A “chargeable lifetime transfer” occurs when you make a gift into a trust. An outright gift to an individual is a “potentially exempt transfer” (PET), and provided you survive it by seven years it drops out of account for IHT purposes. If you die within this seven year quarantine period, the PET becomes a chargeable transfer and is included in the calculation of IHT on your death.
A transfer to a trust, however, is immediately chargeable to IHT. You can take account of your nil rate band (currently £312,000), but if your “cumulative total” of chargeable transfers in the previous seven years is more than that, the rest is charged to IHT at the “lifetime rate” of 20%.
In this article I want to concentrate on a technique for reducing the IHT charges suffered by the trust itself, rather than by the individual who set it up. Since the changes in the 2006 Finance Act, most trusts these days are “relevant property” trusts, which means that they are themselves liable to IHT.
There are two types of IHT charge on a trust. There is a “principal charge” on the tenth anniversary of the creation of the trust and every ten years thereafter, and there is a “proportionate charge” in between these principal charges every time capital (not income) leaves the trust by being passed out to a beneficiary.
The calculation of both these charges is hideously complicated, but the starting point is the amount of the nil rate band available to the trust. If it has the full £312,000 available to it, and the capital in the trust (or in the case of a proportionate charge, the capital leaving the trust) is less than £312,000, then there is no IHT to pay.
The amount of the nil rate band available to the trust is calculated by taking the current nil rate band, and then deducting all the chargeable transfers made by the same “settlor” (the person who put the capital into the trust) over the seven years before the trust was set up. Other chargeable transfers made on the same day are included in this total. Remember that point – you will see its importance in a minute!
It is quite common for a trust to be set up by a person’s Will. Assuming that the individual concerned has an estate worth more than the £312,000 nil rate band, then it is quite likely that the trust will have no nil rate band available to it because it has been used up by the chargeable transfer of all his wealth deemed to occur at the date of death.
This will mean that when the tenth anniversary comes round, or when property leaves the trust before that date, the IHT payable will be increased because the trust will have little or no nil rate band to set against the value to be taxed. In a worst case, the maximum IHT liability will be 6% of the value of the trust’s assets.
This is where “pilot trusts” come into their own. Instead of setting up the trust by way of the Will, the trust is set up during the person’s lifetime, with a nominal amount of capital (say £10).
Assuming the person involved has made no previous chargeable transfers, the trust will therefore have the whole nil rate band available to it. Subsequent additions to the trust do not change this position, so when the person dies, they can leave significant wealth to the trust and this will not alter the amount of nil rate band available to the trust when the tenth anniversary comes round.
In some cases, a person may want more than one trust set up. If so, the second trust is set up the day after the first one, also with a nominal £10. This second trust will have a nil rate band available to it of £312,000 minus the £10 put into the first trust.
To take a different example, if you want to set up a trust with £100,000 for the benefit of your (adult) children during your lifetime, and to leave your assets in trust for your grandchildren when you die, you set up a “pilot trust” for the grandchildren on Monday, and then set up the lifetime trust for your children on Tuesday.
If you do it the other way round or do both on the same day, the grandchildren’s trust will have its nil rate band reduced by the £100,000 that went into the lifetime trust for the children. You then leave the assets for the grandchildren in your Will to the pilot trust.
The key point is that the trust’s nil rate band is determined on the day it is set up, and does not alter when subsequent transfers are made to it.
This technique will not reduce the IHT payable on the death of the individual concerned, but it will reduce the IHT payable later by the trusts themselves on their tenth anniversaries or when property is transferred out.
Setting up “pilot trusts” is a job for an expert, as there are several procedural pitfalls to beware of. For example, the £10 must actually be received by the trust, because in law a trust only comes into being when it receives property. It is quite a common practice to keep a £10 note on the trust file to prove it was received by the trust at the time it was set up.
It is also important that the trust is set up before the Will is signed, so that the Will can leave the assets concerned to a trust that is already in existence.
There is no substitute for proper professional advice if you are considering using a pilot trust. A solicitor who specialises in Wills, or a properly qualified tax adviser, will be able to talk you through the fine detail that must be got right if the pilot trust is to achieve its objective.