Trust classification and tax treatment

Trusts Discussion
1

Hi there,

I am working with a client who wants to set up a trust with them as settlor / trustee, and their 2x 9 year old children as beneficiaries. They want to gift their home where they have lived for the last 12 years to them, and then pay 4% of the market value of the home (£400k home so £16k/year) to the trust each year, so £8,000 per year to each child. The trust would retain control of the house and any decisions on its future use etc, upon death, the house would pass to the children.

My understanding is that - the trust would be classified as an “interest in possession” trust, i.e. the trust is holding the asset for the children to gain after the client’s death, and the children are benefiting only from the income until then. No CGT as this is a sale of a main residence, no stamp duty as gifted, and the income tax would pass to the 2x children, and would be within their personal allowance so therefore no income tax payable.

Can I check I’m not missing anything here please?

thanks
Michael

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2

Inheritance tax?

(this phrase just because i need 20 characters)

3

There can be no CGT holdover on the property passing onto the trust.

As the parent of the minor beneficiaries the income will be treated as the settlor’s income, despite the fact that he is paying it to the trust/beneficiaries, so there would probably be a double income tax charge.

Unless the rent paid is the “market rate” a gift with reservation may arise. That the rent is a percentage of the “presumed(?)” market value does not mean it is the “market rate”. You would need to review the rent regularly (at least every other year) to try and make sure a GWR does not accidentally arise?

As a chargeable lifetime transfer, IHT would be payable on the gift into trust in any event, and the property would be subject to the IHT relevant property regime.

Not sure it’s the most effective arrangement to put in place!

Paul Saunders FCIB TEP

Independent Trust Consultant

Providing support and advice to fellow professionals

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4

Is there a mortgage?

5

As intimated by Paul, are you inferring that you understand that the settlement of the property into trust gives rise to a gift with reservation for IHT which can effectively be removed by the parent paying the trustees a market rent?

Or is it a bare trust you are trying to create with the parent as sole trustee holding the property for the children?

Malcolm Finney

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6

Presumably the settlors will be exempt from capital gains tax because of main residence exemption. So inheritance tax is the first tax to be considered.

The gift into trust will be a chargeable transfer, with IHT due at 20% on the amount in excess of any available annual exemption under S.19 and the settlors’ unused nil rate band.

The risk of a retention of benefit is avoided by giving full consideration for the settlors’ continued occupation. The rent suggested is unlikely to be the market rent, even for the first year. Reviewing it every other year, as is suggested, could result in the rent paid in the intervening years being less than the market rent. The effect of such a pattern, if the market rent increases annually, would be seen if the ‘relevant period’ is the seven years immediately preceding death. If less than market rent is paid in the intervening years, say years 2, 4 and 6 out of the last 7 years of the settlor’s life, this will result in a reservation of benefit in each of those years, ceasing at the end of that year, with a consequent deemed PET under S.102(4) FA 1986. Each would be; equal to 50% of the value of the house at the end of the year.

A proper application of this sub-section would give a disastrous extra liability. Ignoring any changes in the value of the house, the deceased settlor would have notional chargeable transfers totalling 150% of its value, three times the amount otherwise in the estate if this exercise had not been taken.

Others have pointed out that the trust income, the rent paid for the settlors’ occupation, will be assessable on the settlors as parents (S.629 ITTOIA 2005), so long as the children are unmarried infants. So, if a settlor’s marginal income tax rate is 40%, he or she will have to pay 140% of their share of the rent.

Thus, to be certain of achieving an inheritance tax saving, a full market rent must be paid throughout the ‘relevant period’; a period ending on the donor/settlor’s death and beginning 7 years earlier, or if later the date of the gift. Of course, at the time the house is settled, the settlors won’t know when the relevant period starts.

As remarked, SDLT will be due if the house is settled subject to a mortgage liability. Would the amount of the children’s income chargeable on their parents be reduced by any mortgage interest paid by the trustees?

7

A rent is surely market if there are regular rent reviews and all other terms and conditions are market. If that were not so an entirely commercial tenancy where the market rent until the first review ceased to be market at times over the term would not arguably be a market rent at those times. Since a fixed rent with reviews is a totally common feature of market transactions it must also be such in principle between connected parties. The amount of that initial rent is a separate constituent element of the market appraisal

Jack Harper

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Legislation governing residential letting will affect what is full consideration. But market forces must result in the figure varying from year to year… Hence the possibility of the pattern I suggested, if the rent is not at least annually reviewed…

9

This article - Lack of supply is key for student landlord Empiric in today’s Times indicates the volatility of residential rents, albeit in a particular area…

10

Thanks all for the replies. There is no mortgage. I am glad I found this site. I am a qualified accountant with no experience of trusts and thought I’d sense check my clients request using the HMRC guidance before contacting a specialist solicitor with a “pre-vetted” plan to save costs. His goal is to put the property in trust as he plans to get married and wants to avoid the house becoming a marital asset, and also has a legal dispute which he does not want to end with a charge on his house. There is no mortgage. If anyone has any suggestions on the best way of achieving this with no / minimal increased tax liability I would be very grateful.

Thanks
Michael

11

The court has power under s423(1) Insolvency Act 1986 to order, amongst other outcomes, the reversal of a transfer of property into a trust if it was done with the substantial purpose of defeating actual or potential creditors. It may or may not matter that there were other purposes e.g. estate planning. There is no requirement that the settlor be insolvent.

Jack Harper