From life policy to trust

Nicholas Acomb, partner at law firm Stevens & Bolton, looks at the inheritance tax obstacles you need to overcome when transferring policies into trusts.

Before 22 March 2006, writing life policies in trust rarely raised any question of chargeable transfers on creation, nor of periodic charges to inheritance tax (IHT). However, following the Finance Act 2006, the IHT treatment of many trusts used for life policies changed, a key point IFAs need to be aware of in order to maximise benefits from such policies.

By way of a brief overview, trusts of life policies are used:

• for tax efficiency, avoiding the policy-forming part of the life-assured’s estate for IHT purposes;
• to control the destination of the policy value;
• to ensure payment of the sum assured without having to await probate.

A life assurance policy is a ‘chose in action’, a bundle of rights including the right to be paid out a sum assured on the death of the life assured, and with some policies a right to surrender the policy for value. A policy can be transferred into trust after it has been issued, either by deed of assignment or by a declaration of trust. Alternatively, where the life policy application is accompanied by a letter of request, the life company can issue the policy upon the terms of a specific trust.

Types of trust, IHT and Finance Act 2006

There are three main types of trust:

• Discretionary trusts, where trustees have discretion to distribute capital and any income to a class of beneficiaries.
• Interest in possession trusts, where a beneficiary has a right to receive any income for a period of time, say until the trustees’ exercise of a power of appointment in favour of a wider class of beneficiaries. The trustees have discretion over capital distributions.
• A bare trust (nomineeship), where trustees hold an asset on someone’s behalf, with no powers to distribute the asset to anyone else. The beneficiary (at age 18 or over) can call for the asset at any time.

The status of a bare trust has not changed.  The transfer of a policy into a bare trust should qualify as a potentially exempt transfer. Following the Finance Act 2006, whether a life policy is transferred to a discretionary trust, or an interest in possession trust, it will be a transfer to a ‘relevant property trust’, and will be a chargeable transfer for IHT. However:

• Broadly, a charge to IHT will arise only if the value transferred is more than the nil-rate band, currently £325,000. This will depend upon the value of the policy at the date of transfer, generally its open market value. But there are special IHT valuation rules for policies provided that the minimum value of the policy is the amount of the premiums paid prior to the transfer.
• A term policy is unlikely to have any intrinsic value.

A relevant property trust can also incur charges to IHT at up to 6% every 10 years and on capital distributions. However, broadly, at a 10-year anniversary, the trust would incur no charge if the value of the policy falls within the nil-rate band. Similarly, for a trust created within the nil-rate band, there would generally be no IHT charge on distributions during the first 10 years.

Any additions to the trust are also taken into account, and the payment of premiums on the policy can be regarded as additions for this purpose. Previous chargeable transfers made by the settlor in the seven years prior to creating the trust, and any other trusts created by that settlor on the same day, can also affect the charges.

Other issues to consider

• Payment of premiums. An individual who pays premiums on a policy held in a trust makes a transfer of value. This transfer may be exempt either under the annual £3,000 exemption, or the normal expenditure out of income exemption. Otherwise, the premium payment on a policy held in a relevant property trust will be a chargeable transfer.
• Problems with joint policies. Typically, both lives assured would be the original policy owners. If transferred into trust, both need to be excluded from benefit from the trust otherwise the IHT reservation of benefit provision would be infringed. If the policy is a joint life first death policy, transferring the policy into trust may not be sensible, because the surviving life assured could not benefit from the policy proceeds, since they would have been excluded from benefit under the trust.
• Problems with single-life policies. While a single-life policy written in trust would exclude the life assured from benefit, the trust could still benefit a spouse, widow or widower without contravening the reservation of benefit rules. But if that spouse pays the premiums, such payment would be a gift under the reservation of benefit rules, resulting in the value of the policy forming part of that spouse’s estate for IHT. A spouse could be treated as paying premiums if they are paid from an account held jointly with the life assured.
• Capital gains tax (CGT). Life policies are exempt from CGT unless they have been assigned for consideration. So normally they can be transferred into and out of trust free of CGT with no CGT on payment of the sum assured.
• Income tax. Life policies are non-income producing assets, so there are no income tax charges on trustees. The exception is a non-qualifying life policy (a single premium insurance bond), which can generate income tax charges on a chargeable event, a policy gain arising on encashment. Where such policies are held in a UK trust, the income tax is charged on a living settlor, otherwise on the trustees.

Since the Finance Act 2006, transferring policies into trust needs careful consideration if IHT charges are to be avoided. The type of policy used may determine whether value is being transferred for IHT. Some types of policy may cause subsequent practical difficulties if transferred into trust. And, as has always been the case, care needs to be taken over who pays the premiums.