IHT charges arise on discretionary trusts every ten years on the value of the trust property at that time and also on the value of any property which leaves the trust (if for example it is appointed out to one or more beneficiaries of the trust). The maximum charge at a ten year anniversary is 6%.
However, in calculating any such charges on a particular trust it is necessary to take into account any other trusts which the individual may have set up on the same day (the trusts are then referred to as “related trusts”); the effect of this is that the IHT charges on any one trust are likely to be much higher. Even if the trusts are not set up on the same day if any property is subsequently added to one or more trusts on different days this also impacts on any IHT charges on the other trusts.
It is therefore ideal for trusts not to be set up on the same day (which occurs where trusts are set up under a will; generally undesirable) and, if property is added to more than one trust, it is done so on the same day.
How they can help
Pilot trusts are designed to mitigate the IHT charges referred to above by ensuring that each trust can benefit from a full nil rate band (NRB) currently £325,000.
The term “pilot trust” refers to a discretionary trust set up by an individual (referred to as the settlor) with nominal property. Thus, the property settled initially is usually £5 or £10. The intention is to then add more significant property at a later date.
Typically, more than one such trust is created around the same time. The trusts typically are set up in the individual’s lifetime and on his death a large percentage of his estate is then divided amongst the trusts. By doing this the IHT charges which arise on the trusts in the future, following his death, are greatly reduced.
Practical examples
Example 1
Tommy Tucker on his death settled £650,000 on a discretionary trust set up in his will. Ten years later the IHT charge on the trust property will be 3% of £650,000 ie £19,500 (this assumes the value of the trust property remains at £650,000).
Tommy could have set up two pilot trusts in lifetime (putting £5 in each). On his death £325,000 is added to each trust. Ten years later there is no IHT charge on either trust as each trust has its own NRB of £325,000.
In simple terms, the bigger the likely estate on death the more pilot trusts are set up in lifetime.
Example 2
Harry White is extremely rich and his estate on death amounted to £3.25 million. He wished to settle his estate on trust.
To avoid significant future IHT charges he created 10 pilot trusts in his lifetime then settling £325,000 on each trust on his death; alternatively, he could have utilised 15 trusts, for example, which would reduce potential future IHT charges even further (although increasing administration costs for the trusts).
Another possible use of the pilot trust is with respect to life policies. A life policy offers an effective way of providing funds for the surviving spouse/children following death of a spouse.
Example 3
Billy Smith took out a life policy for £975,000 and settled it on a discretionary trust for his spouse/children. On his death the trustees receive the £975,000 which is not subject to IHT at that time as the monies do not form part of Billy’s estate. Ten years later the IHT charge on the trust will be 4% of £975,000 ie £39,000.
Billy could have set up three pilot trusts in his lifetime and took out three life policies each for £325,000. Ten years after his death no IHT charges arise on any of the three trusts.
Administration of trusts
It is to be noted that the more trusts which an individual creates the higher are any associated running costs (eg fees for professional trustees; fees for preparation of trust accounts etc). These fees cannot, of course, be ignored but may be relatively insignificant when set against any long term IHT savings. In addition, capital gains tax (CGT) charges within the trusts may be a little higher as the annual exempt amount (currently £5,300 for trusts) is split amongst the number of trusts thus reducing each trust’s exempt amount of any capital gain; however, any corresponding CGT charge is relatively de minimis.
Practical Tip :
The larger the likely estate of an individual on death the greater is the incentive to consider whether it is worthwhile setting up one or more pilot trusts in lifetime - even as a precaution. For the smaller estate it may not be worthwhile, but asking a professional adviser for confirmation may be a small cost to pay.
Malcolm Finney
