IHT planning: Why couples should set up individual trusts
It is said that Gordon Brown ditched his plan to call a General Election in the autumn of 2007 after the then opposition leader, David Cameron, spoke of his party’s intention to raise the inheritance tax (IHT) threshold to £1m when the Conservatives assumed power.
IHT was a hugely unpopular tax at the time with petitions being foisted on Downing Street and repeated calls for an overhaul of the system being made.
Fast forward through the financial crisis to today, with a recovering economy, escalating house prices and the IHT threshold frozen for the last five years, disgruntlement at this tax is raising its head again. In fact the Institute of Fiscal Studies has recently projected that 1 in 10 estates will be paying inheritance tax by 2018/19.
As a result, people are being urged to consider their IHT mitigation plans. One popular method is a legal arrangement called a trust, which allows a person – known as the settlor – to transfer ownership of assets to somebody else – the trustee – for the benefit of the person the trust has been set up for – the beneficiary.
If you put cash or assets into a trust, they no longer belong to you so will not be considered as part of your estate for IHT purposes when you die, meaning a smaller tax bill for your children and grandchildren.
For couples, an important consideration is whether to set up a trust individually or together.
‘Single settlor trusts’ are the more favoured option because they suit most people’s circumstances.
For example, many people who are seriously concerned about reducing their potential IHT liability and require a trust-based solution are widows, widowers or bereaved civil partners.
Trusts are also popular among people who remarry and have children from a previous marriage and want to keep their estate separate from that of their current partner with the intention that it will ultimately be inherited by their own family rather than that of their partner.
Finally, certain popular IHT mitigation plans available from life offices and other financial services providers are often only available on a single settlor basis as this can increase their overall benefits.
And there are a number of benefits.
‘Gift with reservation’ rules
To be effective for IHT mitigation, any gift must be outright and unconditional. If you continue to enjoy any benefit from it, the gift will be regarded as a ‘gift with reservation’ and its full value would still be treated as part of your estate for IHT.
An example of a ‘gift with reservation’ is that you give away your house to your children but carry on living there. (The only way this would not be considered a ‘gift with reservation’ would be for you to pay a market rent to your offspring while you continue living there.)
If a trust is established by a single settlor and this person owns the assets being gifted, the settlor’s spouse or civil partner can be included as a potential beneficiary without bringing the ‘gift with reservation’ rules into play.
If the trust had been set up jointly the spouse couldn’t be deemed to be a beneficiary without bringing the ‘gift with reservation’ rules into play, therefore the asset would be treated as part of the estate for IHT purposes.
Another benefit of a single settlor trust is that if the trustees made a loan to the survivor, rather than a capital payment, and this is repaid on his or her eventual death, this is likely to be an allowable deduction against the deceased’s estate and reduce their IHT liability.
Unless there are very good reasons to do so, payments to the spouse while the settlor is alive should not be made because it would be very difficult to prove that the settlor did not derive any benefit, directly or indirectly, from them and so remove the IHT benefits of the trust.
If each spouse/civil partner set up their own trust, with each as a potential beneficiary of the other’s trust, this could be regarded as an ‘associated operation’. This means both plans are treated as one, meaning that the ‘gift with reservation’ rules would apply.
To avoid this scenario, the trust wording will often only permit the surviving spouse/civil partner to potentially benefit after the settlor’s death or, alternatively, allow the trustees to add the survivor as a beneficiary at that time.
Eddie O’Gorman is director of IHT specialist, The WAY Group