Discretionary trust taxation and the order of gifting

With changes expected to be announced to inheritance tax and capital gains tax later this week, many of those with estates likely to be susceptible to inheritance tax on death are considering whether they should bring gifting plans forward in order to take advantage of the current regime. With this in mind, I thought it might be useful for me to provide some insight into the use of trusts as part of an estate planning solution that may also involve one or more outright gifts. This is something that crops up a lot - particularly where substantial estates and complex needs are involved, as it will not always be possible to fully meet objectives with a single solution.

In such cases, it will be important to be aware of the impact that earlier gifts can have on those made later so that that the overall planning strategy can be implemented in such a way that tax-efficiency is optimised.

Generally speaking, in cases where all gifts are likely to be made within a short timeframe, the optimum order will be:

• Exempt gifts and Loan-only trusts
• Non-exempt gifts to trusts
• Potentially exempt transfers (e.g. outright gifts)

To appreciate the rationale for this, it is first necessary to understand the inheritance tax (IHT) regime that applies to discretionary trusts.

The relevant property regime

Discretionary trusts provide control and flexibility, as well as potential protection from third party claims on the estates of beneficiaries and will therefore be the preferred option for many parents and grandparents who are looking to make provision for children and grandchildren but who are not yet ready to place substantial sums under their control.

However, this additional control and flexibility comes at a tax cost as discretionary trusts (as well as most other flexible trusts created during lifetime since 22 March 2006) are subject to a regime of inheritance tax charges – known as the relevant property regime. The key features of the regime are that:

• The gift to the trust is immediately chargeable to IHT – however, the first £325,000 is taxed at a nil rate with only the excess over and above this amount subject to IHT (at the lifetime rate of 20%) when the gift is made. In this respect, it is important to remember that gifts within a seven-year period are ‘cumulative’ so the amount of the gift taxable at the nil rate will be affected by any other chargeable gifts made in preceding 7-years;
• If death occurs within 7-years of the gift, tax is recalculated at the death rate of 40%. In cases where there is tax to pay, taper relief may be available and a credit will be given for any lifetime tax paid. Otherwise, the gift will just use up part of the deceased’s nil rate band (in same way as a potentially exempt transfer (‘PET’);
• Death of a beneficiary will not give rise to an IHT charge, however, there will be IHT ‘periodic’ charges every 10 years; as well as IHT exit charges where capital (such as withdrawals from an investment bond) are distributed from the trust.

Broadly speaking a periodic charge at ten-yearly anniversary will arise if: the value of the trust fund at the anniversary date exceeds the nil rate band available to trustees.

In this regard, it is important to appreciate that the nil rate band available to trustees is not necessarily the nil rate band in force at anniversary date. This is just the starting point. The nil rate band actually available to any given trust for the purposes of calculating a periodic or ten-yearly charge is the nil rate band in force at the anniversary date LESS the combined total of the settlor’s cumulative total of chargeable transfers made in the seven-year period ending on the date that the trust was created and any capital distributions made to or for the benefit of beneficiaries in the preceding 10-year period.

The nil rate band available to the trust - example

In March 2018 Sara created a discretionary trust (trust 1) in the sum of £175,000 for the ultimate benefit of her adult children.

In October 2024, Sara creates a second trust (trust 2) for the benefit of her grandchildren and gifts £100,000 to this trust.

The trustees invest in a bond and by April 2034, the second trust is worth £200,000. The nil rate band has not increased.

The nil rate band available to trust 2 will be £325,000 - £175,000 = £150,000

An IHT periodic charge will therefore arise at the trust’s 10th anniversary as the value of the trust fund at that date (£200,000) exceeds the nil rate band available to the trustees of £150,000.

Avoiding the charge

In an attempt to avoid the impending charge, Sara’s trustees decide to distribute £100,000 from Trust 2 in year 9.

Unfortunately, this does not improve the trust’s position. As mentioned above, in order to calculate the charge at the trust’s tenth anniversary, capital distributions made to or for the benefit of beneficiaries in the preceding 10-year period will further reduce the nil rate band available to the trustees! The value of the trust fund at the anniversary date will still be the value of the bond at that point (which we will assume will now be £100,000 as a result of the withdrawal); however, the nil rate band available to the trust will be further reduced to £325,000 - £175,000 - £100,000 = £50,000. The net result is therefore the same as the lower value of the trust fund will exceed the reduced nil rate band by the same amount as it would have done had the distribution not been made.

In this scenario, the periodic charge can only be avoided if entire trust fund is distributed before the anniversary date.

 

 

Calculating periodic and exit charges

Bob created a discretionary trust for £325,000 in February 2016. He had made no gifts in the seven-year period prior to setting up the trust.

By February 2026, the trust fund has grown in value to £450,000. This time, let’s assume that the standard nil rate band amount has also increased – to £400,000. As no previous distributions have been made, the tax due in February 2026 will therefore be £450,000 - £400,000 = £50,000 @ 6% = £3,000.

If we express the tax payable as a percentage of the trust fund at the anniversary date, we will see that this equates to a ‘settlement rate’ of 0.67% (i.e. £50,000/450,000 x 100). This rate is important for the purposes of calculating IHT exit charges on subsequent distributions of capital from the trust.

IHT exit charges are levied on capital distributions made from the trust to beneficiaries. They do not apply to distributions of income (but note that withdrawals from a bond that are distributed to a beneficiary will be capital distributions), loan repayments made to a settlor of a loan plans or to  and payments made to a settlor of a discounted gift trust in satisfaction of his retained rights as these rights are not part of the trust fund and so cannot be ‘distributions from the trust’. Where an IHT exit charge applies, the rate of tax is a proportion of the settlement rate charged at the most recent anniversary and this apportioned rate (which is apportioned on the basis of how many quarter-year periods have elapsed since the last ten-yearly anniversary) is then levied on the distribution.

As a rule of thumb, if there is no charge on entry, there will be no exit charges on distributions made in first 10 years; and if there is no charge at a ten-yearly anniversary, there will be no exit charges for next 10 years and so on.

So, returning to the example of Bob – if a distribution of £50,000 had been made in year 6, the IHT exit charge would have been nil. Whereas, if no distribution had been made until year 16, the IHT exit charge would have been £50,000 x 0.67% x 24/40 = £201.

This is of course a simplistic overview of the position. In many cases, the calculations will be more complex. Such complexities can arise if there are other related settlements or (i.e. other trusts created on the same day) or additions that need to be taken into account; or where property has not been relevant property throughout the entire ten-year period.

Combining outright gifts (PETs) with chargeable lifetime transfers (CLTs)

When combining PETs with CLTs and exempt transfers it is important to bear in mind that PETs not survived by 7 years can impact on the nil rate band available to later created discretionary trusts. This is because even through they are not chargeable when made, they can become chargeable retrospectively if not survived by seven years, thereby reducing the nil rate band amount available to the trust when the tenth anniversary is reached.

Example

Graham, aged 79, has an estate of £2.2m. Almost three years ago, in December 2021, Graham gave a property worth £150,000 to his son, Peter. He is now looking to carry out some further IHT planning with a cash sum of £250,000.

As Graham requires ‘income’ from his proposed investment – and is in reasonable health for his age – a discounted gift trust (DGT) arrangement is recommended. Graham’s discount is £100,000 so no IHT will arise when he makes the gift (a CLT of £150,000) on 1 November 2024.

Unfortunately, Graham dies three years after establishing his DGT - in November 2027. The failed PET (which was potentially exempt when made just under 6 years before Graham’s death) becomes chargeable as a result of Graham’s death.

On 1 November 2034, the DGT fund is worth £340,000 and the nil rate band amount has increased to £365,000. However, when we come to calculate the nil rate band amount available to the trustees, we now find that there is a chargeable gift in the seven-year period ending with the date that the DGT was created. Consequently, the nil rate band amount available to the trustees must be reduced £150,000 (the value of the failed PET) to £215,000. This results in a liability to inheritance tax of £7,500 (£125,000 x 6%).

If the PET had been made after the DGT was created, the nil rate band available to the trustees at the tenth anniversary wouldn’t have been affected by the failed PET and there would therefore have been no tax to pay.

The general rule is therefore to make gifts in following order:

1. Exempt gifts and Loan-only trusts
2. Non-exempt gifts to trusts (CLTs)
3. PETs (i.e. outright gifts)

This will be especially important where the client is older or in ill-health and there is a greater risk that they will not outlive the PET. Provided that this order is followed, the death of the client within seven-years of implementing the planning should not have any adverse effect on the nil rate band available to any trusts that are created as part of the overall strategy.

What about the 14-year rule?

It is true that where gifts are made in the order suggested above, that a CLT can impact on a later PET for up to 14 years after the CLT it is made. However, where an IHT planning strategy involves making PETs and CLTs within a relatively short timeframe of each other, the 14-year rule has significantly less relevance as if the client does not survive his PET by 7-years, he is unlikely to have survived his CLT either (meaning that 14-year rule or not, the CLT will have used some or all of the nil rate band that would otherwise have been available to the PET). The 14-year rule therefore has more impact where there is a larger time gap between the CLT and the later PET and so, when implementing a solution that involves both PETs and CLTs, PETs should generally be made after the CLTs to avoid any impact on the nil rate band available to the trust created by the CLT should the client fail to survive his PET by seven years.

Conclusion

Clients who are considering using a combination of outright gifts and gifts to trusts to reduce the estate might be tempted to get the outright gifts out of the way while the trust and investment recommendation is being fine-tuned. Unlike gifts to trusts, outright gifts can be made quickly and with little or no paperwork – especially where the gift is of cash – and the client’s rationale may be that the sooner they are made, the sooner they are out of the estate and the more likely it is that they will attract ‘PET treatment’ as it currently applies. However, it is important for clients – particularly if elderly or in poor health – to understand the potential implications of the order in which different categories of gift are made. In some cases, the order of gifting can mean the difference between no IHT at the trust’s tenth anniversary and a significant one.