How do I use a Discretionary trust to save Inheritance Tax
Many techniques for saving Inheritance Tax involve avoiding assets coming in to the estate, or transferring assets out of the estate. The reason for this is obvious – anything that is in the estate and available to the tax payer is going to be subject to Inheritance Tax on his or her death.
Both of these techniques involve the tax payer having no access to the funds involved themselves. The optimum situation in Inheritance Tax planning is to have assets which are not comprised in the estate, but which are at the same time available to the individual tax payer. This is difficult because of the reservation of benefit rules. There are two particular ways to achieve this position making use of a discretionary trust, where the person concerned is a beneficiary, but where the capital value does not form part of their estate subject to Inheritance Tax.
Trusts for inheritances
One circumstance where this can be achieved is in relation to monies being inherited. If those assets are passed instead to a discretionary trust for the benefit of that beneficiary and his or her family, rather than going directly into their taxable estate, they will have access to the monies, but without the funds forming part of their own estates.
Discretionary trusts, which are also called relevant property trusts, are not entirely free of tax. They suffer tax at a rate of anywhere between 0% and 6% every ten years, but assuming these rates do not change significantly, and they have been at this level for many years, this compares very favourably with the 40% rate that would otherwise apply.
Monies being inherited can go into a trust because that is what the Will says. Alternatively a deed of variation can be completed after death, to achieve a similar outcome. There is no reservation of benefit on the gift into trust that is being made by a variation, because the effect of the deed is that the transfer is treated as having been made by the deceased.
Aside from monies being inherited, the other area where this technique can be used to great advantage is in relation to monies coming from life assurance or pension policies. We are not talking here about avoiding the monies being available to the taxpayer as such, as in any event the funds concerned would only pay out on his or her death. What we are trying to achieve is having funds held in the tax shelter of a trust for the benefit of the policy holder’s main beneficiary, typically a spouse, and children.
Many people will have both life cover and a pension fund; these may be individual policies or through membership of a group scheme of some sort. The differences between these arrangements is really only relevant for the mechanism for transferring the death benefits, as the tax planning principle is the same for each.
With an actual life policy, the policy itself would be assigned into trust. With a group death in service benefit scheme, the monies would be payable at the discretion of the scheme trustees, so in that case it would be a question of completing an appropriate nomination or expression of wish form. The scheme trustees are not obliged as a matter of law to follow this, but in practice are almost certain to do so.
If a self employed person has a retirement annuity policy, sometimes referred to as a Section 226 policy, which will have been put in place before the change to personal pensions in 1988, then an assignment of the policy and the death benefits will be required, although the documentation will need to take care to leave the pension elements of the policy payable as a pension to the policy holder or surviving spouse.
Post 1988 policies are personal pensions. Whilst a few of the earlier versions of these would be dealt with by way of assignment (so you should check the policy terms) most are written on a master trust basis where the benefits are payable at the discretion of the scheme trustees, so a nomination form will be needed. The same would apply to money purchase arrangements in company schemes.
The form of trust
The trust needs to be in what is called ’the relevant property regime’. This means that no individual has a qualifying interest in possession (which would mean that the capital value was attributed to them for Inheritance Tax) and the trustees are subject to the 6% maximum tax regime referred to above.
It used to be that the trust had to be genuinely discretionary but if a lifetime trust is set up now giving an individual a right to income, although it is treated accordingly for income tax purposes it will still be ’discretionary’, in other words relevant property, for the purposes of Inheritance Tax. The income tax treatment, which needs to be considered carefully, may well lead you in the direction of conferring a right to income.
So it is possible to set up a trust for a surviving spouse which is either discretionary for maximum flexibility; or which gives the survivor a right to income, but probably with powers of appointment for additional flexibility as well.
The surviving spouse will have full access to the funds concerned, which would normally be intended principally for their benefit during their lifetime. Children would be included as other potential beneficiaries, and the deed would be drafted with the maximum flexibility.
Because of this, and the ability of the trustees to change the terms of the trust, it is vital that appropriate trustees are chosen. Typically the main beneficiary would be one of the trustees along with others whom both parties can rely on to act appropriately and in accordance with the spirit of the arrangement. With this in mind it is not uncommon for independent professionals to be involved in this role, as obviously they would have no personal interest in the trust. It would also be advisable for there to be a letter of wishes setting out exactly how the policy holder would expect their monies to be used, and this should give some assurance to the survivor that the funds would indeed remain available to them, which would normally be the intention.
In the event of any uncertainty about this on behalf of the survivor, then as a final safeguard it would be possible to give the survivor the right to appoint and remove trustees. Effectively this gives them complete control of the trust, but without undermining the tax status and therefore treatment of the funds.
Because discretionary trusts are subject to a tax regime in their own right, albeit at a lenient rate, it is quite common to set up more than one trust. This is on the basis that the scale of charge to tax depends on the size of the trust; two medium sized trusts would have an effective lower rate than one large one. However, it is probably not sensible to have too many individual trusts, even where that could be used to bring the tax rate down, or eliminate the charge altogether. Each individual trust requires administering and there is usually a cost attached to that. The maximum tax saving at present rates is 6% over ten years, or 0.6% each year. It is possible that the additional trusts needed to make a saving of this order would generate additional work and expense that outweighed the tax saving.
Inheritance Tax planning
Coming back to the bigger picture, you are making the monies concerned, which might be a reasonably significant sum, fully available to the surviving spouse, whilst keeping all of the value away from the tax charge on his or her death. The ten yearly tax charges within the trust should only slightly erode the overall 40% tax saving being sought.
The knock on effect of having monies in this form, from the point of view of further Inheritance Tax planning, is that if those monies are available to the survivor, there may be monies in his or her own estate which are then surplus to requirements and which can be gifted on to the next generation, so reducing the estate exposed to Inheritance Tax.
The cliché used to describe what is possible here, so often not possible because of the reservation of benefit rules, is ’having your cake and eating it’. That is not a bad description of a situation where monies are yours for practical purposes, but not yours in the eyes of the tax man – very satisfying tax planning!