Tax planning in the UK changed radically in 2006. Although trusts had been used since the Crusades, to protect assets and beneficiaries, Finance Act 2006 contained an unprecedented ‘attack’ on trust planning. Without warning, trusts of all types became subject to the special inheritance tax (‘IHT’) charges that previously applied only to discretionary trusts.
Since 5/4/06, there is a chargeable transfer for IHT whenever a UK domiciled person sets up a trust (or a non-domiciled person puts UK situated assets into a trust). Now, in order to create a lifetime trust, the following tax charges will apply:
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- An immediate 20% IHT bill for the settlor* on any value settled that exceeds the nil rate band (currently £325,000) unless the assets are otherwise exempt from IHT;
- A further 20% IHT bill if the settlor dies within 7 years of the transfer to the trust;
- A charge to IHT on the trustees on every 10th anniversary of the trust’s creation, if the trust assets exceed the nil rate band (the periodic charge);
- A potential charge to IHT on the trustees every time they appoint capital out of the trust (the exit charge).
* any person creating the trust or adding funds/assets to it
The old favourites ‘Accumulation & Maintenance Trusts’, which were ideal for holding funds for children or grandchildren, were effectively abolished. Although existing life interest trusts were given limited ‘grandfathering’, any new life interest trusts are subject to IHT as if they were discretionary trusts with the exception of certain Will Trusts and trusts for disabled people.
Sadly, the attack on UK trusts continues. The new 50% rate of income tax will apply to every UK based trust where the trust pays the special trust rates, from 6 April 2010, even if its level of income is well below the threshold at which individuals pay this new ‘super-tax’. Offshore trustees will also pay income tax at the new 50% rate if they have UK source income (e.g. rental income from a UK property).
So what alternatives are there for donors who want to make gifts to the next generation? Clearly there are outright gifts, but this results in the donor losing control. Likewise, a ‘bare trust’ only allows a nominee to hold the gift until the recipient reaches the age of majority. Many donors feel uncomfortable at the thought of their child/grandchild having complete and unrestricted access to the funds or assets at age 18.
Even if they trust their child/grandchild with the money, donors are often worried about their offspring’s future spouses and divorce. If funds or assets have been given to the child outright, the full value will be available for distribution by a divorce court.
This is where family partnerships have been gaining popularity. Partnerships are not new. Family partnerships have been used for US estate planning for a very long time.
The main Partnership Act in the UK dates from 1890. Limited Partnerships were introduced in 1907 and Limited Liability Partnerships came in 2000. The choice between the different partnership structures may depend partly on the age of the proposed family partners and partly on the need for limitation of liability. If the business of the partnership will be limited to making investments, a general 1890 partnership may be the best solution. If the partnership will be trading, the protection provided by a Limited Partnership or Limited Liability Partnership may be attractive.
Structured correctly, a family partnership can mimic the protection provided by a trust, without falling foul of the new IHT rules introduced in Finance Act 2006. In addition, a partnership is transparent for tax purposes, so each partner is liable to tax, at his/her normal rate, on their share of partnership income and gains.
A partnership deed can include detailed provisions governing when partners can have access to their funds, which partners will run the partnership and how long the partnership will operate for. Senior partners can have powers of control similar to those of trustees, whereas junior partners can be treated as the beneficiaries. Unlike trusts, a partnership can continue indefinitely, or a shorter fixed period can be agreed, for example until the junior partners are adults.
There are problems, however, with minor children. First, parents can be taxed on the income of their minor children but that is the same with trusts. More importantly, a child under 18 cannot enter into a contract and that would include a partnership agreement. A nominee can be appointed to hold the child’s partnership interest, but when the child reaches 18 s/he would be able to disclaim.
There are two schools of thought as to what would happen when a child disclaims. Some suggest that the child would simply be faced with a ‘take it or leave it’ decision. Disclaiming would mean the child ceased to be a partner. This could have adverse tax consequences for the person who set up the partnership (as it would constitute a reservation of benefit). However, case law suggests that a disclaimer could be even worse. The child might be able to keep their capital account, but disclaim any debts. That certainly would be a rather expensive 18th birthday present!
Of course, many firms of solicitors and accountants have been trying to find a way round this problem and some (e.g. Penningtons Solicitors LLP) have designed partnership structures that deal specifically with minor children. The aim is to ensure children are tied into the partnership in a way that prevents them from disclaiming or having control at age 18. Where all the partners are adults, these issues obviously do not arise.
A family partnership (of any type) can be a ‘collective investment’ for regulatory purposes, if some of the partners are not actively involved in the running of the partnership. A collective investment must be operated by a person or company authorized by the Financial Service Authority.
This is usually solved quite easily by the family’s fund manager taking on that role, in almost exactly the same manner as the fund manager would run the investments of a family trust. The main difference is that the partners cannot simply give a discretionary mandate to the fund manager and expect a report (and a nice lunch!) once a year. Instead the partners who are running the partnership need to be more actively involved in the decision making process, to demonstrate that they are running the partnership as a business.
With the apparent constant attack in the UK on trusts, we will almost certainly see an increase in UK family partnerships in the years to come. The beauty of a partnership is that it is flexible, so the partners can agree to vary the terms as time goes by. This could be particularly useful with young adult children, as it allows the older partners to pass control down a generation in stages. Farming partnerships have been doing this for years.
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