Discretionary will trusts – navigating the first 10 years of exit charges

Discretionary will trusts can be an exceptional estate planning tool, but care needs to be taken when it comes to the charges.

Planning is the key here – with the right strategy it’s possible to ensure your clients’ beneficiaries benefit in a tax efficient manner.

The initial choice is clear: through their will, clients can either leave assets to their loved ones outright or place those assets into a trust. The trust is part of the will but just like a lifetime trust clients appoint trustees to manage the assets for the chosen beneficiaries.

Normally trustees will be given total discretion over which of the chosen beneficiaries actually receives anything from the estate, as well as when and how – hence the ‘discretionary’ part of the trust.

Discretionary will trusts are relevant property trusts and therefore can be subject to inheritance tax (IHT) charges – at outset, at every tenth anniversary and when the trustees distribute money to beneficiaries.

If a discretionary trust is set up during lifetime the money settled into the trust is a chargeable lifetime transfer. Where the total chargeable lifetime transfers made in a rolling seven year period exceeds the IHT nil rate band (NRB, currently £325,000), an entry IHT charge applies. This amounts to 20% of the excess over the available NRB and falls on the trustees to pay from the trust property.

During the life of the trust there will be calculations needed on every ten-year anniversary as well as when any assets are distributed by the trustees to the beneficiaries.

However, when the discretionary trust is set up on death the excess over the available NRB will be subject to IHT at 40%. When you consider transferable NRBs, the available NRB on an estate can be more than the £325,000 lifetime gifting limit.

On death any part of the estate that passes to the surviving spouse is an exempt transfer and will not use the NRB, and since 9 October 2007 any unused NRB can be transferred to a surviving spouse. For example, if a husband dies and leaves his estate to his widow, she can take his unused NRB and add it to her own. This means that when she dies, her estate will only incur IHT if it’s worth more than £650,000 currently.

The unused NRB available to transfer to a spouse is expressed as a percentage rather than a monetary amount and so increases with any future increases to the NRB. Therefore if an individual does not use any of their NRB, their spouse can claim 100%. If the NRB on the death of the spouse has risen to, say, £350,000 then the personal representatives of the spouse’s estate can claim 100% NRB of £350,000.

Where the personal representatives can claim a transferable nil rate band of a deceased spouse, more assets can be placed into the trust before inheritance tax is payable.

Normally, if there is no IHT payable when the trust commences then in the next ten years there is no exit charge when assets are distributed to the beneficiaries – but complications arise when there has been a transferable nil rate band meaning that more assets can be placed into the trust before IHT is payable.

Case study

  • Leonard died in November 2018 leaving £400,000 into a discretionary will trust. He had made no gifts in the previous seven years.
  • His wife, Penny, died in January 2016 leaving everything to Leonard.
  • Leonard’s personal representatives claim Penny’s unused NRB, giving his estate a £650,000 NRB.
  • The transfer into the discretionary trust is within the £650,000 NRB so no tax is payable on the transfer, leaving £250,000 NRB for the residual estate.
  • In November 2020 the trustees decide to distribute £100,000 to a beneficiary.

The trustees believe that as there was no entry IHT charge payable when the discretionary will trust commenced, then as the distribution is within the first 10 years there is no exit charge.

Unfortunately, having spoken to their adviser they find this assumption is incorrect as a trust only has one NRB for periodic and exit charges. The adviser explains that to calculate the exit charge due on the distribution the trustees must first establish the hypothetical effective rate of tax which is calculated as 30% of the lifetime rate of IHT. As lifetime IHT is 20% then the hypothetical effective rate of tax is 20% x 30% = 6%.

  • £400,000 - £325,000 =£75,000
  • £75,000 x 6%
  • Hypothetical charge = £4,500

Once the hypothetical charge has been calculated the trustees must establish the effective rate of tax applying to the trust.

  • £4,500/£400,000 = 1.125%

This tax rate is then applied to the amount of the capital distribution. However, there is a proportionate reduction based on the number of complete calendar quarters, with 40 representing the number of quarters in a ten-year period. The trust commenced in November 2018 and the distribution was made in November 2020, so the trust has completed eight quarters.

  • £100,000 x 1.125% x 8/40 = £225

So, even though there was no entry IHT charge on the £100,000 distribution, in November 2020 the trustees have an IHT liability of £225 which they must report within six months of the event.

In line with a commitment made by the Government at the autumn 2017 Budget, on 7 November 2018 HMRC published a consultation on ‘The Taxation of Trusts: A Review’. This considers whether the current system for taxing trusts meets the principles of transparency, fairness, neutrality, and simplicity. The consultation period closes on the 30 January 2019 and they are seeking views before consulting later on a specific proposal for reform.

In the meantime, the above highlights the need to seek advice as the taxation of trusts is clearly a complex area.

Kim Jarvis is a Technical Manager at Canada Life. She has worked in the life industry arena for over 20 years, with experience in trusts and their taxation, product development, the impact of new legislation on the industry and delivering training. She is an affiliate of the Society of Trusts and Estate Practitioners and a Chartered Insurer.