Using a Bare Trust to Avoid Inheritance Tax
Up until now, it has been relatively unusual for people to use bare trusts, as discretionary trust offer the trustees significantly more control over the trust assets. Bare trusts are likely to make a comeback as the total value of discretionary trusts settled in a lifetime or on death is liable to a potential income tax charge on the tenth anniversary.
Potentially Exempt Transfer
The main reason for the possible income tax charge with discretionary trust is that a person is only allowed a lifetime limit equivalent to the Nil Rate Band and a gift into a Bare Trust is treated as a Potentially Exempt Transfer. Potentially Exempt transfer means the gift can be unlimited and provided the settlor lives a full seven years after the gift so no IHT will be due.
Also, no income tax is chargeable on the trust if the value exceeds the Nil rate band on the 10th anniversary, and it does not count as part of the total amount gifted into the trust.
A further advantage is the trust has the full allowance benefit for capital gains tax and not half the exemption as is applied to discretionary trusts.
Bare Trusts are partway between full trust and outright ownership. The trustees have the usual trustee responsibilities, but for tax, the liability arises on the beneficiaries and not the trustees.
Why Bare Trusts are not much used?
The reason Bare Trusts are not used often is that once the beneficiaries have reached 18 years of age, they can demand the transfer of all the capital. Also, if the beneficiary dies, the assets form part of their estate for IHT purposes.
Usual uses of Bare Trusts in the past
Grandparent setting aside money for grandchildren’s education is quite a common use. The Capital Gains Tax arising on the beneficiaries is advantageous, and the grandparents may also want to use their full discretionary allowance for other purposes like inheritance tax planning.
The present uses of Bare Trusts
For the very wealthy, gifts may want to be made into a discounted gift trust using a Bare Trust arrangement which retains the right for up to 5% return of capital tax-free yearly to the settlors and cannot be wound up by the beneficiaries during the life of the settlor.
Using a Bare trust enables a large gift to be made which not generating an immediate income tax charge on the trust if the gift exceeds the current Nil rate band allowance (£325,000 in tax year 2013/14).
The wealthy settlor can also gift £325,000 into a discretionary trust at the same time, thus reducing the value of the estate after seven years and making a significant saving on Inheritance Tax. Like all Inheritance Tax planning, it can be complex and expert advice should always be sought as mistakes can have serious financial consequences.