The Budget delivered on 26th November contained no significant changes to Inheritance Tax (IHT). Following the reforms announced in the 2024 Budget to Business and Agricultural relief, together with the upcoming changes to the way unused pensions are treated, the lack of fresh announcements was not unexpected; however, the continued freeze on Inheritance Tax bands until 2031 announced as part of this year’s Budget is a stealth tax increase, that will drag more estates into the scope of IHT and increase the burden on estates already impacted.
The nil rate band for Inheritance Tax – i.e. the amount an individual can give away before IHT applies – has remained static at £325,000 since 2009, and the recent measures announced effectively mean this band will not have increased for 22 years. Granted, the Main Residence Band, which covers the family home when left to direct lineal descendants, and the transfer of bands between spouses, give additional headroom before death duty becomes payable. Despite this, increases in the value of investments and residential property over the last two decades mean that even modest estates are now at risk of an IHT charge.
Given these factors, it is no surprise to us that Inheritance Tax planning is becoming a key financial consideration for families. Protecting family wealth and ensuring this can be passed on to the next generation without onerous tax liabilities, is a common topic of conversation with clients, and one that will become a more pressing issue for many once the changes to the treatment of unused pensions come into force in 2027.
Introducing Discretionary Trusts
In a recent edition of Wealth Matters, we started to consider how Trust planning can be used to mitigate a potential IHT liability and focused on Loan Trusts as being a way to protect future growth on the value of assets from IHT, whilst the settlor (the person making the loan) retained the ability to receive repayment of the loan, if they required funds. This only provides partial protection from IHT, as the outstanding loan remains in the individual’s taxable estate.
A more effective, but less flexible, form of IHT mitigation is to make a gift into a Discretionary Trust. To be effective for IHT purposes, the settlor needs to be excluded as a beneficiary. Without this exclusion, the settlor would retain a “reservation of benefit,” rendering the gift ineffective for IHT planning. An often-cited example of this is an individual gifting the family home into Trust but remaining resident in the property without paying a market rent. This would be considered such a reservation of benefit.
Gifts into Trust reduce an individual’s nil rate band by the amount of the gift, although gifts into Trust over £325,000 are liable to an upfront charge to IHT of 20% on the excess above the nil rate band. Assuming the donor lives for seven years, the gift is then considered outside of the donor’s estate.
The Discretionary Trust Deed will set out who can benefit from the Trust; however, the Trustees will have discretion over who receives benefits from the Trust and in what proportions. No single beneficiary has any direct entitlement to the Trust assets, and instead, the Trust Deed names a pool of potential beneficiaries. In most cases, this will be the direct family of the settlor (children, grandchildren, and great grandchildren) and can include direct lineal descendants not yet born. The settlor will usually appoint themselves as one of the Trustees, along with their spouse, and adult children.
This creates a “family trust” that can benefit any family members in the future. When we discuss establishing such lifetime Trusts with clients, the settlor often considers situations such as helping grandchildren through university, advancing funds at key birthdays, or providing funds for future generations to help them place a deposit on their first home, as being an appropriate time to consider advancing funds from a Discretionary Trust.
Keeping funds within a Trust arrangement can also help protect family wealth in the event of matrimonial breakdown within the family, or where funds that would otherwise be gifted directly to family members, may be spent unwisely.
Tax and Trust investments
When investing Trust assets, the Trustees need to adhere to the requirements of the Trustee Act, and ensure that Trust funds are prudently invested, provide adequate diversification and are reviewed to consider whether they remain appropriate.
Discretionary Trusts are subject to a punitive tax regime, which makes the choice of investment vehicle even more important. Trustees pay tax at a rate of 39.35% on dividend income and 45% on interest, and they also only receive 50% of the Capital Gains Tax allowance enjoyed by an individual. As a result, an Onshore Investment Bond is often selected as an investment vehicle, as it is taxed internally at a lower rate, and segments of the Bond can be assigned to beneficiaries when the Trustees agree to advance funds. The act of assignment does not trigger a tax charge, leaving the beneficiary to surrender the segments advanced at their own marginal rate of tax, which is often lower than the rate applicable to Trusts.
How we can help
Establishing a Discretionary Trust during an individual’s lifetime can be an effective tool to reduce a potential Inheritance Tax liability and protect family wealth. Decisions around the creation of the Trust, the selection of an appropriate investment strategy and ongoing management of the Trust assets are areas where our experienced team can provide advice.
It is, however, important to recognise that Trust planning is just one tool available to mitigate a potential Inheritance Tax liability. Other options, such as Business Relief investments, regular gifting strategies or protection policies, may be more appropriate, depending on your circumstances. Our independent advisers can take a holistic view of your potential estate and consider solutions from the whole of the market and provide advice on the option or options that best suit your needs. Speak to one of our team to start a conversation.
