Up, up and away: pilot trusts

25 Sept 2012Feature

Chris Thurlow explains the many benefits of pilot trusts

Despite adverse legislative changes in recent years, the discretionary trust (whether full blown from the outset or starting as a pilot trust) remains a major tool for the private client practitioner for assisting clients to protect assets, protect individuals and provide flexibility, particularly under the terms of an individual’s will.

Regime change

One of the downsides of discretionary trusts is the inheritance tax (IHT) relevant property regime that applies. The regime also applies to many trusts for minors, other than bare trusts or bereaved minor’s trusts, and to a more limited extent to 18-25 trusts, which would have qualified as accumulation and maintenance (A&M) trusts prior to 2006.

Generally, the regime imposes an IHT charge on each ten-year anniversary of the trust being established, as well as an exit charge when capital is distributed to beneficiaries.

The maximum rate of IHT under current rules is six per cent. Though still preferable to the 40 per cent rate that applies to assets held by individuals on death, if the relevant value of the trust exceeds the IHT nil rate band (set to stay at £325,000 until 5 April 2015), the charge can still be significant.

On the other hand, if the relevant value of the trust is within its available nil-rate band, the rate would be zero per cent. Therefore, it would be beneficial (but not necessarily practical) for the trust to have a relevant value of less than the available nil-rate band.

To calculate the nil-rate band available to the trust, one must take into account any chargeable dispositions by the settlor in the seven years prior to setting up the trust. The initial value of any ‘related settlements’ and the value of any capital distributions from the trust in the previous ten years of the trust (if applicable) would also be relevant in determining the tax rate.

As related settlements (i.e. trusts set up on the same day, for example, date of death) will affect the IHT payable by the trust, there is no benefit in simply splitting a person’s estate between multiple trusts which are contained within the will itself. The most tax-efficient option is therefore to consider ‘pilot trusts’.

Flying solo

What is a pilot trust?

A pilot trust is simply a discretionary trust set up by an individual during their lifetime with a small initial gift, the intention being that assets will be added to the trust in the future. The initial gift could be, for example, a £10 note attached to the completed trust deed.

Assuming the settlor has not made any chargeable transfers in the previous seven years, a pilot trust will have a full IHT nil-rate band allowance available. It is then possible to set up a number of additional pilot trusts on subsequent days, again with an initial gift, of say £10, per trust. Each pilot trust would then have a virtually full IHT nil-rate band.

Under the terms of the settlor’s will, their estate could be split equally between each pilot trust. Assuming the division means that each pilot trust’s fund will be within the available nil-rate band, the relevant property regime would be avoided for at least the first ten years of the trust.

At the first ten-year anniversary of the trust following the date of death, charges may apply if the relevant value of the trust fund has increased in value to more than the available nil-rate band at that time. However, the IHT payable would still be lower than if the whole fund was held within one trust.

To ensure that each trust has its own nil-rate band and is not ‘related’ to any of the other trusts, it is essential that the trusts are set up on different days. In addition, it is advisable to change the terms of the trust deeds in another material way so that they are not each identical. Possibly the most simple way to do so would be to include a different UK charity as the default beneficiary in each trust (i.e. the beneficiary that would inherit at the end of the trust period if funds were still held).

There are a number of key points and tips for the establishment of pilot trusts.

The relevant property regime will apply to each pilot trust from the date that the trust is established (i.e. the date that the £10 initial gift is made). The ten-year anniversaries would therefore relate to the date of the ?gift rather than the date of death. Unless and until further assets are added to the trust, there would be ?no IHT payable by the trust and no need for an IHT account to be submitted to HMRC.
Section 144 of the IHTA 1984 applies where assets are transferred to pilot trusts under the terms of a will. Therefore, any distributions within two years of death out of any of the trusts will be ‘written back’ as if they had been made by the testator under the terms of his will directly.
The CGT annual exemption and income tax standard rate band available to pilot trusts generally will be split between the pilot trusts (and any other trusts set up by the settlor either during lifetime or by their will). However, the split is subject to a minimum CGT annual exemption, currently £1,060, and a minimum standard rate band for income tax purposes of £200.
Pilot trusts can also be used to protect death in service benefit lump sum payments paid by an employer, lump sums paid on death from the deceased’s pension and, in some instances, life assurance payments from falling into the estate of a surviving spouse and being subjected to IHT at 40 per cent on his or her death, while retaining access to those funds for that surviving spouse.
If a settlor wishes to set up a lifetime discretionary trust for IHT planning purposes, careful consideration should be given to the possibility of the creation of pilot trusts either in relation to the settlor’s will or to the other potential benefits listed above. If the pilot trusts are set up after the creation of a lifetime discretionary trust, either the available nil-rate band for each pilot trust will be reduced by the relevant value of the assets gifted to the lifetime trust, or it will be necessary to wait at least seven years before setting up the pilot trusts to ensure the full nil-rate band is once again available.
It is possible to use pilot trusts in relation to lifetime trusts. If a settlor wishes to place assets of, say, £500,000 in trust, there will be an initial 20 per cent IHT charge (the lifetime IHT rate) on the balance over the available nil-rate band. ?Pilot trusts will not assist with this initial charge.? However, if pilot trust one is set ?up on day one (with £10), pilot ?trust two on day two (with £10) and the £500,000 asset is transferred equally between them on day ?three, each trust will benefit from a nil-rate band for the purposes of the relevant property regime for the future. In addition, each trust (holding half of the larger value ?asset, £250,000) would be worth ?less than the current nil-rate band.
Currently, pilot trusts used on ?this basis are generally excluded ?from the disclosure of tax ?avoidance schemes rules, but ?the rules should always be borne ?in mind.

Pilot trusts: an example

Albert died on 1 May 2012 with an estate of £1m and had made no chargeable transfers in the seven years prior to death. Albert was a widower and had decided that either: (a) a discretionary trust would suit his family’s circumstances; or (b) his residuary estate should be held in trust for his very young grandchildren, subject to their reaching age 25.

In either event, Albert’s estate would be entitled to his nil-rate band and a transferable nil-rate band claimed from his late wife’s estate, totalling £650,000 (assuming 100 per cent transferable nil-rate band). IHT of £140,000 would therefore be payable, leaving a distributable estate of £860,000.

For illustration purposes only, if the relevant value of the will trust remained at the same level for the first ten years and no capital distributions were made between the two-year and ten-year anniversaries of death, at the ten-year anniversary an IHT charge of £32,100 would be payable (i.e. £860,000 less £325,000 and then charged at six per cent).

In addition, exit charges would be payable on any capital distributions after the second anniversary of Albert’s death (any distribution made from the trust within two years would be written back into Albert’s will by section 144 of the IHTA 1984).

If Albert had instead set up three pilot trusts during his lifetime and distributed his residuary estate equally between them, each trust would initially hold assets worth just over £285,000 (i.e. £860,000 divided by three), well within the available nil-rate band of £325,000.

There would, therefore, be no exit charges prior to the first ten-year anniversary of the creation of the trust (i.e. date of death) and there would only then be a ten-year charge (and later exit charges) if the relevant value of the trust had increased to more than the available nil-rate band at that time.

Chris Thurlow is a partner at ?Hart Brown Solicitors