In the second of a two-part insight into bare and discretionary trusts, Jeremy Pearson explores potential inheritance tax charges
Last month, we covered the practical side of bare and discretionary trust arrangements. But Mr & Mrs Down are now having second thoughts about putting all this money in trust - if their circumstances change, can they get their money back?
What about the inheritance tax (IHT) considerations if they keep the trust arrangements? They may be simple for a bare trust and complex for a discretionary trust, but it is vital that you know both before advising clients.
Can I get my money back?
Mrs Down has a very wide outlook on life and all this discussion about what could happen in future leads her to ask: "When I am a widow, my lifestyle could change radically. Could I get the money back out of the trust at that time if I needed it?"
(She is obviously expecting to outlive her husband.)
In a bare trust, this is unlikely as Pat and Luke are the only people that can get a payout from the trustees. If the trustees pay out anything to Mrs Down, they will be committing a breach of trust.
Of course, if Pat or Luke receives money from the trust and then decide to make a gift to their mother, without any undue influence, that is entirely a matter for them - and a potentially exempt transfer (PET) by them.
In a discretionary trust, assuming the gift was to be IHT-effective, this would have been possible only if Mr Down had been the sole settlor. Mrs Down could then have been added to the list of beneficiaries and receive a payout.
Apart from a beneficiary receiving a payout and then making a gift to her of their own volition, the only circumstances where she could benefit - and then only indirectly - is after remarriage. That is, a new husband could be included as a beneficiary because he was not a settlor.
So, what about IHT? The whole point of taking out a trust was so that Mr & Mrs Down could reduce their potential IHT liability. It is vital to look at the IHT position from the point of view of the settlors, beneficiaries and trustees.
The three perspectives
Since the changes to trust taxation in March 2006 and the widespread adoption of discretionary trusts as the trust of choice, there has been an increased burden on trustees.
This is because the relevant property rules require them to send in an IHT account every ten years if above the relevant limit and to report "exits: in various circumstances. This is covered in more detail below.
From a settlors' viewpoint, in a bare trust their lump sum gift into the trust will be a PET. As Mr & Mrs Down have not made any other significant gifts in the past, they can use their annual exemptions for this and the last year (£6,000 each) to reduce the amount of the PET. There are no lifetime IHT charges and the settlors do not have to report the gift to HMRC.
But in a discretionary trust, the settlors' lump sum gift into the trust will be a chargeable lifetime transfer (CLT). As Mr & Mrs Down have not made any other significant gifts in the past, they can use their annual exemptions for this and the last year (£6,000 each) to reduce the amount of the CLT.
If the CLT (plus any others made in the previous seven years) is more than the settlors' available nil-rate bands, there is 20% tax on the excess payable by the trustees.
If this tax is paid by the settlors on their behalf, it is "grossed-up" to 25%. Otherwise, no IHT is payable at outset. For a new investment, the settlors do not have to report the gift to HMRC unless it exceeds the nil-rate bands.
From a beneficiaries' point of view, in a bare trust if Pat dies, her share of any capital still in the trust will be assessed to IHT as part of her estate. Likewise, if Luke dies.
The beneficiaries could actually gift their share of the trust fund (by assignment) to their children. If they do so, it will be a PET and may, therefore, become chargeable to IHT if they die within seven years of the gift.
To avoid being caught by the "gift with reservation" rules, the donor must exclude themselves from any possibility of ever benefiting from the trust once they have given away their share.
In a discretionary trust, there will not be any IHT charge when a potential beneficiary dies as they have no vested right to any share of the trust fund. This is why there are ongoing IHT charges throughout the life of the trust (these are covered below in more detail).
As for the trustees, they are charged with the governance of the trust and that includes paying any tax that may arise.
Income tax and tax on capital gains may be due in respect of the trust investments, but they can also be liable to pay IHT.
The first instance is at outset if the chargeable transfer - together with any other chargeable transfers in the preceding seven years - exceeds the nil-rate band.
Afterwards, there may be IHT to pay on distributions ("exits") or on each ten-yearly anniversary of the trust. But only for relevant property (i.e. discretionary) trusts in all these instances, there are never any charges on a bare trust.
For ten-yearly IHT charges in a discretionary trust, IHT periodic charges apply and the value of the trust must be ascertained after every ten years.
But if it is a discounted gift trust, it is the discounted value at that time which has to be calculated and for a gift & loan trust, the amount of the outstanding loan is disregarded (as it is not relevant property).
However, there will normally only be an IHT bill if the trust is over its available nil-rate band on the anniversary date.
In 2021, if the value of Mr & Mrs Down's gift trust was £500,000 and the nil-rate band was £400,000, there would still not be a periodic charge. This is because each of the joint settlors' share of the settlement is entitled to a nil-rate band - a total of £800,000.
In addition to the trust value, you also have to add on any distributions made by the trustees in the ten-year period concerned - for calculation purposes only.
If the settlement had been by Mr Down alone, IHT of £6,000 would be payable. The trustees will be responsible for sending the appropriate forms to HMRC with the payment for any tax due.
Alternatively, Mr & Mrs Down may decide to pay the tax bill on the trustees' behalf. If they do so, it will be treated as a further gift and the bill grossed-up to £7,500.
Regarding exit charges in a discretionary trust, there will only be an IHT bill when the trustees distribute capital if the value of the trust was greater than the nil-rate band at outset or on a ten-yearly anniversary prior to distribution.
The tax rate on exit is the same rate as the periodic charge - or 30% of the initial charge in the first ten years - but is reduced further.
The reduction reflects the time elapsed in the current rolling ten year period and is based on completed quarters.
So if the settlement had been by Mr Down alone and IHT of £6,000 payable, that gives us a rate of 1.2% of the value of the trust. If trustees then distribute £100,000 to a beneficiary a year-and-a-half later, the exit charge is £100,000 x 1.2% x 6/40 (quarters) = £180.
The trustees will be responsible for sending the appropriate forms to HMRC with the payment for any tax due.
The additional flexibility of a discretionary trust through not having to decide on beneficiaries absolutely is preferable. But it comes at the price of added complexity, ongoing IHT assessment and possible lifetime IHT bills.
Even though limiting the investment to the nil-rate band for each settlor reduces some of the impact, it is not like the old days of flexible trusts when it was "live seven years and that's it".
A bare trust does have that characteristic, but it does need beneficiaries who can be trusted to do the right thing.
What we have also seen since 2006, when the trust taxation rules changed, is a combination of a nil-rate band discretionary trust and a gift & loan trust, taking loan repayments every seven years to facilitate further gifts.
That may suit the younger, richer estate planning client, but the choice of trust must be tailored to the individual client.
Jeremy Pearson is technical support manager at Canada Life
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