John Hancock takes a look at the different ways to mitigate inheritance tax
Much has been written about the changes to the inheritance tax (IHT) treatment of trusts post-22 March 2006. But what about the headline IHT-planning solutions, typically offered by life companies, which are based on these underlying trusts - solutions such as a whole of life policy to provide for the tax?
The reality is that, at a high level, these 'solutions', and their target market, remain the same. If we rewind to the relatively straightforward days pre-22 March 2006, the same 'solutions' existed from life companies as do today. The difference was that the trust wrapper choice was, by default, almost always a flexible power of appointment trust and, therefore, there was less of an argument to consider the choice of trust as a separate stage of the planning process.
This all changed post-March 2006. Advisers were suddenly faced with a more clearly-defined two-stage approach:
Stage 1 - choosing and recommending the most appropriate IHT-planning 'solution' to provide and/or mitigate the tax.
Stage 2 - choosing the most appropriate underlying trust, together with the additional work of explaining the relevant tax treatment to clients.
The target market tends to be older clients, either approaching or at retirement. They're typically more receptive about tackling the IHT problem as they've probably experienced, first hand, the pain of losing 40% of their loved ones' estate over the nil rate band to the taxman. Second, they're more likely to have inherited money, or have tax-free cash from pension arrangements.
IHT mitigation - single premium solutions
There are a number of ways in which clients can reduce their potential IHT liability, the most straightforward being an outright gift. We know most people are reluctant to do this either because they can't afford to or because they want to retain control of the gifted asset. There are a range of trust-based solutions, many using an investment bond as the investment vehicle, which can help to address both issues - access and control - for clients with capital to invest.
Investment bonds can offer advantages for trustees in that they don't generate taxable income - they are often referred to as 'non-income producing assets' - and there is normally no need for the trustees to consider a tax return.
Note that if using an investment bond as the investment for a discretionary trust and capital is withdrawn and distributed to beneficiaries, although the amount withdrawn may not give rise to a chargeable event, there may be an exit charge. Payments of capital may also have an impact on the trust at its next 10-year anniversary.
Choosing the most appropriate IHT mitigation solution
It's by no means an exact science but younger clients within the target market are less likely to be able to afford to give up any access to their capital at the current time. The good news is that there's a potential single premium planning opportunity whatever degree of access is required.
(a) Access to capital and growth - nil rate band discretionary will trust
With this arrangement nothing is given away during the lifetime but the trust is written into the will ready to receive assets on first death.
Married couples or civil partners set up, during their lifetime, individually owned bonds on a joint life last survivor basis to which they have unrestricted access. Whoever dies first, assuming their bond still exists on death, up to the amount of the nil rate band, goes into the discretionary trust. The surviving spouse will be a potential beneficiary, giving them access if required, providing the trustees agree this is appropriate.
Taking loans against the trust property to reduce the survivor's estate on death is not without risk. In the recent Phizackerly case, where the surviving spouse created a debt on his estate against trust property that he had owned and gifted during his lifetime, the loan was not deductible against the surviving spouse's estate. It is important, therefore, that if the trustees are thinking of distributing capital to the surviving spouse, they carefully consider the facts.
(b) Access to capital but not growth - loan trust
More adventurous clients might wish to consider a loan trust, subject to sufficient investment fund cover. This allows individuals who are happy to relinquish access to any growth on their investment to place that growth immediately outside their estate safe in the knowledge that they can have ad hoc access to their initial capital (the loan) at any time.
So, although the arrangement doesn't have an immediate impact on the estate value, the growth on the investment doesn't make the tax problem any worse as it's always outside the estate. Effectively, the asset is 'frozen' for IHT valuation purposes. Each time a loan repayment is requested, as long as the money is spent, that will reduce the amount assessable to IHT.
(c) Restricted access to capital with periodic withdrawals - discounted gift trust
As clients increase in age, the willingness, to deal with their IHT situation will increase. With this comes the need to consider making a more immediate impact by giving away.
A discounted gift trust offers a solution for clients who can afford to give away capital but require a regular stream of withdrawals of pre-determined amounts on specified dates. Therefore, there is the comfort that funds will be available each time the client survives to the next withdrawal date. Also, the 'future income rights' give the potential for an immediate part reduction in the value of the gift (chargeable or potentially exempt transfer depending on the underlying trust) rather than having to survive for seven years before the gift is outside the estate. Investment growth is outside the estate from day one.
(d) No access - gift trust
A gift trust offers a straightforward solution for those who can afford to give away money safe in the knowledge that they will never need access to the gifted amount. Growth is outside the estate from day one and the whole amount is outside the estate if the client lives for seven years.
There's plenty to discuss with clients at the 'what does it do for me?' level of IHT-planning, before considering the more technical area of choosing the most appropriate underlying trust. It may be appropriate to use more than one of these solutions, though with the caveat that they shouldn't be set up on the same day and care should be taken over the order in which they're set up so as to minimise potential trust tax charges at a later date.
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