Discretionary Trusts in Wills

1.    There is no Inheritance Tax payable on property passing between husbands and wives or civil partners whose relationship is registered under the Civil Partnership Act 2004, during their lifetimes or on death because of the ‘spouse exemption’.  In this note ‘spouse’ shall include both husband and wife and civil partners.

Where property is given to someone else, no Inheritance Tax is payable up to a certain amount, known as the nil rate band.  On values over this limit, the rate is currently 40%.

2.    Mirror Wills, where each spouse leaves the whole of his estate to the survivor, are not Inheritance Tax efficient because these Wills do not make use of the nil rate band available on the first death.

A gift up to the limit of the nil rate band to anyone other than the surviving spouse – a child for example – incurs no Inheritance Tax on the first death and also reduces the estate of the survivor, thus reducing inheritance tax on the second death.

3.    You may not feel comfortable, however, passing assets to the value of the nil rate to someone other than the surviving  spouse as  he or  she may not be  able to do without them.

4.    An alternative therefore, is for assets up to the nil rate band to be left on a discretionary trust for the benefit of the family as a whole, with the surviving spouse being one of the beneficiaries.

5.    This trust can receive assets up to the maximum amount of the nil rate band available, such amount being reduced by any gifts that you make within seven years of your death and any other legacies included in the Will.  The trust is set up in such a way that the surviving spouse is one of the potential beneficiaries jointly with the children, grandchildren and any other people or organisations you wish to name.

The trust comes into effect on the first death and can last up to 80 years.  It can be wound up after the death of the surviving spouse or could be retained by the family for tax planning or other purposes.

6.    Discretionary trusts have the following advantages:

• Income can be paid to any of the beneficiaries, including the surviving spouse, as the trustees decide;

• The death of a beneficiary does not give rise to any inheritance tax being payable;
  
  
• The income and capital of the trust can be used by the trustees in a flexible way so as to produce the most tax advantageous distribution taking into account the circumstances of the beneficiaries at any given time;

• The trust will include provision allowing the trustees to make loans to any of the beneficiaries.

7.    The following tax considerations will arise in the administration of the discretionary trust.

Inheritance Tax

If the trust is still in existence after ten years, the trust fund will be assessed to tax at that date and on each subsequent ten year anniversary while the trust continues.  However, inheritance tax is only payable on the amount by which the valuation of the trusts assets exceeds the nil rate band at that date and the rate of tax is a maximum of 6% which compares very favourably with the 40% rate that is payable on death.

Inheritance tax is also potentially payable each time capital is paid out of the trust.

Income Tax

Income is taxed on the trustees as though they are higher rate tax payers (subject to a basic rate band of £1000) – at a rate of 40% for all income except dividends, which are taxed at 32.5%.

Income paid to beneficiaries always carries a 40% tax credit, all or part of which can be recovered by the beneficiary depending on his personal tax position.

Capital Gains Tax

The trustees will have a maximum annual capital gains tax exemption which is equivalent to one half of the exemption available to an individual.  Trustees pay capital gains tax at 40%.

8.    There will be costs involved in looking after the trust, its assets, dealing with the annual income tax and capital gains tax returns and generally ensuring that the inheritance tax savings envisaged by the arrangements will remain in place.

9.    The surviving spouse can be one of the trustees of the trust.

10.  If such a trust is included in the Wills there should be assets in the sole name of the first to die to use as much of the nil rate band as is possible.
Assets in joint names (other than those held as ‘tenants in common’ will not be subject to the terms of the Will and therefore will not be available to pass into the trust, as these assets will pass to the surviving owner automatically by survivorship.  It may therefore be necessary to re-arrange them into individual names rather than retaining them in join names.

If a share of property is to be included, it may be necessary to alter the type of joint ownership so that each owner has a separate share in the property which will pass under the terms of each Will.  This is generally known as severing the joint tenancy.

There are potential tax pitfalls in including a share of a property as an asset of the trust but in practice these can be avoided by transferring the deceased’s share of the property to the surviving spouse subject to a charge (like a mortgage) over the property in favour of the trustees.  The trustees would then own the benefit of the charge, the value of which is initially fixed, either at the value of the deceased’s share of the property, or if less, the nil rate band.

On the death of the surviving spouse the property will be in his or her estate but the value of the charge will be deductable against it which reduces the inheritance tax liability that will then be payable.

Fore more advice on your particular circumstances, please contact us on 0845 686 3838 for an appointment.