More people than ever are considering the potential impact of Inheritance Tax (IHT) on their wealth and looking for ways to protect assets from tax on death. Amongst a range of different options, gifting assets away to family members is one of the simplest methods of reducing the value of your potential estate, mitigating an IHT liability, and transferring family wealth to the next generation.
Making outright gifts is, however, not always possible or the gift could result in unintended consequences. If the beneficiary of the gift is under the age of eighteen, they cannot receive gifts directly. Grandparents gifting larger sums to their children could inadvertently add to their children’s IHT concerns due to the value of their own assets. We regularly see situations where family members are gifted funds to help purchase a home, only for a relationship to break down, leading to dilution of family wealth through a divorce settlement.
Instead of gifting funds directly, settling money in Trust can be an effective planning tool that helps protect family wealth and avoids the pitfalls that can arise when making outright lifetime gifts.
There are a range of different Trusts that individuals can establish, with an Absolute (or Bare) Trust being the simplest. This is where funds in Trust benefit a single individual, usually a minor, who accedes to the Trust capital at the age of eighteen. A more flexible arrangement is, however, often preferred, where the donor can retain control over when assets held in Trust are paid to beneficiaries.
Increased flexibility
Discretionary Trusts provide this flexibility, as the Trust wording allows the funds held in Trust to be paid to anyone within a pool of potential beneficiaries. Trust wording will often allow children, grandchildren, and great-grandchildren of the settlor to benefit, although it could also include other named beneficiaries. The Trust is flexible in that it allows the Trustees to decide who receives funds from the Trust, and when. The following provides an example of how gifting into a Discretionary Trust would work in practice, to protect family wealth.
Mr & Mrs Smith own property and other assets valued at £2.5m and wish to gift funds across generations of their family. They have not undertaken any lifetime gifting previously. Mr & Mrs Smith each gift £325,000 into a Discretionary Trust, which avoids any immediate Inheritance Tax charge as this is within their Nil Rate Bands. Mr & Mrs Smith appoint themselves as Trustees, to retain control over the Trust assets, but also appoint their daughter as an additional Trustee, to ensure continuity in the event of death of one or more of them.
The potential beneficiaries of the Trust are any of Mr & Mrs Smith’s children and grandchildren. The Trustees invest the Trust funds in a diversified managed investment portfolio and future growth is therefore outside of the Smith’s own estates. Beneficiaries receive Trust capital at various intervals, to help grandchildren through further education, and to provide one older grandchild with a deposit for their first home. The remaining funds held in Trust continue to grow over the longer term, enabling future generations of the family to benefit. After seven years, the gift into Trust falls outside of Mr & Mrs Smith’s estate for Inheritance Tax purposes.
Wider planning options
When using a Discretionary Trust, the Settlor (i.e. the person setting up the Trust) cannot benefit from the Trust, if the gift is to be effective for IHT planning. There are, however, a range of different options that can provide the Settlor with access to the funds gifted into Trust, whilst ensuring that the funds held in Trust grow outside of their estate.
Discretionary Gift Trust arrangements allow the Settlor to receive a regular stream of capital payments from the Trust, and the value of the gift for IHT purposes may be subject to a discount, based on the age and health of the Settlor. Loan Trusts are a further alternative that can be effective in certain circumstances. The Settlor lends funds to the Trust, which can be repaid to the Settlor if required, whilst growth in the value of the Trust capital is outside of the Settlor’s estate.
Tax considerations
Discretionary Trusts can be powerful tools when it comes to protecting family wealth. They are, however, subject to a more punitive tax regime than individuals, with interest and savings income taxed at 45% and dividends at 39.35%. It is therefore important to consider the most appropriate method of establishing the Trust and arranging the Trust assets, to avoid unnecessary tax liabilities.
Most transfers into discretionary Trusts are Chargeable Lifetime Transfers (CLTs). Unlike gifts to individuals, which are Potentially Exempt Transfers, CLTs may give rise to an immediate IHT liability if the value of gifts exceeds the Nil Rate Band. Discretionary Trusts are subject to a liability to IHT on the 10th anniversary of the creation of the Trust and each 10-year anniversary thereafter, and a potential IHT charge is also payable when assets leave the Trust. These charges are, however, modest when compared to the rate of IHT charged on death.
Administrative matters
In addition to tax considerations, Trustees will also need to ensure that they properly administer the Trust, including registering the Trust with HMRC, via the Online Registration Service, and filing annual tax returns as required. It is, therefore, essential that Trustees keep good records and seek advice from an Accountant or Solicitor. Where FAS provide Trustees with investment advice, we can provide detailed reports of income and capital events for each tax year, to simplify the reporting process.
The need for tailored advice
It is important to consider Trust planning as one of a range of options available which can help mitigate a potential IHT liability. Each option has benefits and drawbacks and therefore selecting the right path, or paths to take, will depend on your individual circumstances. Our experienced advisers can show you examples of various Trust planning advice we have given to clients, to help you select the right option. Speak to one of the team to start a conversation.
