Using a case study, Neil Jones, tax and estate planning manager, Canada Life, looks at how a bare trust can help in a situation where a potentially exempt transfer becomes chargeable, creating an imbalance in wealth divided amongst beneficiaries.
When considering estate planning and passing on wealth to future generations, just a simple straightforward gift from one person to another will suffice. An outright gift to an individual is a potentially exempt transfer and therefore the requirement is that the donor survives for seven years, otherwise the amount gifted will remain in their inheritance tax calculation.
Sometimes even with a straightforward gift, or number of gifts, care needs to be taken as to the order and structure and a simple bare trust can make life a lot easier and reduce issues after death.
Let’s look at a simple example – take Pete, he has an estate of £1,000,000 and wants to gift £150,000 to his daughter, Karen. He can make the gift and it is treated as being exempt, providing that he survives seven years, hence potentially exempt. His main objective is not to reduce inheritance tax but to help his daughter financially with money he does not anticipate needing in the future.
Sadly, Pete dies a couple of years later. The gift he made is no longer exempt as he failed to survive the required seven years – it is therefore a failed potentially exempt transfer and becomes chargeable. Despite the gift his estate has increased back to £1,000,000, so when calculating the inheritance tax liability on his death, currently the first £325,000 is chargeable to inheritance tax at 0%, known as the nil rate band. Anything over this is chargeable at 40% but can reduce to 36% if charitable legacies are included.
As gifts are added to the inheritance tax calculation before the estate on death, the £150,000 lifetime gift uses the first £150,000 of the nil rate band. This effectively means that £150,000 of the estate he leaves on death will be pushed over the 0% band and be subject to 40% tax.
This all sounds straightforward, however there can be complications when making multiple gifts.
Let’s expand Pete’s situation – he is a widower with three children; Jake, Ben and Karen and he decides that he wants to make lifetime gifts of £150,000 to each of his three children following his wife’s death. Again this is not primarily to reduce inheritance tax but to allow his children to benefit from his wealth before he dies. For simplicity we will say that Pete’s wife used her nil rate band at the time she died so he only has a single nil rate band available.
He writes three cheques, invites them round for dinner and presents each with a cheque for which, as you can imagine, they are very grateful. Pete has now made three potentially exempt transfers totalling £450,000 and over the next few days the children pay the cheques into their respective bank accounts.
If Pete dies a couple of years later, how does the inheritance tax position change?
- When Pete’s executors calculate his inheritance tax liability, again they need to first add in the gifts he made during the previous seven years. This is the three failed potentially exempt transfers totalling £450,000.
- Lifetime gifts are added in chronological order and despite Pete giving the cheques on the same day, the gift has not actually occurred until the cheques are cashed. We shall say that Karen was the most efficient and first to the bank, followed by Jake and then Ben.
- As Karen’s gift was completed first, this goes into the inheritance tax calculation first, followed by Jake’s and then Ben’s. In total these gifts exceed Pete’s nil rate band by (3 x £150,000) – £325,000 = £125,000, and to be more precise Karen’s and Jakes’ gift fall within the nil rate band, however Ben’s is partly taxable, in fact £125,000 is taxable.
- The excess over the nil rate band applies solely to Ben’s gift and is subject to 40% inheritance tax, so a liability of £125,000 x 40% = £50,000 arises. There is no taper relief on this amount as Pete died a couple of years after making the gift. As this liability arises from a gift the liability falls on the recipient, in this case Ben.
This leaves the family in an uncomfortable position. Pete thought he was helping each of three children equally, but one child is left with a large tax liability and this could cause issues between the children as Ben’s net gift was only £75,000. Naturally he is not happy that such a situation could arise, knowing that this is not what his father intended.
What could Pete have done to ensure such an imbalance does not arise?
How could a bare trust have helped?
The use of a simple bare trust could have removed the potential for such a circumstance to arise. Some will think that this would over-complicate a simple example of gifting. I imagine that anyone caught in Ben’s situation would think it very worthwhile and sensible.
If Pete had gifted the £450,000 into a bare trust with the three children as equal beneficiaries then he would have made one single potentially exempt transfer and gifted the full amount on a single day.
The trustees, which could have been himself and the children, could have distributed the money to the beneficiaries [Jake, Ben and Karen] at a later date, or immediately, whichever they preferred. On Pete’s death the dates of the distributions from the trust to beneficiaries are irrelevant when considering his inheritance tax position; the date of the gift from Pete to the trust is the important factor.
The position of Pete’s death is that the whole £450,000 gift was made on the same day and whilst the same inheritance tax liability will arise on Pete’s death, as the total gift would still have exceeded the nil rate band, the liability will fall evenly on the three beneficiaries.
Although the inheritance tax is not mitigated, the position for the beneficiaries is clearer and more balanced due to the use of a simple bare trust. If Pete had wanted to look at more focused inheritance tax planning then his adviser may have recommended a different strategy combining different trust structures. There are a wide variety of solutions available, but a simple bare trust can be a valuable asset in an advice toolbox and can make even simple gifting, simpler.