As we get older and become more financially secure it is only natural that we consider the future for our children and grandchildren. However, the situation is brought into sharper focus by the fact that UK inheritance tax (IHT) may well significantly reduce the amount that we are able to leave them. An individual is currently allowed to leave only £325,000 to his or her heirs without the estate incurring an IHT bill. The value of any assets above the level of this nil rate band is subject to IHT at 40%, meaning that for larger estates HMRC can become the largest single beneficiary and property may need to be sold to fund the tax liability. In 2015/16, for example, it is estimated that total IHT receipts were £4.2bn.
Inheritance Tax Mitigation
IHT mitigation is therefore an important objective for a number of our clients, but at the same time people often worry that simply gifting capital away too early might compromise their own financial security, or that the money will be mis-used or perhaps even ‘disappear’ through a divorce. For this reason, many are attracted to planning solutions using specialist trusts, such as discounted gift trusts (DGTs) and loan trusts, where control of – and continued access to – assets is balanced with varying degrees of IHT efficiency.
These schemes are well established in law and are recognised by the tax authorities, but also have some limitations. In simple terms, loan trusts provide maximum flexibility and control, but any IHT benefits can take many years to become effective; DGTs on the other hand can offer instant IHT mitigation, but access to capital and income is strictly defined.
Flexible Reversionary Trust
Another potential solution that has also been used legitimately for many years (but which is less well-known) is an arrangement called a Flexible Reversionary Trust (FRT), which combines many of the benefits of DGTs and loan trusts.
Under a FRT a lump sum gift is made into a series of fixed term investment bond policies, via a trust. After 7 years the gift will no longer form part of the settlor’s (donor’s) estate for IHT purposes. On a gift of £325,000 this could mean a reduction in IHT of £130,000. For a married couple gifting a combined £650,000 to a FRT arrangement, the IHT saving could therefore be £260,000.
Crucially, the FRT structure also allows the settlor to receive a yearly ‘income’ as each policy matures. In contrast to a DGT however, the FRT payments don’t need to be taken and can instead be re-invested in a new policy, either for the settlor’s use at a later date, or to be allocated by the trustees to one or more of the potential beneficiaries (typically children and grandchildren). As the settlor is also typically a trustee, a high degree of control is retained over who should benefit, and at what point.
A gift into an FRT is technically a Chargeable Lifetime Transfer (CLT) for IHT purposes and any amount gifted above the IHT nil rate band will result in an immediate tax charge at the lifetime IHT rate of 20%. For this reason it is generally recommended that the amount gifted into a FRT should be within the available nil rate band. It is also worth remembering however that if the settlor lives for 7 years after making the gift then a new nil rate band would be available to make further CLTs, or to reduce IHT on the residual estate.
A Serious Consideration
No other trust solution offers the Flexible Reversionary Trust’s combination of IHT mitigation, control and access to capital and so it should be a consideration for anyone seeking to transfer their wealth effectively to future generations.