Saving on IHT through discretionary trusts

The Inheritance Tax (IHT) nil rate band has remained static for over ten years now. During this time, property prices and investment values have continued to rise. This means that IHT, once only a consideration for the very wealthy, is now affecting many more families.

Discretionary Trusts are one method of reducing your IHT bill, passing on money to your family, and keeping some control over your hard-earned wealth.

What is a Discretionary Trust?
A Trust allows you to ring-fence assets, such as cash, investments, or property, for the future use of your beneficiaries.

There are three main parties to the Trust:

• The Settlor – the person who makes the original gift.
• The Trustees – who have responsibility for managing and distributing the Trust’s assets.
• The Beneficiaries – the individuals who will receive income or capital from the Trust.

Normally, the Settlor will be one of the Trustees. It’s important to appoint at least one other person as a Trustee, as they will be able to look after the Trust if the Settlor is no longer able to.

To be effective for IHT planning, the Settlor should not be able to benefit from the Trust.
A Discretionary Trust allows the Trustees to have the final say over how the Trust funds are distributed. It is more flexible than an Absolute Trust, which designates a specific amount to each beneficiary. However, it is significantly more complicated, and there can be tax implications.

Tax Treatment of Discretionary Trusts
The taxation of Trusts can be complicated, but the main implications are:
Inheritance Tax (IHT)

• The gift into Trust is a Chargeable Lifetime Transfer (CLT). If this gift, and cumulative gifts over the past seven years, are over the nil rate band (£325,000), an immediate IHT charge of 20% applies.
• If you die within seven years, the gift is added back into your estate, and incurs a further IHT charge of 20%.
• After the full seven years have elapsed, the gift is outside your estate and will reduce your IHT liability.
• However, further IHT charges may apply within the Trust. If the value exceeds the nil rate band at the ten-year anniversary, IHT of 6% is charged on the excess.
• Proportional IHT charges will also apply if any capital is distributed from the Trust after the ten-year anniversary.

Income Tax

• If the Settlor retains an interest in the Trust that tax position is complicated and outside the scope of this article.
• Where the Settlor retains no interest in the Trust, the first £1,000 of Trust income is taxed at the basic rate, i.e. 20% for most types of income and 7.5% for dividends.
• If income is retained by the Trustees, or distributed on a discretionary basis, the remainder is taxed at 45% for most income and 38.1% for dividends.  If the Trustees have to pay the income to the Beneficiaries under the terms of the Trust then the Trustees have to account for basic rate tax on the income, as above, and if there is any further liability to income tax on this income in the hands of the Beneficiary once it is amalgamated with their other income then this is taxed at the normal higher rates or additional rates of income tax.

Capital Gains Tax (CGT)

• The Trust has a CGT exemption equivalent to half the personal exemption. The full exemption is currently £12,300, which means that Trusts have £6,150 to set against gains realised.
• The exemption is split between Trusts set up by the same Settlor. So if you set up two Trusts, each one would have an exemption of £3,075.
• CGT of 28% is charged on any gains above this exemption.

The Trust Assets
You can either place existing assets into Trust, or make a cash gift for the Trustees to invest.
You can also designate life policies and death in service benefits into Trust. This means that the policy benefits are paid outside the Settlor’s estate, and no immediate IHT applies.

Many Trusts hold investment bonds. These work well with Trusts, for the following main reasons:

• Placing an existing bond into Trust does not have immediate income or capital gains tax implications. It may incur IHT if the value is over the nil rate band.
• Bonds have an annual withdrawal allowance of 5% per year, which can be carried forward to future years if it is not taken. This means that the Trust can produce an income for the beneficiaries without incurring tax.
• Tax only applies if the bond is fully or partially encashed. This makes it easier for the Trustees to administer as there is no need to complete an annual tax return.
• The bond is divided into segments. Segments can be assigned to beneficiaries before they are encashed. This means that the gains are taxed at the beneficiary’s rate rather than the (usually higher) Trustee rate.

Trusts can also hold investment accounts, shares, and property. However, these would generate an income, and potentially capital gains if the assets are sold. Tax advice would always be recommended.

How Could a Discretionary Trust Benefit You?
The main benefits of a Discretionary Trust are:

• The capital will drop out of your estate after seven years.
• Any growth on the investment will accumulate in the Trust, rather than in your own estate.
• You can still retain some control over the money, rather than making an outright gift.
• Your legacy is protected if any of the beneficiaries get divorced, are declared bankrupt, or lose capacity.
• The Trust funds are not considered to be in the estate of any of the beneficiaries. This can help with intergenerational wealth planning.