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Discretionary Trusts

The position with regard to Inheritance Tax and Wills has been subject to a degree of change following the Pre Budget Report on 9th October 2007. This article will give you a balanced view of the changes which were implemented and give you guidance on how your Discretionary Trust Wills can still be an invaluable planning tool.

The situation before 9th October

The basic inheritance tax position for married couples and civil partners before October 2007 was fairly straightforward.

If the first spouse died and left everything to the survivor then, on the first death, there would be no inheritance tax payable, due to the availability of spouse exemption. However, in these circumstances the nil rate band of the first to die had not been fully utilised. With the survivor owning all of the assets there was a bunching effect which meant that, on their death, there could be a large inheritance tax bill since they only had their own Inheritance Tax threshold to set against the bunched estates.

To mitigate this liability each Will contained a nil rate band Discretionary Trust. This Trust ensured that on the first death the nil rate band was fully utilised. Whilst the inherent tax saving was the predominately main reason why such Wills were recommended they were also able to shelter assets to protect beneficiaries eg if a member of the family had matrimonial/debt issues or if you were concerned about the impact of home fees. They could also be used a vehicle to shelter business assets to maximise the Inheritance Tax relief available.

The situation after 9th October

Despite the varied reporting on the changes the position has not changed at all for single people or as much as might be thought for married couples and civil partners.

The new Inheritance Tax rules:

For second deaths occurring on or after 9th October 2007 the inheritance tax impact of the 'bunching' of estates at the time of that death can be reduced by the survivor's Executors making a 'transfer claim' to the tax office. The effect of this claim is that the proportion of unused nil rate band on the estate of the first to die can be clawed back for the benefit of the second estate. A transfer claim would involve ascertaining the proportion of the unused nil rate band of the first to die and then transferring that to be set against the taxable value of the survivor's estate.

The effect of this is that if none of the nil rate band had been utilised on the first death the estate of the survivor could claim back the full value of their unused nil rate band. Meaning, in effect, that the available nil rate band for the second estate would be £650,000 (being £325,000 x2) for the tax year 2009/10.

It must be remembered that the Inheritance Tax threshold has not been increased to £650,000.

The effect of the new rules will also vary depending upon the circumstances of the case concerned and specific advice must be taken to confirm how the changes will effect you.

Do I still need a Discretionary Trust?

Previously, Discretionary Trusts were primarily completed by people wanting to mitigate their Inheritance Tax liability. The changes in the rules have reduced their necessity to a certain extent but we would argue that there is still a role for Discretionary Trusts as part of your long term planning.

If instead of using a suitable trust arrangement everything is left to the survivor outright then:

  • The survivor can spend all the money
  • The survivor may have financial problems and their creditors might take everything they have
  • The survivor may remarry and leave their estate to their new spouse
  • The survivor may enter means-tested long term care. In this case most of their estate may be paid out in care fees
  • The survivor might lose the mental or physical capacity to handle their own affairs. This could lead to their being exposed to financial abuse by third parties and their affairs might need to be taken over by the Court of Protection
  • If the first spouse/partner to die has any business or agricultural property which is relieved by inheritance tax business property relief or agricultural property relief then unless those assets are either given away outright to non spousal beneficiaries or into a flexible discretionary trust arrangement then the benefit of that type of valuable relief is lost
  • If the value of the assets in the estate of the first to die eg a share in the family home or shares/ any investment / interest paying bank account grow at more than the rate of increase in the nil rate band for inheritance tax purposes (which has broadly grown at the 'headline' inflation rate or RPI) as they have in the past then it would be advantageous to make use of the nil rate band of the first to die at the time of the first death. In short the growth in value of the assets is taken out of the value of the equation at the second death

Summary

The changes to the Inheritance Tax regime are to be welcomed. But, it is important that you take appropriate advice to ensure that your personal position is adequately protected. The use of a Discretionary Trust in your Will is still the best way you can ensure that your estate passes to the people you want, in the way you wish, whilst still leaving your Inheritance Tax mitigation options open.

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