Mitigating Inheritance Tax and Ensuring Financial Flexibility: The Role of Flexible Reversionary Trusts in Client Care Planning.
The original article written for My Care Consultant / Spotlight can be found by clicking the image above.
Life is unpredictable. Whether it concerns a global pandemic, the economy, or your personal finances, health, and relationships, much of what lies ahead in life remains uncertain. Yet we crave security. We want to feel safe and have a sense of control over our lives and well-being.
This uncertainty is compounded by the complexity of the Care Sector, which requires specialist knowledge and is a minefield for clients and non-specialist advisers alike. No one knows who will need care, whether that care will be health related or social, or who might pay for it. However, as the population ages, it is reasonable to assume that the number of people requiring care or become care providers will increase.
The Consumer Duty Legislation which came into force 31st July 2023, has been described as the ‘biggest overhaul of the UK’s Financial Services industry in 20 years’. The Duty sets higher standards of consumer protection in financial services and requires firms to be open and honest, avoid causing foreseeable harm, and support the consumer in pursuit of their financial goals. Whilst there is no shortage of information and guidance on this topic, and it is not my intention to add to it here, it’s important to note that the Duty and its impact will continue to evolve as it filters through the complex geology of financial services.
Consumer Duty provides an opportunity for Financial Advisers to stand out from their peers due to the FCA stipulation to ‘avoid causing foreseeable harm’ or, in other words ‘foreseeable risk’ to their advisory business.
In FG22/5 and PS22/9 the FCA stipulates:
“Whether harm is considered foreseeable would depend on whether a prudent firm acting reasonably would be able to predict or expect the ultimately harmful result of their action or omission in connection with the product or service”.
A client looking to mitigate Inheritance Tax may be recommended to gift £325,000 + into a Discretionary Trust. After 7 years, it would fall out of account for Inheritance Tax (IHT) and be effective*. Most would consider this good planning and would be right to a point.
But what if this client needed care in later life? Our experience as Professional Trustees is that wealthy clients want to pay for the best care they can afford, rather than avoid the care fee assessment. If (free) NHS Continuing Healthcare (CHC) funding is not relevant (including for those receiving NHS / Local Authority funded aftercare as a result of being sectioned under s117 of the Mental Health Act), then the social care means tested system will apply. If a client needs to pay for care or requires capital to adapt their home, the money in the Discretionary Trust is not available. This is because the Settlor / Client having gifted a sum of money into a Discretionary Trust is no longer the legal owner of that asset and cannot draw upon it to afford control, quality and choice of care should they need it.
Could this have been avoided?
As good as cash flow modelling is, it is a ‘best guess’ of what the future might look like based on the assumptions made. Whilst this situation may not cause a problem for some clients, the cost of care, the length of time care needs to be funded, and what additional capital expenditure might be required are unknown and could become an issue for others.
This is just one example of what we call ‘the gifting dilemma’, clients wishing to mitigate an IHT liability but reluctant to give away assets (lose access) because of the ‘what ifs’ in life. Often, “What if I need care, how will I pay for it?”
A potential solution to this gifting dilemma, which also insures against the risk of cash flow modelling failing, is a Flexible Reversionary Interest-in-Possession Discretionary Trust (FRT)
One of the standout features of an FRT is its adaptability to changing circumstances by providing the Settlor access to capital in Trust, via a long established carve-out principle accepted by HMRC. Life is unpredictable, and clients care needs may evolve over time. An FRT can be used to meet these changes, whether they involve varying care costs, the need for different types of care, or changes in the client’s financial situation.
Financial support could be extended to include the increasing number of care providers who may have given up work and provide ‘unpaid care’ for an older adult. That care could be paid for direct by the Settlor by taking back Reversions or the carer could be added to the Beneficial Class and paid directly from the Trust. This Trust framework would work equally as well if the Settlor was to become a care provider and needed additional financial support if they were to reduce hours or give up work. This adaptability ensures that the Trust remains relevant and effective for the Settlor however their circumstances might change.
Flexible Reversionary Trusts mitigate IHT whilst ensuring financial flexibility to meet care needs should they arise, avoiding foreseeable harm to the client and risk to the advice being given. The frequency and rate at which the assets can pass back to the Settlor (Reversions) are discussed and agreed upon at outset. Reversions are only taken if the Settlor needs capital that is not available from income or capital they retain within their IHT assessable estate. The Trust can distribute assets to Beneficiaries at any time, via appointment or loan, ensuring that family wealth is preserved and available for future generations. This is particularly important for individuals who wish to leave a legacy and who will provide guidance for the Trustees in the form of a Letter of Wishes.
Passing assets to Beneficiaries is a subject in its own right and beyond the scope of this article. However, the general principle is “once it’s out, keep it out” which requires a Trust framework with a full (workable) Loan Facility. If you ‘loan’ Trust assets to the Beneficial Class, the loan remains an asset of the Trust, and a debt of the Beneficiary. The loan protects those assets in the hands of the Beneficiaries from various social impacts like divorce and bankruptcy and enables true, intergenerational tax planning, avoiding further assessment to IHT for up to 125 years (England & Wales). Passing assets direct via Will or Intestacy is the quickest way to erode family wealth.
When considering gifts to disabled persons, whether for Inheritance Tax (IHT) planning or other purposes, it’s crucial to address the potential for unintended consequences. A gift to a disabled person, either during lifetime or via a Will, could have catastrophic consequences if they rely on means-tested benefits or are unable to manage their own finances. Depending on the individual’s circumstances, the gift or inheritance might increase their vulnerability, necessitating careful consideration and specialised advice to avoid affecting means-tested benefits or the need for a deputyship order.
Disabled people often receive means-tested benefits (income related) and payments towards their care from local authorities. There are capital limits for both types of support. If their assets exceed the upper limits they will lose any means-tested benefits. Therefore, preserving these benefits is essential, and the use of a Trust beneficial.
Assets held in both non-Reversionary Discretionary and Reversionary Interest-in-Possession Discretionary Trusts, as mentioned earlier in this article, can effectively preserve means-tested benefits. Additionally, consideration should be given to Section 89 Trusts (S89) for Vulnerable Beneficiaries.
Where a Trust qualifies as a Disabled Person’s Trust, special rules apply that can result in more favourable tax treatment than other Trusts. Specifically, income and capital gains can be assessed on the disabled Beneficiary rather than the Relevant Property Regime (RAT).
The gift into a qualifying Disabled Person Trust by the Settlor is a Potentially Exempt Transfer (PET) and will fall out of account for IHT after 7 years. The Lifetime Inheritance Tax charge, Periodic Charge or Exit Charges do not apply. This may be a particularly attractive aspect of Disabled Person Trusts especially for gifts in excess of the current and available NRB of the Settlor.
When the disabled Beneficiary dies, the assets of the Trust will form part of their Estate for the calculation of IHT. However, the proportion of any IHT that relates to the assets of the Trust will be payable by the Trustees, not from the disabled person’s personal assets.
The main advantage of a S89 Trust is the favourable tax treatment that it receives, particularly for larger considerations. If the disabled or vulnerable person meets the relevant conditions for a Disabled Person’s Trust, then a direct comparison of the differences between the types of Trust should be made and a view taken on a case-by-case basis.
Where gifting or making financial provision for a disabled person is not required, an FRT remains a powerful tool which can help avoid foreseeable harm, ultimately delivering better client outcomes.
*Provided the Settlor did not make a Potentially Exempt Transfer during the inter-vivos period of the Discretionary Trust.