Feature

posted 1 Jul 1996 in Volume 1 Issue 5

Wills: Use of Discretionary Trusts - for the relevant IHT and CGT circumstances

Ralph P. Ray FTII, B.Sc(Econ) TEP solicitor, tax consultant with Shoosmiths & Harrison. (Statutory references below are to Inheritance Tax Act 1984 unless otherwise stated. Rates are those applicable as from 6 April 1996 e.g IHT nil rate band of £200,000)

Two Year Discretionary Trusts Under s144

Where an individual demonstrates a lack of decision over the ultimate destination of his estate (perhaps because the relative needs of possible beneficiaries are in the process of rapid

change), and so that it is desired to postpone a choice until the very last moment, advantage can be taken of s.144. These provisions allow distributions to be made within two years of the death without any charge to IHT out of assets settled on discretionary trusts by the will. In the appropriate circumstances, therefore, the individual should make a will settling his estate (or part of it) on discretionary trusts, specifying in the definition of beneficiaries the whole range of persons who might remotely be considered as candidates for his bounty. The trustees can then, within two years of the death, either act on any informal letter or memorandum of wishes left behind by the testator in the choice of beneficiaries and the amount to be appropriated to the chosen beneficiaries; or alternatively, make the decision themselves in the light of the circumstances. This proposal can have a cash flow disadvantage, tax being payable in respect of the creation of the trust fund (i.e. on testator's death as to his net estate) and reclaimed if appropriated to an exempt party e.g. a spouse. There should be no distributions to a widow(er) within the first three months after the spouse's death as this will lose the surviving spouse exemption s.65(4). (There is no charge to IHT in respect of transfers during this period - see Frankland v IRC 1996 STC 735 ). Moreover, even after that period, a distribution to the spouse, followed shortly thereafter by PETs from such spouse, may be attacked by the Revenue (e.g. as a s268 associated operation). For CGT reasons, during the two year period the unrestricted CGT holdover relief under TCGA s260 will not be available because in terms of s144 during that period there is no "chargeable" transfer as required by sub-clause 2(a) of S268. However, gains during this period from the date of death values may well be small.

Using The NIL Band with Discretionary Trusts

Discretionary trusts can also be used to enable a surviving spouse to enjoy the benefit of a fund without the penalty of wasting the nil band referred to above. Under this method a discretionary trust of the nil band could be used, the distributions from which to the surviving spouse would only be used in cases of need.

For example, assume that husband and wife each have an estate of £500,000; and that the husband dies first wishing his widow to be the primary beneficiary. Under one alternative the husband could give his widow his £500,000 estate (absolutely or by way of life interest) ensuring that no IHT was payable on his death. On her death, however, having regard to the bunching effect, other things being equal, IHT would be payable on an estate of £1,000,000 (currently £320,000 of IHT). A more sophisticated alternative would be for the husband to give his widow only £300,000 and settle the remaining £200,000 (currently constituting the nil band) on discretionary trusts, with informal directions to the trustees to treat the widow as the principal beneficiary. So, if she was in need, she could have a capital distribution or, perhaps, more appropriately, a loan, which should be a deduction from her estate on her death (but watch FA 1986 s103 especially if there have been lifetime gifts to her from husband); or she could receive income distributions. In that case the IHT at current rates would be reduced to £240,000 (i.e. on the widow's estate of £800,000) and with the discretionary trust fund constituting a nil band. There would be an IHT saving under this alternative of £80,000 (£320,000 - 240,000).

This is regarded as one of the most effective - yet simple - IHT savings that can be introduced in a will. Moreover, as the use of variations may become restricted that saving of £80,000 by use of the mini-discretionary trust would no longer be a mere alternative to doing a variation!! Note that the use of s.144 discretionary trusts may also become short lived.

An additional advantage is that, especially after the death of the surviving spouse, further tax benefits can be obtained by skipping a generation, e.g. in favour of grandchildren, by way of income and/or capital distributions.

Ensure that in lifetime (not merely under the Will), husband and wife each have sufficient assets to take advantage of their respective nil bands (one never knows who will die first!). This may for example require lifetime severance of a joint tenancy, emphasising the advantage of a joint holding being as tenants in common - not as joint tenants.

Imposing an upper limit

Question:

Should an upper limit be placed on such discretionary trusts, because the government may increase the nil band substantially; and/or because business/agricultural assets at 100%/50% relief applies?

Answer

Probably not if the surviving spouse is a discretionary beneficiary - because she/he can benefit by income or capital

distributions within two years of death s144 applying. If the trust fund is a nil band then (not taking into account BPR/APR relief at 100%/50% rate because not available for calculating the effective rate until first 10 year anniversary s68(5)), there is no IHT liability for any distributions before the first 10 year anniversary (but obtain specific instructions when making the Will)!

Ensure that there will be some assets in the residuary estate to avoid abatement of the nil rate band.

There are, however, six possible danger areas to be borne in mind:-

1. Related settlements (s62 - trusts having same commencement dates and same settlor). The value of the other property settled by the will (i.e. the related settlement(s)) could form part of the cumulative total of transfers to which the 10 yearly charges on the discretionary testamentary trust will apply. Likely solution use of "pilot" lifetime trust.

2. If the discretionary trust continues for more than 10 years, the IHT 10 year anniversary and interim charges may accrue ss64-69.

3. CGT distributions out of the trust would not be from executors to legatee with the relief afforded under TCGA s62(4) but instead a distribution as trustees.

4. IHT distributions to widow(er) within 3 months s65(4).

5. No CGT holdover relief in the 2 year period from death.

6. Where assets are left to a beneficiary absolutely or by way of a life interest, CGT exemption and market value uplift apply (subject to the restriction in TCGA s74 in respect of a life interest where holdover relief has been claimed on creating the trust).

If the home is the main asset in the estate of the first spouse to die - say the husband, he could gift the nil band in his will as a monetary legacy to chargeable parties by use of a mini discretionary trust so as not to waste the nil band: (£200,000 x 40% = £80,000). The residue (i.e. in particular the home) is left to the widow. The nil band gift would be satisfied by a charge on the property in favour of the trustees of the mini discretionary trust (who are likely also to be the executor/trustees of the will). That charge could be on favourable terms for the widow, e.g. free of interest and deferred as to payment of the capital, albeit preferably, payable on demand by the trustees. The charge should then be a deduction from the widow's estate on her death subject to a possible disallowance if husband has made lifetime gifts to spouse: FA 1986 s103. She would have had use and occupation meanwhile. It is important that the trustees should be specifically authorised in the will to allow the charge to be free of interest and to defer calling in the capital (i.e. permitting the payment of the legacy of the discretionary trust to be deferred), and notwithstanding that one of the trustees is the beneficiary of the home.

Business and Agricultural Property Relief Using Discretionary Trusts

A double relief! (See Taxation 25.03.93)

- Spouse 1 ("H") in his Will leaves business/agricultural property (plus the nil rate band sum) to a discretionary trust in favour of the family including Spouse 2 ("W"). On H's death, BPR/APR relief obtained 1ST TIME. Ditto CGT death exemption and market value uplift.

- H leaves W his investment assets or she owns such assets in her own right.

- W purchases at arm's length (e.g. under a market value option granted to her in H's Will), the business/agricultural assets from the trustees.

- On W's death after 2 years from the purchase, her estate should also be eligible for the relief, i.e. 2ND TIME! Ditto CGT death exemption and market value uplift.

- Life assurance: consider the following:

- Term cover for surviving spouse for at least two years, or more effectively.....

- Life assurance on non-business owning spouse to cover the risk of her dying before husband or two (or three ) years thereafter, such life assurance should be written under appropriate trust arrangements.

Ancillary aspects:

- adapt for the farmhouse

- W could delegate management responsibilities if wished.

- She need suffer no loss of income because she is a beneficiary of the discretionary trust.

- consider application of these arrangements by way of deed of variation, but more provocative and Ramsay implications.

Example:-

Mr Planner owns the following assets:-

1. Stock Exchange securities, Building Society and bank deposits £1,200,000

2. A 30% holding in Adam Planner Ltd which manufactures widgets the shares are valued at £400,000.

3. Planner Farm which Mr Planner has owned and farmed for many years valued at £600,000.

In his Will Mr Planner leaves assets numbered 2 and 3 to a discretionary trust in favour of his widow, children and grandchildren. He also leaves £200,000 of assets in number 1 into the trust. The remaining (investment) assets he leaves to his widow coupled with an option for her to buy the business and agricultural assets from the trust at market value.

The effect:-

(a) On Mr Planner's death:

No IHT

CGT exemption and market value uplift

(b) On Mrs Planner's death:

No IHT (assuming she survives two years from the exercise of the option and assuming that there are no surplus investment assets over the nil band)

No CGT and market value uplift

o for lifetime discretionary trusts, there is no CGT holdover relief restriction in connection with non-business assets - see Taxation and Chargeable Gains Act 1992 s260.

o the CGT holdover into a discretionary trust of non-trading assets depends under TCGA s260, on the existence of a chargeable transfer. This was considered a possible grey area, namely it could be argued that if 100% BPR applies it could not constitute a chargeable

transfer particularly as the donor's estate had not been reduced having regard to the 100% relief. The CTO have however confirmed that in their view a gift qualifying for 100% BPR and APR is a chargeable transfer for the purposes of s260.