Wide class of potential beneficiaries
With a Discretionary Trust, the settlor makes a gift into Trust, and the trustees hold the Trust fund for a wide class of potential beneficiaries. This is known as ‘settled’ or ‘relevant’ property. For lump sum investments, the initial gift is a chargeable lifetime transfer for Inheritance Tax purposes.
It’s possible to use any available annual exemptions. If the total non-exempt amount gifted is greater than the settlor’s available Nil-Rate Band (NRB), there’s an immediate Inheritance Tax charge at the 20% lifetime rate – or effectively 25% if the settlor pays the tax.
The settlor’s available NRB is essentially the current NRB less any chargeable lifetime transfers they’ve made in the previous seven years. So in many cases where no other planning is in place, this will simply be the current NRB, which is £325,000 up to 2021/22. The Residence Nil-Rate Band (RNRB) isn’t available to Trusts or any lifetime gifting.
Again, there’s no initial gift when setting up a Loan Trust, and the initial gift is usually discounted when setting up a Discounted Gift plan. Where a cash gift exceeds the available NRB, or an asset is gifted which exceeds 80% of the NRB, the gift must be reported to HM Revenue & Customs (HMRC) on an IHT 100.
When family protection policies are set up in Discretionary Trusts, regular premiums are usually exempt transfers for Inheritance Tax purposes. Any premiums that are non-exempt transfers into the Trust will be chargeable lifetime transfers. Special valuation rules for existing policies assigned into Trust apply.
As well as the potential for an immediate Inheritance Tax charge on the creation of the Trust, there are two other points at which Inheritance Tax charges will apply. These are known as ‘periodic charges’ and ‘exit charges’. Periodic charges apply at every ten-yearly anniversary of the creation of the Trust.
Exit charges may apply when funds leave the Trust. The calculations can be complex but are a maximum of 6% of the value of the Trust fund. In many cases, they’ll be considerably less than this – in simple terms, the 6% is applied on the value in excess of the Trust’s available NRB.
However, even where there is little or, in some circumstances, no tax to pay, the trustees still need to submit an IHT 100 to HMRC. Under current legislation, HMRC will do any calculations required on request. For a Gift Trust holding an investment bond, the value of the Trust fund will be the open market value of the policy – normally its surrender value.
For a Loan Trust, the value of the trust fund is the bond value less the amount of any outstanding loan still repayable on demand to the settlor. Retained rights can be recalculated as if the settlor was ten years older
For Discounted Gift schemes, the value of the Trust fund normally excludes the value of the settlor’s retained rights – and in most cases, HMRC are willing to accept pragmatic valuations. For example, where the settlor was fully underwritten at the outset, and is not terminally ill at a ten-yearly anniversary, any initial discount taking account of the value of the settlor’s retained rights can be recalculated as if the settlor was ten years older than at the outset.
If a protection policy with no surrender value is held in a Discretionary Trust, there will usually be no periodic charges at each ten-yearly anniversary. However, a charge could apply if a claim has been paid out and the funds are still in the Trust.
In addition, if a life assured is in severe ill health around a ten-yearly anniversary, the policy could have an open market value close to the claim value. If so, this has to be taken into account when calculating any periodic charge.
Where discretionary Trusts hold investments, the tax on income and gains can also be complex, particularly where income-producing assets are used. Where appropriate, some of these complications could be avoided by an individual investing in life assurance investment bonds, as these are non-income-producing assets and allow trustees to control the tax points on any chargeable event gains.
Bare Trusts give the trustees discretion over who benefits and when. The Trust deed will set out all the potential beneficiaries, and these usually include a wide range of family members, plus any other individuals the settlor has chosen. This gives the trustees a high degree of control over the funds. The settlor is often also a trustee to help ensure their wishes are considered during their lifetime.
In addition, the settlor can provide the trustees with a letter of wishes identifying who they’d like to benefit and when. The letter isn’t legally binding but can give the trustees clear guidance, which can be amended if circumstances change. The settlor might also be able to appoint a protector, whose powers depend on the Trust provisions, but usually include some degree of veto.
Family disputes are not uncommon, and many feel they’d prefer to pass funds down the generations when the beneficiaries are slightly older than age 18. A Discretionary Trust also provides greater protection from third parties, for example, in the event of a potential beneficiary’s divorce or bankruptcy, although in recent years this has come under greater challenge.