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Trusts to hold investment bonds for inheritance tax planning

The way in which assets held within trusts are treated for inheritance tax purposes depends on whether the choice of beneficiaries is fixed or discretionary. The most popular types of trust commonly used for inheritance tax planning can usually be written on either an “absolute” or on a “discretionary” basis and the taxation treatment is very different for each.

Absolute, or “bare” trusts

When trusts select beneficiaries who cannot be changed later, they are set up on an “absolute basis”. Gifts into absolute trusts are regarded as belonging to the beneficiary and so the settlor, or the person making the gift, must be excluded from all benefit. An investment bond held within an absolute trust is regarded as belonging to the beneficiaries so when they receive distributions from it this is not regarded as a transfer of value since it was already their property by virtue of their absolute interest.

A gift into an absolute trust is regarded as a Potentially Exempt Transfer and so there is no immediate charge to inheritance tax, unlike discretionary trusts, below. For more on their tax treatment, please refer to our guide on the taxation of absolute trusts.

Discretionary trusts

When trusts select beneficiaries who can be changed later, they are set up on a “discretionary basis”. The settlor of a discretionary trust must be excluded from any benefits under the trust in order to avoid falling foul of the “Gifts With Reservation” rules. Trustees use their powers of discretion which can be defined in the trust deed. In the future, trustees can add or change beneficiaries as and when required.

Gifts into Discretionary Trusts are deemed to be Chargeable Lifetime Transfers and may be liable for immediate tax for any amount exceeding the available nil rate band at the rate of 20%. Discretionary trusts may also be subject to periodic 10 year and exit charges. The calculation of these charges is complex so we have written a guide to the taxation of discretionary trusts.

Investment Bonds and trusts

Investment bonds are often used for inheritance tax planning in conjunction with the following types of Trusts, many of which can be set up on either an absolute or discretionary basis :

Takes part of the investment bond out of the Estate immediately. You have to take an income and the rest of the investment becomes exempt to inheritance tax after 7 years.

The investment bond falls out of the Estate as the loan is repaid, typically at 5% per annum. More suitable for those with a life expectancy of at least 20 years.

Suitable for beneficiaries who require an income with the capital paid, often to another beneficiary, at the end of the term or a predetermined age.

A portion of the investment bond is gifted to named beneficiaries and the other part is held for the benefit of the Settlor.

Suitable for UK resident non domiciled individuals who can exclude an offshore investment bond from being liable to UK Inheritance Tax.

A wide variety of trusts can be written in a will with gifts into trust to take place after the death of the Settlor. These can be codified in a will or written posthumously using a Deed of Variation. If no will is in place trusts can be defined by the laws of Intestacy and a bond must be written in a statutory trust.

  • Lifestyle Trusts

Lifestyle Trusts are a form of Discretionary Trust where distributions can be made to beneficiaries at future dates for predefined amounts. The Settlor can continue to access capital and the bond would fall outside of the estate after 7 years. After 7 years the trust would continue to be subject to the standard charges for a discretionary trust.

Deciding on which trust to use for an investment bond depends on a variety of factors, such as wanting to be able to change the future beneficiaries, access to capital and/ or income and the domicility of the bond owner. Care needs to be taken to ensure that not only is the right trust used but that it does not have unintended inheritance tax consequences on other existing trusts caused by the cumulation principle.

For more on how we can help trustees comply with their duties and responsibilities, see our section on Investment Bonds for Trustee Investments.

For guidance regarding different types of trust and their tax treatment, HMRC have published help and information covering their use for inheritance tax planning and their taxation. To find out more about how to report tax due to HMRC refer to our section trustee reporting responsibilities.

Many trusts are available from the investment bond providers and we have produced an article which shows you some of the options available.