Inheritance Tax (IHT) is levied on that part of an Estate which passes on death to beneficiaries, other than a spouse, and which is above the inheritance tax threshold, which is called the Nil Rate Band (NRB).
The rate of tax is the percentage applied to that portion above the NRB and is currently 40%. The NRB for 2005/6 was £275K for 2006/7 is £285K for 2007/8 will be £300K for 2008/9 is expected to be £312K and for 2009/10 is expected to be £325K.
If money or property is given away prior to death then there is a sliding scale as to what proportion should be taken into account. Gifts more than 7 years prior to death are free of IHT. Gifts 6 years prior pay 20% 5 years 40% 4 years 60% 3 years 80% 0-2 years 100% of the full rate of 40%.
The government is trying to close loopholes, and many weird and wonderful technically elaborate schemes designed by practising tax barristers have been targeted, especially where the principle of law has been, by clever and devious means, circumvented.
Wills by their very nature cannot transgress the principles involved which are where a trust donor places assets in trust the donor cannot use those assets and avoid IHT. This rule is known as the reservation of benefit and is the main issue with loophole finders. In Wills the donor dies and so cannot use the assets post mortem and thus cannot transgress the law.
There are one or two exceptions, but in the main this is the case. One exception is where property was wholly owned by the testator who gave a portion prior to death to a spouse, and the remainder in trust upon death. Happily, there is a special way of dealing with this instance.
Wills seek to avoid IHT by making full use of the Nil Rate Band threshold for both husband and wife, thus doubling the use of the threshold which would otherwise not have been the case.
Simple Wills leave everything to the surviving spouse. There is no IHT because the spouse has an exemption. So if the first to die was worth a half a million quid and left it all to the surviving spouse outright there would be no tax to pay, even though the estate of the first to die was above the tax threshold (NRB).
However the surviving spouse would now be worth a least half a million quid but would have only his/her own threshold to deduct. So in 2005/6 this would leave £225K or more to be taxed at 40% which would be about £90,000 in tax to pay.
The executor on the second death would have to write out a cheque to the taxman for £90,000, and any interest on top if payment is late. Very often the money has to be borrowed to pay it and banks charge hefty arrangement fees and interest as well.
The maximum IHT which can be saved in instances like this amounts to 40% of the unused threshold which was available on the first death. So in 2005/6 it was £110,000, not a bad saving. This is rising so in 2009/10 the saving will be £130,000.
The NRB on the first death can only be used if a gift is made to use it on a quid quo pro basis, and the gift has to be to someone or something other than a spouse. So to use £100K in allowances a £100,000 gift has to be made.
A gift could be made to the children or grandchildren on the first death, and this would qualify. The disadvantage is that the surviving spouse may need that money later to live on by which time it may have been spent.
If there was any existing arrangement to pay it back HMRC would cancel the allowance immediately so any potential savings in tax would be lost. It would have to be a gift with no strings and thus would be impossible to enforce any repayment if required.
If a child divorced, became bankrupt or died the money would probably end up entirely out of reach anyhow.
However, the advantage of a gift within the NRB on the first death is that it passes tax free and the estate of the surviving spouse would be reduced by that amount, eliminating tax on the second death pro rata.
There is a better way of making the gift to retain these advantages without losing the use of the money or property. This is by simply using family trusts.
Some surviving spouses need assurance that they can use the estate during their lifetimes otherwise they would rather have the children suffer the tax and be grateful for what they do get.
Clever people before death seek ways of having the best of both worlds. The use of the estate for their spouse AND the tax saving for their children. You can be clever and do this too, with a little help from us.
Estates usually comprise both money and property. Money and property which does not comprise the family home, up to the NRB, can be placed in a discretionary trust free of tax on the first death, with the surviving spouse and the children as potential beneficiaries. The family home is treated slightly differently, see below.
The trustees make the decisions but can include the surviving spouse, and can award the income from the assets or the use of them to any of the beneficiaries at their discretion.
All trustees have to agree to any decision, so regular meetings are essential for which minutes should be kept (witnessed by a third party in writing!) and it is hoped, and perhaps even reminded in a memorandum from the deceased, that there is a moral duty, but not a legal one, to see the surving spouse has priority over the use of assets and income.
One way to do this is for the trustees to agree to accept an IOU from the spouse for some of the trust capital upon which a rate of interest should be applied. The interest can be waived and the capital recovered after death from the spouse's estate.
Special powers are required to implement this strategy. Old Wills, before 1999, containing these trusts may not now be effective unless they have been upgraded.
So during the life of the survivor the capital is available and on the death of the survivor the loan is recovered and trust assets pass tax free to the children. The trust is then closed.
If the survivors estate, after paying back the loan, is also below the tax threshold, then that will pass tax free to the children too. A happy result all round.
During the life of the trust upon each 10th anniversary, and only if the assets have risen in value above the NRB by that 10th year, there will be an interim charge to IHT of 6% of the excess value above the NRB.
This is very unlikely to amount to much if anything at all, and certainly should not be a deterrant to setting up the trust in the first place.
If the family home is part of the estate of the first to die, usually by design by creating a tenancy in common then special care has to be exercised.
Up to August 2006 it was considered risky for the family home to be part of the discretionary trust, so it was switched for debt and the debt is held by the discretionary trustees in place of the property.
As it became quite common for the spouse to write an IOU as debt the government changed the nature of IOUs so that they are now considered to be transactions. Strange how a repayable loan becomes a transaction to suit the government. The upshot is that such IOUs on property now fall within the Stamp Duty Land Tax regime (SDLT).
Due to the outcry from the labour heartlands which are now becoming wealthier due to property price inflation and increased home ownership, the SDLT threshold has been raised to £120K (budget 2006). As it is half the property which is involved, it is only properties worth more than £240K (2006/7) that are likely to suffer, and the rates vary as to the value.
The alternative to paying SDLT is for the Will to contain 2 trusts instead of one. The second trust being an interest in possession (life interest) in the residuary estate. The executor could raise a debt directly upon the family home to the value of the half share and this charge could be transferred to the trustees of the discretionary trust instead of a share in the family home or an IOU from the spouse. The executor would then transfer the title of that half share, now subject to the debt, to the trustees of the life interest trust, who would include the surviving spouse.
Single trust Wills need to be upgraded to include the second trust and special powers to be able to implement this strategy.
Using a second trust means that the surviving spouse could change homes after the first death without falling foul of any IHT rules. The nature of the second trust is such that the survivor would have exclusive use of that share of the home, obviously they still own the other half, so they have exclusive use of the whole property.
The surviving spouse can be a trustee of this trust too provided that the co-trustee is not a trustee of the discretionary trust, but the co-trustee could be the executor.
In these instances where tax solutions are written into Wills, the surviving spouse should not be the executor who signs the application for probate.
Once again there should be a rate of interest attached to the charged debt but the interest can be waived at a later stage.
In 2006 HMRC failed to win a test case and it is now thought that a share of the family home may be put into a discretionary trust without having to switch it for an instrument of debt, providing that the surviving spouse in occupation had an Immediate Post Death Interest (IPDI).
It would be folly to try to implement these arrangements without expert guidiance, either in writing the original Wills or implementing their provisions post mortem.
Lack of proper trust administration can lead to a failure of the strategy so good administration post mortem is essential.
Having written thousands of Wills and assisted in probate and subsequent trust administration for surviving spouses of our sadly deceased clients, we have the experience to assist families in providing complete solutions to Inheritance Tax, and all at very reasonable fees.
