Discretionary Trust and Tax Implications of Financial Gifts

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When contemplating enhancing your children’s financial future through a substantial gift, or setting up a discretionary trust for their benefit, it’s crucial to be informed about the potential tax implications in the UK. The realm of tax can be complex, especially when it involves gifting and trusts. Gifts of money to your children might seem straightforward but delve a bit deeper, and you’ll uncover the nuances of Potentially Exempt Transfers (PETs) and the intricacies of setting up a discretionary trust.

While PETs can be free of inheritance tax if you survive for more than seven years post-gifting, a discretionary trust, on the other hand, has immediate taxation implications, albeit with certain exemptions if planned carefully. The decision between making a direct financial gift or utilising a discretionary trust has significant tax considerations and could impact the financial well-being of your beneficiaries. The following information will explore these two avenues, highlighting the importance of the timing of such gifts, the potential tax liabilities, and how to navigate these waters efficiently to ensure your generosity achieves its intended effect without an undue tax burden.

The Benefits of a Discretionary Trust

This contrasts sharply with the treatment of a lifetime financial gift into a discretionary trust.  Such a transfer is immediately chargeable to inheritance tax at a lifetime rate of 20%.  However, if the value of the transfer into the trust is less than the inheritance tax nil rate band (£325k), then the transfer into the trust is not subject to the immediate 20% charge. Should the Transferor survive for seven years he/she regains their lifetime IHT exemption of £325k.

Is a Discretionary Trust right for me?

A complication can arise where Potentially Exempt Transfers are made and then subsequently a discretionary trust is set up and transfers are made into it.  If the person dies within seven years of the PET’s, the failed PET’s become chargeable to inheritance tax and affect the order in which the nil rate band of £325k is used.  What this means is that the £325k is now applied against the earlier failed PET’s instead of the transfer into the discretionary trust.

The result of this is that the beneficiary of the now failed Potentially Exempt Transfer may have a tax liability to pay if the PET exceeded the nil rate band of £325k and by that stage (up to seven years after receiving the gift), the cash may now be spent.

Taper relief can reduce any Inheritance Tax charge where the Transferor has died between three and seven years from the making of the gift.

Furthermore, because the Potentially Exempt Transfer was made before the discretionary trust settlement, periodic and exit charges for the trust could be impacted.  A discretionary trust is assessed to inheritance tax every ten years or whenever capital is transferred out of the trust (an exit charge).  The trust has its own nil rate band for calculating these periodic and exit charges, but in this scenario, the nil rate band is reduced by any chargeable transfers, including failed PET’s, in the seven years before the trust was created.

Avoiding an Inheritance Tax Charge on your Financial Gift

The order of gifting is very important if you are planning to make a series of gifts, whether they be outright gifts or gifts into a discretionary trust as the order they are made in can affect subsequent trust charges.  The recommended order of gifting is to make the chargeable lifetime transfer into the discretionary trust first and then make the potentially exempt transfers.

Finally, if you are considering making lifetime gifts in excess of the £325k inheritance tax nil rate band, you should limit the transfer into the discretionary trust to no more than £325k and apply the balance of the amount of gifting towards PET’s as this will avoid a lifetime Inheritance Tax charge.

If you would like more assistance to ensure your financial gift is made in the most tax efficient way possible, please get in touch.