For the last ten years, the inheritance tax (IHT) nil rate band has remained static. During this time, markets, investments and property values have continued to rise, meaning that IHT is becoming more of an issue and affecting progressively more people.
One way of reducing your IHT bill whilst ensuring that more money is passed onto your family and retaining some control over the capital, is through the use of discretionary trusts.
What is a discretionary trust?
A trust allows you to put aside assets, such as cash, investments, or property, for the future use of your beneficiaries.
The three main parties to a trust are as follows:
- 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.
The settlor will usually be appointed as one of the trustees, however, it is important that at least one other person is appointed as a trustee to ensure that the trust is looked after if the settlor becomes unable to. It is also important to note that the settlor should not be able to benefit from the trust in order for the IHT planning to be effective.
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 main tax considerations for trusts are as follows:
- Inheritance tax (IHT)
- A gift into trust is deemed to be a chargeable lifetime transfer (CLT). If the sum of gifts over the previous seven years, including this gift, are greater than £325,000 (the nil rate band) then an immediate IHT charge of 20% is levied.
- If you were to pass away within seven years of making the gift, the gift is returned to your estate and will incur a further IHT charge of 20%. However, if you were to survive the full seven years after the gift was made, then the gift is deemed to be outside of your estate, meaning that there will be no IHT liability on it.
- It is important to consider that if the value of the trust exceeds the nil rate band at its ten-year anniversary, then an IHT charge of 6% is levied on the portion of the trust above the nil rate band.
- Proportional IHT charges will also apply if any capital is distributed from the trust after the ten-year anniversary.
- Income tax
- If the settlor is still alive, trust income is taxed at their marginal rate.
- After the settlor’s death, 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.
- The remainder is taxed at 45% for most income and 38.1% for dividends.
- Capital gains tax (CGT)
- The trust has a CGT allowance of £6,150 to set against realised gains.
- The exemption is split between trusts set up by the same settlor. Therefore, 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
In terms of the assets held within a trust, you are able to either make a cash gift for the trustees to invest as per their wishes, or you are able to place existing assets directly into a trust.
Assets that you can place directly into a trust include life policies and death in service benefits. The benefit of placing these in trust is that the benefits being paid will be outside of the settlor’s estate and therefore there will be no immediate IHT liability.
Existing investments, shares and property can also be transferred into trusts. However, it would always be recommended to seek tax advice before doing so.
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, as this can help with intergenerational wealth planning.
Disadvantages
Of course, there are some downsides to setting up a trust:
- To be effective for IHT planning you must not benefit from any of the assets held within the trust. Therefore, you must consider whether you can afford making the gift in the first instance.
- The IHT benefit only applies if you survive for seven years after making the gift. If you were to die within seven years, any gifts made within the previous seven years are also added back into your estate.
- Trusts are taxed at a higher rate than personal investments.
- There is still the potential liability for IHT at the trust’s outset, ten-year anniversaries and when capital exits the trust.
- If you require long-term care, placing money in trust could be considered deliberate deprivation of assets. This means that while you cannot actually access the money, it will be counted in your means test and may reduce your eligibility for help with your care costs.
What are the other options?
Trusts are not the only option for mitigating IHT. Some other potential solutions are:
- Making outright gifts using your annual allowances or making large gifts which will fall outside of your estate after seven years.
- If you own a business, shares in a private company, or have investments in alternative investment market (AIM) stocks, or an enterprise investment schemes (EIS), then you may be able to claim business relief. This could result in the eligible assets receive 100% IHT relief after two years. It is important to bear in mind, however, that these investments carry a high level of risk and volatility.
- Insuring the liability. If you set up a whole of life plan in trust, this could provide a sum, outside your estate, for the trustees to settle any IHT bill.
- Setting up a family investment company. This can be effective for larger estates, but it is complicated and specialised tax advice is recommended.
As with many financial planning solutions, a combination of approaches often results in the best outcome. If you would like to discuss this further with a member of our Financial Planning team, then please do not hesitate to get in contact.