Bare Trust as IHT mitigation tool?

by Readers Question

9:57 AM, 11th November 2019
About 3 months ago

Bare Trust as IHT mitigation tool?

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Bare Trust as IHT mitigation tool?

I wonder if anyone could comment on this case.

Two sisters own an unencumbered (mortgage free) leasehold flat with share of the freehold on the residue of a 999-year lease, value approximately £1.2-1.5 million, in London as tenants in common. They are both retired and in their late 60s.

To mitigate inheritance tax, they are considering setting up two Bare Trusts, one for each, into which each will transfer their 50% ownership as donor for the benefit of the other.

Since the property is and has always been their only residence, they will be entitled to Private Residence Relief (PRS) and they envisage that there will be no CGT payable on transfer of the asset into a Bare Trust.

As it is their private residence there is no rental income generated therefore no income tax liability arises.

Since they will be transferring property assets into a Bare Trust, they understand that this will be considered Potentially Exempt Transfers (PET) and there will be no liability to IHT on set up and no IHT liability at 10 yearly intervals, as would have been the case with a Discretionary Trust. Should they survive 7 years then the asset in trust becomes IHT free on death of either and can pass to the surviving sister IHT free allowing her to continue living in the flat unencumbered.

Are their assumptions correct? Can a Bare Trust be used in this scenario or is it only a Discretionary Trust that can remove assets from an estate?

Any comments or suggestions welcome.

Frederick



Comments

Colin McNulty

14:58 PM, 19th November 2019
About 3 months ago

Reply to the comment left by Iain at 19/11/2019 - 07:11
Thanks Iain, you are of course correct. I realised my folly whilst out walking the dog, which of course was to presume that at 4am and only 1 cup of coffee down was the right time to be thinking about such things! 😉

Frederick Morrow-Ahmed

13:47 PM, 22nd November 2019
About 3 months ago

Thank you to everyone who made their very valuable comments and suggestions.

To update, I believe the sisters are aware that by throwing money at the problem, vis a vis WOL insurance, the IHT liability could be met. However, they are asset rich (relatively) but income poor (or at least not income rich) as they are pensioners.

So downsizing, as suggested my Iain, or a mortgage after first death, as suggested by Mark, would appear to be their most practical options.

My main reason for putting up this thread was to try and get a handle on the mechanics of the working of trusts, specifically bare trusts versus discretionary trusts. It may help other landlords too in expanding their knowledge base.

Dissecting one step at a time:

Item1
Sister-A dies after more than 7 years, her 50% share of the property in her bare trust passes IHT FREE to her sole beneficiary, Sister-B (true or false?)

Item2
At this point, what happens to Sister-B’s bare trust? Her sole beneficiary has passed away, does the trust continue or does her 50% share now pass to the estate of Sister-A and is subject to IHT on this estate?

Item3
If the latter, how does this differ from a discretionary trust? Would this have continued in existence, hence affording Sister-B the luxury of continuing to live in the flat without the burden of IHT?

Item4
If Item1 is indeed correct, then the only reason for failure is the swap mechanism. If there was no swap involved then theoretically a bare trust could be used to protect an estate on a linear basis. X dies after 7 years and leaves his estate IHT free to the trust’s beneficiary Y. If this is correct then why would anyone use a discretionary trust with its attendant costs?

Mark Alexander

14:12 PM, 22nd November 2019
About 3 months ago

Reply to the comment left by Frederick Morrow-Ahmed at 22/11/2019 - 13:47
I believe single premium Whole of Life policies can also be purchased. You might want to check into this too.

The premium could be funded via a small equity realease type mortgage is cashflow tight.

Iain

9:21 AM, 23rd November 2019
About 3 months ago

Reply to the comment left by Frederick Morrow-Ahmed at 22/11/2019 - 13:47
Hi Frederick. I was going to go through and offer true or false answers but I don't think those scenarios work properly.

First of all, forget about bare trusts. It's a misnomer. They're not trusts in the same way as a discretionary trust.

In a bare trust the beneficiary owns the asset for all purposes, it's just that its registered in someone else's name. It's a nominee arrangement.

It might be easier to picture if we create a hypothetical situation. We still have sisters A and B but now they each own separate properties, 1 and 2.

Sister A owns property 1. Sister B owns property 2.

Sister A creates a bare trust over property 1 with sister B as the beneficiary. The result is that sister B now owns property 1 for all purposes, including tax and including inheritance tax, but it is registered in Sister A's name as trustee.

If sister B does the same but with property 2 then sister A now owns property 2, but it is registered in Sister B's name as trustee.

There are no tax savings to be had.

With that in mind, let's look at your scenarios.

1. This isn't right. If each sister places their share in a bare trust for each other then there is a swap, not a gift. The 7 year rule doesn't apply, the sisters just own each other's share in the property. You're right back to where you started from.

2. The trust doesn't continue because it's not really a trust. The assets in the trust belong to the beneficiary and are distributed in accordance with the terms of her will (and subject to IHT as part of her estate).

3. A discretionary trust is a true trust in that the assets in the trust do not belong to the beneficiaries. To simplify it a bit, they belong to the trust itself and are managed by the trustees for the benefit of the beneficiaries. Discretionary trusts can be used to keep assets out of a person's estate whilst letting them still use those assets.

However, if a person sets up a discretionary trust that they can benefit from then the gift with reservation of benefit rules apply. That person is treated as owning the trust's assets for IHT purposes, so there is still a charge to 40% on death.

Discretionary trusts are used for IHT planning when passing assets down to the next generation, though, because after that point IHT is charged at 6% every ten years on the trust's assets rather than 40% every generation, which is usually around every 25-30 years or so. Many family businesses are held in trust, as are aristocratic fortunes, partly because arguably IHT is lower overall and easier to plan for but also because discretionary trusts prevent beneficiaries frittering money away and it prevents fragmentation of ownership of businesses and estates.

Hopefully that has answered 4 as well!

Frederick Morrow-Ahmed

11:47 AM, 23rd November 2019
About 3 months ago

Hi Iain, Thank you very much for that very exhaustive explanation. I think the root and source of my confusion lies in the 7-year PET rule, which is also stated on the government’s own website.

If a bare trust is not a trust at all where does the PET come into it?

You have described it most lucidly in your example:

Sister A creates a bare trust over property 1 with sister B as the beneficiary. The result is that sister B now owns property 1 for all purposes, including tax and including inheritance tax, but it is registered in Sister A's name as trustee.

However, I think I can now finally see where I have gone astray. I did not read the government’s website statement carefully enough. I quote:

https://www.gov.uk/trusts-taxes/trusts-and-inheritance-tax
“Bare trusts
These are where the assets in a trust are held in the name of a trustee but go directly to the beneficiary, who has a right to both the assets and income of the trust.
Transfers into a bare trust may also be exempt from Inheritance Tax, as long as the person making the transfer survives for 7 years after making the transfer.”

What I missed out in the above is that the operative word is “INTO”, namely: “Transfers INTO a bare trust may…”

In other words, it is just reiterating what we already knew, that bare trusts are not subject to charges, unlike discretionary trusts.

I had misinterpreted the above statement as meaning “Transfers FROM a bare trust may…”!

I can now understand why lawyers are trained to pore over each and every word and to cross the “t”s and dot the “i”s!

Are you a lawyer Iain?

I cannot now see any use for bare trusts at all. They wouldn’t even protect the assets from a creditor or an ex-spouse. I guess their only use may be to “hold it in trust” (literally) for a minor until he/she reaches the age of 18.

Thank you very much Iain for finally making a wise man out of me. It was an arduous task! I wish you great success in managing your property portfolio during these troubled times!

Frederick Morrow-Ahmed

11:53 AM, 23rd November 2019
About 3 months ago

Reply to the comment left by Frederick Morrow-Ahmed at 23/11/2019 - 11:47
Thanks to your urging Iain, the penny finally dropped. The written word was INTO not FROM!

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