September 2008

Taking care with different trusts

Many people think that the attack on trusts carried out by Finance Acts 2004 and 2006 has meant the end of the trust. Not so. A structure invented as long ago as the 1400s is hardly likely to bow down and die in the face of two ill thought out and badly drafted statutes.

We have to remember that both the original and also the current use of trusts has been as much for estate planning and the management of financial affairs as it was, or is, for the legitimate avoidance of tax. Never forget that the primary purpose of the trust is to manage assets especially for those people who are either too young or not competent to manage those assets for themselves. This has been the case ever since the inception of the trust and while the tax benefits can in some, but not all, cases be an add on extra, the tax bogey man may not be thought of as the primary opponent. Look positively at what the trust can do for individuals not at what it may be able to save in tax.

As with so many things in life we cannot understand the present unless we have knowledge of the past Before 22 March 2006 there were basically three types of trust and each trust had its own separate tax regime. That was all very straight forward and we lived with it for 30 years without too much difficulty. What has happened now is that there are still three kinds of trusts but, for new trusts, only one kind of trust tax regime.

However, for trusts established before 22 March 2006 there are transitional rules. Life interest trusts or interest in possession trusts are where income is paid as of right to A and, on the death of A, the capital passes to B. This is a trust in its simplest form and they remain subject to the same IHT regime as previously. Indeed, this regime has been extended in the sense that if the life tenant is replaced with another life tenant before 6 October 2006 the new life tenant inherits the old tax status of the previous life tenant.

The discretionary trust is the one type of trust which has not changed its tax regime. Indeed, the tax regime for all trusts, of whatever kind, but established after 22 March 2006 is now the discretionary trust regime, more properly called the relevant property regime.

It works as follows. If you put any kind of asset into a discretionary trust then provided its IHT value is under £312,000 there will be no IHT payable when the trust is established. Of course if the asset that you put into the trust has the benefit of IHT business property relief or agricultural property relief you can give to the trustees assets of an unlimited value because the IHT value is nil because of the reliefs given by BPR and APR. (There are some cases where only 50% relief is available so you do need to check). Husband and wife can each make such a discretionary trust and after seven years they will have taken £624,000 out of their IHT estates, saving £249,600 IHT. Do that over 21 years and they will have saved £750,000 in tax, probably more, because over the years the nil rate band will increase and so the IHT saving will increase.

There is another tax point that you must bear in mind. With a post 22 March 2006 settlement and a discretionary settlement whenever made there will be an inheritance tax charge at every tenth anniversary after its establishment. The tax will be no more than 6% of the value of the fund after deducting the nil rate band in force at the date of that ten yearly anniversary. Now the contrast; if you retain the asset until you die there is no ten yearly charge to IHT but a 40% tax charge to inheritance tax at death. So, on one analysis, you would have to experience seven ten yearly charges, i.e. 70 years of the trust, before the trust taxation came to a total of 42% as against the one off hit at 40% on death. If you can keep the trust IHT charge down to a very small amount or even nil, then this is a very good way of reducing the IHT bill for the family.

If there is an appointment of capital out of a trust then there will be an IHT charge at a maximum of 6% but dependent on a lot of complex factors. However, it is not possible to take chargeable assets out of a discretionary trust without paying this exit charge.

So it now does not matter for trusts created after 22 March 2006 whether the trust is a life interest trust or a discretionary trust. Both are subject to the relevant property IHT regime. The choice is between the complete flexibility over income and capital that trustees of a discretionary trust have against the security that the life tenant has in receipt of income in a life tenant type trust.

Of course life is never quite as simple as that because in the discretionary trust the income tax burden on trustees and beneficiaries where the trust is invested in shares paying a dividend is less attractive because it is more expensive than in the standard life interest trust. Many life interest trusts have an overriding power of appointment so one day the life tenant can wake up and discover in the post a letter from his trustees saying that they have exercised that overriding power and he is no longer the life tenant.

A matter of will

Now a word of distinction between trusts created in lifetime and trusts created by will.

All new lifetime trusts are all treated for IHT purposes as discretionary trusts unless the capital vests in the beneficiary at age 18. From this point the trust will end and you will find an 18 year old with a large amount of capital which belongs to him or her at precisely the age when they cannot manage it, and more likely to do themselves harm than good. So much for the social policy lying behind Finance Act 2006.

On death the standard form of life interest trust created on death remains precisely as it was before 22 March 2006. However, it now has a new acronym, IPDI, Immediate Post Death Interest. Why? Ask someone else! If you have an IPDI then there is no ten yearly charge, no exit charge, and the capital value of the trust is added to the pre-estate of the life tenant on his or her death.

You can have a half way house, what might be called a Club 18-25 trust. This is where if the capital vests in the beneficiary at an age no later than 25 then there is a liability to IHT when the trust ends, a compulsory exit charge. The maximum rate of this charge is 4.2% assuming that the beneficiary is made a beneficiary before he or she has attained the age of 18 years. Effectively the rate of IHT for the 18-25 trust is 0.06% per annum.

But, Club 18-25 trusts can only be made by parents and only by a will and not in their lifetime. Why? I have no idea whatsoever. Ask your MP, not that any MP I have asked has a clue.

There are other special kinds of trusts particularly for the disabled who are incapable of managing their own affairs. However, these trusts are so complex in their rules and capital gains tax and inheritance tax issues seem to pull in opposite directions so that many of us prefer the standard discretionary trust to deal with beneficiaries with these kinds of disabilities. In my experience they work just as well as the convoluted type of trust deed you have to prepare for a disabled persons trust.

The nil rate band trust contained in a will is a standard form of discretionary settlement which by definition only operates on the death of the testator. It has its own advantages and problems all of which will be considered in the later article. The simplicity of them has not been helped by the alleged reform announced by the Government on 9 October 2007 whereby in some circumstances two nil rate bands are available on the death of the surviving spouse or civil partner (but not cohabitees please remember).

Additionally, you must also remember that with regard to all trusts, and indeed to all giving whether into trust or otherwise, there are certain basic rules that must be followed. The most fundamental of these is that the donor has to cut himself or herself off from any benefit from the asset given. So to take an example which is still questioned by people; there is no point in giving your house away to your children if you are going to live in it. Forget the seven year rule. You are still retaining a benefit out of the house by your free occupation of it and the gift period does not even start to run. It would be different if you gave away the house to your child or into a trust and paid a market rent for the rest of your life but that market rent is paid out of your after taxed income and is received as taxable income. However, the critical point to note is the absence of any retained benefit. That is why the rule is known as 'gift with a reservation of a benefit'. To be effective, a gift must be a gift must be a gift. Indirect benefits destroy the potential for inheritance tax saving.

Far from being an ugly dead duck, the trust is a beautiful live swan. Its advantages are the giving away of capital for tax purposes but retaining control and the direction of investment policy in the hands of the trustees. These advantages are as valid now as they have been at any time within the last 600 years. Tax is always with us and is always a problem; but problems are there to be overcome and for many people trusts are vehicles which ought to be carefully considered among their various financial planning options.

Geoffrey Shindler
Partner
Lane-Smith and Shindler