Inheritance Tax-effective Wills

This article was written before the pre-Budget announcement on 9th October 2007 (although the figures have been updated so as to be accurate for the 2008/09 tax year) and does not take into account of the changes announced at that time.

Please see attached for an explanation of, and comment on, the proposed changes. It should be noted that the legislation which will effect these changes has yet to be approved by Parliament.

The ‘nil-rate band’

At the current time the nil-rate band – being the amount of your estate which is not subject to Inheritance Tax - is £312,000. This will rise to £325,000 for the 2009/10 tax year and £350,000 for 2010/11.

Subject to certain exemptions and reliefs any excess is taxed at 40%. There is an exemption for assets passing from one spouse to another on death where both spouses are resident in England & Wales.

Your Wills

However, it is not particularly tax-effective to leave your entire estate to the surviving spouse outright as this increases the value of their estate and therefore the potential tax liability on their death. Two nil rate band allowances of £312,000 were available prior to the transfer. After the transfer the survivor holds all of the assets but with only one nil rate band allowance of £312,000 being available to reduce the Inheritance tax payable. The other nil rate band allowance has been wasted.

By using the nil-rate band within your Wills you could create a potential inheritance tax saving of up to £124,800.

Outright Gift

To make your Wills more tax effective you could each include a gift of a sum equal to or less than the nil-rate band to those whom you wish to benefit on both your deaths. This would take effect on the death of the first to die and would remove the sum gifted from the survivor’s estate, thus creating a potential Inheritance Tax saving on the death of the survivor.

However, it should of course be remembered that the welfare of the survivor of you is probably a greater factor than tax planning. You should ensure that the survivor of you would be able to maintain their standard of living and have a contingency fund to meet future uncertainties – e.g. the need for residential care etc. Your expected future income and outgoings are also a relevant consideration in this respect.

A Nil rate band Discretionary Trust

If you do not feel that such an outright gift to under the Will of the first to die would leave the survivor sufficiently well provided for, but wish to maximise the potential for Inheritance Tax savings, then you may wish to consider the incorporation of a discretionary trust under the terms of your Wills.

This would provide that a sum of money, again equal to or less than the nil-rate band, would pass into the Trust Fund on the death of the first to die. The Trustees would have the absolute discretion to use the Trust monies to benefit any one or more of a number of named beneficiaries – e.g. the survivor of you, your children, grandchildren, favourite charity etc.

Whilst the survivor of you would be able to benefit from the Trust fund, receiving capital and/or income, the monies remaining in the Trust Fund on their death would not form part of their estate for Inheritance Tax purposes.

None of the beneficiaries would have any guaranteed right to receive monies from the Trust Fund, but would be reliant on the Trustees exercising their discretion in their favour. It is therefore perhaps better to think of them as ‘potential beneficiaries’.

The choice of Trustees is therefore very important. The survivor could be appointed as one of the Trustees, enabling them to have some say in the administration of the trust. You could also appoint one or more of the other potential beneficiaries to be Trustees, but there might be an argument for appointing an independent third party who has no interest in the trust fund if your priority is the protection of the survivor of you.

Memorandum of wishes

It is usual to accompany a discretionary trust with a memorandum explaining to the executors what your overall intentions are in setting up the trust in the Will. It must be a vague indication of your intentions and must not restrict the discretion of the trustees.

Trust Administration

It is important to realise however, that any trust that comes into effect on the first death must be properly created and managed. It is no good for the trustees to think that all they have to do is to let matters drift by. The trustees would have to meet, decisions made as to what assets/investments should form part of the trust, the trust would need to be registered with the Inland Revenue because it is a potentially taxable vehicle in its own right and indeed, in the longer term a decision might be made to hold assets in trust for more than one generation.

Other action required

You would each need to ensure that you had sufficient assets which could be used to make up the amount left either by way of an outright gift or into the Trust. This would mean ensuring that, where possible, any liquid assets were held in your respective sole names rather than jointly. If you co-own your home or any other property then you may need to ensure that this was held as ‘tenants-in-common’ rather than as ‘joint tenants’.