The main tax regime that affects trusts is Inheritance Tax (IHT).
Premium Equalisation
Although the life assured/settlor is included as a potential beneficiary of the trust, it is not treated as a Gift with Reservation if it is used alongside the appropriate share agreement, because it represents a reciprocal commercial arrangement.
To make sure the transaction is seen as a genuinely commercial arrangement, premiums should be ‘equalised’ so that each business owner pays a fair amount in relation to the potential benefit they may receive from the other owners’ plans. All the owners’ premiums on their plans will be different, as they are based on things such as age, health and sum assured. So, if premiums are not equalised, then the difference in premiums paid could be interpreted as transfers of value for IHT purposes. This may not matter if the difference is small, because it is likely to be covered by annual IHT exemptions.
However, unequalised premiums could cause a greater problem in the event of a claim; the money being paid into the trust could be treated as a substantial gift for IHT purposes if the premiums are not equalised and the arrangement is consequently not deemed commercial.
As an example of the equalisation calculation, for a business with three owners, the formula shown below would be used to work out owner A’s equalised share of premiums to be paid. The same principle would be applied for partners B and C and then the three partners would arrange between themselves to settle the differences in premiums actually paid.
| A’s Sum Assured x B’s Premium |
+
|
A’s Sum Assured x C’s Premium |
| Total Sum Assured – B’s Sum Assured | Total Sum Assured – C’s Sum Assured |
Relevant Property Regime
Discretionary trusts are subject to the ‘relevant property’ regime for IHT purposes. In theory this regime can result in immediate IHT payable on lifetime transfers into trust (in this case the policy and the regular premiums), plus ‘periodic’ charges at every tenth anniversary and ‘exit’ charges on capital distributed between ten-year anniversaries.
However, where it is a business trust, the payment of premiums will not be treated as gifts or lifetime transfers where they are made as part of a property commercial arrangement (see above re. equalising the premiums to ensure the arrangement is accepted as commercial). The policy itself has no surrender value and therefore transferring it into a trust does not incur any IHT.
With regard to the tenth anniversary charges, in general these will not apply for life cover because after a death claim, the funds will normally be paid out of the trust immediately to the other business owners to enable them to purchase the deceased’s interest in the business. This means that funds are rarely sitting in trust at a tenth anniversary, so no IHT will be due. In the unlikely event that they are, then the excess of the proceeds over the available nil rate band will be subject to IHT up to a maximum of 6%.
In a case where a critical illness claim is paid to the trust, and the ill business owner chooses not to sell their shares immediately, the claim proceeds could then remain in trust beyond the tenth anniversary of the trust’s creation. If so, periodic and exit charges could arise unless the trustees decided to release the funds from the trust and for all the business owners to hold this money personally.
Pre-Owned Asset Tax (POAT)
This is an income tax charge, applied to the perceived annual benefit, if an individual can benefit from an asset they used to own (in this case, the life assurance policy). No tax charge will arise where the annual benefit is £5,000 or less; if it is more than this, the entire amount is added to other income for the tax year when being assessed for income tax. For life assurance policies, the annual benefit is calculated as 4% of the open market value of the policy. As this is usually zero while the life assured is in good health, there is usually no tax liability under this regime.
Where the POAT regime could become an issue for the settlor is if they suffer from a critical or terminal illness and the claim proceeds remain in the trust for any length of time (usually if they decide not to sell their business interest). If this happens, the value of the trust fund will be considerably higher and so 4% may exceed the annual limit.
These potential POAT charges can be avoided by removing the settlor as a potential beneficiary from the trust. We would generally recommend that the settlor should only be removed as a beneficiary when a payment is actually going to be made, to retain the flexibility within the trust to assign the plan back to them should they leave the business.