Wills and Inheritance Tax Update

The Chancellor of the Exchequer’s Pre Budget Report on 9th October 2007 introduced major changes to the way Inheritance Tax is calculated for married couples and civil partners.

Introduction

There has been press speculation as to whether tax planning Wills are still of use to couples and whether any action needs to be taken now to plan for effective tax mitigation on death. The purpose of this article is to de-mystify the consequences of the changes and discuss the tax planning options available.

Terminology

There are four key terms which are referred to when discussing Inheritance Tax planning.

Inheritance Tax - is the 40% tax on the value of a person’s estate at death in excess of the available Nil Rate Band.

Nil Rate Band - refers to the tax free allowance available to each individual on death. This is £312,000 for the 08/09 tax year. The Nil Rate Band will be reduced by
any lifetime gifts made in the seven years before death.

Discretionary Trust - is a very flexible form of trust. A Discretionary Trust of the whole or part of a person’s assets, known as their ‘estate’, can be created in a Will. The trustees have the power to manage the trust fund and make distributions to any of the beneficiaries named in the Trust at their discretion. Distributions can take advantage of tax considerations, or provide for the needs of individual beneficiaries.

Spouse Exemption - any transfer of assets to a surviving UK domiciled spouse or civil partner are free of Inheritance Tax. This does not affect the Nil Rate Band of the deceased. If the whole of the estate passes to a surviving spouse or civil partner the Nil Rate Band is not used.

Effect of the changes

Where the survivor of a marriage or civil partnership dies on or after 9th October 2007 their personal Nil Rate Band is increased by the amount of Nil Rate Band that was available at the death of their spouse.

Example: Husband dies leaving his whole estate to Wife. None of Husband’s Nil Rate Band has been used. On Wife’s death her own Nil Rate Band (currently £312,000) is increased according to the percentage that was not used on Husband’s death. Wife’s £312,000 allowance receives a 100% uplift giving a £624,000 tax free allowance at her death.

The available allowance is calculated at the time of the second death. No action needs to be taken on the first death to transfer the allowance. It is recommended that detailed records of the estate of the first to die are retained so that they can be referred to on the death of the survivor.

It is important to have an appropriate Will to ensure that the spouse exemption is used effectively and to avoid an intestacy.

Inheritance Tax Planning - Before October

2007 Passing the whole of an estate to the surviving spouse before October 2007 meant that the Inheritance Tax allowance available on the first death was not used. The survivor could only use his or her own single allowance at death. The Nil Rate Band available on the first death was wasted.

To make use of both allowances married couples or civil partners could make Wills leaving their estate, up to the value of the Nil Rate Band, in a Discretionary Trust, with any assets over the Nil Rate Band passing to the surviving spouse or civil partner outright. There was no tax to pay on the first death, and and both the Nil Rate Band and the spouse exemption were used effectively. This ensured that the Nil Rate Band was not wasted. Part or all of the Nil Rate Band Discretionary Trust fund could be distributed to the surviving spouse if they required it, or could be retained and passed on to other beneficiaries as the need arose.

On the second death, the trust fund would not form part of the survivor’s estate. Only the survivor’s own assets in excess of their own Inheritance Tax allowance would be subject to tax. On current allowances, this form of tax planning used to save up to £124,800 Inheritance Tax.

Do I need to make a will, or change my tax planning will?

Married couples and civil partners should make wills to use the spouse exemption effectively, and allow the survivor the flexibility to use the transferable Nil Rate Band allowance on their death.

If you die without making a Will (known as intestacy) the estate will be divided according to the Intestacy rules. These only allow a spouse or civil partner a set share of the estate. This is not an effective use of the spouse exemption or the Nil Rate Band.

Holding funds in a Discretionary Trust still has benefits, and the new tax advantages can still be used if the trust is administered to maximise these advantages. If, after the first death, the value of the Nil Rate Band is placed in the Discretionary Trust and distributed to the surviving spouse within two years, it will be treated as a direct gift to the survivor from the deceased. The estate will be treated as if the Nil Rate Band was not used, and the survivor can claim the transferable Nil Rate Band allowance on their death.

Example: Husband dies leaving his estate in a Nil Rate Band Discretionary Trust. Wife feels that more tax could be saved if 100% of Husband’s Nil Rate Band allowance was transferred to her to be used on her death. The trust funds are not needed for any other family member.

If, within two years of the death, the trust assets are distributed to Wife, the trust is treated as if the allocation of the trust fund was a direct gift from Husband to Wife, leaving the Nil Rate Band untouched. On Wife’s death her own Nil Rate Band receives the transfer of 100% of Husband’s Nil Rate Band, as it was not used on his death. Wife’s Nil Rate Band allowance is doubled as she uses her own allowance and has received Husband’s allowance as well.

This has exactly the same end result as the changes introduced in the Pre Budget Report.

Nil Rate Band Discretionary Trusts

As beneficiaries of a Discretionary Trust are not automatically entitled to the trust fund, they are not treated as owning the underlying assets in the trust. This is advantageous as the trust fund will not be considered if the surviving spouse is assessed for residential care funding. If a beneficiary divorces, he or she has no direct interest in the trust and the trust fund cannot be treated as a matrimonial asset. Similarly, the trust fund does not form part of a beneficiary's assets on bankruptcy.

If the surviving spouse re-marries and leaves the whole of their estate to their new spouse, any funds in the Discretionary Trust would be safeguarded and could be available for the children from the first marriage. This helps to keep the trust fund within the family. Under the new system, the surviving spouse or partner can take time to consider their family circumstances and the overall tax position. A Will which includes a Nil Rate Band Discretionary Trust does not prevent the survivor from making use of the changes to the tax system and it allows them the flexibility to choose the best tax planning route in their circumstances.

Summary

• Changes to the Inheritance Tax system pass on the tax-free Nil Rate Band to the surviving spouse without the need for trusts within a Will.
• Existing Wills containing trusts can be used to achieve the same result and retain the transfer of Nil Rate Band for the survivor but action must be taken within two years of the first death.
• Discretionary Trusts within Wills still have advantages, particularly where family members include children from more than one marriage or relationship.

Please contact Virginia Taylor on 0161 941 4000.