Inheritance Tax receipts are on the rise and are expected to grow significantly in the future, particularly owing to the changes announced in the Labour Budget in October 2024. Join us as we continue to lay out the options that are available to you when it comes to planning your legacy; in this video we will focus on the particularly complex area of Trusts, what they are, and how they can be used to both mitigate IHT, and protect your family’s wealth in the future. Grab a coffee, or something stronger, and let’s get into it!

Welcome to the third in our mini-series on Inheritance Tax Planning as part of our Insightful Planning with Astute videos. Before we get into it: if you have the benefit of working with Astute and this video raises any questions, then please don’t hesitate to get in touch with your Astute financial planner. If you are new to Astute and would like to get in touch, you can contact us here: https://www.videoask.com/f6b4a6ot3

So, what is a Trust? Quite simply, a Trust is a legal entity created by the appropriate paperwork, usually by way of a Trust Deed – that’s it. Let’s compare it to a limited company, which is a legal entity in its own right that has a founder, directors and shareholders. The individual who sets up a Trust is a settlor (like the founder of a company), Trustees control the Trust once it is in place (like the directors of a company) and those who benefit are the beneficiaries (like the shareholders).

A Trust can be established during your lifetime or upon your death, and can take on the ownership of your assets for a predetermined period of time into the future. There are 3 main types of Trust: A Bare Trust, an Interest-In-Possession Trust, and a Discretionary Trust. Let’s talk about some of the main features of each. All of these Trusts have a settlor and Trustees (i.e. someone whose assets move into Trust and someone, or some people to manage the Trust once the assets are there). Their main difference lies in how the beneficiaries of the Trust are treated, those who stand to benefit.

With a Bare Trust, the beneficiary and their share of the trust fund is named outright. Only that individual can benefit from the money held inside and it cannot be changed; their name is baked into the Trust Deed itself.

Interest-In-Possession Trusts, or “IIP Trusts”, which are most commonly established on death under the terms of someone’s Will, have more than one type of beneficiary. The “life tenants” receive an income from the Trust during their lifetime, and then the “remaindermen” can utilise the capital once the life tenant have died.

Discretionary Trusts are the most flexible of all, allowing a settlor to name a “class” of beneficiaries as well as individuals; for example “my children and grandchildren”. It is then up to the discretion of the Trustees (hence the name of the Trust) to decide who benefits from part or all of the money held within, and when. They will often seek guidance from an accompanying “letter of wishes” written by the settlor outlining how they would like the money to be used; though this is not binding on the Trustees.

While there are also a variety of specialised trusts for specific situations, such as Bereaved Minor and Disabled Persons Trusts, in this video, we will mainly be talking about IIPs and Discretionary Trusts as they have the most value to your estate planning. We will cover how they can be used and how they are taxed as well as their pros and cons.

IIPs are often created by a Will. These are used when you want (or group of people) to be able to have use of an asset (note; not the capital value of the asset) but for other beneficiaries to ultimately receive the capital from the asset. For example, if you left some cash to an IIP in your Will, the “life tenant” could receive the interest from the cash, but the cash itself would only be available to the remaindermen once the life tenant had died.

One of the most common uses of an IIP is when dealing with a main residence. Let’s look at an example and, as always, we’ll pick on John & Jane for this. John and Jane are married, but they each have children from previous relationships. They own a home together which, if something happened to one of them, they want the other to be able to live in for the rest of their life. However, they are both keen to ensure that their own respective children receive their share of the property once they are both gone.

Let’s say John & Jane had simple Wills leaving everything to each other in the first instance and then to their separate children. If John dies, the home would pass entirely to Jane, and then on her subsequent death, the home would pass in its entirety to her children as per her Will, thus disinheriting John’s children of his share of the home.

Instead, John & Jane write their Wills in a way that establishes an IIPs on their deaths to receive their share of the home. Under the terms of the IIP, if John dies first then Jane can benefit from the asset in her their lifetime (i.e. live in it) but once Jane has also passed, what was John’s share of the property will pass to his children, while Jane’s share simply passes to her children – thus achieving the intended outcome. It is very important to know that a home must be owned as “tenants in common” rather than “joint tenants” for this arrangement to work, so that John and Jane have a distinct share of the property, rather than the property automatically passing to the other on death

Now, an IIP does nothing to mitigate IHT; with an IIP written into your Will, such as the one we have considered for John & Jane, the assets held within are considered to become part of the life tenant’s estate. So although the share of the property would pass to the IIP under the spousal exemption, in the case of the previous example, it would be considered part of Jane’s estate when she died. Legacy planning isn’t always about managing tax; sometimes it’s about making sure the asset ends up with the right person and putting controls in place to allow that to happen.

Discretionary Trusts are a different beast altogether; they allow for similar kinds of control to be put in place, but the tax treatment is very different. Every single beneficiary is only ever a “potential beneficiary”; no single person is entitled to anything. So whose estate does the asset belong to? The answer is: nobody’s. This is how Discretionary Trusts are used to mitigate IHT; because, after 7 years, the assets held within are not considered to be part of anyone else’s estate.

In the previous video, we introduced the concept of lifetime gifting and how gifts reduce the available nil-rate band, or consume it if assets are left to a non-spouse on death. Gifts or bequests to a Discretionary Trust work in the same way; they reduce the giftor’s available nil-rate band for 7 years. However, unlike outright gifts to individuals, there is a lifetime IHT rate of 20% payable if you make a gift into Trust that exceeds your available allowances.

So, if John gifts £425,000 into a Discretionary Trust, the £100,000 above the nil-rate band of £325,000 would be subject to immediate IHT of £20,000. Gifts into Trust occupy your allowance for 7 years whether you die or not and it is for this reason that the timing of making gifts into Trust is important. Unlike outright gifts, gifts into Discretionary Trusts can have an effect on IHT due on further gifts for up to 14 years, rather than the usual 7. Fully explaining this “14-year rule” would take another video all on its own, so I’ll just say at this stage that if you are planning to make sizeable gifts and you have engaged in Trust planning in the past, please seek professional advice so that you do not get caught out by these serious complexities.

Although money in a Discretionary Trust, once 7 years has elapsed, will then always sit outside individuals’ estates and thus, in theory, never be subject to the main rate of IHT again, this is unfortunately not quite as good as it seems. Depending on the size of the assets in the Trust, there could be IHT due every 10 years or whenever capital is distributed from the Trust. The reporting and paying of this tax falls on the Trustees, so it’s useful to have a good Planner and Accountant in your corner.

OK so that’s how Trusts are taxed – are you still with me? Now let’s go through how they can be used to mitigate IHT, which I’m sure is the part you have all been waiting for.

At the very heart of it, use of a Discretionary Trust is a mechanism for stopping your assets falling into another person’s estate and becoming subject to IHT again when they die. They also provide an element of control after you die, with your Trustees continuing to enact your wishes once you’ve gone. They are an excellent tool for what we refer to as “bloodline planning” which can help your beneficiaries benefit from your assets without those assets technically becoming theirs until they are distributed. This offers protection from uncontrollable life events such as divorce or bankruptcy. This is where they excel compared to making gifts outright to individuals.

Gifts can be made to a Trust during your lifetime, starting the 7 year clock and providing an IHT saving if you survive that period. Trusts can also be established under the terms of your Will to receive some of your assets, though care should be taken here. We mentioned earlier that a Trust is a legal entity. Firstly, even if this Will Trust is for the benefit of your spouse, and so this arrangement would render you ineligible for the Residence Nil-Rate Band.

You should note that once a Trust is established, any capital that is distributed outright to your beneficiaries will then form part of their estate.

A handy but intricate strategy to be aware of is that a Discretionary Trust can be given the power to loan money to it beneficiaries; this gives them the benefit of the capital but creates a debt against their estate back to the Trust, with the potential to prevent the capital amount from forming part of their estate.

When doing this, it is important to engage with your Financial Planner to determine whether you can afford to give up all future access to some of your capital, and that it is indeed available to gift without concern that you may need to access it in future. If you have the benefit of working with Astute this would involve a full lifestyle cashflow forecasting exercise.

Where the need for future access is a legitimate concern, but you still wish to engage in some form of gifting for IHT mitigation reasons, there are types of Discretionary Trusts that can be used which do not rob you of total access.

One is a Loan Trust, where you only ever loan capital to the Trust which you can recall any time. Because you reserve the right to recall the loan, the capital never actually leaves your estate, but any growth achieved on the capital is for the benefit of the beneficiaries and not part of your estate.

Another is a Discounted Gift Trust, which allows you to transfer capital to a Trust starting the 7-year clock ticking, but provides you with a contractual tax-efficient income stream in your lifetime. This Trust gives you some immediate IHT savings as well as some after 7 years, but the trade-off is that if you don’t spend the income it will build back up in your estate over time.

Finally, unused personal pension funds can also be left to a Trust, but you will be pleased to know I’m not burdening you with the complexities of this topic until our next video.

Trust planning is extremely complex, but used in the right way can provide you and your family with hugely significant tax savings, especially when considering IHT. Here we have covered how Trusts work from an IHT planning view, there are many other taxation and investment issues that would need to be addressed, including choosing the right savings vehicle for the Trust to hold; it all needs clear and professional advice over time.

In my view, gifting and Trust planning is woefully underused in Financial Planning, often because of the complexity and the general lack of knowledge and experience around the subject. If you think that you could benefit from this type of planning, and any other planning needs, please do not hesitate to contact us so that you can engage with our in-house Trust Specialist Service and the sizeable benefits we could offer. Just one more video to go in our mini-series of IHT planning – see you then!