Discounted Gift Trust Case Study

Eleanor and Felix are a married couple who are 68 and 70 respectively. They have four children, several grandchildren and possibly more in the future. Both are in good health and expect to live for at least the next seven years. Having recently downsized from their old family home, Eleanor and Felix have a significant amount of cash in the bank, and are aware that there will be a potential Inheritance Tax (IHT) liability on second death. They have not previously made any significant gifts.

They want to mitigate IHT but are conscious that their desired day to day expenditure is greater than their pension income. Rather than making outright gifts to family now, they simply want their family to benefit after second death.

The adviser considers the situation and identifies these important facts about Eleanor and Felix -

• Potential IHT problem needing addressed.
   
• Capital ‘rich’ but income ‘poor’.
   
• Requirement to top up their regular income.
   
• Both healthy and under 90.
   
• Beneficiaries to benefit after second death.

The adviser recommends they each establish a discretionary Discounted Gift Trust (DGT) and explains -

• It’s for those with a potential IHT liability but unable to lose full access to their investment.
   
• Access is provided to each by means of a series of pre-set capital payments.
   
• Each has the opportunity to choose the level of payment and its frequency.
   
• An analysis of their forecasted income and expenditure needs will help establish the payments required.
   
• The term discounted is used because the value transferred on establishing the trust is less than the amount invested.
   
• Both in good health so discount will be available and that is immediately outside their estate.
   
• Their respective discounted gifts will be comfortably below £325,000 and so will avoid a lifetime ‘entry’ charge on the Chargeable Lifetime Transfers (CLTs).
   
• If either of them had been aged, or rated, over 90 then the discount would be negligible.
   
• The two discretionary trusts ensure flexibility over those who will potentially benefit from the remaining capital after death of the settlor. Potential beneficiaries will include future grandchildren (and great-grandchildren).

Eleanor and Felix learn that a gift into a DGT is a transfer of value where the value is determined by the ‘loss to the estate’. That will comprise the amount invested less the value of the right to the repayments (see below). The open market value of these repayments depends on age, health and size of the repayments. The adviser explains that HMRC’s preference is that full underwriting should be carried out prior to the DGT being effected. The actual amount of the discount may need to be ultimately agreed with HMRC, but the Insurance Company offers an indication of the value at inception based on medical evidence provided.

Both Eleanor and Felix apply for a UK Insurance Bond on a single owner, single life basis. Each then completes a DGT deed. In their deed, each selects the size of the payments and the frequency (e.g. monthly, quarterly etc.). In both cases, the withdrawals selected are within 5% limits, even accounting for ongoing adviser charging. Assuming no shortfall, both have the right to these regular payments for life, and on death that right ceases and so does not swell the value of the deceased’s estate. The trustees then have the discretion to distribute the remaining capital to any of the class of beneficiaries. This includes children and remoter descendants but excludes the settlor. The surviving spouse is however a potential beneficiary. What this means is that when one of them dies, the survivor will still enjoy the regular payments from their own DGT but in addition, the trustees of the first deceased’s DGT have discretion to advance any remaining funds to the survivor should that need arise.

The adviser explains that it would have been possible, instead, to have set up a joint DGT and in that event the total joint repayments would have continued after first death, and simply ceased after second death. That would be less flexible, but would probably have created a bigger discount. The adviser however clarifies that the main objective of the DGT is to mitigate IHT and carve out access to pre-determined capital payments for expenditure needs. Although the discount provides an immediate reduction in the estate, it is only relevant for death within seven years – both however are in good health.

They learn that it is not sensible to maximise the pre-determined capital payments just to increase the size of the discount. If a settlor carves out access to more capital than actually needed for expenditure then it could be counterintuitive to the overall IHT mitigation strategy, as the excess would build up inside the estate. 

When each spouse dies, the bond in their DGT will pay out if the deceased was the sole life assured. The chargeable gain will be taxed on the deceased in the year of death. Given their low level of income it is not anticipated there will be any tax to pay, and the proceeds can then be distributed as the trustees see fit.

Both Eleanor and Fred are setting up a tax efficient arrangement offering the prospect of regular, fixed repayments for life which they require to top up their income. An immediate IHT discount is available because the value transferred on establishing the trust is less than the amount invested. After first death the survivor can benefit from any capital remaining in the deceased’s trust at the discretion of the trustees.

This is only an example of advice and isn’t based on specific client’s circumstances. Your clients individual needs, circumstances and tax situation will vary.