Taxation in the United Kingdom/Inheritance tax/Discretionary Trusts

How to use a Discretionary Trust Will to pay less Inheritance Tax in the UK.

Typically, most unmarried couples who make Wills leave everything to each other. That’s understandable, but it’s not always the best thing to do, and it could mean that the family loses out financially because of Inheritance Tax.

If your estate (your savings, house, possessions, any insurance policy payouts, etc) is worth over £312,000 (2008/09 figure), then Inheritance Tax is charged at the rate of 40% on any amount above this figure.

If £312,000 sounds a lot to you, think again. Many people have considerable assets, especially if they own their home. A large number of couples now have a joint estate worth well in excess of the current Inheritance Tax threshold (IHT) of £312,000.

If an unmarried couple have made Wills leaving their estates to each other, they may have liitle or no tax payable on their estate when the first one dies. Potentially, a tax liability arises when the second partner dies. Without proper planning, a large inheritance tax bill can be incurred when the estate is finally passed on to the children. This means that your family and loved ones could lose a sizeable part of their inheritance – swallowed up by the taxman.

Typically, for many couples, the situation works out like this . . .

Mr White and Ms Green have an estate - including home, cash, investments, insurance payouts, etc, worth £500,000, jointly owned. They wish to give everything to the survivor when the first one dies, and on the second death, they wish everything to go to their children. Mr White dies first and leaves everything to his partner. Tax is not payable as his share of the estate, say, £200,000, is below the IHT threshold. The balance of his nil rate allowance (£112,000) is lost. A problem then arises when Ms Green dies.

Tax is payable on Ms Green’s death as follows:

Mr White’s assets of £200,000 pass to Ms Green on his death. On Ms Green’s death, all her assets (less tax) pass to their children. Tax is payable at 40% on amounts over £312,000, therefore Ms Green’s estate will incur a tax charge of £75,200. This means that their children will only receive £424,800.

By giving everything to his partner in his Will, Mr White wasted the balance of his tax-free allowance of £112,000, and more tax was paid than was necessary.

Inheritance tax could be avoided by passing assets directly onto the children on Mr White's death. This way Mr White’s tax free allowance would be used but there is, of course, an obvious problem with doing things this way. Carrying out the provisions of the Will - giving Mr White’s share of the estate to their children – could leave Ms Green short of money. She may even have to sell their home, and her standard of living could suffer badly. She would also have no control over the money held by the children.

A better way of avoiding Inheritance Tax is to take advantage of a special tax saving technique called a Nil Rate Band Discretionary Trusts.

By incorporating a Nil Rate Band Discretionary Trust into his Will, Mr White can enable Ms Green to continue to benefit from their estate, while minimising - or even eliminating - inheritance tax. Essentially, this involves setting up a trust, which makes a loan to Ms Green.

Discretionary Trust Wills work by making use of the Nil-Rate band of both partners, rather than just that of the surviving spouse (as would normally be the case).

It works like this...

First the couple need to ensure they jointly own all the assets, or have an fairly equal interest. Then Mr White puts his share of the estate into a trust which takes effect on Mr White’s death. A loan of the full value of his estate is made to Ms Green from the trust, in return for an I.O.U. from her; there is no interest on the loan, which will be paid off on her death. On Mr White’s death, Ms Green’s has access (via the loan) to the trust monies (Mr White’s estate) making her total assets equal to their original joint assets (i.e., £500,000)

On Ms Green’s death, her assets pass to her children and the loan is repaid out of her estate. Therefore, the total value of Mrs Green’s estate was £500,000. Less the I.O.U. for the original value of Mr White's estate (say 50%, or £250,000) from Mr White’s Trust, leaving Ms Green with a net estate of £250,000, which is at the Inheritance Tax threshold, therefore no tax is due.

The children, therefore, get £250,000 from Mr White’s Trust plus £250,000 from Ms Green’s estate. Because both these sums are below the Inheritance Tax threshold, there is no tax to pay. The children receive a total of £500,000 and the taxman receives nothing.

Using a Nil Rate Band Discretionary Trust has:

• Enabled the family to save over £70,000 in inheritance tax • Given Ms Green control over the assets of the partnership after the death of her partner • Enabled her to maintain her lifestyle (without having to sell major assets such as her home) • Maximised the amount of family wealth passed on to future generations.

Setting up a Discretionary Trust Will takes a little more time and costs slightly more than an average Will, but for most people the advantages are overwhelming. There’s a lot to think about, this is just a simple guide and you really need to take professional advice.