Discounted Gift Trusts (Part II): The Potential Disadvantages of a DGT into a Discretionary Trust
[In the last article we discussed how these work and their advantages].
The gifted Relevant Property (the settled trust fund minus the “carved out” discount) is now a CLT, not a PET as previously. If this Relevant Property value exceeds any exemptions and the settlor’s remaining NRB, there will be an immediate IHT charge on the excess at 20%, or 25% if the settlor pays the IHT.
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10-year anniversary charges will also apply if the Relevant Property exceeds the effective NRB of the trust at the anniversary. This will be at up to 6% of the excess. Please note that the Relevant Property is the value of the overall trust fund minus the settlor’s discounted interest at that anniversary.
The Importance of Underwriting
As our 60 year old client gets older, and even if their health remains good, the discounted value of that settlor’s “carve out” reduces. Where a 5% withdrawal starts at age 60 with a 70.8% discount, which drops to 56.7% and 41.0% at ages 70 and 80 respectively. By age 90 providers cannot certify a CTO agreed discount, and by the time of any anniversary at this date, the whole trust fund would, therefore, be relevant property. Likewise, if the client was terminally ill at a 10-year anniversary then the discount would also be near to 0%.
Pre FA 2006, it was always highly advisable to obtain underwriting at the outset. This was to minimise the likelihood of the discount being challenged by HMRC if death occurred within seven years of the gift. This remains the case now, though it is all the more important because it also certifies the CLT value for reporting purposes. After some insurance company representations, HMRC has confirmed that there is no requirement to re-underwrite at each 10-year anniversary. In practice it is acceptable to add 10 years to the settlor’s age at each 10-year anniversary, provided the trustees are not aware of any significant deterioration in the health of the settlor. However, the HMRC may later wish to obtain evidence of the health of the settlor from the time of an anniversary if death were to occur shortly after a 10-year anniversary.
In the usual way, exit charges may also be payable when distributions of capital are made and there has been a previous initial charge or 10-yearly charge. Importantly, the HMRC have confirmed that payments of the settlor’s fixed annual withdrawal of capital will not be subject to exit charges, or any reporting requirements.
Relatively Small Anniversary and Exit Charges
Once past seven years the gift is outside of the donor’s estate. The overall benefits of the planning will have been achieved immediately with the discount and then after seven years for the remainder of the trust fund. It is the relatively small discretionary trust tax charges which may apply which then become the concern.
The tax cost, relative to the overall benefit, is small even where the timings have been unfortunate and where poor health and then death have not enabled distribution before a 10-year anniversary.
Extra Considerations for Advisers post FA 2006
In the writer’s opinion, these Discounted Trusts will continue to be widely used and effective post FA 2006. Indeed the use of a discretionary trust, rather than an interest in possession trust, will be an enhancement for many clients. However, and as with term assurance written in trust, the number of trust and tax considerations are now greater than before.
Firstly, advisers will need to consider the suitability of the CLT amount, after the deduction of the “discount”; and that this is kept within the available NRB. The likelihood of this creeping over the future NRB also needs to be considered. Of benefit, the withdrawals (as a return of the settlor’s “carve out”) are not factored into this and so this will keep the Relevant Property Value down. However, if the discount is reduced suddenly before a 10-year anniversary, because of ill health or death, then the Relevant Property value will rise suddenly, and this may cause a periodic charge. Even though any charge will be relatively small, the adviser must consider from where the tax will be found, and if the bond can be surrendered during the settlor’s life for the trustees to meet such a charge.
These tax uncertainties, although relatively minor, along with the initial reporting requirements do add to the complexity of these products.
Underwriting should always be completed for discounted gifts, either into a discretionary or base trust. Alas, many advisers are tempted not to do this. This is because a poor initial health assessment may stand in the way of a product sale. Underwriting is worthwhile simply as it tells the adviser whether a gift of any size is worthwhile at that stage of a client’s age and health. It now also has a formal significance, as it confirms the size of the initial CLT for the tax and reporting requirements.
Absolute Trusts –The Lazy Option
At first glance this may appear the favoured route for an adviser to recommend, rather than a discretionary trust. This is because the tax and reporting position will be much more straightforward. However, what of the inflexibility and inheritance and income tax consequences for the beneficiary of such an arrangement? Will these be compared with the flexibility and often minor tax charges of a discretionary trust, and will the respective suitability of each option be fully discussed with the client?
Post both FA 2006 and Pre-owned Assets Tax, new and old discounted gift trusts remain an extremely effective planning option. Discounted gift trusts will continue to enable thousands of marginally wealthy settlors to protect their assets from IHT, while also providing a regular capital withdrawal, overcoming gift with reservation, and securing an immediate discount.
These plans remain most suitable for those clients who wish to supplement their income, who are in reasonable health, and who have reached retirement.
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