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Discounted Gift Trust: Q&A

Author Image Barrie Dawson Technical Specialist
Last updated on 29th Mar 2018

Overview

Questions from advisers answered on Discounted Gift Trust

 

Your questions answered

Q1: If the client is declined a discount does this mean a DGT is unsuitable?

A1. No, because the main objective of a DGT is not to get a discount. The main objective for a DGT is to gift capital into trust with the aim of mitigating an Inheritance Tax (IHT) liability and also carve out access to pre-determined capital payments for life to help maintain expenditure needs. 

To illustrate the above point let’s consider a hypothetical client situation:

 

Gill

Status

70 years old, divorced, retired & 2 children

Cash

£150,000

Investment bonds

£400,000

Property

n/a (rents accommodation )

Pension Income

£20,000 per annum

Current expenditure

£25,000

Gill is concerned about her IHT liability. She does not wish to make cash gifts to her children at this point but is happy to gift £300k into a discretionary trust to help mitigate her IHT liability. However, Gill relies on withdrawals from her bonds to meet expenditure needs so she can only make the gift if she can retain access to regular payments to meet her expenditure needs. 

Gill’s main objectives are to make a gift into trust which has the potential to reduce her IHT liability and also carve out access to regular payments of capital to meet her expenditure needs. A DGT can be used to meet both of these needs regardless of whether or not she will get a discount. Clearly a discount would provide an immediate reduction in her estate which would be a valuable IHT benefit. However, even if she is declined a discount the DGT provides her need for access to the capital. It also still provides the potential to help mitigate her IHT liability if she survives 7 years.

Q2: If a discount is available should the settlor carve out access to the maximum withdrawal available, after considering the income tax position, to increase the size of the discount?

A2. As highlighted in the previous question, the discount is by-product of the terms of the DGT, not the main objective. The objective is to make a gift into trust but also retain access to capital to meet expenditure needs. If the settlor carves out access to more capital than they actually need then it could be counterintuitive to the overall IHT mitigation strategy. 

To illustrate the above points let’s look at the client scenario for Gill again:

 

Gill

Status

70 years old, divorced, retired & 2 children

Cash

£150,000

Investment bonds

£400,000

Property

n/a (rents accommodation )

Pension Income

£20,000 per annum

Current expenditure

£25,000


After carrying out analysis of Gill’s income and expenditure needs forecast it has been determined that she needs to carve out access to £650 per month (£7,800 annually) from the £300k she is willing to gift. Based on her age and assuming good health the discount could be 30.26%. This would reduce the transfer value of her gift to £209,250 which is an immediate reduction of £90,750 in the value of her estate.

The level of discount is linked to the level of payments carved out by the settlor so what if Gill increased her payments significantly to £2,000 per month (£24k annually)? This would increase the discount to 88.68% and in turn reduce the value of her gift to £33,950, which is an immediate reduction of £266,050 in the value of her estate.

On the face of it this looks like a no brainer should she die within the first 7 years. However, Gill is in good health and expects to survive 7 years. She states her parents and grandparents lived into their late 90s. So what would be the impact if Gill did live 7 years or even 20 years after setting up the DGT but did not spend the additional capital carved out to increase the discount required? Below is a table illustrating the potential outcome (assuming no growth).

 

DGT with £7,800 per year

DGT with £24,000 per year

Value of estate 7 complete years after gift into DGT

£250,000

£363,400

Value of estate 20 complete years after gift into DGT

£250,000

£575,000

As you can see from the table the benefit of the discount falls away after 7 years. In both examples where Gill carves out more than is required there will be an IHT liability on the estate. In the 20 year example Gill’s estate value is higher than it was when the planning commenced. It is clear from the above that the IHT mitigation strategy can fail if the driver for recommending a DGT is based on getting a high discount rather than meeting the clients expenditure needs.

Could Gill gift the payments from the DGT? Yes, but this is likely to be a Potential Exempt Transfer or Chargeable Lifetime Transfer depending on how the gift is made. Therefore she would still need to survive 7 years from the date of each gift for it to be outside her estate but if this continued until death there would always be gifts that fail the 7 year test.  Such an exercise could overcomplicate the IHT planning as well as being ineffective.  Issues could also arise should the settlor lose mental capacity and the ability to make gifts of the excess capital may no longer be possible.

It is important to carefully analyse the clients current and future expenditure needs when determining the settlor’s payments from a DGT. The results of this analysis should be the starting point for the settlors payments stream, not the level of discount that could be achieved. 

Q3: My client set up a bond and DGT and receives £500 each month. Can this DGT ‘income’ be gifted using the normal expenditure out of income exemption?

A3. No, as payments from the trustees to the settlor in a DGT are capital, not income. For example, using the payments from a DGT to cover the premiums on a WOL policy held in trust would not be covered by the normal expenditure out of income exemption. 

As detailed in HMRCs IHT manual (IHTM14250) common sources of income for the purpose of the normal expenditure out of income exemption are employment and self-employment income, rents from property, pensions, interest and dividends. 

IHTM14250 also states that payments received on a regular a regular basis may appear to be income but are in fact capital in nature and uses receipts from a discounted gift scheme as an example.

Q4: Is the Ongoing Adviser Charge taken into account when calculating the discount?

A4. No. The discount is based on the payments expected to be paid to the settlor during their life. The size of the discount will depend on the level of payments being carved out by the settlor and their life expectancy which will be assessed taking into account their age and state of health.

Q5: Can the trustees distribute some of the trust fund to a beneficiary during the settlor’s lifetime?

A5. Sometimes the trust wording prevents trustees from making payments to the beneficiary whilst the settlor is alive. If the trust allows it, then generally the trustees would only consider it if a beneficiary is experiencing financial difficulties and their options are limited. However, before making a payment to the beneficiary the trustees would need to be satisfied the payment would not adversely affect their ability to maintain payment of the settlor’s rights for the rest of the settlor’s life. Effectively they would need to carry out analysis to determine a sufficient amount of capital to retain to maintain payments and may need to change the investment strategy to meet this objective.

Q6: If the trustees pay the settlor 5% of the bond from outset does this mean their payments will end after 20 years when the tax deferred allowance has been exhausted?

A6. No. The trustees are required to continue making payments to the settlor until the settlor dies or until such point that the trust fund is exhausted, whichever event is first.

Remember that 20 years is just a common example of how long the 5% tax deferred allowance on a bond would last if 5% withdrawals are taken from outset. For example, if the settlor required 5% of £200k each year then at the end of the 21st anniversary the trustees (assuming there had been no other withdrawals during the term) would receive a chargeable event certificate showing an excess gain of £10,000. Who is liable for tax on the chargeable gain will depend on whether it’s an absolute or discretionary DGT. See pages 24 and 25 of our estate planning guidance for further guidance on assessing who is liable for a chargeable event gain for a bond held in trust.

Q7: My client set up a DGT just over 7 years ago. As the gift is outside of their estate can they instruct the trustees to stop making payments to them from the trust?

A7. Yes, but it’s not simply a case of asking the trustees to stop the payments.

To stop payments the settlor would need to relinquish their entitlement to capital payments and a solicitor would be able to draft a suitable deed in order to achieve this objective. However, this would also be deemed a further gift by the settlor so the settlor’s retained rights would need to be valued to determine the value of the transfer for IHT purposes. To calculate the value of the settlor’s retained rights, underwriting and actuarial expertise will be required and it is unlikely this will be offered by the DGT provider as this service is generally only available for free at outset.

In view of the above it is important that the client understands they are carving out access to capital payments for the rest of their life because although in theory it is possible to stop payments, the cost of employing legal, underwriting and actuarial expertise is likely to be expensive.

Q8: Are the payments from a joint settlor DGT reduced on first death?

A8. Again this depends what the trust wording says. In general, the full payment will continue until second death. As such it is important to carry out sufficient needs analysis at outset to ensure the full payment will be required on first death otherwise excess capital could build up in the surviving spouses estate. If this is a potential issue and a discretionary trust basis has been agreed then a single settlor DGT for each of them may be more appropriate. On first death the survivor will continue to receive payments from their own DGT which are aligned to their expenditure needs but as they will be a potential beneficiary of their late spouse’s DGT the trustees could consider making payments from the trust fund to them if the financial needs arises.

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