Discretionary trusts and taxation

On creation 

In general, where a trust is created by a regular premium protection plan, there’ll be no 20% lifetime inheritance tax (IHT) charge since the value of the gift made is simply the premiums paid on the plan. Such premiums are usually exempt from IHT either because they fall within the annual exemption (currently £3,000 a year) or because the premiums qualify as normal expenditure out of income based on the proposer’s spendable income.  
 
Where there are two donors, they are treated as making the gift 50/50.  
 
If the premiums are not covered by the available exemptions, the premiums will be chargeable lifetime transfers. However, even where neither of the exemptions apply, provided the premium paid plus all other chargeable lifetime transfers made by the donor in the previous seven-year period doesn’t exceed the nil rate band there will be no tax charge. It is only if the nil rate band is exceeded in any seven-year period that the excess would be subject to a 20% lifetime IHT charge.  
 
Where an existing whole of life plan is placed into trust, the value of the initial gift is the greater of the market value (usually the surrender value) or the premiums paid to date. Again, provided this is within the available nil rate band, no tax charge will arise. 
 
In the case of an existing term or whole of life plan, where there’s no surrender value, there’s usually no value placed on the gift unless the client is in serious ill health at the time the trust was created. If the client is seriously ill (in practice, where they die within two years of the transfer to the trust), HM Revenue & Customs (HMRC) will usually treat the value of the plan as the sum assured, although perhaps this may attract a discount.  
 
Form IHT 100a may need to be submitted to HMRC depending on the value of the plan transferred and taking into account any other chargeable lifetime transfers made by the client in the last seven years.  

Ongoing periodic and exit charges 

Periodic and exit charges apply where there’s a value within the trust. The valuation rules described above for whole of life plans apply equally for the purposes of these charges. HMRC has confirmed that they don’t expect individuals to have medicals every ten years for the purposes of the legislation. Provided the individual isn’t seriously ill to the best of their knowledge and belief, no further action would be needed.  
 
HMRC has also indicated that for the purposes of the ten yearly charge, generally the surrender value of the plan will be acceptable, though bear in mind that for a whole of life plan the total premiums paid over the ten-year period will be used if greater than this figure.  
 
The value of the trust at the tenth anniversary (and each subsequent tenth anniversary) may be subject to IHT at 6% on the excess above the trust's nil rate band at that time.  
 
More commonly, charges may arise if a claim is made on the plan and the proceeds remain in the trust for a period of time. An exit charge shouldn’t arise where proceeds are paid out within the first ten years if the value of the initial gift (including the cumulative total of the settlor’s chargeable transfers in the seven years prior to the gift) plus any added property is below the nil rate band. If funds continue to be held in trust beyond a ten-year anniversary any exit charges will depend on the rate of the previous periodic charge. 

Example

It’s May 2015. David doesn’t want to make any lifetime gifts. Instead, he takes out a plan with a sum assured of £400,000 payable on death which is intended to meet the IHT liability on his estate. He writes this in a discretionary trust for the benefit of his three children.  
 
The monthly premiums qualify as normal expenditure out of income and therefore no immediate IHT charge will arise on setting up the trust. Assuming he dies 15 years later the IHT implications for the trust will be as follows: 

In most cases, no IHT liabilities will arise in connection with protection plans in trust. Remember that only discretionary trusts are subject to the relevant property regime. Plans that have been placed in bare trusts don't have periodic and exit charges, but the value of the plan will be part of the named beneficiaries' estates for IHT purposes. 
  
Please note: Only a unit-linked whole of life plan will attract a surrender value.

So, should you still recommend the use of a trust?  

The answer is most certainly yes. Even if the trust does suffer an IHT charge at 6% because, for example, the life assured dies on or around a tenth anniversary, this is usually preferable to suffering a potential charge at 40% on the plan proceeds as part of the estate.  
 
Clients wishing to avoid this regime could of course consider writing their plans on a life of another basis. This will avoid probate and IHT on the death of the life assured but doesn’t solve either problem if both the owner and life assured die at the same time. In addition, insurable interest problems may arise.  
 
If the client wants flexibility to change beneficiaries yet still minimise charges, a discretionary trust could be used where the plan under trust has a sum assured valued at less than the available nil rate band since no IHT charges will arise within the trust.  
 
For sums assured in excess of the nil rate band, consideration could be given to writing a number of plans each with a sum assured less than the nil rate band. Each plan can then be placed into a separate trust, and each trust should have its own nil rate band provided the trusts are established on separate days. This is called a ‘Rysaffe’ arrangement.  
 
A bare trust would avoid the charges, but this offers no flexibility in changing beneficiaries and as noted previously, if the beneficiary dies at the same time as the life assured, an IHT charge may arise on the beneficiary’s estate.