Trusts: Do you know all the options?

Nick Homer, protection proposition manager at Zurich Financial Services, discusses trust planning options.

Before the 2006 Budget, intermediaries tended to recommend three types of popular trust: – bare, discretionary and interest in possession to their clients for IHT mitigation purposes.

Interest-in-possession (IIP) trusts were by far the most popular due to their combination of flexibility and tax treatment as potentially-exempt transfers. However, since that Budget, new gifts into pre and post-Budget interest-in-possession trusts mean that the trusts are treated for tax in the same way as discretionary trusts, making discretionary trusts the more preferable option going forward.

Importantly though, pre-2006 Budget interest-in-possession trusts that continue to receive regular premiums, for life plans, are not caught by the new rules. Increases to these plans may also avoid the trust being brought into the post-Budget rules if they form part of the policy contract conditions.

All transfers into what was an interest-in-possession trust from the 22 March 2006 onwards are classed as chargeable lifetime transfers for IHT purposes. Many intermediaries will be familiar with potentially-exempt transfers, but some may have less experience of chargeable lifetime transfers. It is important that intermediaries working in this area appreciate how these transfers work and the impact the legislation has on their clients.

Discretionary trusts

Gifts into discretionary trusts that are above the prevailing nil-rate band – taking account of any other chargeable lifetime transfers made by the settlor in the past seven years – are taxed at half the death rate, currently 20%, when they are established.

The trust also pays a periodic charge every 10 years, on any assets valued above the then nil-rate band. This tax charge is a maximum of 30% of the lifetime rate, currently 6%.

In addition, there is an exit charge, if capital is distributed to a beneficiary of the trust. This is also a maximum of 6%.

Thankfully the reporting limits of chargeable lifetime transfers (CLTs) have been significantly increased – gone are the old limits of anything over £10,000 (or if the cumulative total of transfers over 10 years exceeds £40,000) needing to be reported to HMRC. Now slightly more complicated rules apply but the limits are now at a more realistic and manageable level for these gifts.

For entry charge purposes there will be no need to report a CLT if the cumulative total of all chargeable lifetime transfers made by the transferor in the seven years before the current transfer (but including that transfer), does not exceed 80% of the nil rate band (currently £260,000) and the value of the current CLT does not exceed the nil rate band (including previous CLTs) made by the transferor in the seven years before the current transfer).

For example, if the current CLT is £100,000 and CLTs made in the previous seven years total £100,000 then the current CLT of £100,000 does not need to be reported as it is less than £225,000 (i.e. £325,000 less £100,000) and the cumulative total is £200,000 which is less than £260,000 (80% of current nil rate band, there is no need to report the transfer to HMRCustoms via the IHT 100 and IHT 100(a) forms.

Exit and periodic charges under a discretionary trust will, broadly speaking, not need to be reported if the amount involved does not exceed 80% of the nil rate band (currently £260,000).

Chargeable lifetime transfers

Discretionary trusts have typically been used for generation jumping. For example, if a third generation of potential beneficiaries inherit the trust’s assets, IHT is saved on the estate of the previous two. The difference in taxation lies in the fact there is no interest in possession at outset and neither is one imposed by a certain age.

This brief overview does not represent all the possibilities that must be considered, but in a nutshell the trust can run for its full perpetuity period, usually 125 years, without its assets being attributable to an individual’s estate for IHT purposes. If the customer does not want to face the possibility of these tax charges, he or she could consider bare trusts.