Life Interest Will Trusts
Life Interest Will Trusts - what are they and how do they work? Ingrid McCleave explains in her third article in her tax and trusts series how Life Interest Will Trusts are impacted by different events and the implications for the main types of tax.
A. Life Interest Will Trusts
Under a Life Interest Trust (sometimes called an Interest in Possession Trust), the Trustees have no power to accumulate the income within the trust. Under the terms of a Life Interest trust, the Trustees must pay out the income of the trust, to a nominated beneficiary, or beneficiaries. The Trustees cannot hold back any of the income and keep it within the Trust.
The beneficiary is called the life tenant and is legally entitled to the net income of the trust, after taxes and expenses each year. A life tenancy does not necessarily mean a right to the income for the rest of one’s life. For example, a life tenant could be given a right to income until a specified age or a certain point in time e.g. on the event of remarriage or bankruptcy. When that interest ends, the capital of the trust will pass to another beneficiary called a remainderman or sometimes also called reversionary beneficiary. If the Trustees have power to remove future income, this does not negate the existence of a current life interest. An exclusive right to enjoy an asset within a trust is also an Interest in Possession, even if that asset does not produce any income, therefore if the Trustees permit a beneficiary to occupy a dwelling house at less than full commercial rent, or no rent, this will create an interest in possession.
Trustees will have flexible powers to distribute capital at their discretion. It is therefore possible for the life tenant to receive a capital distribution or for the remainderman to receive trust capital before the tenant has died.
B. Inheritance Tax position of a Life Interest Will Trust/ Interest in Possession Will Trust
Where a life interest is created on death, the inheritance tax treatment depends on the identity of the life tenant.
Where the deceased spouse/civil partner has a life interest or right to occupy in the trust, the transfer on death is exempt from inheritance tax. This mirrors the rule that transfers to spouses/civil partners are exempt. Where the deceased is UK domiciled and the spouse/civil partner is non-UK domiciled, the spouse exemption on the life interest/right to occupy is limited to £325,000. Where any other individual has a life interest/right to occupy, the transfer on death of the life interest/right to occupy is chargeable and subject to inheritance tax.
On the death of the life tenant, the trust assets will be treated as part of the life tenant beneficiary’s estate and the executors must declare the value of the underlying assets on the life tenant’s death estate return. If the life tenant only has a right to income or to occupy part of the trust fund, the same proportion of assets in the life interest trust is deemed to form part of his estate. Assets held by the deceased life tenant in his own right i.e. personal assets, make up his free estate. The value of his free estate less any liabilities of the estate, plus the value of the underlying assets in his share of the life interest trust, make up the total amount chargeable to inheritance tax.
Even though the life tenant was only entitled to the income of the trust during his lifetime, on his death we pretend that the capital assets underlying his life interest are part of his estate for inheritance tax purposes.
It is not subject to the exit charges and principal charges (10-year anniversary charges) that Discretionary Trusts are subject to.
C. Lifetime cessation of a Life Interest/Interest in Possession Will Trust
In certain circumstances, a life tenancy can end whilst a life tenant is alive. It could be terminated under the trust deed for example, where the life tenancy terminates at a certain age. Alternatively, the life tenant can bring his right to income or to occupy (life interest) to an end at any time. One example of this may be a life tenant transferring his right to income or to occupy to another person. Alternatively, they may decide to waive their right to income or to occupy to accelerate the remainderman’s interest coming into being. The remainderman may be an individual who inherits the underlying capital assets of the life interest trust absolutely or it may be a discretionary trust.
The inheritance tax treatment of the lifetime cessation of the life interest depends on whether capital assets leave the trust or another beneficiary take a successive interest in possession, or the capital assets go to the remainderman.
If the life tenancy terminates during the lifetime of the life tenant and the assets leave the trust i.e. the underlying capital assets pass to another beneficiary i.e. remainderman, this is usually a potentially exempt transfer by the life tenant. This means that the life tenant has to survive 7 years after the event for it to fall completely outside of his estate for inheritance tax purposes.
The exceptions to this general rule are where the life tenancy ceases and the assets pass to the life tenant’s spouse, in which case the transfer is exempt, or the life tenancy ceases and the assets pass to the life tenant, in which case there is no transfer of value and no inheritance tax is due.
Any inheritance tax payable, as a result the life tenant not surviving seven years, is usually paid by the Trustees, although the life tenant’s estate could be made liable for any tax, which remains unpaid by the due date.
Where another beneficiary takes a successive life interest during the lifetime of the current life tenant without assets leaving the trust, there is a transfer of value for inheritance tax purposes because assets will be leaving the estate of the current life tenant. The new life tenancy now comes under what is called the relevant property regime and the transfer will be immediately chargeable to inheritance tax. Any inheritance tax due will be paid by the Trustees. The annual exemptions of £3000 for current and preceding year will be available as deductions, assuming the previous life tenant has not already used them.
An Example: A deceased testator leaves their entire net estate on a Life Interest Trust for their spouse/civil partner for life, with reversion to their children on their spouse’s death and a clause providing for the spouse’s interest to terminate on the event of their remarriage. If the spouse dies during the life tenancy, the underlying value of the capital assets of the trusts will be added to their personal net estate for inheritance tax purposes and the inheritance tax due will be apportioned between the spouses executors and the life interest Trustees. The children will receive the trust assets, net of the trusts share of the inheritance tax due.
If in the above example, the spouse remarries, the life interest trust will terminate, the underlying trust assets will pass to the children. This is a potentially exempt transfer by the spouse and the children will pay inheritance tax if the spouse dies within 7 years. There is no exist charge on the assets passing to the children as the assets are not coming from a discretionary trust, as explained above.
The same applies if you substitute the children’s reversionary interest, to that of discretionary trust i.e. a discretionary trust receives the assets on termination of the life interest, whilst the life tenant is alive, or the life tenancy subsist and the life tenant gives it away.
D. Disposal of a Life Interest in a Life Interest Will Trust/ Interest in Possession Will Trust
An interest in possession is a right to income. This right is an asset in itself and could have significant value. The life tenant may therefore want to sell his interest. The purchaser would then become entitled to the trust income. Any gains are not chargeable to tax, provided the life tenant received his interest via the original will and did not purchase his interest from the original life tenant. If you do not want to risk a life tenant selling their interest, then you need to consider a Protective Trust arrangement, whereby, if the life tenant attempts to sell his interest, the life interest ceases and the trust become fully discretionary, but is not subject to exit or principal charges.
E. Income Tax position for Trustees of a Life Interest Will Trust/ Interest in Possession Will Trust
If it receives rental income, the property business profits are fully charged at the basic rate of 20%. The same rate applies regardless of the level of income. Property income deductions are the same as they are for individuals.
If interest is received, it is wholly charged at the rate of 20% regardless of the level of income. Interest is received gross. Trustees are not entitled to the personal savings allowance.
Dividends are received gross and are charged at the dividend ordinary rate of 7.5%. The dividend allowance is not available to Trustees.
Life Interest Will Trusts are not allowed to take a deduction for any expenses incurred in managing the trust.
F. Capital Gains Tax position of a Life Interest Will Trust/ Interest in Possession Will
If a Trustee appoints an asset to a beneficiary (they are deemed to have disposed of the asset at market value) or sells a trust asset at market value, this is a disposal by the Trustees for capital gains tax purposes and capital gains could arise. Trustees receive an annual capital gains tax annual exempt amount, which is equal to half of an individual’s annual exempt amount (currently £12,300, so £6,150 for a trust). The Trustees annual exempt amount is divided by the number of UK trusts settled by the same settlor/testator (the person who set up the trusts) after the 6th June 1978. Overseas trusts and trusts no longer in existence are ignored.
Capital Gains Tax implications of the death of the Life Tenant – when a life tenant dies, the trust’s assets will either pass to the remainderman and the trust will come to an end, or, the trust will continue, either with another life tenant taking a successive life interest, or with the trust fund becoming discretionary, with no rights to income.
The capital gains tax position on the death of the original life tenant gives rise to a deemed disposal by the Trustees of all of the assets in the trust at that time. This is regardless of whether the trust continues or ends.
The deemed disposal takes place at market value. Capital gains, or losses, will arise to the Trustees at this point.
Under general capital gains tax principles, death is not an event, which triggers a charge for capital gains tax purposes. Therefore, any gains arising on the deemed disposal will not give rise to a capital gains tax charge.
Business Asset Disposal Relief – This is a capital gains tax relief available to tax payers who sell or give away their businesses. It reduces the rate of capital gains tax paid by taxpayers on qualifying disposals to 10%. Gains are eligible for Business Asset Disposal Relief up to a maximum life time limit, which is currently 1 million pounds. The relief is also available where a Life Interest Will Trust makes a disposal. In order for a Business Asset Disposal Relief claim to be made in respect of trust gains, the beneficiary that fulfils the criteria must have a life interest in the trust.
Fully discretionary trusts cannot claim Business Asset Disposal Relief.
For a Life Interest Will trust disposal to qualify, the disposal must be of either (i) a business owned by the Trustees, but run by the life tenant, either alone or in partnership or (ii) shares in a qualifying company. The qualifying company must be the life tenant’s personal trading company and the life tenant must have had a minimum of 5% shareholding and must be an employee or officer of the company throughout a period of 2 years, ending within the 3 years up to the date of the disposal. It is not therefore essential that the beneficiary had a 5% shareholding and worked for the company at the date of disposal by the Trustees, but he must have satisfied these conditions in 2 of the 5 years up to the date of disposal. The Trustees have no minimum shareholding; it is the life tenant who must own at least 5% of the shares. It is not necessary for the life tenant to have had a life interest for 2 years.
The life interest must be permanent; it cannot be for a fixed term, although it can be revocable. This allows Trustees to create a life interest (if it was a purely discretionary trust), just before the share sale to obtain the relief, then revoke that life interest later.
The Trustees and life tenants must make the claim for relief jointly, since it is the life tenant’s relief, which is being utilised. The life tenants lifetime gains ceiling of £1 million is reduced by any gains for which Business Asset Disposal Relief is given to the Trustees.
Where a life interest trust has more than one life tenant, the gains eligible for Business Asset Disposal Relief are apportioned by reference to the qualifying life tenant’s proportional entitlement to the trust income.
Investors Relief - this relief enables individuals to claim relief on a disposal of shares in an unlisted trading company in which they do not work. This is available to the Trustees of a Life Interest Trust, provided a beneficiary has a life interest in the relevant shares for at least 3 years prior to the share disposal. The other conditions are that prior to disposal of the shares, the Trustees have subscribed for and owned shares in the unlisted trading company for at least 3 years. A further condition is that the eligible beneficiary has not been an employee of the company for at least 3 years prior to the share disposal and his interest in possession is not for a fixed term. The qualifying gains will be taxed at 10%. The beneficiary has a lifetime gains ceiling of £10 million in which investors relief can be claimed. This is in addition to their Business Asset Disposal Relief. The Trust does not have its own lifetime allowance, but instead uses the beneficiary’s lifetime allowance. The Trustees and the beneficiary make the claim jointly.
Principal Private Residence Relief – if the Trustees own a Trust property and one or more beneficiary’s occupy that property as their only or main residence, Principal Private Residence Relief is available on the disposal of the property. The following periods are exempt for Principal Private Residence Relief: (i) the period during which the property was occupied by the beneficiary; (ii) the last 9 months of ownership; (iii) deemed occupation period which include periods of absence up to 3 years, periods of absence during which the beneficiary was abroad by reason of his or her employment, periods of absence up to 4 years where the beneficiary was required to work elsewhere. The deemed occupation periods can only apply to trust gains where the same beneficiary occupied the trust property, both before and after the period of absence.
G. Tax Position of a Beneficiary of a Life Interest Will Trust/ Interest in Possession Will Trust
The net income of the trust after taxes and expenses will flow through to the beneficiary. This income is taxed on the beneficiary in the year in which is arises. As this income will have already been taxed in the hands of the Trustees, the life tenant will receive tax income and this income will need to be reflected on her self-assessment return. Trust management expenses are deemed to have been paid from dividend income in priority to interest and rents, thereby reducing the amount of income received or deemed to be received by the life tenant. If trust management expenses exceed trust income received by the life tenant for the year, the trust management expenses will be carried forward and deducted from income arising in future years.
If the life tenant is a basic rate taxpayer or has losses, the tax credits attaching to the income can be recovered. The trust income retains its character and is taxed as rental income, savings income and dividend income respectively, in the hands of the life tenant. The life tenant will be entitled to a personal savings allowance in respect of his trust interest and to the dividend allowance in respect of his trust dividends.
Certain capital receipts are treated as income e.g. life assurance gains and offshore income gains, among a few. These are taxed at 45%.
Sometimes the Trustees mandate trust income to the life tenant e.g. bank interest and dividends. In these circumstances, the Trustees do not report or pay tax on the income, the life tenant is directly chargeable on her self-assessment return.
The property business profits are calculated as for a discretionary trust and interest costs are subject to the same restriction, however, the Trustees are not entitled to the 20% tax reducer. Instead, the tax reducer is given to the life tenant via their own income tax computation, so the Trustees must notify the life tenant of the amount of interest, which has been disallowed.
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