MONEY IN THE RIGHT HANDS: PROTECTION TRUSTS AND ALTERNATIVES

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1 TECHTALK This article originally appeared in NOVEMBER 18 edition of techtalk. Please visit for the latest issue. MONEY IN THE RIGHT HANDS: PROTECTION TRUSTS AND ALTERNATIVES Timely payment of protection death claims can be achieved via modern claims processes, joint life first death or life of another policies. Trusts are the traditional solution but need to be used correctly. BERNADETTE LEWIS Bernadette joined the group in She has over 35 years experience in Financial Services with both intermediaries and providers. She has broad and deep technical experience across pensions, protection, tax and trusts. Trusts are a long standing solution to getting protection policy death benefits into the right hands at the right time. But where inheritance tax (IHT) on a death estate isn t a concern, it s worth considering the alternatives. A key protection aim is ensuring that when a life assured dies, their survivors get access to the funds they need as soon as possible. Providers historically insisted that if there was no surviving policy owner, the deceased s legal personal representatives had to obtain a grant of representation (e.g. probate) before they d pay out any death benefits. However, most providers now take a more flexible approach at least once they re satisfied that there will be a valid claim. Even without making a formal commitment, they ll often arrange to cover at least some immediate costs such as paying directly for a funeral, or even meeting an inheritance tax bill before a grant of representation is issued. It s also possible to set up life cover in ways that normally ensure there s a surviving policy owner without using a trust.

2 For some couples, a joint life, first death policy is a pragmatic solution. JOINT LIFE, FIRST DEATH For some couples, a joint life, first death policy is a pragmatic solution. The proceeds are legally payable to the surviving policy owner on first death. Brian and Mary Ann are married and have a mortgage. Their wills leave all their assets to each other so their IHT transfers on death are exempt. Even with their mortgage fully repaid, the survivor s death estate would be around 300,000 against an available standard plus transferable IHT nil rate band of 650,000, so IHT isn t a concern. They take out joint life, first death term assurance. Brian dies in an accident five years later. Mary Ann claims the policy proceeds as the surviving owner, with no need to obtain a grant of representation. She uses the funds to repay the mortgage. LIFE OF ANOTHER A life of another policy can be another solution if the life assured dies, there will normally still be a living policy owner to pay the death benefits to. Currently, married couples and civil partners have automatic insurable interest in each other. Everyone else has to demonstrate insurable interest when taking out a policy on someone else s life. Automatic insurable interest may be extended to cohabitees and the proposer s children and grandchildren if Law Commission proposals from June 2018 become law. Jon and Michael are cohabitees, with no children and joint and several liability to repay their mortgage. They own their home worth 200,000 as joint tenants and their wills leave all their other assets to each other. If Jon dies, he d make a non-exempt transfer to Michael of 150,000 less his 100,000 share of the mortgage. If Michael dies, he d make a non-exempt transfer to Michael of 105,000 less his 100,000 share of the mortgage. So IHT is not a concern. However, while Jon could cover the mortgage repayments on his own if Michael died, Michael couldn t if Jon died. Michael can afford to take out a life of another policy on Jon s life Michael s liability to repay the full mortgage if Jon dies supports insurable interest. If Jon dies during the policy term, the death claim is payable to Michael as the policy owner and its value isn t part of Jon s IHT estate. Insurable interest is required at the outset, but not later. So where life of another insurable interest doesn t exist, someone can take out an own life policy and then assign it. Anna wants to be buried in the West Indies. Her child Mona is happy to pay the premiums on a whole of life policy to cover the costs but has no insurable interest in her parent. Anna arranges an own life policy then assigns the legal ownership to Mona. When Anna dies, the death benefit is payable to Mona, who organises the funeral her parent wanted. The policy value is outside Anna s IHT estate. A life of another policy can be another solution.

3 TRUSTS AND IHT Discretionary and flexible trusts relating to protection policies and created after 21st March 2006 fall into the IHT discretionary trust regime. These trusts are subject to IHT periodic charges every 10 years if the value of the trust fund exceeds the trust s available IHT nil rate band. The trust s nil rate band can be affected by the settlor s IHT transfers in the seven years before creating the trust. IHT exit charges can also apply when trustees pay funds out to beneficiaries. It remains to be seen whether the Office of Tax Simplification s current IHT review will lead to any changes in the treatment of pure protection policies in trust. If trustees have to pay any IHT, income tax, capital gains tax or stamp duty in connection with a trust, they now have to join HMRC s trusts register. These complications can be avoided with bare trusts, but at the cost of any flexibility over who can benefit. Edgar takes out a 700,000 whole of life policy on 20th May 2007 in a flexible trust. His spouse Frannie is the default beneficiary and his children and grandchildren are potential beneficiaries. This non-bare trust falls into the IHT discretionary trust regime. Edgar made no potentially exempt or chargeable lifetime transfers in the seven years before setting up the policy in trust, so the trust benefits from the full IHT nil rate band. His premiums are covered by the normal expenditure out of income IHT exemption. Edgar dies in an accident on 18th May 2017, leaving no time for the trustees to make a death claim and pay the proceeds to beneficiaries before the trust s 10 year anniversary. The IHT periodic charge is 6% of 700,000 (value of trust fund) - 325,000 (trust nil rate band) = 22,500. This could also lead to an IHT exit charge when the trustees distribute the trust funds. The requirement to pay the IHT periodic charge also triggers the requirement for the trustees to join HMRC s trust register. The trust still serves an IHT planning role, as the policy death benefit is outside Edgar s IHT estate. If Edgar had died a few days later, the trust value would have been effectively nil on 20th May 2017 the policy had no surrender value and he was in good health. No IHT charges would have applied to the trust. EDGAR 20TH MAY TH MAY 2017 IHT PERIODIC CHARGE Takes out a 700,000 whole of life policy in a flexible trust Dies in an accident leaving no time for the trustees to act before the trust s 10 year anniversary 6% of 700,000 (value of trust fund) - 325,000 (trust nil rate band) = 22,500 It isn t just unfortunately timed deaths that can cause problems. It s also possible for IHT charges to apply if a life assured is in severe ill health around a 10 year trust anniversary. The open market value of a term assurance with no surrender value is based on a theoretical purchaser paying a discount to the claim value, taking over the remaining premiums, and hoping to profit when claiming the death benefit.

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5 REVIEW TRUSTEES There can be significant delays at claim stage if, for example, a family loses touch with a trustee. There s also a problem if a trustee loses the mental capacity to deal with financial affairs. This applies even if a lasting, continuing or enduring power of attorney is in place, because the attorney can t act as a substitute trustee. Settlors can avoid these and other problems by arranging for no longer suitable trustees to retire or be removed and new trustees appointed in line with the trust provisions. Protection providers usually offer trust deeds for straightforward situations, but clients may have to pay for their own legal advice in some cases. It s also possible for complex family circumstances to create problems. In such cases, appointing impartial trustees might help avoid post death disputes. John sets up a 25 year term assurance in a flexible trust, making his spouse Tasha the named default beneficiary. The potential beneficiaries include the settlor s spouse or civil partner, children, grandchildren and remoter descendants all defined in these generic terms. At this point in time, Tasha and their child Jim are the only possible potential beneficiaries. John appoints Tasha and her sibling Sam as his co-trustees. Time passes and the couple divorce. Later still, John gets remarried to Carrie and they have two children together Charlie and Miranda. John doesn t amend his co-trustees or create a letter of wishes to guide them following any of these changes in his circumstances. When John dies 21 years into the term, his surviving spouse Carrie tries to claim on the policy. The provider informs her it s in trust and the proceeds are payable to Tasha and Sam as the surviving trustees and legal owners. Tasha and Sam have the discretionary power to appoint the death benefits to any of the trust s default and potential beneficiaries. As well as Tasha and Jim, the trust provisions mean these now automatically include Carrie, Charlie and Miranda. Tasha and Sam disagree with Carrie s insistence that John must have meant just for her, Charlie and Miranda to benefit. All parties are now consulting their own legal advisers. TRUSTS ARE LEGALLY BINDING Using or not using trusts involves balancing potential outcomes that could arise decades into the future. Dissatisfaction can arise if a trust settlor finds they re legally bound by restrictive trust provisions they no longer consider relevant. In 1990, DeDe sets up a whole of life policy to pay for her funeral. She uses a style of trust common at the time, leaving the death benefits to her spouse if he s alive when she dies, but to her two children if he predeceases her. She appoints him and their two adult children as her co-trustees. DeDe s spouse dies in She tries to surrender the policy which she feels she no longer needs. She s upset when the provider insists on paying out to herself plus her children as trustees and joint legal owners, and that the trust provisions bind the trustees to paying the surrender proceeds to her children. If no trust had been in place, there may have been a delay in payment if DeDe had died, but she could have accessed the surrender value at any time for her own use. TRUSTS AS A SOLUTION Of course, with engaged clients, the right trust, and suitable trustees in place, a trust can be a great solution to getting protection policy death benefits into the right hands at the right time. A trust can be a great solution to getting protection policy death benefits into the right hands at the right time. Jake s spouse has died when he sets up a whole of life policy in a discretionary trust to pay the anticipated IHT due on his estate. He appoints his only child as a trustee along with himself. He prepares a non-binding letter of wishes. Jake begins to show early signs of dementia a couple of years later. He resigns as a trustee shortly afterwards, appointing his child s spouse as a replacement trustee. He confirms his letter of wishes at the same time. He s still mentally competent to understand these actions. When Jake dies, the trustees claim the death benefits. They pay the proceeds to Jake s child as a trust beneficiary. He uses the funds to settle Jake s estate s IHT liability, indirectly benefitting all the legatees of Jake s will. It all works out well. When Jake died, there were two living and mentally competent trustees. This met the requirements for trustees using their discretionary powers to appoint the trust funds to beneficiaries. And the trustees were happy to follow Jake s non-binding letter of wishes. Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given. Scottish Widows Limited. Registered in England and Wales No Registered office in the United Kingdom at 25 Gresham Street, London EC2V 7HN. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Financial Services Register number