If the settlor is in poor health or older, they may not live as long and so the market value and the discount are lower, and the potential IHT saving is less.
Advisers may receive varying levels of discounts from different providers based on the underwriting interpretation and assumptions used. This can be down to factors like future interest rates, costs, taxation and mortality.
If the provider is not following HMRC guidance, the level of discount can be challenged by HMRC after the settlor’s death. So it is important to know how it has been calculated.
Valuation, medical evidence and underwriting
While it is not essential for a DGT to be underwritten, it does provide robust evidence of the value of the discounted gift at the time of establishing the arrangement. This will help to:
- Establish the discounted gift with HMRC if the settlor dies within seven years and HMRC contests the value of the discounted gift; and
- Determine whether an immediate IHT charge is likely to arise when the gift is made (under a discretionary trust-based scheme).
Should you use a discretionary or bare trust?
A discretionary trust will give the settlor and trustees greater flexibility over the choice of future beneficiaries and control over when they become entitled. However, it will fall under the relevant property regime and the chargeable lifetime transfer rules.
DGTs under a discretionary trust are often only recommended where the 'cumulative total' is below the IHT nil rate band of £325,000 when added to the value of the discounted gift (the cumulative total is the total value of all chargeable gifts made in the seven years prior to setting up the DGT).
This avoids the potential IHT treatment of complex calculations for CLTs and time-consuming reporting at outset.
A bare trust will offer no flexibility to change beneficiaries or to control when the beneficiaries become entitled to the trust fund.
However, gifts to this type of trust are treated as potentially exempt transfers and the relevant property trust tax rules will not apply.
The tax implications
For a DGT set up on a discretionary trust basis
When the settlor creates the trust, they will be treated as making a CLT equal to the value of the discounted gift.
As the settlor is making a CLT rather than a PET, if the discounted gift exceeds the settlor’s available nil rate band, there will be an immediate IHT charge of 20 per cent on the excess.
The right to future income or reversions usually has no value immediately before death and is not included in the estate for IHT purposes.
If the settlor survives their gift by seven years, the discounted gift drops out of account for IHT purposes.
There may be periodic (every 10 years) and exit charges whenever capital payments are made to beneficiaries. Reporting requirements may also apply.
Payments made to the settlor should not give rise to IHT exit charges, as they are treated as being made from a separate fund to which the settlor is absolutely entitled.
