Paul Davies reviews the way trusts and life assurance policies can be used to meet succession planning challenges and considers some of the issues arising
Apparently, failing to write life assurance in trust is still one of the most common inheritance tax planning errors. Both trusts and life assurance policies can have a significant role to play when it comes to succession and inheritance tax planning.
Where term assurance policies are concerned, there is no economic benefit to the original policyholder in retaining the policy. The only reason to do so would be to retain complete power over disposition of the proceeds. However, a well-written trust deed can achieve a similar result without the same inheritance tax cost.
A problem can arise if the premiums payable under the policy exceed £3,000 per annum. If the policy is in trust, paying the premiums on the policy constitutes a transfer of value that is an immediately chargeable transfer. Once the payments exceed the £3,000 annual exemption, those payments are, potentially at least, subject to inheritance tax.
There is an exception for life assurance policies written on ‘interest in possession' trusts prior to 22 March 2006. If that does not apply then, in the majority of cases, paying the premiums will escape inheritance tax for some other reason e.g. as regular gifts made out of surplus income, or because the payments fall within the ‘nil-rate band'.
In the latter case however, the payments made in the seven-year period prior to death will be taken into account in determining the inheritance tax liability when the person dies and/or the amount of their nil-rate band that can be transferred to the estate of their surviving spouse.
Fortunately, the reporting obligation for lifetime transfers was relaxed with effect from 6 April 2008. Cash transfers are only reportable once the amount chargeable in aggregate in any seven-year period exceeds the nil-rate band. This may seem like common sense but it was not previously the position and many payments were reportable even though no IHT was payable.
Advisers must remain alive to the possibility that a client has made a chargeable transfer within seven years of taking out a life assurance policy that is written in trust. The client's previous history of chargeable transfers will of course impact on the advice given vis a vis the IHT payments arising in respect of paying the policy premiums.
If the sum assured is more than the £325,000 nil-rate band, the adviser should consider the potential benefit of writing multiple policies in trust, so giving each trust its own IHT allowance for the purpose of calculating periodic and exit IHT charges under the IHT regime generally applicable to trusts. This is a particular issue for trusts that are expected to remain in existence in the long term, rather than being wound up soon after the life assured dies.
Loan trusts, discounted gift schemes, and everything in between
Life assurance companies have been most astute over the years in packaging life assurance together with trusts in a way that addresses a variety of issues for customers.
These schemes have one thing in common - they are not a straightforward trust of a life assurance policy.
On the whole they go some way to achieving what, for IHT purposes, can be considered akin to the ‘Holy Grail' - giving something away and continuing to receive a benefit from it (without triggering the application of the ‘gift with reservation of benefit' rules).
The two most popular and enduring arrangements are the ‘loan trust' (where funds are provided to the trust by way of loan, instead of gift) and the ‘discounted gift trust' (where the settlor retains a right to receive a flow of payments out of the trust fund in future).
There are permutations on these arrangements but the loan trust and discounted gift trust are both tried and tested and are also well known.
Both the loan trust and the discounted gift trust achieve their objectives because they involve the settlor of the trust in something other than a straightforward gift. This allows the settlor to retain a benefit under the arrangement.
Since March 2006 these schemes have a secondary attraction. The nature of the arrangements in each case is such that the ‘transfer of value' made by the settlor for IHT purposes are reduced.
Under the loan trust, the settlor makes only a nominal transfer of value because the amount put into the trust is put in by way of a loan rather than a gift. Under the discounted gift trust, the size of the transfer of value made by the settlor depends on an actuarial assessment of the net present value of the expected future payments to be received by the settlor. Accordingly, both the loan trust and discounted gift trust may enable an intending settlor to settle a larger sum into trust without paying IHT than would be possible if he or she were to make an outright gift.
Valuation
The general valuation rule for IHT is that everything is valued at its ‘market value' e.g. the price it might reasonably be expected to fetch if sold in the open market. When it comes to valuing life policies, there is a rule that exists, seemingly, only to trap the unwary. The rule prevents the value of policies from being artificially decreased by including unusual conditions in the policy terms. However, the rule only applies to lifetime transfers, not to transfers on death.
The value of a life policy or contract transferred before death is not to be less than the total premiums paid, less sums received in respect of the policy, before the transfer. The rule does not apply to most term assurance policies, and there is provision for any losses on unit-linked policies to be reflected in the value at the date of transfer.
Suppose an individual takes out a unit-linked policy and pays premiums of £20,000 per annum for 15 years. He then transfers the policy into trust. At the date of transfer the value of the policy is £180,000. At the date of allocation the value of the units was £280,000.
The deemed value is therefore reduced by £100,000 (from £300,000 to £200,000). The value is not £180,000.
Note: For the purposes of this article, ‘trust' means a settlement to which section 43(2) Inheritance Tax Act 1984 applies and so does not include a bare trust
Paul Davies is a solicitor, chartered tax adviser, trust and estate practitioner, and partner at Lane-Smith & Shindler LLP
