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Making gifts – order of gifting

When making gifts for IHT purposes, it is essential to consider the order in which gifts into trusts are made. The order in which gifts are made will dictate the future taxes applicable to the trusts created.

Case study

Consider Alan who wishes to create a discretionary trust of £325,000 for his grandchildren. Alan chose a discretionary trust as he was concerned about giving his grandchildren absolute access to these funds. The discretionary trust also provides the required flexibility to cater for any new family members that he may want the trustees to add to the list of beneficiaries.

As Alan has declared a discretionary trust, it falls under the chargeable lifetime transfer (CLT) rules. The gift into the discretionary trust falls within the current available nil-rate band (NRB) of £325,000 (frozen until 2020/2021), therefore no initial charge will apply.

Additionally, Alan wishes to make an outright gift of £325,000 to his adult children via bare trusts. These gifts would be considered potentially exempt transfers (PETs), so entry, 10-year periodic and exit charges are not applicable. Combining both bare and discretionary trusts means that he can give away £650,000 without any immediate liability to tax.

At this point all Alan’s objectives seem to have been addressed. But, supposing Alan dies eighteen months later, how will this impact IHT? The key question now is ‘in what order were the trusts created?’, as this will determine which trust benefits from the NRB.

The scenarios on the following pages assume that the residual estate has been passed to the spouse under the inter-spousal transfer exemption, annual exemptions have been utilised and the spouse has utilised their NRB should they predecease them.

Scenario 1 – PET before CLT (writing a bare trust before a discretionary trust)

In this scenario, we will assume Alan declared the bare trust before the discretionary trust.

The PET would be allocated to the current available NRB (for illustrative purposes, we will assume an NRB of £340,000 applies). Therefore, the calculation is £340,000 minus £325,000. This would leave £15,000 of unused NRB which can be used against the CLT.

The CLT would be taxed as £325,000 minus £15,000 (£310,000) x 40%, minus any tax paid on entry (nil). This leaves £124,000 of IHT to pay.

There would be no taper relief available as Alan did not survive for three years after making the gifts. The £124,000 tax can be paid by the trustees of the discretionary trust. Assuming there are no payments to the beneficiaries in the first ten years, and that the value of the discretionary trust has by then grown to £410,000, the calculation at the first 10-year periodic charge point will be:

Chargeable transfers within seven years prior to the creation of the trust:

£325,000 (failed PET as the gift was made to a bare trust) + £410,000 (current discretionary trust value)
Less (assumed) NRB for tax year 2025/2026 - £400,000 = £335,000
x 20% lifetime rate = £67,000
Effective tax rate (£67,000/£410,000) x 30% = 4.90%
Tax due (4.90% x £410,000) = £20,090

Scenario 2 – CLT before PET (writing a discretionary trust before a bare trust)

In this scenario, we assume Alan declared the discretionary trust before the bare trust.

The CLT would be allocated to the current available NRB (for illustrative purposes we will assume an NRB of £340,000 applies) which would leave £15,000 unused NRB to be offset against the failed PET. The PET would be taxed as £325,000 minus £15,000 (£310,000) x 40%. This leaves £124,000 of IHT to pay. There would be no taper relief available as Alan did not survive for three years after making the gift.

The 10-year periodic charge on the discretionary trust would be as follows:

Chargeable transfers within seven years prior to the creation of the trust:

£0 (because the gift into the bare trust was made after the gift into the discretionary trust)
+ £410,000 (current discretionary trust value)
Less (assumed) NRB for tax year 2025/2026 - £400,000 = £10,000
x 20% lifetime rate = £2,000
Effective tax rate (£2,000/£410,000) x 30% = 0.15%
Tax due (0.15% x £410,000) = £615

In this example we have focused on the impact of the 10-yearly periodic charge. The same principles will also apply when calculating ongoing exit charges when the trustees look to distribute from the trust to the beneficiaries in the first and subsequent 10-year periods.

Effective trust and product planning

The entry, exit, and 10-yearly periodic charges which now apply to flexible and discretionary trusts means the order in which gifts are made into trust will impact immediate and future tax payable. Therefore, careful consideration is required. By executing the deeds at different times, future taxes can be reduced or even negated. There may be other factors which require consideration but the diagram below outlines, for the majority of multiple transactions, the order of events which is most effective in reducing tax liability.

The entry, exit, and 10-yearly periodic charges which now apply to flexible and discretionary trusts means the order in which gifts are made into trust will impact immediate and future tax payable. Therefore, careful consideration is required. By executing the deeds at different times, future taxes can be reduced or even negated. There may be other factors which require consideration but the diagram below outlines, for the majority of multiple transactions, the order of events which is most effective in reducing tax liability.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown at the top of this article. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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