How a Discounted Gift Trust can help with Inheritance Tax Planning
At outset of a Discounted Gift Trust, or DGT as they are commonly referred to, the settlor requests a series of regular capital payments payable for their lifetime, or until the fund is exhausted. This series of payments is generated from partial withdrawals, usually from an investment bond subject to a suitable trust.
The total value of the payments is ‘carved out’ from the original gift and is retained within the estate for IHT purposes as it is not given away. This retained amount is known as the ‘discount’. In effect, it is an exchange of part of the initial gift for an income stream.
The term ‘discounted’ is used because the value transferred on establishing the trust is less than the amount invested. This is the logical consequence of the fact that the settlor is entitled to a stream of capital payments. The settlor's transfer or gift is the bond/policy premium less the value of the payments receivable during his/her lifetime.
The income, based on life expectancy of the settlor and actuarial calculations, is given a market value, i.e. what someone might expect to pay for such an income stream. This figure is then used to establish a reduced value of the gift for IHT purposes.
The result of the discount is that an instant IHT saving can be achieved, as the discount is immediately outside the estate.
In the event of the settlor dying within seven years, this retained "bag of rights" should in theory be returned to their personal representatives. However, the accepted IHT treatment, as has been tested many times and accepted by HMRC, is that this right to an income for life has no value once the settlor has died, and therefore no money has to be returned.
The effect is that the discount is deemed to leave their estate on day one of settlement of monies into the trust- the remainder will be treated like any other gift into trust and brought back into calculations if death occurs within 7 (in some cases 14) years. So in effect, there is an immediate IHT reduction upon creation of a discounted gift trust.
There are two basic types of DGT but many variations on the general DGT theme.
Those based on a Bare/Absolute Trust structures and those based on a Discretionary Trust structure.
Use of a Bare/Absolute trust structures trigger an IHT potentially exempt transfer (PET) by the donor. The trust fund is within the beneficiary's IHT estate. (In this context the trust fund is the policy/bond value less the value of the settlor's rights to payment.) Under an Absolute Trust the gift creates a discounted PET, which, after seven years from the date of the gift, becomes exempt from IHT. If the settlor dies within the seven years, the PET becomes chargeable and may be included in their estate or may be taxable on the person who received the gift.
The use of a Discretionary Trust structure triggers an IHT chargeable lifetime transfer (CLT) by the settlor and the trustees are thereafter within the relevant property regime.
Under a Discretionary Trust the gift creates a discounted CLT, which may attract an entry charge if the value of the gift when added to any other CLTs made in the previous seven years exceeds the settlor’s current nil-rate band. Again, CLTs drop out after seven years as long as no PETs are created after the CLT. The discretionary structure gives greater flexibility.
So a transfer will either be a discounted potentially exempt transfer (PET) or a discounted chargeable lifetime transfer (CLT) depending on whether an Absolute trust or a Discretionary trust has been chosen.
It is important to note that the discount quoted by an insurer is not guaranteed and HMRC can challenge the underwriting opinion and therefore figures quoted. However, a prudent approach by the insurer, i.e. underwriting in advance for all cases and strict use of the HMRC-prescribed interest rate in the discount calculations, should help to minimise the likelihood of any challenge
Who is the Discounted Gift Trust suitable for?
It may be suitable if you:
Need the potential for immediate and future IHT reduction
Are likely to survive seven years
Need fixed regular payments
Are in reasonable health.
It may not be suitable if:
Are older than 90 next birthday (either true age or mortality rated)
Are unlikely to have an IHT liability
Do not need regular payments
Are not in good health
You might change your mind about the amounts you want back from the trust and when.
A discounted gift trust is a very powerful planning tool for anyone in later life whose intentions are to draw income from their investments throughout their lifetime, then to pass on the remainder to their beneficiaries, as it allows for this and at the same time helps to reduce the amount of Inheritance Tax that might eventually have to be paid. DGT is unique in that it achieves an immediate reduction in the estate and fully exempts an asset from IHT after seven years, yet it allows you to take an income for life. This is recognised as a legitimate tax-saving device and HMRC even has a section advising about it on their website. https://www.gov.uk/hmrc-internal-manuals/inheritance-tax-manual/ihtm44112
However, there is of course always the absolute need for professional and experienced financial advice and your financial adviser will generally work together with a client's lawyers and accountants when advising on and setting up this vehicle.