A lot of married couples who are concerned about inheritance tax have put in place wills containing a legacy to a tax-saving trust. The aim is to ensure that part of the estate of the first spouse to die equal to the nil rate band inheritance tax band (£325,000 for 2009/10) is protected from inheritance tax on the death of the survivor.
In a common case, after the death of the husband (H), his will would put a legacy equal to the nil rate band into a discretionary trust where it can be used, if required, by the surviving wife (W) but where it will not be subject to inheritance tax on W’s death. W will have her own nil rate band on her death.
H and W therefore ensure that they get the benefit of two nil rate bands, not just one nil rate band on the death of the survivor of them.
The same route was used by civil partners as well.
Sometimes after the first death, these trusts were funded with an IOU from W or with a charge over H and W’s house, which were often index linked but which are not likely to keep up with increases in the nil rate band. These ways of funding a discretionary trust were often used in order to avoid certain capital gains tax and inheritance tax difficulties if part of the matrimonial home was put in the trust, and also to simplify the trust.
The pre-Budget report in October 2007 proposes a significant change for married couples and civil partners. The change is that on the death of the surviving spouse or partner, their executors will be able to make a ‘transfer claim’ to use up any unused part of the nil rate band of the first spouse or partner to die. The change applies if the first spouse or partner died before October 2007, so widows and widowers can benefit even if their spouses died many years ago.
H dies in 2007 leaving £300,000 to W. H’s nil rate band is £300,000 and H uses no part of it. W dies in 2010. Her estate is £700,000, including what she inherited from H. The nil rate band at her death is £350,000. Before the Pre-Budget Report, W would have the benefit of the nil rate band of £350,000 and the balance of her assets (£350,000) would be subject to inheritance tax giving a tax bill of £140,000. Following the Pre-Budget Report, W’s executors can make a transfer claim to use H’s nil rate band. 100% of his nil rate band is available, and therefore W’s executors can claim an additional 100% of the nil rate band at W’s death, i.e. a further £350,000. W’s nil rate band and H’s transferred nil rate band add up to £700,000 which covers the whole of her estate, so there is no inheritance tax to pay.
Of course, well advised married couples could always have achieved much the same result through their wills. But the change is to be welcomed. It will stop married couples and civil partners accidentally losing a nil rate band.
It must be remembered that the change does not increase the basic nil rate band, and that the change does not apply to single people or co-habiting couples.
As with any significant tax changes, it will take a while for all the implications of the new rules to be understood.
It is only married couples and civil partners who need to check the effect of the new rules on them. The new rules do not apply to co-habiting couples or family members who share a house and want to benefit each other when one dies and a trust along the lines of a nil rate band trust may still have significant benefits in saving inheritance tax.
On balance, a sensible course of action for married couples and civil partners may well be to leave their nil rate band trust wills as they are to hedge their bets.
However, this may be a good time to take stock and review your wills and the inheritance tax position. Please contact us to arrange an appointment to do so.
The change is new, and it will take some time for its implications to be understood and worked out in practice. Some common questions already being asked are - Should we scrap the nil rate band discretionary trusts in our wills? Two reasons for scrapping the wills and going back to simple wills under which H simply leaves everything to W and vice versa, are:
- The nil rate band trusts will enable H and W to use two nil rate bands, but the first will be the nil rate band at H’s death. That could be lower than the nil rate band at W’s death.
- In the example above, using a nil rate band trust would give £650,000 in nil rate bands in total (the £300,000 0n H’s death and the £350,000 on W’s death) leaving £50,000 of W’s estate exposed to tax at 40% and a tax bill of £20,000.
Nil rate band trusts are, in technical trust and inheritance tax terms, difficult and complicated. Doing away with them simplifies things greatly.
But our view is that the decision should not be rushed. There may be perfectly good reasons for having a nil rate band trust (see below), and in any event keeping the trusts in the wills means that you can hedge your bets. If after H’s death it is right to set up the trust, that can be done; if on the other hand it is better to wind up the trust, that can be done by paying everything out to W (see below).
- Should we keep nil rate band discretionary trusts in our wills?
If H dies, setting up the nil rate band trust in his will means that other benefits can be achieved:
- The money in the trust can be protected against being spent or wasted by W.
- The money in the trust can be preserved for the people H ultimately wants to benefit, and will not be dissipated by W, for example by giving it away during her lifetime or by leaving it to a new spouse following a remarriage.
- The assets in the trust will be protected from a claim for contributions towards nursing home fees because they will not be taken into account for means testing purposes.
- The trustees can run the trust and manage the assets in it. They can continue to use the assets for the benefit of W even if W loses mental or physical capacity.
- The nil rate band goes up year by year, generally speaking, but there is no guarantee that it will always do so. It could be frozen or reduced. Locking in the inheritance tax benefit at the level of the nil rate band on H’s death might therefore be beneficial.
- The assets held within the discretionary trust may grow at a faster rate than the nil rate band. And the opportunity benefits of the income and interest earned on the trust assets, or interest saved if for example money is lent to H’s children who use it to repay mortgages, should be taken into account.
Of course, some of those reasons may lead to the conclusion that the trust in the will should cover not just the nil rate band, but the whole of H’s estate. Any such trust should be in flexible form to enable the trustees to make the most appropriate decisions after the first death.
There is also the point that certain types of business assets and agricultural assets attract 100% relief from inheritance tax. There are many conditions attaching to the reliefs, but a key one is that the assets have to be owned by the taxpayer for two years at his death. Valuable business or agricultural assets could therefore be subject to significant inheritance tax charges if W inherits them outright and then dies within two years of H. That risk can be avoided by adding the assets I to the nil rate band trust in H’s will.
So there may still be extremely good reasons for keeping the trust, or indeed extending it.
Moreover, the tax rules currently allow you to wait and see what is best. H would not be burning any bridges by leaving his will unchanged at his death. W and his executors and family will be able to decide what to do about the nil rate band trust after H dies. In the two year period after H’s death it will be possible for the trustees to wind up the trust by paying everything out to W. There is a reading back rule in section 144 of the Inheritance Tax Act 1984 which means that for inheritance tax purposes it will be as if the trust never existed and as if W had inherited everything from H free of any trust.
- My spouse died more than two years ago and we set up a nil rate band trust. What should we do?
Because H died more than two years ago, the reading back rule described above will not apply and it will not be open to you to wind up the trust and take advantage of the new rules.
H and W are victims of the new change. The nil rate band trust has been created and H and W have locked in the nil rate band rate applying on H’s death. This is particularly the case if the trust has been established with an IOU from W or with a charge over H and W’s house, which may be index linked but which are not likely to keep up with increases in the nil rate band.
Therefore it will be necessary to continue with the trust. Perhaps this will be a good time to review the trust arrangement and to consider any planning opportunities available.
Trusts already in existence should be reviewed by the trustees every year, ideally, and the trustees should keep careful records of their meetings and decisions, even if their decision is that no change needs to be made.
- My spouse has died within the last two years and we have already set up a nil rate band discretionary trust. What should we do?
Much depends on how the trust has been set up, and what W’s views are. W needs to consider carefully the arguments for and against keeping the nil rate band trust set out above, taking account of her overall inheritance tax position and exactly how the trust has been set up, e.g. with an IOU or a charge.
If the decision is to wind up the trust in favour of W, if that is done within two years of H’s death the reading back rules described above will apply, and it will be as if W had inherited the assets direct from H. W would therefore be able to take full advantage of the new rules.