Understand the role that Gift Trusts play in inheritance tax planning.
A Gift Trust is for individuals who want to carry out inheritance tax (IHT) planning whilst retaining a degree of control.
It’s for individuals who no longer need access to these assets now or in the future.
The transfer into trust will create either a potential exempt transfer (PET) or a chargeable lifetime transfer (CLT) subject to the ‘seven year rule’.
What is a Gift Trust?
A Gift Trust is an IHT planning arrangement that allows the investor to carry out IHT planning whilst retaining a degree of control. There are 2 types available Absolute and Discretionary.
Under an Absolute trust the beneficiaries are named at outset on the deed and cannot be changed at a future date. Under a Discretionary trust there are normally no named beneficiaries but instead a class of prospective beneficiaries. This class normally includes children, grandchildren and so on. Typically the settlor can widen the class to include siblings, nieces, nephews etc. and perhaps non-family beneficiaries if appropriate.
Why use a Gift Trust?
Clients may not be quite ready to pass funds outright to their beneficiaries. They may have “wayward” adult children who have gambling issues, alcohol issues or they have concerns over their sons/daughters choice of partners. They may be concerned that their son or daughter may get divorced and they don’t want their hard earned cash being counted as an asset. There are lots of reasons why individuals do not want to pass on their wealth directly to their beneficiaries.There are two types commonly available which are Absolute gift trusts and Discretionary gift trusts.
Absolute trusts are normally used for minor children due to the fact that on reaching age 18 (16 if written under Scot’s law) the beneficiary is entitled to the trust fund.
Discretionary trusts offer more flexibility for the trustees.
How is a Gift Trust structured?
Gift Trusts are typically used in conjunction with insurance bonds – both new bonds and existing bonds. The ownership of the bond passes to the trustees of the trust. Clients can subsequently top up a bond that is held in a gift trust.
How do you set up a Gift Trust?
In the main if it’s a new bond being placed into a new trust, the settlor (the person who is creating the trust) may be able to date both the bond application and the trust deed the same day. If it’s an existing bond that the settlor is placing into trust the trust deed will be dated on the date that the last person signs the trust deed.
What access do settlors and the beneficiaries have to the trust fund?
Settlors have absolutely no access to the trust fund whatsoever – you will normally find a settlor exclusion clause within the deed along these lines – Settlor exclusion clause The Trust Fund shall be possessed and enjoyed to the entire exclusion of the Settlor and of any benefit to him by contract or otherwise and no provision of this Settlement and no discretion or power shall operate so as to allow any of the capital or income of the Trust Fund to become payable to or applicable for the benefit of the Settlor in any circumstances whatsoever.
In respect of the beneficiaries this depends on whether it is an Absolute trust or a Discretionary trust that has been chosen.
Under an Absolute trust – the beneficiaries can demand the trust fund once they reach age 18 (16 if written under Scot’s law) and the trustees are legally obliged to inform the beneficiary that the trust fund exists. The trust fund will form part of the beneficiary’s estate for IHT. If an absolute beneficiary dies the trustees have to look at the will or follow intestacy rules to see who will then benefit.
Under a Discretionary trust, it’s up to the trustees to decide who will benefit and when they will benefit from the trust fund. As long as the beneficiary is in the class of beneficiaries the trustees can allocate funds to them. This is why clients should choose their trustees wisely as ultimately they will be dealing with the trust fund. It is advisable for clients to lodge a letter of wishes with the trustees to give them some guidance, after their death, as to how they want the trust fund divided up. Remember that a discretionary beneficiary cannot demand monies from the trustees nor does this form part of their estate for IHT while inside the trust.
What IHT is payable when using a Gift Trust?
A transfer into a Gift Trust will either be a PET or a CLT depending on whether an Absolute trust or a Discretionary trust has been chosen.
Absolute Gift Trust
Under an Absolute trust the gift creates a PET which after seven years from the date of the gift becomes exempt from IHT. If the settlor dies within the seven years, the PET becomes chargeable and may be included in their estate or may be taxable on the person who received the gift.
Discretionary Gift Trust
Under a Discretionary trust the gift creates a CLT which may attract an entry charge if the value of the gift when added to any other CLT’s made in the previous 7 years exceeds the settlor’s current nil rate band. Again CLTs drop out after seven years as long as no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs this can lead to a 14 year timeline. If a PET fails and become chargeable it pulls in any CLTs made within 7 years of the failed PET thus potentially going back 14 years.
Discretionary trusts may also be subject to periodic charges every 10 years and exit charges which are explained here.
Remember gifts i.e. PETs and CLTs eat into the nil rate band in chronological order thus when calculating any IHT liability they will be applied first against the nil rate band.
Don’t forget settlors can top up both Absolute or Discretionary trusts it just creates a new transfer i.e. PET or CLT with the 7 year clock starting from the top up date for this new premium.
What income tax is payable when using a Gift Trust?
When a chargeable event occurs within the trust, the tax on the gain is assessed as follows.
Absolute Gift Trust
Where a chargeable event arises under an Absolute trust, the gain is assessed on the beneficiaries of the trust in proportion to their share of the trust fund. However if the settlor of the trust is a parent of the beneficiary and the gain arises whilst the beneficiary is unmarried and under age 18, any gain over £100 will be assessed on the settlor of the trust.
Discretionary Gift Trust
Where a chargeable event arises under a discretionary trust, the gain is assessed on the settlor if alive and UK resident and in the tax year in which the settlor dies. Thereafter it falls on any UK resident trustees, and if none on UK resident beneficiaries receiving a benefit under the trust from the gain.
If the trust is set up on a joint settlor basis with the settlors as lives assured there is potential for half of the gain to be assessed at the trustee rates of tax. After first death, when the remaining settlor dies in a later tax year (who is the last life assured) the bond will automatically come to an end and the gain is assessed half on the settlor who has just died and half at trustee rates of tax. It may be worth considering younger lives assured when setting up a joint discretionary trust.
Trustees are able to assign segments to beneficiaries as long as they are over age 18 for tax planning reasons. The assignment is not a chargeable event but a distribution from the trust fund.
On 7 November 2018, HMRC issued a consultation document “The Taxation of Trusts: A review”. In simple terms, the consultation sets out the government’s thinking on making trusts fairer, simpler and more transparent. At the time of writing, the government is notmaking specific proposals for reform.Instead, the government will weigh up the views and evidence presented and consider the options for targeted reforms.
On 23 November 2018, the Office of Tax Simplification published its First Report regarding its review of the IHT regime. This concluded that too many people have to fill in IHT forms, with the process being complex and old fashioned. The recommendations therefore relate to administrative issues. The second report covering wider areas of concern (technical and design issues) was published in July 2019. This included a recommendation that the ‘seven year clock’ should become a five year clock. Also, the 14 year rule should be abolished.