TrustsWillsWhy use a Flexible Life Interest Trust?

A Flexible Life Interest Trust (FLIT) is a mixture between a life interest trust and a discretionary trust. The trust will name a life tenant and other discretionary beneficiaries. Whilst the life tenant, who is usually the testator’s surviving spouse or civil partner, is alive they are entitled to all income generated by the trust. The trust also includes a discretionary power that allows the trustees to transfer capital to the life tenant. The trustees may have the power to transfer trust capital to the other discretionary beneficiaries whilst the life tenant is alive.

On the life tenant’s death, the trust will not end and will continue as a discretionary trust for the discretionary beneficiaries.

In this week’s article we will examine the benefits that can be obtained when using a FLIT in a will, along with potential disadvantages. The benefits normally fit into three different categories; asset protection, flexibility and inheritance tax (IHT) planning.

Reasons to use a FLIT – Asset Protection

Asset protection is likely the main reason to place assets into a FLIT as the trust combines the asset protection benefits of both an ordinary life interest trust and a discretionary trust.

Whilst the life tenant is alive, the trust allows them benefit from the trust fund due to their entitlement to income and potential to benefit from capital at the trustees’ discretion. However, as they are not entitled to the capital and can only benefit at the trustees’ discretion, capital held on the trust is protected from third party claims on the life tenant such as bankruptcy or sideways disinheritance.

These benefits also apply to an ordinary life interest trust. Where a FLIT differs is what happens when after the life tenant’s death. With an ordinary life interest trust, the beneficiaries would be entitled to the trust capital (subject to any age contingencies or other conditions in the will). As they are entitled, there is no protection in the event that a beneficiary is not in the best position to receive their inheritance, for example if the beneficiary was insolvent, had addiction or gambling concerns or was spendthrift. In that event, any inheritance might be lost to third parties or wasted by that beneficiary.

A FLIT however extends protection to the discretionary beneficiaries. They are not entitled to an inheritance when the life interest ends, and they can only benefit at the discretion of the trustees. This ensures that beneficiaries are protected on the life tenants death, be that from themselves or from third party claims on them. The trustees could potentially make occasional benefits to them whilst any concerns are ongoing, and only transfer larger benefits to them when it is safe to do so.

Reasons to use a FLIT – Flexibility

A FLIT offers flexibility as to how the trustees will benefit the beneficiaries of the trust. It may not always be sensible for each beneficiary to inherit capital outright.

The testator may for example wish for the trustees to make small gifts of capital to the life tenant outright or loan them large amounts of capital that would be repayable to the trust on death. The same applies to the discretionary beneficiaries.

This flexibility allows the trustees to adapt to changing circumstances. Whilst the situation for the proposed beneficiaries may be perfect at the time the will is written, that is not to say that it will be at the time of death. A FLIT gives the trustees the discretion to make decisions on whether to benefit the proposed beneficiaries at the time of death, or hold off an inheritance due to issues that were not present at the time the will was made.

Reasons to use a FLIT – Inheritance Tax Planning

Assuming the life tenant is a spouse or civil partner, a FLIT ensures that the spousal exemption is retained. This is because the life tenant will be treated as inheriting the trust capital for IHT purposes. When they pass, any capital in the trust would be taxed as part of their estate.

There are also no anniversary or exit charges whilst the life tenant is alive, although these may apply after the life tenant has passed.

Between the testator’s death and the life tenant’s death, the trustees and life tenant could attempt to make gifts from the trust to the other beneficiaries as a form of IHT planning. Any gifts made to the other beneficiaries would be seen as a potentially exempt transfer from the life tenant’s taxable estate and the usual 7-year rule will apply.

The discretionary trust on second death might offer an inheritance tax protection for the beneficiaries. If a beneficiary has an IHT liability, then inheriting outright is likely inadvisable as this will only increase that beneficiaries’ own inheritance tax liability. A FLIT will allow the trustees to keep hold of the inheritance within the trust, keeping it outside of that beneficiary’s estate. The trustees could then make occasional gifts or loans of capital if needed. Any inheritance tax advantage to the beneficiaries would need to be balanced against the potential anniversary and exit charge liability for the trust.

Disadvantages of a FLIT

Unmarried couples can use a FLIT, but it may not be the most tax efficient option available to them as the spousal exemption and transferable NRB is not available to them. Nil Rate Band Discretionary Trusts may be a better option for unmarried couples.

Although the life tenant having no entitlement to the capital is a benefit to the trust, this may leave the life tenant feeling vulnerable as their access to capital is dependent on the trustees exercising their discretion. This might particularly be the case for couples where one party holds most of the wealth. This could be mitigated against by making the life tenant one of the trustees so they have some control, although the consent of other trustees would still be required.

Then nature of a FLIT may be difficult for lay trustees to understand, particularly when compared to an ordinary life interest trust which is much simpler.

The trust may become liable for IHT anniversary and exit charges after the life tenant’s death depending on the size of the trust fund. Any liability for these would be avoided if an ordinary life interest trust was used and the beneficiaries were entitled on the life tenant’s death.

Due to the ongoing discretionary trust on the life tenant’s death, this may affect the availability of the residence nil rate band and lead to a higher IHT liability.

Chris Rattigan-Smith