Discounted Gift Trusts – how to gift away assets and retain an “income” from them
Tuesday 13th July, 2021
Many people are aware that they have an Inheritance Tax liability, but feel that they cannot afford to do anything about it, as they rely on their excess assets to provide an income to meet their expenditure requirements. They are asset rich and income poor. Unfortunately, there does not seem to be a way to gift away the assets, while retaining access to the income generated, without falling foul of the Gift with Reservation rules.
However, the Discounted Gift Trust offers an option to give away the asset, while carving out a right to "income" from the assets for life. In the article below I will explain what Discounted Gift Trusts are, how they work, their advantages and disadvantages and who they might be suitable for.
There are many reasons for gifting away assets during life. Quite often it is purely altruistic, with a focus on helping children or loved ones with a financial foot-up. However, the reasons for making gifts can often be more complex and multi-faceted and also relate to the desire to reduce the value of an estate for Inheritance Tax purposes.
Now, in order for a gift to be valid for Inheritance Tax purposes, the donor has to give up all possession and rights to the asset. If possession and enjoyment are not effectively transferred, then regardless of legal ownership, the property is taxed as part of the estate of the donor as a gift with reservation. HMRC therefore treat the gift as if the donor never made it. As a result, the value of the gifted assets will still form part of the donor’s estate for Inheritance Tax purposes.
A common example of a gift with reservation is where a couple gift their main residence to their children, but then continue to live in it rent free. This will be treated as a gift with reservation, as they have retained possession of the property and have continued to benefit from it. As a result, when they die, the property will still be treated as if it belongs to them. In order for the gift to not fall into the gift with reservation trap, the couple would need to pay their children a commercial rent for continuing to live in the property.
The gift with reservation rules generally deal with the situations where a person gifts a property away, but continues to enjoy it. However, there is another layer of rules brought in to prevent a situation where assets have been gifted away and disposed of, and the proceeds have been used to purchase a new property from which the donor benefits. In these situations, the donor can be liable for pre-owned asset tax, a form of Income Tax based on the value of the benefit they are receiving.
There are other problems associated with gifting assets away. One that I often encounter is the fear that if a parent gifts an asset to their child, the child might get divorced or go bankrupt and lose half the asset due to a divorce or bankruptcy settlement. This means that half the gift (if not more) will walk out the door, never to be seen again, in the pocket of a person who was never meant to benefit from the gift in the first place.
In addition to this risk, there is also the loss of control. Now, for many people who have responsible loved ones that can be trusted to be sensible with the gifted assets, this is not a problem. However, for those who dearly love their prospective beneficiary, but couldn’t trust them with a packet of crisps, it becomes a real problem. They know that the second the gifted money hits the beneficiary’s bank account, it will evaporate into frivolousness.
The problem with gifting assets away
The problem with the preowned asset and Gift with Reservation rules, is that many people want to make gifts to their loved ones, but cannot simply give up all access to the assets themselves.
For example, they may have enough assets to meet their needs and therefore simply wish to give away any growth in the value of the asset, in order to stop their IHT liability getting worse. They cannot afford to give away the actual cash or property, as they need these to meet their current and future requirements. They just don’t need the excess above this, so they are keen to gift the growth away, so it doesn’t simply build up in their estate and cause further liability.
Alternatively, there are situations where an individual is asset rich, but income poor. They are therefore very keen to gift assets away, in order to reduce the value of their estate for Inheritance Tax or estate planning purposes, but they need the income or growth from these assets to meet their expenditure requirements.
In other circumstances, an individual might feel happy to gift assets away, as they are pretty sure that they have more than they actually need. However, giving away your wealth is risky. If you live longer than you expect, or your costs suddenly spike due to care home costs, gifting away the assets will leave you short. Therefore, the more risk averse people may wish to have a right to ask for some of the gifted assets back, should the unexpected happen in the future.
In all the above examples, the donor seems to be shackled by the Gift with Reservation rules or preowned asset rules. If they gift away the assets, but are seen to retain some benefit, then surely it will fall foul of at least one of these limitations?
However, in all these situations, there is a solution. These solutions have been around for many years and are accepted by HMRC as acceptable options to achieve the goals highlighted in the scenarios above, without contravening the rules.
They involve making gifts into trust and effectively carving out certain benefits for yourself, which you, as the settlor, wish to retain access to.
Along with reducing the size of your estate for Inheritance Tax purposes, these gifts into trust can also protect the gifted assets from attack by third parties, as discussed above, and also allow the settlor (donor) to retain control over how the assets are managed, and how and when they are distributed.
In this article I will focus on the solution for people who wish to gift assets away, but wish to retain access to an “income” from the gifted assets. This is called a Discounted Gift Trust.
There are solutions to the other circumstances, however, I will cover these in later articles.
What is a Discounted Gift Trust?
A Discounted Gift Trust (DGT) is a trust structure which allows the settlor (donor) to gift away assets, while setting up a right to fixed, regular payments for themselves from the gifted assets, for the rest of their lives.
The trust establishes two clear and separate rights:
- The settlor's right to fixed, regular payments for life, agreed and set at the outset
- The beneficiaries' right to the trust fund after the settlor's death
As the two rights are distinct from each other, it is possible to distinguish what has been given away and what has been retained by the settlor. As we can see, the settlor has carved out a right to receive the payments for the rest of their life. The settlor never gives away the right to the payments, and as a result, it therefore cannot be treated as a gift with reservation for IHT purposes.
As we mentioned before, the settlor has carved out a right to payments from the trust assets for the rest of their lives. They have not given this right away. Now the value of that portion of the assets can be roughly calculated, as the level of payments is agreed and fixed at the outset and an estimate of the settlor’s life expectancy can be made.
This is really important, because the value of the settlor’s retained future payments can offer an immediate reduction in the amount of the settlement treated as a gift, known as the discount. The discount is often described as a reduction in the value of the gift based on the present-day value of the payments the settlor might receive during their lifetime.
The easiest way to understand this is through a basic example. Mrs. Smith wishes to gift away £300,000 to her son and his wife. However, she wishes to receive a fixed, regular payment from the gifted assets for the rest of her life, to help meet her expenditure requirements. She therefore uses a DGT to provide this facility.
An actuary then calculates (based on her life expectancy, the level of payments she will receive and a number of other factors), that the value of the payments paid during her life will be approximately £100,000. She has therefore retained a right to approximately £100,000 of payments. The £100,000 will be the value of the discount.
When Mrs. Smith gifts the £300,000 into trust, £100,000 (as the discount) will be immediately exempt for IHT purposes, even if she dies in the next month. This will result in an immediate IHT saving of £40,000, even though it will be the full £300,000 (or the value of the investment at the time) that gets passed to the beneficiaries.
You may wonder why the retained rights do not trigger an IHT liability. After all, £100,000 is still being passed to the son and his wife. The reason is that the discount is based on the hypothetical market value of the right to income, carved out by Mrs. Smith.
That makes no sense, you say. Well, imagine I come up to you and I say, “I have a right to receive £5,000 per year for the rest of my life. I would like to sell it to you. What are you willing to pay me for it? By the way, I am going to die tomorrow.”
What is the value of that right to income for life in that situation? It’s zero, isn’t it? Therefore, the market value of the retained right to income in the case of the DGT is zero.
The important bit to understand here, is that there could be an immediate IHT saving and you could also gift more into a Discretionary Trust structure, because a portion of the settled assets is treated as a retained right and has no value for IHT purposes.
Discounted Gift Trust Flow Chart
As we can see from the above diagram, the trust is set up initially by the settlor. They create the trust and establish its parameters and who the beneficiaries will be.
The settlor also appoints the trustees. The settlor can be one of the trustees if they want, but it is important to note that the trustees must be unanimous in their decisions relating to the trust assets. The more trustees there are, the more likely it is that there will be disputes.
It is also important to ensure that there is always more than one trustee at a time. This is to make sure that a situation doesn’t arise where all the trustees are dead or have lost capacity to deal with the trust. In this situation, the personal representatives of the last trustee to die appoint a new trustee. This is clearly not ideal and there is a strong argument for appointing a corporate trustee at the outset, as this will avoid both the problem of disputes and the problem of trustees dying.
The settlor agrees the level of payments they will receive for the rest of their lives. This is fixed and will not change, so it is important that the right level is chosen. If it is too high, the payments will simply build up in the settlor’s account, where it will be subject to IHT upon the settlor’s death. This seems a bit self-defeating. This type of planning relies on the payments being spent and not simply building up in the settlor’s estate.
It is important to note that these payments are treated as capital and not income. They cannot therefore be subsequently gifted away using the gifts out of excess income exemption. Furthermore, the income cannot be switched off or varied once it has been turned on. Even if the payments are eroding the value of the capital in the trust, it cannot be changed. It will simply continue being paid until the settlor dies or the assets within the trust have been exhausted.
The last two paragraphs highlight a very important point. If you do not need to retain a right to payments from the trust assets, then this type of trust is more than likely not suitable for what you are trying to achieve.
The settlor then gifts the assets into the trust. As you can see, the transferred assets fall into two separate pots. The retained fund, which is the value of the expected payments the settlor will receive during their life. This is outside of the estate for IHT purposes from day one.
The other pot is the gifted fund. This is the value of the funds settled into the trust, less the value of the retained rights. This is treated like any gift (Potentially Exempt Transfer or Chargeable Lifetime Transfer depending on the trust structure) and the value of this fund will fall out of the settlor’s estate after 7 years following the gift being made.
Any growth achieved on the assets once they are settled into the trust is immediately outside of the settlor’s estate for IHT purposes.
When the settlor dies, what remains of the trust assets will be distributed to the beneficiaries in line with the wishes of the settlor and (depending on the trust structure used) the discretion of the trustees. It is important to note that the trust assets cannot be distributed during the life of the settlor.
The trust structure
The trust itself can be set up on a Discretionary Trust basis or a Bare Trust basis.
You can almost think about the Discretionary or Bare trust structures as the chassis of the trust. It determines the nature of the trust and how it is treated from a tax perspective. The discounts and carved out rights to income etc are all additions that can be built onto either structure and change the way it functions, but not it’s nature. It’s a bit like a Swiss Army Knife. You can add a cork screw and a Ferrier’s pick to the mix of knives and it will give you the additional option to remove stones from a horse’s hoof, while opening a bottle of wine. However, the basic structure remains a Swiss Army Knife.
If it is set up on a Discretionary basis, the amount of any funds that can be gifted into the trust in any 7-year period will be limited by the settlor’s available Nil Rate Band (plus the value of any discount) and any gift will be treated as a Chargeable Lifetime Transfer.
However, a Discretionary Trust will allow assets to be protected from attack by third parties through divorce and bankruptcy actions against the beneficiaries. It will also prevent beneficiaries being able to demand payment from the trust and will allow trustees to exercise a discretion over who benefits from the trust assets and when.
With a Bare Trust, the gift is a Potentially Exempt Transfer (PET) so there is no limit to the amount gifted into the trust. However, a Bare Trust affords very little protection of the assets from third party attack. In addition to this, the gifted assets are treated as forming part of the beneficiary’s estate, potentially creating an IHT problem for the beneficiary in the future.
It is very important to make the distinction between these two structures. Not only will they determine the level of protection and control over the assets, but they will also determine how the assets are taxed and whether they will be subject to periodic and exit charges.
There are all sorts of implications around whether you use a Discretionary Trust or a Bare Trust structure. It is therefore really worth taking some advice on this.
A Discounted Gift Trust offers a number of potentially fantastic benefits for someone looking to make gifts to loved ones during their lifetime, while retaining a fixed level of payments. These include:
- Reducing the value of your estate for Inheritance Tax purposes
- Potential for an immediate Inheritance Tax saving
- Ring fencing assets for loved ones to provide effective estate planning
- An agreed level of payments from the gifted assets for life
However, they remain complex and, if used incorrectly, can cause more problems than they alleviate.
It is therefore important to take financial advice to ensure that whatever solution is put in place, it is the most suitable one for you.
If this is an area you wish to explore further, don’t hesitate to give us a call.