In the third article in her series on trusts, Helen O’Hagan aims to make the trust journey simple and less complex. Previously she’s looked at gift trusts and loan trusts and now O’Hagan explores discounted gift trusts (DGTs).
These can take different forms, but in this article we will look at a ‘standard’ DGT and will cover:
W – why use a DGT
H – how to use a DGT
A – access for the settlor and beneficiaries
T – taxation of the trust
Why use a DGT?
These are suitable for clients who require a pre-determined regular payment throughout their life time and who wish to combine this with inheritance tax planning. A client who anticipates spending those regular capital payments otherwise the initial benefit of the discount can be overtaken by the repayments accumulating back within the estate. A client who is reasonably healthy and under 90 may be entitled to a discount on the transfer. The age limit of 90 is an industry wide matter arising from HM Revenue & Customs (HMRC) valuation rules. Basically for clients older than that, the discount will be negligible.
How do you set up a DGT?
A DGT normally has to be set up with new monies. Clients can choose from discretionary trusts and absolute trusts. Clients will complete the application form and the trust deed. The dating of trusts can cause confusion and different insurance companies may have different rules. Usually under a discretionary trust the trust and bond are dated the same day. Normally under an absolute DGT the trust deed is left blank and the client will be told what date to insert after the policy has been issued.
Access for settlors and the beneficiaries
What access do the settlors and the beneficiaries have to the trust fund? The settlors carve out regular payments which are payable until both have died if there are joint settlors. This is an absolute indefeasible right to the regular payment stream and the trustees have to ensure that they do not make large payments to beneficiaries that may cause the funds to run out. Normally only small ad hoc payments are available to beneficiaries depending on the rules of the trust. The settlors have absolutely no access to the trust fund whatsoever – you will normally find a settlors exclusion clause within the deed along these lines –
5. Settlor exclusion clause
(1) The Trust Fund shall be possessed and enjoyed to the entire exclusion of the Settlor and of any benefit to him by contract or otherwise and no provision of this Settlement and no discretion or power shall operate so as to allow any of the capital or income of the Trust Fund to become payable to or applicable for the benefit of the Settlor in any circumstances whatsoever.
As stated previously whilst the settlors are alive, some trusts allow small ad hoc payments to be made to beneficiaries, however, on the death of the settlors it depends on whether it is an absolute trust or a discretionary trust that has been chosen.
Under an absolute trust, the beneficiaries can demand the trust fund once they reach age 18 (16 if written under Scot’s law) and the trustees are legally obliged to inform the beneficiary that the trust fund exists. The trust fund will form part of the beneficiary’s estate for divorce, bankruptcy and for inheritance tax. If an absolute beneficiary dies the trustees have to look at the will or follow intestacy rules to see who will now benefit.
Under a discretionary trust, it’s up to the trustees to decide who will benefit and when they will benefit from the trust fund. As long as the beneficiary is in the class of beneficiaries the trustees can allocate funds to them. This is why clients should choose their trustees wisely as ultimately they will be dealing with the trust fund. It is advisable for clients to lodge a letter of wishes with the trustees to give them some guidance, after their death, as to how they want the trust fund divided up. Remember that a discretionary beneficiary cannot demand monies from the trustees nor does this form part of their estate for divorce, bankruptcy or inheritance tax while inside the trust.
Taxation of the trust
What inheritance tax is payable when using a discounted gift trust? A transfer will either be a discounted potentially exempt transfer (PET) or a discounted chargeable lifetime transfer (CLT) depending on whether an absolute trust or a discretionary trust has been chosen. Under an absolute trust the gift creates a discounted PET which after seven years from the date of the gift becomes exempt from inheritance tax. If the settlor dies within the seven years, the PET becomes chargeable and may be included in their estate or may be taxable on the person who received the gift.
Under a discretionary trust the gift creates a discounted CLT which may attract an entry charge if the value of the gift when added to any other CLTs made in the previous seven years exceeds the settlor’s current nil rate band. Again, CLTs drop out after seven years as long as no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs this can lead to a 14 year timeline. If a PET fails and become chargeable it pulls in any CLTs made within seven years of the failed PET thus potentially going back 14 years.
Discretionary trusts may also be subject to periodic charges every ten years and exit charges which are explained in our Estate Planning Guide on our website. At the ten-year anniversary, the value of the relevant property needs to be established for the purpose of calculating the charge that may arise. The value will be the open market value, but it will not include the value of the rights retained by the settlor if he/she is still alive. A second discount calculation will therefore be performed based on the settlor’s rated age next birthday when the DGT was effected, plus an addition of ten years for each ten-year anniversary. If the settlor’s life has been fully underwritten at the outset, then no further medical evidence will be required. Consider a discretionary DGT being set up today, this explains why the insurance company may quote the suggested discount, not only at inception but in ten years time.
Remember gifts i.e. PETs and CLTs eat into the nil rate band in chronological order thus when calculating any IHT liability they will be applied first against the nil rate band.
An important point to note is that you use the premium less any discount granted as the PET or CLT and not the full amount. Broadly it is not normally possible to top up a DGT.
As you can see trusts don’t have to be complex nor convoluted. Our Technical Helpline will be more than happy to answer any questions that you have. You will find more details of the taxation of discretionary trusts in Prudential’s Adviser Guide to Estate Planning
Helen O’Hagan is technical manager at Prudential