or in the future, it is likely that a discretionary trust will be the best solution. Conversely, if the settlor/donor is certain as to who they wish to appoint as beneficiaries, a bare trust may be a more appropriate and simpler solution - at least from a tax perspective.
So, as with most areas of financial planning, there is a choice to be made. Does the client want flexibility and, if so, are they prepared to accept the more complex tax rules that come with it?
Discounted gift trusts
Discounted gift trusts remain a valuable tool for advisers when it comes to IHT planning. The discounted gift element - i.e. the value of the fund minus the settlor's right to income - would be treated as a chargeable lifetime transfer and is therefore subject to tax on settlement.
However, if the discounted gift is below the available nil rate band, there will be no entry tax charge.
Equally, at the ten-year point, it is possible to revalue the trust without the need for underwriting, providing the settlor was underwritten at the outset. HMRC has provided a simple way to calculate the settlor's rights at this time. Providing the trust value minus those settlor rights does not exceed the available nil rate band, there will be no periodic charge.
If the entry and periodic tax charges can be avoided, which in turn should avoid the exit charge; discretionary trusts offer great flexibility with no lifetime cost.
In addition, discounted gift trusts can now be written as bare trusts and we have seen a number of schemes enter the market designed to help advisers maximise the opportunity. With these trusts, trustees are obliged to make payments back to the donor but while it is possible the fund will exceed the level required to maintain the donor's payments, the beneficiaries cannot force the trustees to make any payments to them while the donor is alive.
The future role of the adviser
With an ever increasing focus on inheritance tax, it's clear that further changes in the rules that govern it are likely in the future. This won't make the job of the adviser any easier, but what it will do is increase the value of the advice they provide. Those advisers who stay abreast of the change will be in pole position to manage the needs of their customers. The key of course is ensuring that customers know about the issues early enough to take action and are empowered by the advice given to them to implement the most suitable measures for their needs.
Caring for children and elderly relatives
Similar to June 2007
Square Mile’s series of informal interviews
Fine reduced to £60,000
Two roles created