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Pilot makes soft landing

A discretionary trust can potentially save a pension member’s death benefits from suffering IHT

Pension planning normally involves the provision of lump-sum death-in-service benefits in the event of the member’s death before retirement. Occupational pension scheme trustees will often use their discretion to pay the death benefits to the surviving spouse. While this provides financial security for the spouse, it may result in the payment becoming liable to inheritance tax on the spouse’s subsequent death.

To avoid the death benefits being included in the surviving spouse’s estate, the member could set up a pilot discretionary trust for a nominal amount during his or her lifetime, under which the spouse, children and grandchildren can be potential beneficiaries, to which death benefits under the scheme can be paid.

The trustees of the pilot trust should be named on the expression of wish form completed by the member. Although not legally binding, it is unusual for pension scheme trustees to deviate from the wishes expressed by a member.

The value of the trust fund passed to the pilot trust should not form part of the taxable estate of the spouse on his or her subsequent death despite the fact that the trustees have the ability to exercise their discretion to pay/appoint income and/ or capital to the beneficiaries, which would include the spouse, as the need arises.

When creating the trust, the member would be regarded as making a chargeable lifetime transfer for IHT purposes. However, assuming that the amount of the transfer is nominal, say, within the 3,000 annual exemption, this should not give rise to IHT implications.

Once the death benefits have been paid to the trustees of the pilot trust, the trustees hold these benefits as the trust fund. As the value of assets supporting a discretionary trust are not included in a beneficiary’s estate for IHT purposes, the trust fund will be liable to periodic charges every 10 years. HMRC Capital Taxes has confirmed that the first periodic charge to IHT will be on the 10-year anniversary of the member joining the scheme rather than the 10-year anniversary of the creation of the pilot trust. The charge to IHT at that time will be based on the value of the property then held in the trust. The calculation of the charge, known as the effective rate, is quite complex but will not generally exceed 6 per cent of the excess value of the trust fund over and above the nil-rate band of IHT at the date of the 10-yearly charge.

Any property leaving the pilot trust will be subject to an exit charge based on an appropriate fraction of the effective rate. This is also a complex calculation but the charge will again not generally exceed 6 per cent, as the exit charge is based on the previous anniversary charge or charge on commencement.

HMRC Capital Taxes has recently made it clear that where occupational pension scheme trustees make payment to a separate discretionary trust such as a pilot trust, any payment out of the pilot trust made within two years of the member’s death will not be free of IHT under the normal HMRC concession. However, this is unlikely to have any real impact as pilot trusts are generally intended to exist for longer than two years following the member’s death. If it appears likely that a direct distribution of the death benefits is required within two years of the member’s death, it will be possible for the pension scheme trustees to make such a distribution free of IHT.

Some providers recommend that an interest in possession trust rather than a discretionary trust should be used to avoid any potential 10-yearly and exit charges. However, should a beneficiary with an interest in possession predecease the surviving spouse, the whole value of their share of the trust will form part of their estate and will be potentially liable to IHT at 40 per cent.

There is no perfect solution to this problem but the use of a discretionary trust can enable death benefits to be paid out and remain outside the estate of the member’s spouse and family, saving significant IHT on the spouse’s subsequent death.

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