Aviva Case Study – IHT planning using loan trusts and discounted gift trusts

Learning Objectives:

• To appreciate and be able to clearly articulate the fundamental structure of a loan trust and how it works
• To appreciate and be able to clearly articulate the fundamental structure of a Discounted Gift trust (DGT) and how it works
• To be able to identify for which client characteristics and aspirations  a loan trust and a DGT is best suited 

John and Helen have both reached age 70, worked hard throughout their lives and have accumulated a total wealth of £3,334,500 which is made up of their home, investments (including their ISA’s), a small holiday home and various substantial cash deposits.

In their wills they leave everything to each other and then to their 5 children and 8 grandchildren in shares specified in their wills. On second death, due to their estate being so large (well over, £2,350,000 so that no residence nil rate band will be available) they will only be entitled to the “ordinary” nil rate band, of £325,000 each which is available to most individuals. As, under their current “mirror” wills, the first to die leaves everything to the survivor, the survivor will effectively be able to double the ordinary nil rate band available on their subsequent death. They are surprised to find out that when both of them die, based on current IHT rules and values, more than 1m, almost one-third of the value of their assets will end up with HMRC.

Objectives:

John and Helen are interested in ways to reduce inheritance tax so as to increase the amount that their family will inherit. However, they are not yet ready to make outright gifts and are clear that any planning needs to leave them with an appropriate amount of control over and access to at least some of the assets used in planning. Ideally, they also need to retain a level of regular payments to supplement their pensions. They are also anxious to avoid any solutions that incorporate higher risk and potential illiquidity.

They have also made it clear that they don’t want to “mess around” with the ownership of either their main residence or their holiday home. They would also like to retain access to a reasonable amount of their cash. They know that the ISAs cannot be transferred to others.

Achieving their objectives:

Given their stated objectives and despite the IHT efficiency, Helen and John rule out any investment into business relief qualifying investments.

Through discussion with their adviser however, they are interested in learning more about how trusts (combined with appropriate financial products) could help them to achieve their objectives through the use of £500,000 of their available cash .

Types of trusts

There are many different types of trusts available to John and Helen and its very important they choose the right type or types to meet their needs now and in the future. It may be that more than one trust is required to solve their IHT problem and give them the control, access and flexibility they need.

In relation to the style of trust that would be most appropriate to underpin whatever strategy(ies) they decide to adopt their desire to have maximum flexibility over who gets what and when, leads, quite clearly, to the choice of a discretionary trust with a wide range of potential beneficiaries including their children and current and future grandchildren.

In relation to what type of discretionary trust structure to use the first question they are asked is what access to their investment do they need now and in the future?

As stated above, John and Helen require an income from at least some of their investments throughout retirement as neither of them have very large pension pots. They don’t want to tie up all of their cash though, as they want to be able to give lump sums to their children and grandchildren for things like deposits on houses and funds to help with cars or cost of university as and when those needs might arise.

So, in relation to the requirement for a predictable flow of funds throughout life that can be delivered in a way that is also IHT efficient a discounted gift trust (DGT), would be worth considering. An investment bond is combined with the trust and under the trust Helen and John would retain the right to a fixed level of payments throughout their joint lives. Because of this retained right the value of the amount treated as transferred will be discounted by the value of this retained right.

If the bond underpinning the trust has multiple lives assured it will ensure that after they die the investment can continue inside the trust as a legacy for their growing family.

They decide to invest £250,000  of their available cash into the DGT underpinned by a UK Bond. They are aware that once invested although they can receive a regular flow of payments from the DGT throughout life they cannot access the capital value of the amount transferred .They expect the bond to be in force for a long time and are happy, after their deaths, for the trusts to continue for their family as long as that remains appropriate. The trust would however give power to advance capital to the trustees. If they add their grandchildren as lives assured and chose the maximum segments available it gives the trustees the maximum flexibility possible. As their family is still growing, as mentioned above, they decide that a discretionary trust best suits their needs. It means that there is no need to name specific beneficiaries at outset. The trustees control who gets what from the trust fund after their deaths.

In relation to inheritance tax the initial transfer into a discretionary trust will be a chargeable lifetime transfer (CLT), however, as they are entitled to a discount this is deducted to arrive at the value of the CLT[TW1] [TW2] . Their adviser informs them, as an example, if John and Helen were to set up a DGT and take 4% as a regular withdrawal, using an investment of £250,000 the discount would be £107,000[TW3] . This is based on their current age which is 70  and on them both being in good health. Generally, CLTs drop out of the IHT cumulation after 7 years and will reduce the value of their estate which will be subject to IHT. Any discount granted will be immediately outside of their estate from the day they start the trust.

The regular withdrawals are generally restricted to be within the tax deferred allowance[TW4]  thus there is no tax for John and Helen to pay until a chargeable event arises. Based on them investing £250,000 and withdrawing an amount equal to 4% of the original capital this gives them £10,000 per year. Of course, once an amount equal to the original capital has been returned through withdrawals any further amounts withdrawn could well trigger an income tax liability. It must also be remembered that all of the withdrawn, tax deferred amounts, must be added back to determine the taxable gain in the final tax calculation when the bond is fully encashed.

So, with a regular income provided under the DGT they are interested in planning with the remaining £250,000 available to achieve some IHT efficiency while retaining access to the original capital  

They are advised to set up a loan trust based on a discretionary trust to give them access to their original capital invested should they need it and retain control, via the trustees, over who should eventually benefit.  The loan trust technically “caps” their estate, in that, the outstanding capital is inside their estate but all growth is outside their estate from day one. A kind of “freezer” trust in effect.

Under a loan plan Helen and John would lend £250,000 to the trustees of the loan trust, interest free and repayable on demand. They invest in a UK life assurance bond and John and Helen choose an onshore bond as credit for basic rate tax is given within the fund and they will only have to pay tax on any gain if it pushes them into higher rate.  John and Helen add codicils to their wills to ensure that if there is any outstanding loan left on death it is passed to the trustees of their loan plans[TW5] . This gives the trustees maximum flexibility when a chargeable event arises as to whom pays the tax. Where a bond is set up on multiple lives assured it will continue after the death of the settlors allowing the trustees to assign segments to any of the beneficiaries.  Where a segment or a full bond is assigned to a beneficiary the tax falls on them at their marginal rates of tax.

The loan trust gives them access as “creditors” to their original capital either as adhoc or regular  loan repayments. If, at any time in the future, they decide they no longer need access to their capital they can wholly or partly write off the loan . This is classed as a chargeable lifetime transfer (CLT).

The initial establishment of the trust is not a transfer of value as the loan is expressed to be repayable on demand so there is no CLT or potentially exempt transfer. The outstanding loan will continue to form   part of John and Helen’s estate for IHT purposes until repaid or gifted

When setting up more than one type of trust it is vital that they are set up in the correct order. In this case where a loan trust and a DGT are being set up the loan plan ought to be set up first. This is because there is no transfer of value under a loan plan resulting in this trust having no impact on the cumulative total of transfers to take into account in determining whether there is any IHT on the CLT arising when the DGT is established .

In summary

John and Helen’s  main objectives are to ensure that they pass  funds tax efficiently  to their family while retaining an acceptable level of control over and access to their capital They also want a regular flow of payments to top up their pensions .

The DGT tax efficiently moves the amount invested outside of their estate while providing  them a regular payment stream until death.

The loan plan ensures that growth on the amount committed to the plan is outside of their estates. Crucially it also allows them to retain access to the original capital whenever they need it.

Both plans give John and Helen full control over their assets with them deciding when their family should benefit.