First Death Discretionary Trusts

I have had to explain this concept in writing more often, and over more years, than I care to remember! But I recently nailed it for a couple of lovely clients in a new way, that I hope makes it easier to follow (bearing in mind that it's not easy material!). Their business, life cover, pensions and death-in-service benefits were worth £2.38m:

For the purposes of the discussion below, I divide your estate into two types of assets, namely:

1. Assets which would be non-taxable in the estate of the first of you to die. This includes the first £325,000 of any estate (known as the “nil-band”), assets which qualify for business property relief or agricultural property relief, assets in pension schemes, or life policies written ‘in trust’. (This is wider than the strict legal definition of your ‘estate’.)

2. Assets which would be taxable in the estate of the first of you to die: i.e. everything else (especially, the house).

First Death Discretionary Trusts

The point of first-death discretionary trusts is to capture all non-taxable assets on the first death, and to cocoon those assets so that they never “belong” to the survivor of you and accordingly are not taxed on that second death, either.

Taxable assets, on the other hand, are left to the survivor of you, claiming the “spouse exemption” and therefore at least avoid being taxed on the first death (although any such assets unspent by the time of the second death will be taxed in the normal way).

In an estate where non-taxable assets are potentially a large proportion, first-death discretionary trusts can ultimately save a huge amount: 40% of the value of the non-taxable assets amounts to (40%x2,380,000=) £952,000.

The non-tax advantage of a discretionary trust is that although the assets do not “belong” to the survivor of you, those assets ARE available for the survivor to draw on, if needed.

Your Wills

The best way to establish a first death discretionary trust is in your will itself. This is the only way to capture the business: but other types of first death discretionary trusts are suggested below in relation to other assets.

Life Cover

It is generally unwise for people with estates over the tax threshold to hold life cover unless it is ‘in trust’. This is because assets payable directly to you are taxed as part of your tax estate, whereas assets held in trust are not. So you should get your financial adviser to get all the policies ‘written in trust’.  

In addition to this “first death” saving: there is also tax to be saved by either ‘appointing’ from these trusts so that the proceeds pass to the discretionary trust in your will; or (which may be neater, if your financial adviser can arrange it) getting them written onto discretionary trusts in the first place.

I am always happy to work with financial advisers on this.

Pensions

There is an automatic first-death inheritance tax saving attached to lump-sum pension payments on death and most death-in-service benefits. However to save second death tax one of the following should be done:

a. your pensions ‘nominated’ to the discretionary trust in your wills; or

b. your pensions settled on so-called “spousal bypass trusts” (which is just a term used in the IFA industry for a first death discretionary trust of pension benefits).

Again, your financial adviser can organise, and I’m happy to assist/facilitate.

Rysaffe Planning

Although first death discretionary trusts are designed to avoid the 40% “inheritance tax whammy”, they do suffer inheritance tax of their own, at rates of up to 6% on their value in excess of the nil-band, every ten years (or part thereof). There is a way of avoiding this tax, also, which is – instead of having one big discretionary trust in your will, or just a small number of them – to create a string of discretionary trusts on different days. These are funded with just £10 each, but at your later death each takes funding of about £300,000 – either from your will or from a life policy or pension scheme. The advantage is that each trust is worth less than the nil-band at the outset, so its ten-year charges should be nil, or very small.

What Happens If You Die Without A Will

See this blog by Nina Sampson, about intestacy:

http://www.mary-waring.co.uk/2013/04/what-happens-if-you-die-without-a-will/

Common Misconceptions About Inheritance Tax

The following ideas about IHT somehow seem to have entered the public imagination.

They are all wrong:

If I put all my assets offshore then they won’t be charged to Inheritance Tax.

WRONG!

This is wrong. UK domiciliaries pay IHT on all their assets worldwide.

If I put all my assets in the name of somebody else, they won’t be charged to IHT.

WRONG!

This is wrong. I know people who’ve taken the hugely risky step of putting their homes and investments into their children’s names, in the utterly mistaken belief that it will save tax. Gifts obviously do have their place in tax planning, though, and are discussed in some of my other posts.

I can put all my assets into trusts, and carry on treating them as my own. They’ll then be tax free.

WRONG!

Not so. Generally, the type of trust which is tax effective is the type which prevents you from benefiting from it. Your advisers can perform minor miracles on your behalf with trusts, though, and some of the strategies are mentioned in other posts.

I can form a charity and run my life through it. Then everything I do will be tax free.

WRONG!

Not so, either. Money put into a charity can never be withdrawn again for private purposes. By all means give money to existing charities. By all means create a charity if you have an enterprise that deserves charitable status. But don’t think of a charity as the core of a tax-plan, because that will not work.

If I hold my assets jointly, they won’t be part of my estate, and therefore won’t be taxable.

WRONG!

This is wrong. Your “tax estate” is bigger than your “estate”, and includes your share of jointly held assets.

I expect this misconception arises from two things:

a.            firstly because a little knowledge of the law is a dangerous thing, and many people have cottoned on to the (correct) idea that joint assets are not in your “estate”; and

b.           because, in fact, assets held jointly by a husband and wife do pass to the survivor inheritance tax free – and people have seen this happen, perhaps with their parents. However, that had nothing at all to do with the joint ownership: transfers between husbands and wives always are inheritance tax free, due to the “spouse exemption”.

The “£3,000-a-year gift”, which is mentioned so often in the financial pages of the newspapers, is one of the best things you can do to save tax.

WRONG!

Not really. It is quite a painless way of saving tax, but you would have to do it for years and years before you made any serious inroads into your tax problem. The rules are explained in other blog posts. But look at other, better, strategies first. And, as explained here, limiting yourself to £3,000 is not necessarily wise.

Debts are Deductible.

WRONG! ish

I always have trouble with this one. After all, debts ARE deductible from your tax estate, so my clients are always a bit nonplussed when I insist on ignoring their debts when I calculate their inheritance-tax exposure. But there is method in my madness. The trouble with debts is that so often they come with built-in safeguards for paying them off. Endowment mortgages, for example, have life-cover built into them. Repayment mortgages are usually attached to mortgage protection policies. Credit card debts, store cards and financing deals are often covered by payment protection.

Also, these protections usually kick-in on the first death. So a young couple with 10% equity in a £1million home, and not much else, might think of their wealth as £100,000 and therefore outside the tax net, whereas actually the second-death estate would be £1,000,000, with a six-figure tax exposure.

Besides, guess what, if we find that you do have unprotected debts, then we’ve already discovered an inheritance tax saving!

Always start calculating from your gross estate.

IHT on Gifts to Minors in Wills

It makes me weep that I need to discuss this. I genuinely do not believe that the government intended to make this bit as complicated as they did. The old (pre-2006) rules for gifts to minors, called the “A&M Trust” rules, were simple, secure and tax-favourable. So, everybody followed them, leaving gifts in wills “to those of my grandchildren who survive me and attain 21” or suchlike. Very straightforward. Nobody thought of creating “bare trusts” (whatever they are) or leaving their children “intermediate income” (whatever that is), because although those options existed in theory, frankly why would you want to do them, and who needs to think about those things, anyway? Well, now you do.

I think the treasury felt that some very rich people with clever lawyers were taking advantage of the A&M Trust rules, so, using a sledgehammer to crack a nut, they simply abolished them. Then, they realised that they needed at least two new statutory regimes to partially replace them. So now, you need to consider a string of options, and to trade-off simplicity -v- security -v- tax-favourableness. Instead of the one option you had before (where the only choice you really had to make was whether the beneficiaries inherited at 18 or 21 or 25, and where even that decision didn’t affect the tax position) you now have to choose between:

a.            Relevant Property Trust. (Example: “to those of my grandchildren who survive me and attain 21”.) Simple, secure, tax-unfavourable. This is the simple option I mentioned above, the kind that would previously have fallen squarely within the A&M Trust rules. This is still unquestionably the best option for those whose estates aren’t in the tax net anyway – indeed, if you aren’t in the IHT net this is the only option I would seriously discuss with you, if you consulted me about a will. The tax disadvantage, however, is that they are taxed as discretionary trusts, suffering ten-year charges and exit-charges. The maximum rate of any charge is 6%, so what I often find is that people whose estates are taxable nevertheless work their way through the following options with me, but then decide to come back to this one: taking the view that the tax charges may be a reasonable price to pay for the simplicity and security of it.

b.           Bereaved Minor’s Trust. (Example: “to those of my children who survive me and attain 18”.) Simple, insecure, tax-favourable. This is a statutory regime, available only in the wills of the parents of the child concerned, and only where the minor gets their money outright, with no strings attached, at 18. And, really, that’s what I mean by “insecure” in these examples – the minors in question taking absolute control of their inheritance the moment they reach 18, whether or not they are mature enough to handle the amount of money involved. The tax advantage is that there are no ten-year charges or exit-charges.

c.            18 to 25 Trust. (Example: “to those of my children who survive me and attain 21”.) Simple, secure, tax-middling. This is another statutory regime, available only in the wills of the parents of the child concerned, and only where the minor gets their money outright, with no strings attached, at an age between 18 and 25. Gifts of this kind become relevant property trusts upon the minor in question reaching 18. Therefore there cannot be a ten-year charge (because there are less than ten years between someone reaching 18 and the same person reaching 25) and the maximum possible exit charge is 4.2% (because exit charges are calculated by reference to the number of years elapsed before the next ten-year charge would happen: in this case there are seven years between ages 18 and 25, and 7/10ths of the maximum 6% is 4.2%).

d.           Bare Trust. (Example: “to those of my children who survive me absolutely”.) Simple (in theory), insecure, tax-favourable [unless the minor dies]. In this case, the gift to the minor is “absolute”, so he or she owns the money outright, even if he or she is only an infant. This may seem to be the ultimate in insecurity, although in practice trustees do actually have to look after the money and the child cannot demand it from them until attaining majority, at 18. The only reason to consider this is the tax consequence: the money actually belongs to the child, so the trust isn’t truly a trust at all, and isn’t taxed as one. Therefore there can be no ten-year charges and no exit charges.

e.            IPDI. (Example: “to pay the income to those of my children who survive me, from the date of my death, and to pay the capital to each of them when he or she attains 21”.) Complicated, secure as regards capital, tax-favourable [unless the minor dies]. The idea of an IPDI is that if you grant someone a right to income, by a trust in a will, from the date of death, then that trust is taxed in tandem with the beneficiary’s estate (and not as a relevant property trust). The tax upside is that there are no ten-year and exit charges. But the assets are taxed in tandem with the minor’s estate, so if the fund is big enough it suffers 40% tax on the minor’s death.

But just to clarify: although I have described some of these options as “tax-favourable” and “tax-unfavourable” none of them avoids the IHT on the death in question (and the old rules didn’t do that either). Leave money to a child or a grandchild (indeed, actually, to anyone except a spouse, civil partner or charity) and you pay IHT on it. The only question we are discussing in this section is whether there might be yet further IHT on the fund before the minors receive their share.

International Estate Planning - Full Version

Here is the full one-hour version of this talk, in four parts:

Annual Residential Property Tax (ARPT)

There are some serious changes about to come in (April 2013) for UK residential property owned through an offshore company.

The political background to the change is that historically the UK has promoted itself as a tax haven for non-domiciled individuals, and has maintained a tax regime full of rules favourable to “non-doms” and “res-non-doms” when compared with the tax treatment of English residents and domiciliaries.

One common example is the use of a non-resident corporation (often a BVI company) to hold English residential property. One of its main advantages is that the property’s value is outside the scope of inheritance tax. This saving arises because – from one angle – the property is owned by a corporation not by an individual, so its owner cannot die; also – from the other angle – the death of the non-domiciled individual doesn’t lead to any tax because what he owns (i.e. shares in a BVI company) are “excluded” from inheritance tax: being the non-UK-situated assets of a non-UK domiciliary.

In the past, governments have seen planning of this kind as advantageous to the economy and have not challenged it. Foreign individuals can bring their wealth (and their businesses, and their expertise) into the UK with the benefit of tax-neutrality.

However the current coalition government perceives things very differently. In its eyes the need to “balance the country’s books” is paramount: the economy is in poor shape, budgets are being cut, the tax-take needs to be maximised and there needs to be a perception that rich non-domiciliaries are paying their share.

Against that background, we are now faced with a number of punitive taxes, the clear intention of which is not so much to raise tax, as to encourage the break-up of these structures.

Unfortunately, the decision is NOT clear cut in a case like this. There is not one recommendation to make, and overall the decision has to be one for each individual client. There are three options, and they are:

1. No action. Keep the structure as it is.

     ADVANTAGES

     a. no inheritance tax, for the same reason as when the structure was set up

     b. no scope for stamp duty, since nothing is changing

     c. all the non-tax advantages of the trust from a succession, flexibility, confidentiality and asset protection viewpoint which the arrangement previously had

     d. no costs, except the any advice needed to reach this conclusion, since there is nothing to implement

     DISADVANTAGES

     a. the new Annual Residential Property Tax

     b. the property will henceforth be exposed to Capital Gains Tax, re-based to April 2013

     c. the law may change, penalising this option further or negating any of its advantages

2. Collapse the structure completely.

     ADVANTAGES

     a. no new Annual Residential Property Tax

     b. most likely no Capital Gains Tax on general principles (i.e. assuming that the owner will be non-resident)

     DISADVANTAGES

     a. inheritance tax payable at death (This is a crucial point - £15,000 is an unintended and unexpected cost of the structure, but you would have to pay it for over 66 years to match the inheritance tax hit on a £2.5 million property.)

     b. various non-tax issues: for example that there would henceforth be an undervalue transaction in the title to the property.

     d. the law may change, in ways less favourable to non-domiciled property owners than the current laws (you could argue that the subject matter of this email is an example of this already occurring)

3. Tweak/Restructure.

     This would involve retaining some elements of the existing structure but reorganising it in such a way – if possible – that the existing advantages are obtained without giving rise to the new tax charges. This is obviously the most nebulous of the three, and cannot be explained in terms of simple advantages or disadvantages. One obvious disadvantage, however, is that tax law may change further – especially if there is a sense that many non-doms are using a particular tweak – in order to negate or penalise the restructuring. Possibilities include:

     a. letting the property: the new rules don't apply to lettings on a commercial basis, so if it is let out to independent tenants at arm’s-length and at full rent the problems do not apply

     b. removing the company from the structure but keeping the trust in place: superficially this appears to achieve the desired effect (no annual residential property tax, no capital gains tax, possibly no inheritance tax on client’s death), but unfortunately introduces a new complication: the trust would cease to be an “excluded property trust” and would instead fall into the regime called the “relevant property trust regime”. The inheritance tax cost of being in that regime could be somewhere close to the ARPT, so it is hard to recommend it in isolation. However there is an argument to the effect that this further tax can be mitigated by burdening the property with debt.

See also Nina Sampson's article on this topic at Business First Magazine, which is a little more up-to-date than my blog above: http://www.businessfirstmagazine.co.uk/heavy-new-taxes-about-to-hit-foreign-owned-properties/

International Estate Planning - Taster

This is the 3-Minute taster for my full-length International Estate Planning seminar.