Setting Up A Lifetime Settlement: The Tax Basics

Malcolm Finney outlines some key tax issues on the lifetime creation of a settlement. 

For the purposes of this article, the terms ‘settlement’ and ‘trust’ will be used interchangeably. 

There are three key parties to the creation of a lifetime settlement, namely, the settlor, the trustees, and the beneficiaries. The settlor is the individual who sets up the trust (i.e. who transfers assets such as shares, cash etc. to the trustees); the trustees are the individuals to whom the settlor transfers the title to the assets and who then hold those assets for the beneficiaries; and the beneficiaries are the individuals who benefit from the trust. 

Herbert transfers a buy-to-let property to Dom and Dick, who are the two trustees who hold the property. 

The terms of the trust are that Dom and Dick are to hold the property on trust for Herbert’s sister Helen for her lifetime, and on her death, the property is to be held for Herbert’s brother Harry absolutely.

This form of trust is referred to as an interest in possession trust. Under the terms of the trust, Helen is entitled to the income generated from the buy-to-let during her lifetime, but she is not able to deal with (e.g. sell) the property. On Helen’s death, the trustees transfer the property to Harry and the trust terminates.

Herbert transfers a buy-to-let property and a portfolio of shares to Dom and Dick who are the two trustees who hold the property. 

The terms of the trust are that Dom and Dick are to hold the property on trust for a class of beneficiaries, including Herbert’s three children, Eunice, Henry and Bert; Herbert’s sister Helen; Herbert’s brother Harry; and the RSPCA.

This form of trust is a discretionary trust. Such trusts provide the trustees with some discretion/flexibility enabling them to grant benefits to those beneficiaries, perhaps in most need, taking into account conditions at the time. By contrast, the ‘interest in possession’ trust (Example 1 above) gave no such discretion to the trustees.

The lifetime transfer of property from settlor to trustees typically occurs by way of gift and constitutes a chargeable lifetime transfer for inheritance tax (IHT) purposes, and may thus precipitate an immediate IHT charge on the part of the settlor. Whether or not such a charge arises depends upon the value of the property settled and the extent to which the settlor has not fully utilised his nil rate band (NRB), currently £325,000. 

Mary settled shares worth £500,000. 

The IHT charge is 20% (i.e. the lifetime rate) on [£500,000 - £325,000] i.e. £35,000. Thus, the trustees actually receive [£500,000 - £35,000] i.e. £465,000. 

Margaret settled shares worth £200,000. 

As the value of the property falls within Margaret’s NRB there is no IHT charge. The trustees actually receive the full £200,000 and Margaret’s NRB is reduced to £125,000.

The availability of the NRB (to which each individual is entitled) means that each spouse is able to set up a separate trust (each worth £325,000), e.g. for the benefit of family and friends, without any IHT charges on set up. In addition, any ongoing IHT charges are also mitigated.

 

Future funding of any trust, once set up, can be achieved without further IHT charges if, for example, the amount transferred is up to £3,000 per annum (referred to as annual exempt gifts) and/or using monies which fall within the ‘normal expenditure out of income’ exemption (i.e. income which may be settled without adversely affecting the standard of living of the settlor, namely, income surplus to requirements of the settlor). Neither exemption gives rise to any IHT charge, whether or not the settlor survives for seven years. 

The setting up of the settlement involves a disposal by the settlor of the property transferred. For capital gains tax (CGT) purposes, the disposal is treated as having been made at market value, and hence a CGT charge may arise on any gain. Thus, settling cash avoids any potential CGT charge.

Where a significant gain arises, it may be possible to hold over the gain (i.e. the gain is not charged to CGT on settlement but is deferred until the trustees dispose of the property concerned). Holdover relief is possible where either an IHT charge arises on the settlement of the property, or if the property settled qualifies as a ‘business asset’ for business property relief purposes (e.g. shares of a trading company, which are not listed).

Horace settles his shareholding in XYZ Plc on discretionary trust. The shares had originally cost him £25,000, and on settlement had a market value of £60,000.

As an IHT charge arises on settlement (even if the IHT charge is at 0%) Horace elects for the gain to be held over.

Thus, Horace suffers no CGT charge, but the base cost of the shares for the trustees becomes £25,000 [£60,000 - £35,000], instead of £60,000.

Where possible, avoid an IHT charge on creation of a lifetime settlement by settling an amount within the NRB.