Discretionary Trust and Tax Implications of Financial Gifts

FREQUENTLY ASKED BUSINESS QUESTION

I am considering making a substantial financial gift to my children and also setting up a discretionary trust for their future benefit.  Are there any tax matters that I should be wary of?

TAX TIP

In the UK, it is possible to gift unlimited amounts of money without incurring an immediate charge to Inheritance Tax (IHT).  Such gifts are called Potentially Exempt Transfers or “PETs”.  If, however, the Transferor dies within seven years of making the gift, the gifts are included within their estate for the purposes of computing the estate inheritance tax liability.  Such gifts are referred to as “failed PET’s”.

The Benefits of a Discretionary Trust

This contrasts sharply with the treatment of a lifetime financial gift into a discretionary trust.  Such a transfer is immediately chargeable to inheritance tax at a lifetime rate of 20%.  However, if the value of the transfer into the trust is less than the inheritance tax nil rate band (£325k), then the transfer into the trust is not subject to the immediate 20% charge. Should the Transferor survive for seven years he/she regains their lifetime IHT exemption of £325k.

Is a Discretionary Trust right for me?

A complication can arise where Potentially Exempt Transfers are made and then subsequently a discretionary trust is set up and transfers are made into it.  If the person dies within seven years of the PET’s, the failed PET’s become chargeable to inheritance tax and affect the order in which the nil rate band of £325k is used.  What this means is that the £325k is now applied against the earlier failed PET’s instead of the transfer into the discretionary trust.

The result of this is that the beneficiary of the now failed Potentially Exempt Transfer may have a tax liability to pay if the PET exceeded the nil rate band of £325k and by that stage (up to seven years after receiving the gift), the cash may now be spent.

Taper relief can reduce any Inheritance Tax charge where the Transferor has died between three and seven years from the making of the gift.

Furthermore, because the Potentially Exempt Transfer was made before the discretionary trust settlement, periodic and exit charges for the trust could be impacted.  A discretionary trust is assessed to inheritance tax every ten years or whenever capital is transferred out of the trust (an exit charge).  The trust has its own nil rate band for calculating these periodic and exit charges, but in this scenario, the nil rate band is reduced by any chargeable transfers, including failed PET’s, in the seven years before the trust was created.

Avoiding an Inheritance Tax Charge on your Financial Gift

The order of gifting is very important if you are planning to make a series of gifts, whether they be outright gifts or gifts into a discretionary trust as the order they are made in can affect subsequent trust charges.  The recommended order of gifting is to make the chargeable lifetime transfer into the discretionary trust first and then make the potentially exempt transfers.

Finally, if you are considering making lifetime gifts in excess of the £325k inheritance tax nil rate band, you should limit the transfer into the discretionary trust to no more than £325k and apply the balance of the amount of gifting towards PET’s as this will avoid a lifetime Inheritance Tax charge.

Here to Help

The team at FPM are here to help with all your finance and tax queries. If you would like more assistance to ensure your financial gift is made in the most tax efficient way possible, contact our Tax Team.