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GIFT AND LOAN/DISCOUNTED GIFT SCHEMES COMPARED
Most gifts (whether to an individual or a trust) are subject to two rules –
The exceptions (to both rules) are –
The exceptions (to rule 1 only) are –
Gifts of any amount (in addition to any of the exemptions) to individuals or bare trusts are potentially exempt transfers and fall out of the IHT net after seven years. Gifts to other trusts are again subject to the seven year rule and are IHT free up to £325,000 per donor. However, to be counted in the £325,000 are any other gifts made by the donor within seven years. If tax is payable, the rate is 20% of the part over £325,000.
£3,000 annual exemption
These should not be dismissed as paltry. If a donor fails to make a £3,000 gift one year, he can double up the following year. If both partners to a marriage/civil partnership made gifts for each of twenty years to a trust, there would be £120,000 in the trust or, if to an individual, out of the donors’ estates (+ any investment growth). If retained by the donors, that £120,000 would suffer IHT of £48,000 on death after twenty years (assuming the Nil Rate Band (NRB) of £325,000 has been used up by other estate).
Gifts out of income
Potentially, there is no ceiling on such gifts. The rule is that a person can gift excess income to another person or a trust, provided that the donor’s normal standard of living is maintained. So for example, if a donor’s income is £50,000 per annum and he only needed £30,000 per annum for his normal living, he could gift the balance. In this example, an annual gift of £20,000 would over twenty years remove £400,000 from the donor’s estate. That £400,000 would suffer IHT of £160,000 on death after twenty years if it had not been gifted (assuming the NRB has been used up by other estate). An extension of this is for the donor to fund the pension schemes of his children or grandchildren from excess income. Every person under the age of 75 is permitted to make pension contributions each year of up to 100% of earned income or if there is no earned income £2,880 each year. A pension contribution is immediately uplifted by standard rate tax relief by 25%. So a gift of £2,880 by a donor to his son’s pension results in £3,600 being received by the scheme. Or, to emphasise the point, a gift of £20,000 out of income into another person’s pension results in £25,000 being received by the scheme.
Rule 2 usually provides the dilemma for a donor. How does the donor keep control of “his money” and still have it excluded from the IHT net? In the main, the answer is the donor cannot achieve that objective unless he resorts to a Trust. But doing that imposes restrictions in that there may be a 20% IHT charge when the gift is made. The donor will normally balance the pros and cons of outright gifting with gifting to a trust and perhaps do both. In a large estate, it is easier for the donor to make outright gifts if he can see clearly that he will never need access to the funds gifted and he trusts the donee to use the funds wisely. Gifting to a trust still requires the donor to have no further interest in the gift but at least the donor can have some control as a trustee over how it is dealt with in the trust. Using a discretionary or flexible trust allows the donor as trustee to “disinherit” an unworthy beneficiary.
More usual is the situation where the donor cannot afford to make the gift for fear that he will leave himself short. There is an answer to this in a Gift and Loan Scheme or a Discounted Gift Scheme.
In a Gift and Loan Scheme, a trust is set up with a nominal gift of £1 (or if the donor already has a trust in existence, he uses that trust). The donor then lends the trust interest free a much larger sum and this is properly documented with a loan agreement. The loan agreement provides that the loan is repayable on demand (thus giving the donor the best of both worlds by allowing him access to his capital if he needs to) or in any other way the donor demands in writing. Usually the donor will receive repayment at 5% per annum over 20 years. If he dies during that period the balance outstanding will still form part of his estate for IHT purposes. At the end of twenty years, the loan is repaid in full and it is out of the donor’s estate for IHT purposes. During the 20 years the donor has what appears to be 5% income from his capital but is in fact not income and not therefore liable to income tax, but a return of his capital. In the hands of the Trust, the loan amount is invested in an investment bond. This is technically a single premium life assurance policy and subject to the rules on life policies. The rules allow the Trust to take 5% withdrawals each year and defer tax. So that is what they do (and pay it to the donor in part repayment of his loan).
There may be a tax liability when the bond is encashed in full. The bond is a life assurance contract for which special tax rules apply. These rules are complex but at their simplest, there is a 20% tax charge on the gain. (Calculation of the gain is also complex, but at its simplest, it is the difference in value between the sum invested and the surrender value plus any withdrawals taken). However if the chargeable event (the encashment of the bond) occurs in the same tax year as the death of the settlor who created the trust, the gain is treated as income of the deceased and should be included in the final tax return of the deceased. The deceased pays tax on the gain only if he was a higher rate taxpayer before account is taken of the gain. Even if he is liable to tax, top slicing relief is available to reduce the tax that would otherwise be paid. The life assurance company will provide a certificate when the bond is surrendered in full certifying the amount of the gain on which tax is calculated.
A Discounted Gift Trust (DGT) works on the basis that the donor makes an outright gift to a Trust. (This is the equivalent of the loan in the Gift and Loan Scheme). Being a gift, it is subject to Rules 1 and 2. So the donor must survive seven years and he must have reserved no interest in the gift. If the Trust is not a bare trust (which is the norm) there will be a tax charge at 20% of the part over £325,000. Strangely, in a DGT, Rule 2 appears to be contravened in that the donor reserves a right in part of the gift (the part which will provide an income for him). However it is settled law that if the reserved interest is carved out at the date of the gift, Rule 2 is not infringed. HMRC have agreed rates of discount with the life companies so that the age of the donor and his state of health determine what discounted value is attributed to the gift. By way of illustration, a 60 year old male in good health making a gift of £250,000 to a DGT would be treated as gifting only £110,000, whereas an 85 year old male in good health would be treated as gifting £190,000.
All DGTs are products of the life companies. Most are designed as flexible trusts so as to provide the donor with the discretion to “disinherit” a beneficiary or give a bigger benefit to one class of beneficiary or individual as the donor as a trustee subsequently decides. As a flexible trust, there will be an IHT charge for any gift above £325,000. So for larger gifts, that is a disadvantage. One or two life companies have got round that problem by wording their DGT as a bare trust and sought the pre-approval of HMRC. In these cases, there is no IHT charge when a gift in excess of the NRB is made to the trust. The consequences of its being a bare trust is that there will be fixed shares for each of the beneficiaries. These shares will be treated as the estate of the beneficiaries for IHT purposes and would be taken into account in an insolvency of the beneficiary but not in a divorce (under Scots Law) of the beneficiary. Most importantly the beneficiary would be free to surrender the bond at will.
Nothing on this website constitutes legal advice and EBS Trustees accepts no liability for any actions taken by any individual in reliance of what is written here.
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