Case Study
Inter Vivos Discretionary Trusts
Thursday 6th November 2008
An Inter Vivos Discretionary Trust is a trust that is created by someone ("the settlor") during their lifetime and which allows the trustees a wide discretion in the distribution of the income and capital from the trust. Distributions can either be to specifically named beneficiaries or between a class or classes of beneficiaries identified by the settlor. The beneficiaries will not have a defined right to any trust property and the trustees will manage the trust and distribute from it at their discretion. A settlor can transfer various assets into a discretionary trust, including cash, investments, land or buildings and other assets such as paintings etc. The trust will terminate on a defined date (as set by the settler) or, more usually, at such earlier date as the trustees in their sole discretion determine. Many trusts are set up in the expectation of children/grandchildren inheriting at some future date, perhaps many decades ahead, and can be set up to include charitable beneficiaries if family have predeceased.
Inter vivos discretionary trusts are a favoured method of tax planning for many individuals, partly because of the degree of flexibility that they offer. Settlors do not have to identify individual beneficiaries (although they can if they wish) - it is sufficient to identify a class of beneficiaries who the settlor wishes to benefit from the trust. Trustees also have a wide discretion within the boundaries of the trust deed itself and discretionary trusts can therefore be adapted to suit changing circumstances. Generally speaking, the settlor and/or their spouse should not be part of the class of beneficiaries of the trust. A discretionary trust offers a flexible alternative to outright gifting and is particularly useful where there are underage or vulnerable beneficiaries, issues of incapacity, inability to manage finances or concerns that money may be spent unwisely or frittered away.
Another advantage of setting up a discretionary trust as a tax planning vehicle is the fact that the settlor can exert some control over the assets transferred by appointing themselves as one of the trustees. Alongwith their co-trustees, they would have discretion to distribute income/capital to either named beneficiaries or a class of beneficiaries as and when they saw fit. As mentioned above, a trust is also preferable to gifting as the trust assets do not form part of a beneficiary's estate unless they are transferred to them - with an outright gift, the assets become part of the beneficiary's estate immediately.
As you would expect, there are certain tax implications which have to be borne in mind when setting up a discretionary trust. Gifts into such trusts in excess of the nil rate band (currently £312,000, increasing to £325,000 in 2008/09 tax year) are subject to an immediate Inheritance Tax charge of 20%. The trust is then subject to a 6% Inheritance Tax charge every ten years, and exit charges are payable on distributions of trust capital.
However, the setting up of an inter vivos discretionary trust is still an effective method of tax planning for wealthy individuals. Such trusts allow individuals to move assets up to the value of the nil rate band into the trust without triggering the 20% entry charge or any other Inheritance Tax charges within the first ten years. The ten yearly charge itself is likely to be relatively modest in comparison to the potential tax saving.
Since the nil rate band is replenished every seven years, it is possible for wealthy individuals to create a new trust every seven years into which they can gift assets up to the value of the then current unexhausted nil rate band without incurring any Inheritance Tax charges on their estate.
Assets transferred into a trust will fall out of an individual's estate altogether provided they survive for seven years after setting up the trust. In addition, the trust assets remain outside the estate of the beneficiaries unless these are actually transferred to them from the trust. In this way, an inter vivos discretionary trust can protect family wealth with a very small Inheritance Tax liability, particularly if the trust is terminated before the ten year anniversary of the setting up of the trust.
If the settlor dies within seven years of setting up the trust, the effect will be the same as making a Potentially Exempt Transfer (PET), i.e. the value of the assets transferred into the trust will be aggregated with the rest of the settlor's estate and any other gifts/transfers made within seven years of their death and Inheritance Tax will be payable at a rate of 40%. However, if the assets gifted into a trust are in excess of the nil rate band, they will benefit from taper relief after a period of three years. This concept allows the value of the gift to be "tapered" for the purposes of Inheritance Tax so long as the settlor survives for at least 3 years. However, it should be borne in mind that any assets transferred into a trust in excess of the nil rate band are subject to an immediate Inheritance Tax charge of 20%.
There are certain administrative costs involved with the running of a trust, including the submission of a trust tax return each year and the payment of tax on any income received by the trust. Where trust income is in excess of £1,000 per annum, dividend income is taxed at 32.5% and all other income is taxed at 40%.
Discretionary trusts are also liable to Capital Gains Tax charges at a rate of 40% for all gains in excess of the annual exemption. The annual exemption is currently £4,600 and where the settlor has set up a number of trusts, this exemption is divided between them subject to a minimum of £920 per trust.
If you would like any further information on the issues raised in this briefing contact
Lesley Hurst, Partner
Direct Dial: 0141 225 2579 or Email: lah@tcyoung.co.uk
Isabel Ewing, Partner
Direct Dial: 0141 225 2563 or Email: iee@tcyoung.co.uk
Please note that this briefing is not a comprehensive statement of the law. Legal advice should be taken on individual circumstances