A discounted gift trust allows the settlor (or settlors) to make an inheritance tax effective gift whilst retaining a right to fixed regular payments for the remainder of their lifetime. The value of the settlor's gift for IHT will be discounted by the estimated value of these future retained payments.
The trust establishes two distinct rights:
- The settlor's right to pre-agreed regular payments for life
- The beneficiaries' right to the trust fund after the settlor's death
As it is separately identifiable as to what has been given away and what is retained for the settlor, there's no gift with reservation for IHT.
Discounted gift trusts may be set up on a single or joint settlor basis (for spouses and civil partners only). When spouses or civil partners consider creating a discounted gift trust (DGT) they will need to decide whether one joint settlor or two single settlor DGTs is most appropriate.
The retained payments
The right to the retained payments on a joint settlor DGT will typically continue at the full amount after the first settlor's death.
However, if two single settlor DGTs are selected, the right to the retained payments on one trust will cease upon the first death. This could be an issue where the surviving settlor relies on the retained payments.
Where the surviving settlor is also a beneficiary of the first settlor's trust then they can of course still benefit from that trust, either in the form of regular payments or larger lump sum payments.
The discount
Joint discounts are calculated based upon combined life expectancy, that is, on the probability of both settlors dying. The discount is not appointed equally but split based upon each settlor’s own life expectancy. This may give a slightly different overall discount compared with two single settlor DGTs, but it will depend upon individual circumstances.
A discounted gift trust will typically offer three trust options. These are:
- Discretionary trust
- Flexible (interest in possession) trust
- Absolute trust.
Under the discretionary trust, no beneficiary has a right to either income or capital. The trustees are able to appoint income or capital at their discretion to any beneficiary within the class of potential beneficiaries named in the trust deed.
The flexible trust names the beneficiaries who are entitled to any trust income. However, if the trust is invested in an investment bond, no income is produced. The trust includes an overriding power of appointment which allows the trustees, which will usually include the settlor, to alter the beneficiaries or their respective shares in the trust. This is especially useful where the settlor may want to alter the beneficiaries in the future. For example, where there are new beneficiaries born after the trust is created, such as grandchildren, or perhaps where the named beneficiary falls out of favour.
Under the absolute trust, the beneficiaries are fixed at outset and cannot be amended by the trustees at a later date. The beneficiary of the absolute trust only becomes entitled to the capital and income from the trust after the retained payments cease upon the death of the settlor. When selecting the absolute trust, the settlor should be certain of who they ultimately want to benefit from the trust.
Key features of a discounted gift trust (DGT):
- A discounted gift trust allows a settlor to give away assets and still enjoy regular payments for life
- The amount treated as given away for IHT may be ‘discounted’ by the future value of the regular payments which have been retained
- To be effective for IHT, payments should be spent by the settlor and not retained in the estate
- The right to the regular payments ceases on the settlor's death and has no value
- Beneficiaries are unable to benefit from the trust until after the settlor has died
If the settlor is considered to be in reasonable health, a calculation is made about the likely total amount of income that will be paid back to him by the trustees.
This is known as the discount and it’s deemed to be retained by the settlor.
The remainder will be treated like any other gift into a trust – such as a chargeable lifetime transfer (CLT) in the case of a discretionary trust, or a potentially exempt transfer (PET) in the case of a bare trust, falling outside the scope of IHT after seven years.
If the settlor dies within seven years, one might think that his retained discount should go to his personal representatives to form part of his estate. However, the HMRC tested and accepted IHT treatment is that this right to an income for life has no value once the settlor has died, so no money has to be returned.
The rest of the money will be treated like any other gift into the trust and brought back into IHT calculations if death occurs within seven years.
As a result of this, there is an immediate IHT reduction upon creation of a discounted gift trust, making it a powerful IHT planning tool for anyone in their later life, whose intentions are to draw income from their investments throughout their lifetime and then pass on the remainder to their beneficiaries.
