Finding value in trusts

With IHT set at 40 per cent, there is a clear opportunity for advisers to help their clients manage their tax exposure and demonstrate real value in the advice they provide. 

There is a perception that trusts are too complicated for clients to understand. Through better understanding, more advisers and clients will realise the effectiveness trusts can have as a financial planning tool. Not only can they significantly reduce a person’s exposure to IHT, they can also ensure the right people get the right proportion of assets at the right time. 

How does a trust reduce IHT?

A trust is a way of transferring the legal ownership of the assets, which takes effect immediately. Where a trust is used and the settlor (the person making the gift) is not able to benefit, this will help mitigate IHT.

There are a several different trust types available. Depending on the type of trust chosen, there may be tax to pay when setting up the trust. Gifts into discretionary trusts, where there is flexibility to change beneficiaries, are considered to be chargeable lifetime transfers (CLTs). IHT entry, periodic and exit charges may apply. CLTs may be subject to IHT at a rate of 20 per cent at the outset.

This depends on the amount gifted into the trust and any previous gifts made. When using a bare trust – a type of trust with ‘fixed’ beneficiaries – there is no immediate IHT liability, but if death occurs within seven years IHT may be payable. The amount will reduce in stages over a seven-year period. Once seven years have passed, the IHT liability on the gift goes away. 

With so many trusts available it is important to choose the right one, not least due to the potential immediate IHT charge that may apply. A good place to start is to ask the client questions that will help determine whether a trust is appropriate and, if so, which type of trust would be suitable.  

Questions to ask your client, having identified an IHT issue:

• Do you require access to income / capital?
• Would you like to gift some or all or your investment?
• Will you require flexible access to the trust fund?
• Will you require fixed, regular withdrawals for the rest of your life?
• Will you want to change, or add to, the trust beneficiaries in the future?

 There are two types of trust commonly used in IHT planning.

1. Discount gift trusts (DGT), retains access to withdrawals

The discounted gift trust is a scheme that gives the settlor the ability to make a gift, while retaining a right to withdrawals. The value of the future withdrawals is called the ‘discount’ and takes into account factors such as age and state of health. The significance of the discount is that the estate should immediately be reduced by the value of the discount. Any growth on the trust fund is also immediately outside the estate, and the DGT can be either be a discretionary or bare trust. 

In general, where a client is in good health for their age and below the age of 90, there should be an immediate IHT saving. 

For example: Jo is 78 and in excellent health for her age.  She makes a gift into a DGT of £500,000 and retains a right to withdraw income of 5 per cent a year.  Based on factors such as age, health and interest rate assumptions, Jo is deemed to have made a discounted gift of £272,303. That is, she was given a discount of £227,697, creating an immediate IHT saving of £91,078 (40 per cent of the discount). Care: Jo’s entitlement to withdrawals is fixed during her lifetime and she will be unable to demand full access to the capital.

2. Loan trusts, access to capital and caps the IHT bill

The loan trust is a vehicle that allows the settlor access to the capital sum, while any growth on that sum is immediately outside their estate. A loan is made by the settlor to the trustees of a trust (either discretionary or bare). Trustees use this loan to invest into an investment vehicle, typically a single premium investment bond.  

The loan amount is not deemed a gift, so will continue to form part of the settlor’s estate for IHT purposes, but as the growth is outside the estate, it effectively caps the IHT bill on day one. Over time, as more money is paid back to the settlor and spent, the less money there will be in their estate for IHT purposes, helping to reduce IHT overtime.  

For example: Austin makes an interest-free loan of £1,000,000 into a loan trust. Assuming no loan repayments are made for the first five years and the bond grows at a net rate of 5 per cent, in the first year the growth would be £50,000 and by year five the compounded growth would be £276,281. This would give an IHT saving of £110,512 (40 per cent of £276,281) on death. The original £1,000,000 would be inside the estate and subject to 40 per cent tax, but if any withdrawals are made, this exposure reduces. 

Placing policies in trust

One area where advisers do expose themselves to being challenged is when they or their clients don’t place their life insurance policies in trust. By writing the life insurance policy in trust, beneficiaries will be able to access the funds instantly and will not need to wait for probate. Probate can be a lengthy process, and if beneficiaries have to wait several months before they have any access to money, it could cause real hardship and added concern.

Before probate can be granted, the probate fee and any IHT due on the estate must be paid, which could prompt more people to use a life insurance policy as a way of ensuring beneficiaries have access to cash to pay the required fees. Advisers setting up policies specifically for this purpose must ensure they place the policy in trust to enable funds to be paid out instantly without the need for probate.

Future requirements

We are seeing growing demand from clients for inheritance tax planning solutions with greater flexibility that can adapt to their changing needs. More flexible trusts are entering the market, such as lifestyle trusts, where people can choose whether to take withdrawals from the trust depending on their circumstances at the time. With the increase in life expectancy and growing care costs, it is becoming more difficult for people to predict what their income requirements might be in the future.

It is important to remember that trusts do not just offer taxation benefits, they can help provide ways to navigate complex family situations. Trusts give people the opportunity to gain greater control over the distribution of wealth on death – a scenario such as the recent Ilott case, where a lady challenged her mother’s will after it was left entirely to charities, would unlikely occur as the Inheritance Act does not apply to trusts. Also, distribution of trust assets against the terms of a trust would be a breach and could be legally challenged. An added bonus is that trusts are confidential, so unlike wills, they do not become public knowledge.

Phil Carroll is proposition director wealth for Intrinsic