A discounted gift trust, often referred to as DGT, stands as a specialized financial instrument designed for individuals aiming to efficiently plan their inheritance tax while maintaining a consistent income.
Historically, the inception of the discounted gift trust came as a solution to the escalating demand for tax-savvy estate planning.
The core essence of a discounted gift trust is to strike a balance between gifting assets and guaranteeing a continuous income flow for the settlor.
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The Mechanics of a Discounted Gift Trust
A discounted gift trust is fundamentally a trust-based inheritance tax (IHT) planning arrangement tailored for those who aspire to execute IHT planning but cannot fully relinquish access to their investment.
In a DGT setup, access typically manifests in the form of a series of predetermined capital payments directed to the investor, who also acts as the settlor of the trust.
The term ‘discounted’ is derived from the fact that the value transferred upon establishing the trust is lesser than the initial amount invested.
This discrepancy arises due to the settlor’s entitlement to a series of capital payments, contingent upon their survival to specific dates.
Variations and Structures of DGT
DGTs are not monolithic and can take various forms.
Predominantly, there are two basic types of discounted gift trust: those rooted in a bare/absolute trust structure and those based on a discretionary trust structure.
The choice between these structures can influence the inheritance tax implications.
For instance, using a bare/absolute trust structure initiates an IHT potentially exempt transfer (PET) by the donor, placing the trust fund within the beneficiary’s IHT estate.
On the other hand, employing a discretionary trust structure triggers an IHT chargeable lifetime transfer (CLT) by the settlor, positioning the trustees within the relevant property regime.
This structure offers enhanced flexibility, and versions accommodating joint settlors are widely accessible.
Recent Developments and HMRC’s Perspective
The HMRC, in its Inheritance Tax Manual, offers insights into how a standard DGT scheme operates.
There’s a significant emphasis on the valuation of the ‘transfer’.
It is widely recognized, based on comments in the Bower case, that HMRC acknowledges the intended functioning of DGTs.
Furthermore, DGTs don’t activate the reservation of benefit provisions since the settlor’s rights are never relinquished.
The settlor’s gift to the trustees is subject to the pre-selected payment stream, which is never given away.
Recent regulations, such as the Disclosure of Tax Avoidance Schemes (DOTAS) introduced in 2004 and later expanded in April 2018, aim to capture IHT avoidance schemes but exempt standard IHT planning techniques like the DGT, provided they adhere to specific criteria.
Benefits of Setting Up a Discounted Gift Trust
Setting up a discounted gift trust offers a myriad of advantages, particularly for those keen on optimizing their financial assets for the future.
From tax benefits to ensuring a steady income, a discounted gift trust stands as a robust financial tool.
Let’s delve deeper into its benefits.
Tax Efficiency and Inheritance
When you establish a discounted gift trust, you’re taking a proactive step towards safeguarding your assets in a tax-efficient manner.
The primary allure of a discounted gift trust is its prowess in minimizing potential inheritance tax liability.
By channeling assets into this trust, you’re essentially diminishing the overall value of your estate. This strategic move can translate into substantial inheritance tax savings.
But the advantages don’t stop there. A discounted gift trust also presents perks related to capital gains tax.
By anchoring assets within the trust, you stand a chance to defer, and in some cases, even curtail capital gains tax implications.
Retaining a Lifetime Income
Beyond the undeniable tax benefits, a discounted gift trust promises another compelling advantage: the assurance of a lifetime income.
The income you garner from a discounted gift trust is contingent on the discount rate you select during its inception.
This pivotal rate will dictate the periodic amount you’ll accrue.
What’s more, the discounted gift trust boasts flexibility in income distribution, empowering you to recalibrate based on your evolving financial requisites.
The Mechanics Behind the Income Calculation
The trust provider undertakes a medical underwriting of the settlor (the person setting up the trust).
Subsequently, they estimate the settlor’s life expectancy, taking into account their lifestyle and overall health.
This data then informs the calculation of the market value of all prospective capital payments the settlor will receive.
Essentially, these capital payments represent the payments a settlor commits to in order to secure regular future payments.
Who Stands to Benefit the Most?
A discounted gift trust emerges as an ideal solution for those aspiring to draw future payments from their trust fund.
These individuals are also keen on initiating inheritance tax planning measures.
To truly harness the benefits of a discounted gift trust, one needs to be in reasonably good health and survive for a minimum of seven years post-establishing the trust.
How Does a Discounted Gift Trust Work?
Understanding the mechanics of a discounted gift trust can be crucial for those looking to optimize their estate planning.
The Initial Investment Process
Establishing a discounted gift trust begins with an initial investment.
You choose an investment vehicle that aligns with your financial aspirations.
After selecting the vehicle, you determine the discount rate. This rate directly influences the income you’ll derive from the discounted gift trust.
It’s essential to understand that the amount treated as given away for Inheritance Tax (IHT) might be ‘discounted’ by the future value of the regular payments you retain.
For the trust to be effective for IHT, you should spend these payments and not retain them in the estate.
The Role of Trustees
Trustees are the backbone of a discounted gift trust.
Upon setting up your trust, you appoint trustees to manage its operations.
They ensure the trust’s assets reflect your wishes.
Moreover, they manage these assets efficiently, always acting in the beneficiaries’ best interests.
Beneficiary Access Post-Settlor’s Death
One of the key features of a discounted gift trust is that beneficiaries cannot access the trust until after the settlor’s demise.
This ensures that the settlor’s right to regular payments remains uninterrupted throughout their lifetime.
After the settlor’s death, the right to these payments ceases, and the trust’s value does not form part of the settlor’s estate for IHT.
Trust Creation and Investment
Typically, the trust is established when the settlor gifts cash to the trustees. Using existing bonds or other investments to create the trust is generally not feasible.
Instead, these need to be cashed in, and the proceeds are used to establish the discounted gift trust. The trustees then invest these funds, often in an investment bond, either onshore or offshore.
Regular withdrawals are set up to provide the settlor’s capital payments. Using non-income-producing assets, like bonds, means there’s usually no trust tax reporting unless there’s a chargeable gain.
Trust Options and Flexibility
A discounted gift trust often offers three trust options: Discretionary trust, Flexible (interest in possession) trust, and Absolute trust.
The discretionary trust doesn’t give any beneficiary a right to income or capital.
Instead, trustees can appoint income or capital to any beneficiary within the potential beneficiaries named in the trust deed.
The flexible trust names beneficiaries entitled to any trust income.
However, if the trust invests in an investment bond, no income is produced.
The trust includes a power of appointment, allowing trustees to alter beneficiaries or their respective shares.
The absolute trust fixes beneficiaries at the outset, and trustees cannot amend them later.
IHT Implications and Calculating the Discount
The creation of a discounted gift trust is a transfer of value for IHT. The IHT treatment depends on the type of trust used.
The value of the transfer for IHT might be discounted by the value of the settlor’s retained payments.
The actual discount is the market value of the settlor’s retained payments, based on factors like the settlor’s life expectancy, the payment level, life assurance costs, and potential tax on these payments.
Types of Discounted Gift Trusts
Understanding the various types of discounted gift trusts is crucial for anyone considering this financial planning tool.
Bare Trusts: Simplicity and Directness
A bare trust, often referred to as an absolute trust, is straightforward in its approach.
When you set up a discounted gift trust as a bare trust, you directly assign beneficiaries.
This means that from the outset, you specify who will benefit from the trust assets once the trust conditions are met.
Key Features of Bare Trusts:
- Direct Assignment: Beneficiaries are named explicitly, and their entitlement is fixed.
- Transparency: There’s no ambiguity about who will benefit from the trust.
- No Changes: Once set, you cannot change the beneficiaries of a bare trust.
Discretionary Trusts: Flexibility at its Core
On the other hand, a discretionary trust offers a more flexible approach to discounted gift trusts.
Instead of directly assigning beneficiaries, you provide the trustees with the discretion to determine who benefits and to what extent.
This flexibility can be particularly useful if your circumstances or wishes change over time.
Key Features of Discretionary Trusts:
- Flexibility: Trustees have the discretion to decide on beneficiaries.
- Adaptability: Beneficiaries can be added or removed based on changing circumstances.
- Potential for Wider Beneficiary Pool: The trust can benefit a broader range of potential beneficiaries, not just those named initially.
Making the Right Choice: Bare vs. Discretionary Trusts
When deciding between a bare trust and a discretionary trust, it’s essential to consider your long-term financial goals and the needs of your potential beneficiaries.
A bare trust offers simplicity and clarity, ensuring that your chosen beneficiaries will benefit.
In contrast, a discretionary trust provides flexibility, allowing for changes in beneficiaries based on evolving circumstances.
Factors to Consider:
- Future Changes: If you anticipate changes in your family or beneficiary circumstances, a discretionary trust might be more suitable.
- Certainty: If you have a clear idea of who you want to benefit and don’t foresee any changes, a bare trust might be the better choice.
- Control: Consider how much control you want to retain over the trust’s beneficiaries. A discretionary trust gives more control to the trustees, while a bare trust offers more direct control to the settlor.
Potential Risks and Drawbacks
Investment Risks
Every investment vehicle, including the discounted gift trust, carries inherent risks. One of the most prominent risks associated with a discounted gift trust is market volatility.
Fluctuations in the market can significantly affect the value of the trust’s assets. To combat this, diversifying the assets within the discounted gift trust is crucial.
Diversification acts as a protective shield against market downturns. By spreading the investments across various assets, you reduce the potential impact of a poor-performing asset on the overall portfolio.
This strategy not only mitigates potential losses but also paves the way for steady growth of the trust’s assets.
Regulatory and Tax Changes
The legal landscape surrounding discounted gift trusts is not static. Laws and regulations can evolve, sometimes rapidly.
It’s essential to stay abreast of any changes in tax laws to ensure that your discounted gift trust remains compliant and continues to serve its intended purpose.
For instance, according to recent information from PruAdviser, the Disclosure of Tax Avoidance Schemes (DOTAS) regulations, introduced in 2004, underwent changes effective from 1 April 2018.
These changes aimed to target IHT avoidance schemes but spared well-understood and agreed-upon IHT planning methods, such as the discounted gift trust, provided they met certain criteria.
The HMRC Perspective on Discounted Gift Trusts
The HMRC (Her Majesty’s Revenue and Customs) has a specific view on discounted gift trusts. In its Inheritance Tax Manual, HMRC provides details on how a ‘basic’ DGT scheme operates.
They have commented extensively on the valuation of the ‘transfer’.
It’s widely acknowledged, based on comments in the Bower case, that HMRC accepts that discounted gift trusts operate as intended.
However, it’s crucial to be aware of HMRC’s stance and interpretations to ensure that the discounted gift trust remains compliant.
Pre-owned Asset Tax (POAT) Implications
The operation of a discounted gift trust should not trigger an income tax charge under the POAT regime.
However, it’s essential to be aware of this aspect to avoid any potential tax implications in the future.
Is a Discounted Gift Trust Right for You?
Before deciding on setting up a discounted gift trust, it’s crucial to weigh the benefits against the potential drawbacks.
While a discounted gift trust can offer numerous advantages, especially in terms of IHT planning, it’s essential to ensure it aligns with your unique financial goals and circumstances.
Always consult with a financial expert to make an informed decision about whether a discounted gift trust is the right choice for you.
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Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.
