Trusts: A Versatile Estate Planning Tool
- steve31008
- Jul 20, 2022
- 7 min read
Updated: Jul 21, 2022
As we wrote last month, IHT receipts have been rising for over a decade, and the trend is set to continue according to Government statistics*. At the same time, the number of trusts being used is falling**.
Yet, family trusts remain one of the most effective estate planning tools and create opportunities to seamlessly transfer assets to the next generation and should not be overlooked.
In November last year, the Treasury, in response to the OTS review of IHT, confirmed that they had decided 'not to proceed with the recommendations at this time'.
This means the IHT planning landscape remains unchanged, and lifetime gifting remains a key part of tax efficient family wealth preservation.
Trusts have a huge part to play in this where donors also wish to retain an element of control over the gifts, and in some cases retain some form of access for themselves.
I would caveat here we are discussing trusts set up during life, which I call lifetime planning, as opposed to trusts that are created through the Will as part of an estate plan, which I call death planning.
So why are clients being put off using lifetime trusts?
Why Is The Use Of Trusts Falling?
HMRC put the continued fall in the numbers of trusts down to the increase in the rate of tax on trust investments allied to the 2006 IHT changes which dragged more trusts into the world of periodic and exit charges.
The administration of trust taxation is also perceived to be complex. Trustees may need to keep accounts and file tax returns and this may incur costs. Decisions on what action to take can be based on the potential IHT savings to be made by making a gift into trust, against the ongoing tax charges on the trust together with any professional fees.
More recently, the requirement for most express trusts, whether taxable or not, to be registered with the Trust Registration Service appears to have become another barrier.
While this may be an 'inconvenience', even if the motives behind the register are well intended, you should not blind yourself to the wealth preservation opportunities a trust may offer.
Particularly if the lack of control and flexibility of making direct gifts to your family may be something you simply aren't comfortable with at the time the gift is to be made.
How To Simplify Trust Taxation
Where trust solutions are recommended to mitigate IHT, the administrative tax complexities may of course be eased by using a bond as the investment wrapper.
Unlike other investment solutions, investment bonds are non-income producing. Income and gains roll up within the plan. This means there are no income or capital gains which the trustees have to report and pay tax on each year. Income tax may only be due when the policy comes to an end or withdrawals of more than the 5% cumulative allowance are taken.
And, unlike other similar investments, chargeable gains remain assessable upon the settlor during their lifetime. So the trustee rate of tax is only payable if the settlor (the person who sets up the trust) is no longer alive.
When trustees are ready to make an appointment to the beneficiary they can assign the bond (or segments) to them without creating a chargeable event. The beneficiary then takes ownership of the bond and can surrender at an appropriate time, with any gains assessed upon them benefitting from their own allowances and tax rates.
Which Trust
Once you have identified how much you wish to gift, you may not want to make an outright gift to an individual, perhaps because you think that a person is not mature enough to use the gift wisely. Or maybe you prefer the gift to be enjoyed by a group of people, such as grandchildren, whenever born.
Different types of trust can allow you to do this while giving you an element of control over who benefits and when.
There are broadly three types of underlying trust for anyone looking to make a gift each giving differing levels of control:
Absolute Trusts
An absolute trust, or bare trust as they are also known, is an arrangement whereby a settlor gives trustees cash or other assets to look after for a named beneficiary (or beneficiaries). The main difference from other types of trust is that the beneficiary(ies) cannot be changed.
Discretionary Trusts
A discretionary trust is a trust that contains a provision giving the trustee discretion to pay to the beneficiary only so much of the income and principal of the trust property as the trustee sees fit.
Flexible Trusts
A Flexible Trust is similar to a Discretionary Trust, but includes both default beneficiaries and discretionary beneficiaries. The default beneficiaries automatically receive a portion of the trust fund, while the discretionary beneficiaries will only benefit if the trustees choose for them to do so.
The more control, flexibility and discretion over who gets what and when, the more complex the tax position could become.
To complicate matters, investment providers use marketing names for packed IHT trust solutions to help investors identify more easily which may be the most suitable. For example, the Gift Trust mentioned below can be an Absolute Trust or a Discretionary Trust, depending on how you want to use it.
Typical Trust Plans
Investment bonds have always been a popular trust investment. Most packaged IHT solutions such as gift trusts, loan trusts and discounted gift trusts use them as the underlying investment.
Gift Trusts
This type of plan is suitable for those who have identified a sum of money that they will not need access to themselves anytime in the future. Unless an absolute trust is being used, clients should be aware that any gifts above their available nil rate band will result in an immediate charge to IHT.
But this still means that a couple can jointly gift up to £650,000 during their lifetime without suffering an immediate charge. They will save themselves IHT on any future growth, and if they survive seven years they will save £260,000 in IHT in respect of the gift. Or put another way, their family could be better off by £260,000 plus the growth on £650,000.
And of course during your lifetime, the trust can be used to benefit your family (or other beneficiaries) - for example it could be used to pay for a grandchild's university education, or as a deposits for a child's first home.
Not everyone will be happy making an outright gift. They may need to retain some access to the capital or need the funds to provide them with a source of regular payments. There are alternative types of trust plan that can help.
Loan Trusts
A loan trust may be suitable for those who may face an IHT liability in future, but don't feel comfortable gifting their capital and never being able to access it for themselves again.
It works by the settlor lending money to the trustees rather than gifting it. The trustees invest the money for the benefit of the beneficiaries. There is no immediate IHT to pay as the right to the outstanding loan remains in the estate i.e. the value of the estate before and after the setting up of the plan is the same, so no value has been transferred. You can ask for repayment of the loan at any time should you need access to capital or set up regular payments if you require an income.
All the investment growth is outside your estate. And each repayment reduces the value of the loan within the estate. But once the loan has been fully repaid you, as settlor, must not take any further payments from the trust.
Example
Anne, 70, creates a loan trust with a loan of £100,000. The trustees invest in an investment bond and loan repayments are set at 4% a year giving her an annual 'income' of £4,000. Anne dies at age 85 and the value of her loan trust (i.e. the surrender value of the bond) at death is now £65,000.
Anne has had loan repayments of £60,000 over 15 years
The trustees repay the outstanding loan of £40,000 to her estate
The investment growth £25,000 (£65,000 - £40,000) is held for her beneficiaries
Discounted Gift Trusts
These trusts are particularly suitable for those who are likely to pay IHT on their estate on death, but who rely on their capital to provide an 'income' in retirement.
Typically this works by gifting a lump sum into trust while retaining a right to regular payments from the trustees for the rest of your life. The trustees invest the lump sum in an investment bond, and the regular payment requested is paid back to you by setting up regular withdrawals from the bond. The amount gifted for IHT is effectively reduced by the value of these 'retained rights'. But because the right to the regular payments cease upon death they do not form part of the estate.
The discount also means that larger amounts can be given away without a lifetime IHT charge, as long as the gifted value (after discount) is less than your available nil rate band. Younger people will generally get a bigger discount unless in poor health, when a discount could be reduced or even disallowed altogether.
Example
Joe gifts £500,000 into a discounted gift trust and retains a right to £20,000 'income' each year. Following underwriting to determine Joe's life expectancy it is estimated that the market value of future payments Joe will receive throughout his lifetime is £200,000. This means the amount Joe has given away for IHT is £300,000. As he has not made any earlier gifts, there is no immediate IHT charge.
If Joe dies within seven years of setting up the trust, then only £300,000 (and not £500,000) would be included in his estate. Any growth would be outside his estate from day one. The potential tax saving due to the discount could therefore be up to £80,000 (£200k x 40%).
If Joe dies after seven years, then the whole £500,000 is outside his estate.
Summary
The statistics suggest that year on year IHT receipts may continue to rise, despite the introduction of the residence nil rate band. Lifetime planning can help to reduce the IHT liability on death. As part of this, trusts remain an effective way of achieving the efficient transfer of wealth to the next generation in a controlled way.
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