Is it ever too late for inheritance tax planning?

In the UK insurance market a discounted gift trust (DGT) is popular due to its potential to provide an immediate IHT saving and the ability to take withdrawals for the lifetime of the settlor(s). These withdrawals are defined in the trust deed when the trust is established with set dates and amount that cannot be increased unless an escalating income has been specified in the trust deed.

For those clients who need flexibility in taking money from their assets but also want to minimise their inheritance tax (IHT) liability, the loan or ‘gift and loan’ schemes should not be overlooked.

There is no maximum age for an individual establishing a trust, although, when packaged solutions are used to mitigate IHT, some limitations can exist. For example, on a DGT the maximum ‘underwritten’ age of a Settlor is now 89 in order to receive any form of immediate discount (HM Revenue & Customs v Bower (Executors of the Estate of) & Ors [2008] EWHC 3105 (Ch) (05 November 2008)).

One of the key benefits of a DGT is the potential for an immediate reduction in the settlor’s estate. However, the potential discount offered by the life office will require the client to be underwritten. When working with a client over the age of 90, or a client in poor health no discount is often offered or if the settlor is below average health, a nominal discount is often offered. In these situations other trust solutions may prove more effective for IHT planning – for example a loan trust. However, much depends upon how long the settlor lives following the IHT planning exercise.

Let’s compare an unlimited liability loan trust and a DGT where the client receives no discount – although it must be remembered that as one is a loan and the other a gift, the two are not directly comparable but both can achieve IHT savings. The comparison focuses on the IHT position for each trust, it does not assess the income tax position and flexibility of withdrawals, the example therefore assumes a 5% withdrawal each year by partial surrender for each trust.

 

Example

For the purpose of these examples we have assumed that the client is 86 years of age, below average health, has £100,000 to invest into a discretionary version of a trust and the nil-rate band has already been used up by previous lifetime gifts. They show the difference in tax saved if the client were to die on the third, sixth or ninth anniversary of the establishment of the trust.

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	Discounted gift trust	Loan Trust
Trust property	£100, 000	£100, 000
Settlor receives	£5, 000 a year	£5, 000 a year (loan repayment)
Immediate reduction in IHT on the estate		Not applicable
IHT on establishment of the Trust	Chargeable Lifetime Transfer of £100,000	N/A. No gift into trust as loan
	(Any growth is outside the estate straight away for both so IHT saving compared to no trust)	(Any growth is outside the estate straight away for both so IHT saving compared to no trust)
On third anniversary
Value for IHT purposes still in settlor’s estate	£100,000 as this gift is a chargeable lifetime transfer (CLT) and assuming the £15,000 ‘income’ has been spent	£85,000 £100,000 less three years of loan repayments assuming they are spent
IHT due if settlor dies	£100,000 x 40% = £40,000	£85,000 x 40% = £34,000
IHT saved if settlor dies	Nil	£6,000
On sixth anniversary
Value for IHT purposes still in settlor’s estate	£100,000 as this is a CLT and assuming the £30,000 ‘income’ has been spent £70,000	£100,000 less six years of loan repayments assuming they are spent
IHT due if settlor dies	£100,000 x 40% = £40,000	£70,000 x 40% = £28,000
IHT saved if settlor die	Nil	£12,000
On ninth anniversary
Value for IHT purposes still in settlor’s estate	Nil as the CLT drops out of estate after seven years and assuming the £45,000 ‘income’ has been spent £55, 000	£100,000 less nine years of loan repayments assuming they are spent
IHT due if settlor dies	Nil	£55,000 x 40% = £22,000
IHT saved if settlor dies	£40, 000	£18, 000

The key point here is that, with the loan scheme, the amount coming back into the settlor’s estate is equivalent to the loan less the loan repayments made. With the DGT, however, the full premium goes back into the estate due to the fact it is a gift and there is no discount. So in the initial seven years a loan scheme is more IHT efficient than a DGT where no discount is offered. After the seven-year period the full amount of the premium falls outside the settlor’s estate.

If death occurs before any loan repayments have been made then there is no difference between the two solutions. In this case gifting may be more appropriate. In both cases there may also be early withdrawal charges on the bond which could negate some of the IHT benefits, especially in the first few years.

A loan scheme, unlike the DGT, allows the settlor access to the whole loan amount at any time. This could be important, for example, should the client need flexibility over access to the funds to provide more ‘income’ or capital in case they go into a care home or the fees of the existing care provider increase more than expected. However, the settlor can only benefit from the original loan amount whereas DGT is limited by the withdrawals, which could over time total more or less than the original capital.

Also, if the value of the bond falls due to the performance of the underlying investments, the IHT liability could be based upon a figure greater than the actual value of the bond. In this instance it could be argued that no IHT planning would have proved more beneficial, but is it worth taking the chance?