Inheritance Tax Planning Trusts

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These may come in various forms:

• 2 Year Discretionary Trust
• Residuary Discretionary Trust
• Nil Rate Band Discretionary Trust
• The Nil Rate Band IOU Trust

Explanation of the 2 Year Discretionary Trust
Introduction - The Inheritance Tax Act 1984 s144 (IHTA 1984) provides that if distribution is made within two years of the testator’s death out of a discretionary trust created by a Will then, the result for inheritance tax purposes is the same ‘as if the Will had provided that on the Testator’s death the property should be held after the distribution’. The result occurs automatically and inevitable.

It is impossible for any Testator to foresee exactly what will be the circumstances of his family or the value of his estate at the time of his death, even a carefully considered Will may well turn out not to be suitable at the time of the Testators death. A 2 year discretionary trust allows the Executors to decide upon the disposition of the estate, with the ability to distribute the estate in the most tax efficient manner.

Explanation of the Residuary Discretionary Trust
Very similar to the above Discretionary Trust but only deals with the residuary estate. This allows the surviving spouse to make decisions over distribution after first death.

Explanation of Nil Rate Band Discretionary Trust
By including in your Will an outright gift to the children of the Nil Rate Band you will have reduced or even avoided any IHT liability. However, it is essential to balance your desire to reduce any IHT liability against the need to ensure that your spouse is able to maintain their standard of living after your death. At this moment in time it is not possible to know when you are to die, or to predict what your estate will be worth when you die and what the surviving spouse’s needs will be at that time, in the future, or to know what the precise amount of the Nil Rate Band at the time of your death. Therefore, incorporating an absolute gift of the Nil Rate Band to the children in your Will could leave the surviving spouse in dire circumstances.

Therefore, these problems can be overcome by creating a Discretionary Will Trust (rather than an absolute gift) of the Nil Rate Band, with the surviving spouse, children, and grandchildren as the potential beneficiaries of the Discretionary Trust. The Trustees of the Discretionary Trust have the total discretion as to which potential beneficiary or beneficiaries to pay either capital or income. Additionally the appointment of the surviving spouse as one of the Trustees of the Discretionary Trust provided the ability for the surviving spouse to have a considerable measure of control over how the Trustees exercise their discretions. The Will also effectively allows the surviving spouse to decide after your death (when they will have a much clearer idea of their needs) how much (if any) of the Nil Rate Band they must keep and how much can be given to the children.

Any capital or interest held in the Trust on your death would then pass to your children free of tax. Should the surviving spouse have not required any of the Trust Funds then the whole of your Nil Rate Band would pass to the children, free of tax and on the surviving spouse’s death. The surviving spouse would also have their own Nil Rate Band to pass onto the children. Under such circumstances it is possible for both Nil Rate Bands to be utilised thus reducing the total amount of tax payable, without, placing the lifestyle of the surviving spouse in jeopardy.

In many estates the house is one of the major (if not the major) asset. Should an absolute gift of the Nil Rate Band be given and there were insufficient assets in the estate to satisfy the Nil Rate Band and the house (or part of the house) had to be used to satisfy the absolute gift of the Nil Rate Band, then the Capital Taxes Office would deem that the house (or part of the house) held in trust was an ‘Interest in Possession’ and the whole value of the house would form part of the surviving spouses estate for Inheritance Tax purposes, thus defeating the object of the trust.

Explanation of The Nil Rate IOU Trust
Most married couples leave everything to each other with the result that more tax is paid than is necessary - take the case of Mr & Mrs Smith. Between them their home, cash and investments amount to £570,000. Mr Smith dies first leaving everything to his wife. There is no tax on his death because gifts between spouses are exempt. But on Mrs Smith’s death the tax is £114,000.

What did Mr and Mrs Smith do wrong?
They failed to use Mr Smith’s tax free band. By giving everything to his wife, Mr Smith wasted the first £285,000 and paid more tax than necessary.

Instead, Mr Smith might have given the £285,000 to his children. This would cut the tax bill by £114,000. The difficulty with this approach is that the survivor may need the £285,000 you’ve given to your children. It is therefore out of the question. This is particularly so where your home is your major asset, as you would have to give away part of your home to satisfy the gift of £285,000 - giving away part of your home is far too risky.

So what should Mr and Mrs Smith do?
Mr and Mrs Smith should make new Wills. But these aren’t conventional Wills. They incorporate a special tax-saving technique called the Nil Rate IOU Trust.

The Nil Rate IOU Trust
The Nil Rate IOU Trust involves a special trust, which can make loans to the survivor. The Nil Rate IOU Trust enables Mrs Smith to inherit her husband’s entire assets subject only to a loan from the trust. In practice there is little to prevent her doing whatever she wishes with the assets. After her death all the assets pass to the children. How it works is shown here. The loan cuts down the inheritance tax on Mr Smith’s death, so the children receive an extra £114,000.

Mr Smith’s assets £285,000
|
On Mr Smith’s death: all assets pass to his wife in return for an IOU for £285,000 given by her to the trust
Mrs Smith’s assets £285,000
+
Mr Smith’s assets £285,000
|
Total £570,000
|
Less Mrs Smith’s IOU £285,000
|
On Mrs Smith’s death:
assets less tax pass to the children
|
Total £570,000
less IOU £285,000
less tax NIL

Balance left to children £285,000

During the life of Mrs Smith there is a Trust containing an IOU for £255.000 - On Mrs Smith’s death the loan is repaid and £285,000 is distributed to the children.
C h i l d r e n r e c e i v e £ 570,000
T a x m a n N I L
AND Mrs Smith does not loose access to assets

In a nutshell, the Nil Rate IOU Trust saves up to £114,000 of inheritance tax, gives the survivor continued access to all your assets and safeguards the position of the survivor even when your main asset is your home.