There’s a lot to consider when considering the right type of trust arrangement. This article from Shoaib Ahmed, Senior Technical Manager at M&G delves into some technicalities of Discounted Gift Trusts and Flexible Reversionary Trusts and where one might be more suited to a client’s circumstances than the other.
When it comes to inheritance tax (IHT) planning, most clients will want to have their cake and eat it. They will want to make gifts, but at the same time retain access to any funds gifted.
What we know is that this type of arrangement would typically fall foul of the Gift with Reservation of Benefit (GROB) rules.
The good news for clients is that there are two trust structures which might let them have their cake and eat it.
This article will take a closer look at the similarities and differences between a Discounted Gift Trust (DGT) and a Flexible Reversionary Trust (FRT) set up with a bond and help you decide which one is right for your client.
How do the trusts work?
A DGT allows an individual to make a gift for Inheritance Tax (IHT) purposes, but at the same time retain the right to an income for life.
A FRT also allows an individual to make a gift for IHT purposes, but with the ability retain access to the funds gifted through selected vesting dates.
How is the initial gift treated?
A DGT can be set-up on a bare trust or discretionary trust basis. This means that there is the added flexibility of whether to make a Potentially Exempt Transfer (PET) or Chargeable Lifetime Transfer (CLT).
Separately, a gift into a DGT may also benefit from a discount, which would reduce the value of the transfer for IHT purposes. The exact size of the discount will be based on the value of the income rights, which is dependent on the health of the settlor at application.
On the other hand, a FRT can only be setup on a discretionary trust basis, meaning that your client will be making a CLT. This limits the amount that can be settled into a FRT without an immediate IHT charge
Unlike a DGT, there is no discount available when making gifts into a FRT.
How are payments made to the settlor?
With a DGT, the payments to the settlor must be determined at outset. The payments are fixed and are paid regularly to the settlor for the remainder of their life.
With a FRT, the settlor does not receive fixed payments. Instead, they retain a revocable right to receive payments back as certain bond segments vest in the trust (revert absolutely) to them.
The vesting dates for these bond segments are chosen at outset in the chosen provider’s trust deed.
Can my client stop the payments?
With a DGT, it is important to remember that the settlor has an irrevocable right to payments for the rest of their life. It is not as simple as simply telling the bond provider to stop the payments.
Therefore, it is not normally possible to stop the payments. In theory, the settlor could ask a solicitor to create a deed that relinquished their entitlement to future payments, and the deed could then be provided to the bond provider.
The relinquishing of rights would be potentially treated as a further gift by the settlor, so there would be IHT implications. You would also have the added complexity of trying to establish the value of the gift, and this would require underwriting and actuarial expertise.
With a FRT, the default position is that the segments will vest at the stated dates, meaning the funds revert to the settlor. But the trustees have choices. The trustees on the anniversary date will have an option to:
- defer the reversion (meaning the settlor’s entitlement is pushed back), or to
- defeat the reversion (meaning the funds are paid to the beneficiary).
Does the role and responsibilities of the trustees differ?
Yes, with a FRT, the trustees must be aware of when segments are set to mature. They must then notify the bond provider of whether they want to defer the settlor’s reversionary interest in the segments (settlor’s entitlement is pushed back further) or defeat it (the segments will be paid or held in a fund for the beneficiaries).
Crucially, if a trustee does not make a decision, then the segments automatically vest, meaning they are held on bare trust for the settlor.
This could mean that the IHT planning could become less effective, or even completely negated. Therefore, a FRT adds an extra level of responsibility onto the trustees, when compared with a DGT.
Can the trustees use the 5% tax-deferred allowance?
With a DGT, the 5% tax-deferred allowance is typically used by the trustees to fund regular payments to the settlor. It is important to remember that the settlor’s entitlement to regular payments does not stop when the tax-deferred allowance is fully used.
So, an income entitlement based on a 5% withdrawal could mean chargeable gains occurring after year 20.
With a FRT, the 5% tax-deferred allowance cannot be used whilst the settlor is alive. But the cumulative allowance can be used by the trustees when the settlor dies.
Can the trustees make payments to the beneficiaries during the lifetime of the settlor?
With a DGT, as long as there is no explicit restriction in the trust provisions, then the trustees could in theory make a distribution to the beneficiary, but they must ensure that it will not affect their ability to maintain payments to the settlor.
In practice, a number of DGT providers have either put in place an effective ban on payments to beneficiaries during the settlor’s lifetime or have put in place significant restrictions (e.g. funds can only be paid in the event of an emergency for a beneficiary).
With a FRT, there is no such restriction, other than having to wait for the vesting dates, which take place annually. The trustees will have the ability to defeat the segments’ vesting dates, thus enabling bond segments to be assigned to beneficiaries.
Final thoughts
In the end, choosing between a DGT and FRT comes down to the client’s objectives and the amount they want to settle into trust. A DGT is typically more suited to clients who want a lifetime income, whilst also potentially benefitting from an immediate IHT reduction through the discount.
Separately, the fact that a DGT can benefit from a discount does mean your client may be able to place more than £325,000 into a discretionary trust without an entry charge.
In addition to this, the option to set-up the DGT on a bare trust basis also provides scope with planning for very large cases.
On the other hand, an FRT offers greater flexibility, making it appropriate for clients who may want to adjust withdrawal levels and potentially distribute funds to beneficiaries during their lifetime.
However, this additional flexibility offered by a FRT does come at a cost, and that is the additional responsibility placed on trustees.
As stated earlier, a trustee failing to keep on top of decisions to be made around vesting dates could result in some or even all funds reverting to the settlor and being held on a bare trust basis, thus making the IHT planning less effective, or in the worst case scenario, ineffective.
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