In the first of a new series that looks to take some of the mystery out of the world of trusts , Helen O’Hagan considers the ‘W-H-A-T’ of gift trusts.
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We are going to take you through a simple and succinct journey of standard insurance company trusts over the next few months. We will start with gift trusts and will cover:
W – why use a gift trust?
H – how to set up a gift trust
A – access for the settlor and beneficiaries
T – taxation of the trust.
Why use a gift trust?
Most advisers will be familiar with gift trusts. There are two types commonly available:
• Absolute gift trusts are normally used for minor children due to the fact that on reaching age 18 (16 if written under Scot’s law) the beneficiary is entitled to the trust fund.
• Discretionary gift trusts offer the most flexibility for the trustees. They are used by clients who want to do inheritance tax (IHT) planning and retain control over their gift.
Clients may not be quite ready to pass the asset outright to their beneficiaries. They may have “wayward” adult children who have gambling issues, alcohol issues or they have concerns over their sons/daughters choice of partners. They may be concerned that their son or daughter may get divorced and they do not want their hard earned cash being counted as an asset.
There are plenty of reasons why individuals do not want to pass on their wealth directly to their beneficiaries.
How to set up a gift trust
Gift trusts can normally be used with new bonds and existing bonds. Clients can choose from discretionary gift trusts or absolute gift trusts, and clients are able to top up a bond that is held in a gift trust. The ownership of the bond passes to the trustees of the trust.
The dating of gift trusts can cause confusion and different insurance companies may have different rules. But if it is a new bond being placed into a new trust, the settlor (the person who is creating the trust) may be able to date both the bond application and the trust deed the same day.
If it is an existing bond that the settlor is placing into trust, the trust deed will be dated on the date that the last person signs the trust deed.
Access for the settlor and beneficiaries
What access do the settlors and the beneficiaries have to the trust fund? The settlors have absolutely no access to the trust fund whatsoever – you will normally find a settlor’s exclusion clause within the deed along these lines:
5. Settlor exclusion clause
(1) The Trust Fund shall be possessed and enjoyed to the entire exclusion of the Settlor and of any benefit to him by contract or otherwise and no provision of this Settlement and no discretion or power shall operate so as to allow any of the capital or income of the Trust Fund to become payable to or applicable for the benefit of the Settlor in any circumstances whatsoever.
In respect of the beneficiaries, this depends on whether it is an absolute trust or a discretionary trust that has been chosen.
Under an absolute trust, the beneficiaries can demand the trust fund once they reach age 18 (16 if written under Scot’s law) and the trustees are legally obliged to inform the beneficiary that the trust fund exists.
The trust fund will form part of the beneficiary’s estate for divorce, bankruptcy and for IHT. If an absolute beneficiary dies, the trustee have to look at the will or follow intestacy rules to see who will now benefit.
Under a discretionary trust, it is up to the trustees to decide who will benefit and when they will benefit from the trust fund.
As long as the beneficiary is in the class of beneficiaries, the trustees can allocate funds to them. This is why clients should choose their trustees wisely as ultimately they will be dealing with the trust fund.
It is advisable for clients to lodge a letter of wishes with the trustees to give them some guidance, after their death, as to how they want the trust fund divided up.
Remember, that a discretionary beneficiary cannot demand monies from the trustees nor does this form part of their estate for divorce, bankruptcy or IHT while inside the trust.
Taxation of the trust
What IHT is payable when using a gift trust? A transfer into a gift trust will either be a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT) depending on whether an absolute trust or a discretionary trust has been chosen.
Under an absolute trust, the gift creates a PET, which after seven years from the date of the gift becomes exempt from IHT. If the settlor dies within the seven years, the PET becomes chargeable and may be included in their estate or may be taxable on the person who received the gift.
Under a discretionary trust, the gift creates a CLT which may attract an entry charge if the value of the gift when added to any other CLT is made in the previous seven years exceeds the settlor’s current nil-rate band.
Again, CLTs drop out after seven years as long as no PETs are created after the CLT. If a settlor creates a mixture of PETs and CLTs, this can lead to a 14-year timeline.
If a PET fails and become chargeable, it pulls in any CLTs made within seven years of the failed PET, thus potentially going back 14 years.
Discretionary trusts may also be subject to periodic charges every 10 years and exit charges.
Bear in mind gifts (i.e. PETs and CLTs) eat into the nil-rate band in chronological order, thus when calculating any IHT liability they will be applied first against the nil-rate band.
Do not forget settlors can top up both absolute or discretionary trusts. It just creates a new transfer (i.e. PET or CLT) with the seven-year clock starting from the top-up date for this new premium.
As you can see, trusts neither have to be complex nor convoluted.
Helen O’Hagan is technical manager at Prudential
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