Inheritance Tax: Some Possible Solutions

A Hand Morgan & Owen Fact Sheet

This leaflet is designed to give you an outline of how Inheritance Tax (IHT) might affect you, and how we might be able to help you to reduce its impact on your estate. It is not a full explanation of the technicalities of IHT, nor is it intended to replace the need for proper legal advice.

IHT is a tax on gifts. You can give property (anything you own including money, assets and houses etc) away during your life, and when you die you are deemed to give away all your property - in both cases IHT may be payable.

There is another tax, Capital Gains Tax (CGT), which also applies to gifts. For lifetime gifts CGT may be payable in addition to IHT.

The Individual
If you give away property during your lifetime, the first £300,000 of any gift is not charged to tax. This is known as the "nil rate band". You can give away up to this sum before you pay IHT. There are also various other exemptions and exceptions which may take a gift outside the charge to pay tax. You should therefore take detailed advice before making a gift of any size, to see if it may be covered by an exemption, or whether perhaps making the gift in a different way could avoid a charge to tax. However, the lifetime gift will generally be a "potentially exempt transfer". That means if the person who made the gift is still alive 7 years later, the gift is completely exempt. If not, it may still be partly exempt, depending on how long the maker of the gift survived. When an individual dies, the nil rate band is still available, insofar as it has not been used up by any gifts made during their lifetime, and there will only be tax to pay on the excess in their estate over the nil rate band.

Married Couples
If you give all your property to your spouse when you die there will be no IHT to pay because husband/wife transfers are completely exempt. However, there is a hidden trap - because when the surviving spouse then dies, all the accumulated property which remains is charged to tax (less that spouse's nil rate band). What has happened is that the nil rate band of the first to die has not been used, and so £300,000 more is subject to tax than would have been charged had the first spouse to die used his/her nil rate band. Under the Pre-Budget Report of 9 October 2007 (which has yet to become law) it will now be possible for the estate of the surviving spouse to claim any unused part of the nil rate band of the first spouse to die. If the claim is successful this will then be added to the surviving spouse's nil rate band. This means that the surviving spouse's estate may have (at current rates) nil rate bands totalling £600,000 available.

The Standard Tax Efficient Will
What you could do, is to use the nil rate band of the first spouse to die, by giving property to someone other than the surviving spouse, usually to a child. This would mean that when the survivor dies, there would be up to £300,000 less in his/her estate, because that much was given away when the first spouse died. This is fine, and will certainly save some tax, but the surviving spouse may well say that he/she cannot live on what is left, and needs the money which was given away to the child to provide him/her with an income.

Using a Trust
As an alternative to paying the £300,000 to a child, a Life Interest Trust or a Discretionary Trust can be used.

In a Life Interest Trust, the person to whom the gift is made (the "life tenant") does not get the money outright, but only gets the right to receive the income from the funds during his/her lifetime. When he/she dies, the capital that has been used to provide the income goes to someone else.

The problem with that kind of trust, as far as tax law is concerned, is that the life tenant is deemed to own the capital also (although in reality he /she has no right to this property), and so when the life tenant dies, his/her estate is increased by the amount of the trust capital, which means that there may be an increased tax charge on his/her estate.

The second alternative is the Discretionary Trust. In this case, nobody has any right to receive anything until the Trustees of the trust so decide. These people, who you name in the document which sets up the trust, have a completion to decide who should benefit from the funds in the trust. In practice they do not have an entirely free choice, and have to work within the quite narrow limits of a (usually) small number of potential beneficiaries that the person making the Will selects - usually the surviving spouse and any children. The surviving spouse can therefore benefit from the trust, whilst not actually owning any of the trust property, nor having any right to income from the trust. Thus on the death of the survivor, the sums in the trust do not form part of the estate, and so tax up to £300,000 can be saved.

There is a problem with this kind of arrangement: which assets should be put into the trust? Where the main asset is a house, it can be inconvenient for the share of the deceased spouse to be taken by the Trustees. Also, if the surviving spouse continues to live there (which is normally the intention), he/she could be taken by the Revenue to own the whole of the property because they continue to have the use of the deceased spouse's share.

The Loan Bank, or Charge Scheme
Currently, the problems of a discretionary trust can be avoided by having a nil rate band discretionary trust combined with a power given to the Trustees to accept a debt from the surviving spouse (of an amount up to the nil rate band) instead of actually paying assets into the trust when the first spouse dies. The assets of the estate can then be given to the surviving spouse, and only on his/her death is anything actually paid into the trust. Not only does this take out of the estate of the first to die the sum of £300,000, but the debt can be deducted from the estate of the surviving spouse when he/she dies.

This is currently the most tax-efficient way of leaving property in estates of around £1 million. It enables the surviving spouse to have the use of all the matrimonial assets during his/her lifetime, whilst avoiding a large part of the tax that would otherwise be payable, thus combining flexibility with tax- efficiency.

Drawbacks? Nothing can be guaranteed. The Revenue currently accept this kind of arrangement, but there are indications that they may attempt to restrict its use in the future.

For more information on tax planning, please contact Peter Harris, Solicitor and Chartered Tax Adviser at our Stafford on 01785 211411, or Shani Carr at Rugeley on 01889 583871.

Published on web site - January 2008

The contents of this article are for the purposes of general awareness only. They do not purport to constitute legal or professional advice. The law may have changed since this article was published. Readers should not act on the basis of the information included and should take appropriate professional advice upon their own particular circumstances.