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Discretionary trusts: cautious optimism [Members]
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Thanks for this. We are having similar discussions. Instead of a discretionary trust, we are likely going for gifts to the middle generation to hold until the children are old enough to manage it (eg age 25). As the middle gen are in peak earning years, this puts income/dividends tax into the same high earner income bands as a trust. Which isn’t ideal either.
What has been suggested by an advisor is a single premium offshore insurance bond to wrap the assets until they are received by the children, upon which the proceeds are taxed as income. This means there is no income to be taxed by the middle generation (except capital gains?). And then when received by the children and the offshore bond is opened, the tax is paid at the children’s rate of income tax age 25 which may or may not be lower than the higher rates now.
This offshore bond method of deferring tax seems similar to the FIC method you mentioned, but perhaps more accessible to people without an FIC already.
Has anyone had any experience with single premium offshore insurance bonds?
I am tickled by the inherent oxymoron of the term discretionary trust
engendered because you specifically don’t trust the discretion of the recipients 😉
This is one of my areas so here we go!
– You can currently contribute more than >£325,000 to a discretionary trust with no immediate inheritance tax charge by contributing assets that qualify for business relief. I know people who have got >£10m into discretionary trust this way with no immediate tax charge. N.b. this is changing next year.
– The 10 year periodic charge can currently be avoided by switching into assets that qualify for business relief at 7.9 years – allowing you to hold for the 2 years required so that at year 10 you qualify for 100% relief from IHT. This is again changing, and trusts will have a £1m allowance for business relief going forwards.
– Please don’t assume that because you’ve waited 7 years between gifts you’ve not got an inheritance tax issue. Chargeable lifetime transfers (gifts to discretionary trusts) and potentially exempt transfers (straight gifts to people) can interact with each other on death. Please get tax advice before doing anything with trusts – at the very least read about the 14 year rule.
– A lot of the annual reporting (assuming no distributions from the trust are made) can be avoided by holding trust assets inside an offshore bond – you benefit from gross rollup on the dividends / income / gains – and tax is only paid when segments of the bond are encashed. These can be assigned out of trust to the beneficiaries and income tax can be paid at their marginal rates (which may be beneficial).
– Especially if you’ve got a big trust, it would be common to loan monies to beneficiaries interest free, rather than distributing it to them. For example, £10m trust, I loan a beneficiary £2m, they use this to buy a house. A loan is not a distribution from a trust is not taxable as they still have to pay it back eventually. This could protect the family assets in the event of say the beneficiary getting divorced (as they have a £2m house, but also a £2m debt to the trust – net position zero), but would also keep the money out of their estate for IHT purposes – so there will be more for future generations.
– For a similar reason, you may consider setting up a discretionary trust and immediately loaning the money out, rather than making a straight gift – if you were concerned about divorce etc, or if you expect your children to also have an IHT problem in the future.
There’s a lot more I could say, and happy to elaborate if anyone is interested.
@all — Cheers for the comments all, and apologies for those that spent time in moderation purgatory. This shouldn’t happen again, it was because you were new commenters. 🙂
@Markabey – there’s no capital gains within an offshore bond. Growth is eventually taxed as income.
You can’t transfer an offshore bond – make sure you’re 100% happy with whoever you set it up with. Their financial strength is important as the bond provider legally owns the assets and you just have an insurance relationship with them. The best ones are typically ‘open architecture’ which means they provide just the legal wrapper, and you’re not locked in to whoever is currently managing the investments in it and you can use someone else.
Your only option for unwiding a bond is typically cashing it in and paying the income tax on the gains (whether at your own rates or assigning to a beneficary and paying it as theirs) – just make sure you’re happy and 100% understand everything before going ahead.
If you’re not careful bonds can be a way for an adviser to lock you into their ecosystem – as you can’t get out without paying the tax.
They can also be set up on a life assured or capital redemption basis – there’s an important distinction between the two.
Life assured – the bond is linked to the life / lives of named people – if you get this wrong and just pick someone who’s relatively old the whole bond could get liquidated if they died – and you could end up with a very unexpected income tax bill.
Capital redemption – typically means the bond runs for a fixed period of 99 years / until cashed in.
If you’re intending to move abroad the country you’re going to can have an impact on which struture you go for – as certain jurisdictions only recongise certain bond set ups.
@SkinnyJames
“it would be common to loan monies to beneficiaries interest free ” – Thank you – absolute banger. This titbit alone has made the whole effort or writing the post worth it.
@Finumus – my pleasure, happy to discuss in more detail if you’d be interested.
Another common example you might find interesting:
Mr and Mrs Smith are already high net worth individuals – with an inheritance tax problem.
Mrs Smith’s mother dies leaving her £1m of cash after IHT is paid.
Mrs Smith enacts a deed of variation. This effectively re-writes her mother’s will, and she re-directs the £1m of cash into a discretionary trust that has been created by the re-written will.
Mrs Smith and her children are potential beneficiaries of the discretionary trust.
The £1m is then loaned out to Mrs Smith – who is free to spend / use it pretty much as she likes. (Incidentally as long as the loan doesn’t accrue interest there’s usually not a periodic charge for the trust).
When Mrs Smith dies, she has a £1m debt to the trust, which is netted off of her assets for inheritance tax purposes, and once the money is paid back it can be used by her children.
She’s both had the benefit of a) being able to use the inheritance from her mother, and b) keeping it outside of her own estate.
@SkinnyJames
OK – wow – that’s also an astonishing idea. This has really got the gears grinding on other ways to use this loan structure – How do I get in touch with you? Are you on Twitter? You can DM me @Finumus1
@Finumus – I’ve sent you a DM on Twitter.
If you’re thinking that you could use the loan to buy more IHT free assets (like Business Relief qualifying) – sadly that is not allowed! 🙂
Yep I was chatting with a friend about discretionary trusts and they were also emphasising the key attraction of making loans to beneficiaries as opposed to payments
@skinnyJames – second that – great outline. Down here in Oz we have no IHT, and no 10yr charge on the discretionary trust. Maybe become part of the great HNW UK exodus I keep reading about post non-dom/IHT changes..
The main one used down here to get money into kids hands when needed but away from divorce/inadvertent misuse of funds -> Loaning funds from the individual (or the trust) to the child to buy property. To belt and brace this, the advisors recommend borrowing a small sum from a bank, and having the family loan registered as a second mortgage (so it is externally visible at time of purchase)
@Andrew Brown that’s interesting! In the UK it would be a struggle to find a bank willing to loan on a property with a second charge.
As always, a great article – thanks @Finumus
In reply on some of the points from my experience managing family trusts for nearly 20 years:
I used Cater Allen Private Bank in Bradford (owned by Santander). A recent comment on the Broker Comparison thread suggests that it’s difficult to find a broker for trusts – I can’t help here as I used ShareDeal Active /Jarvis who have recently closed their business. Another was HL, but I understand they are currently not taking any new trust clients.
Cost estimates appear to be in the right ballpark. My annual tax filing fees were under £1k per trust – but that might be because of ‘mates rates’. Set up costs could be higher – I recently heard from a friend who was quoted over £5k by a local provincial solicitor up here in the grim north to draft a deed.
A small annual cost you’ve omitted is the LEI (legal entity identifier) of around £50 – the number was required by the broker.
Income tax of 45% isn’t too bad if, like in my case, the beneficiary of the trust is a minor, then they can claim back the excess tax on income paid out from the trust. But then that’s another potential annual tax return filing cost (mates rates again – but still £500).
There’s no exit charge if the trust only pays out income to beneficiaries – the exit charge only applies when paying out capital or winding up the trust. This is another accounting fee to add to the list.
When my solicitors pointed out the seven year rule and suggested I set up new trusts (I guess for fee generation purposes they didn’t mention your point about simply contributing another £325k to the existing trusts), I politely turned them down. The administration burden on me, that I’m getting old and that Junior is no longer a minor were my reasons.
To be fair, my solicitors have pointed out other non-fee generation methods of avoiding inheritance tax over the years. Unlike James Dyson and Jeremy Clarkson I didn’t buy a farm, but I have made use of the gifts out of surplus income exemption.
To avoid tax on income invest the funds in investment bonds. These benefit from an insurance wrapper such that no tax is payable. The gain on UK policies is assumed to have had basic rate tax paid. When the trust eventually pays out to the beneficiaries the gain is ‘top-sliced’ by the number of years, and higher rate tax is only payable if that slice of gain takes the beneficiary above the higher rate income tax threshold. Flexibility around when policies are cashed-in, and/or who are the beneficiaries can often result in nil tax.
@MayB One you’re describing an onshore bond, these are not usually used as an offshore bond is usually superior as it doesn’t have the basic rate tax paid along the way. In your scenario if a non taxpayer surrendered the bond they’ve effectively paid 20% tax when it could otherwise have been 0% (depending on amounts etc).
With an offshore bond there’s no tax paid along the way and it’s all paid in the end – which is usually preferable as you have more money compounding (i.e growth on the amount that would have been paid as tax in an onshore bond) and you’re not overpaying on tax if a non taxpayer surrenders it.
@ SkinnyJames – ah, interesting! Thank you. We’ve gone down the onshore route in the past. But I can see what you’re saying. Are there any disadvantages of offshore vs onshore?
Thanks Finumus for writing this and for all comments above.
Skinnyjames would you be able to also send me a dm on twitter? I’m @summarilyso
@MayB One – you’re obviously not covered by the UK regime for things like consumer protection. Offshore ones are typically based in the Isle of Man, Ireland or Luxembourg – so you’d need to be comfortable with whatever equivalent they have in place.
It can also mean that if you die with an offshore bond you need to obtain probate in say the Isle of Man as well as the UK which could be a faff – though there are probate trusts that you can use to avoid this iirc.
The charges can also be slightly higher – though it really depends who you use.
@SkinnyJames – Thank you! Your comments on this article have been very helpful. Maybe you should write the next one! 🙂
When I look to my left and right, pretty much all of us have offshore bonds. They have limitations, and the rules on them have been tightened up since I did mine. Charges are high for Monevator types. When I started mine, almost 15 years ago, it was equivalent of 60bp running on a seven fig sum. Now, I’m paying around 23bp running on an eight fig sum. Larger NAV has diluted fixed costs but mainly I dumped the initial IFA for a much cheaper private bank (JPM via their Lux entity) halving fees.
Silly question (please don’t roast me for it) but, given the cost and complexities, and the never ending tightening of rules and never ceasing need of government to raise more money somehow: isn’t moving overseas to a low tax jurisdiction and then trying to shed both UK residence and UK domicile not a better bet? With £5 mn Mary has a lot of options here.
@Delta Hedge
The problem for Mary, with moving abroad, is that, as with so many of us, our friends and family are in the UK, and some things are more important than minimizing taxes.
Very true.
Perhaps this might work for a two settlor scenario given the existing limitations (with the important caveat that the rules could be changed, even respectively, at any point, and that politicians may see Discretionary Trusts (“DTs”) and FICs as easy targets / low hanging fruit):
Alice and Bob are married with combined assets of £2.7 mn.
This is somewhat unfortunate, as this means that the whole of of their property transferable nil rate bands of £175k each will both be tapered to zero.
That leaves their estate facing, on the death of the surviving spouse, the weight of IHT on £2.05 mn (£2.7 mn less two lots of £325k transferable nil rate bands), or an £820k IHT liability.
So Alice and Bob set up an DT and each put exactly £325k in it.
They do not set up a FIC.
Based on the info in the piece, there would be no upfront 20% charge in that situation, only the currently 6% decennial one.
Of that combined £650k they put £250k into buying TG39 ILG with a 0.125% coupon (on the redemption price), and a real yield presently of 1.98%.
This trades at 78p so in 2039 the DT will receive the present purchasing power of £320k.
The coupon on £250k of TG39 amounts to £400 p.a., and so falls below the £500 p.a. income limit for filing a SATR.
The rest of the £650k (£400k) goes into BRK.A, as a non-dividend paying highly diversified conglomerate with a track record of investor return second to none.
The BRK.A shares can be sold down to pay the 6% charge every 10 years which, with 24% CGT means loosing no more than 8% per decade, or 0.8% annually, which isn’t too bad.
Simples 😉
The estate of surviving spouse now only £2.05 mn.
Only 25k of property TNRB is lost (as only £50k is over £2mn where the taper kicks in, and not £700k, as before).
Therefore, now £975k of the remaining £2.05 mn estate of the surviving spouse is free of IHT, leaving an IHT bill (@40% on the £1.075 mn subject to it) of £430k, which is £390k less than in the no DT scenario.
As country’s financial position collapses in the coming decades, it’s quite difficult to imagine that the 6% per decade charge on DTs will not be ramped up to 10% then to 15% or even to 20%.
Fleeing the UK is undoubtedly undesirable, with a heavy familial price, but it is likely to be more future proof.
NB: Mike Warburton of the Tax Tips column answering reader’s questions in the Daily Telegraph today covers the exact scenario of a £2.7 mn estate with the property transferable nil rate band being tapered to nil. Unfortunately, he doesn’t consider using Discretionary Trusts.
@Delta Hedge – the Residence Nil Rate Band is fairly trivial to reinstate in a lot of cases. A Failed PET (i.e. a direct gift that you’ve made that isn’t exempt from IHT as you’ve not survived 7 years) is chargeable for IHT purposes, but is not accounted for for Residence Nil Rate Band Purposes. So in your case with an estate of £2.7m – if you had enough liquid assets to make a £700k gift on your deathbed, problem solved.
That’s a neat workaround @SkinnyJames. Thank you.
I’d imagine that most estates with over £2 mn have between £2 mn and £2.7 mn in assets because wealth tends to follow some sort of a power law.
The problem, as always with IHT specifically (and more generally for decumulation), is not knowing precisely when one will die. There may be no opportunity for gifting. Charlie Munger used to say that he wanted to know where exactly he was going to die so that he could then avoid ever visiting that place!
@Delta Hedge – bringing us back to trusts, and linking in with the Residence Nil Rate Band, another interesting quirk is that assets that qualify for business relief (i.e. a 100% discount on IHT after a 2 year holding period), despite currently being IHT free do count in the Residence Nil Rate Band calculations. These can be settled into a discretionary trust after holding for 2 years to help avoid this, retaining the IHT discount too (as long as certain conditions are met – generally the trust needs to hold until death / for 7 years if earlier).
It’s also looking like pension assets will count in the Residence Nil Rate Band calculations from April 2027 based on the draft legislation – though tbc!
https://www.gov.uk/government/publications/reforming-inheritance-tax-unused-pension-funds-and-death-benefits
@SkinnyJames #25 – I guess you’ll need to consider potentially crystallising a capital gains tax liability when converting the liquid assets into cash for the failed PET. If this can be done from savings or an ISA then there’s no problem, but if it’s from assets pregnant with gains held in a GIA, then a CGT liability might arise which would otherwise fall away on death. In the example of £700k this won’t be a problem but the tipping point could arise if gains exceeded £1.7m.
#5 – The only bond I’ve seen based on life assured of named individuals only crystallised on the death of the final survivor, so it worked fine for grandfather and his grandchildren.
@Finumus #8 – I thought I’d heard it from your previous post on Family Investment Companies, but perhaps not. The interest free loan concept can be used here too. I understand all family members could subscribe for shares in the FIC at par, then parents can provide an interest free directors loan to the company. That way they maintain an interest in the capital but allow all future gains from the use of the loan to accrue to the company. The loan effectively caps potential IHT.
So, I’m now actively trying to get a DGT set up with investment bonds. The trouble I’m having is that it seems that the investment bond providers don’t allow you to use their products directly and insist that you go via a financial adviser. Are there any providers that sell directly to the consumer? And, if not, am I best looking for an IFA, or a solicitor specialised in trust work?