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Anthony Nixon MA, CTA, TEP, ATT, Solicitor, provides an overview of planning issues involving IHT and Trusts.

The Tax

Inheritance tax (“IHT”) is basically a charge on the value of the assets of anyone who dies. 

IHT is also payable on gifts made in the seven years before death and on certain interests in possession in trusts (see "Trusts" below). 

Lifetime gifts to relevant property trusts (see "Trusts" below) are liable to immediate IHT. These gifts may suffer additional IHT if the donor dies within five years of the gift.

There is a separate regime of ten-yearly and exit charges on assets within relevant property trusts.

Rates of Tax

The main rate of tax is 40%. This applies both to the value of the estate on death and to gifts in the seven years before death. 

Occasionally taper relief reduces the rate of tax on gifts made more than three years but less than seven years before death.

Lifetime gifts to relevant property trusts (“lifetime chargeable transfers”) suffer 20% IHT.

The separate regime for relevant property trusts imposes 6% IHT on the assets of the trust every ten years. 

There is, technically, a rate of 0% on the value up to the IHT threshold (£312,000 in 2008/09). 

Main Exemptions and Reliefs

Gifts made more than seven years before death.

The first £312,000 given away – technically this is taxed at 0%. This “nil rate band” is due to rise to £325,000 in the 2009/10 tax year and to £350,000 in 2010/11.

Gifts between spouses and registered civil partners, whether during their lifetimes or on the death of the first to die, are completely exempt (except in the case of a gift from a UK-domiciled spouse to a non-UK-domiciled spouse, in which case only £55,000 is exempt). 

The estate of a widow or widower whose spouse died before them can claim an extra (or part) nil rate band to the extent their late spouse did not use their own nil rate band. This is usually called the “transferable nil rate band”.

Gifts to UK charities, political parties, and national museums and art galleries qualify for exemption. There are special “conditional” exemptions for buildings, landscape and chattels of outstanding aesthetic or historical importance.

Agricultural land (within the UK [although this restriction may well be contrary to EU law - Ed.]) and business assets (anywhere in the world) can qualify for very generous Reliefs (see "Reliefs for Agricultural and Business Property" below).

There are exemptions for small lifetime gifts, including gifts up to £250 to any one person, a total of £3,000 in each tax year and extra allowances for gifts on marriage. If the annual exemption is not used in any tax year it can be carried forward to give an effective £6,000 exemption in the next year.

There is an exemption for gifts which are “normal expenditure out of income”. There must be:

• a regular pattern of gifts;
• of a specific amount;
• of income from a particular source, or for a specific expense;
• and the gifts must be from the donor’s income.

Provided these conditions are satisfied there is no limit on the amount of this exemption.

There is also an exemption for gifts which constitute normal maintenance of the donor’s family.

The non-UK assets of non-UK-domiciled individuals are free of IHT.  UK-domiciled individuals suffer IHT on their worldwide assets. Non-UK-domiciled individuals suffer IHT on most assets which are within the UK.

Taper relief occasionally reduces the rate of tax on a gift but the relief is much misunderstood and much less valuable than it appears.

Ugly Animals – GROBS and POATS

Lifetime gifts made more than seven years before the donor’s death are usually free of IHT. But this is not the case for a Gift (With) Reservation Of Benefit (“GROB”). 

There is a GROB whenever an individual continues to benefit from what they have given away, for example by continuing to draw on the income, either directly or indirectly or wholly or in part, or by continuing to live in a residential property. 

Where there is a GROB the donor is treated as continuing to own the asset given away, even if the benefit they have reserved only derives from a fraction of their gift.

POAT (“Pre-Owned Assets Tax”) is not an IHT charge. It is a charge to income tax. It was introduced, in 2004, as a specific response to certain IHT planning ideas that successfully found a way around the GROB rules. The main object of POAT is not so much to raise any tax itself, but to persuade people that they are better off electing for any assets that fall within the POAT regime to fall instead within the GROB regime. 

Reliefs for Business and Agricultural Property

These reliefs are extraordinarily generous. They are the most generous of any country in the developed world that has an equivalent to IHT. Relief is most commonly given at 100%, which means a complete exemption from IHT on the assets concerned.

There is usually no relief at all unless the asset concerned has been owned for a minimum of two years. In the case of agricultural property, relief is available on land which is farmed by others. But in this case the owner must have owned the land for seven years in order to claim IHT relief. 

"Agricultural Property Relief"  (APR) can extend to farmhouses as well as to farmland, but the relief is limited to “agricultural value”. This is taken to be the value of the asset concerned on the assumption that it is subject to a perpetual condition barring its use for any purpose other than agriculture. Land with development value will not always qualify for agricultural relief on the whole of that value, but sometimes that value will qualify for business relief instead.

"Business Property Relief" (BPR) is available on the assets of a sole proprietor’s business, a share of a partnership business, or shares and securities in a company which is unquoted (this includes shares quoted on AIM). The important exception to business relief is that businesses which mainly consist of holding or dealing in investments, including investment in land or buildings, are completely barred from business relief.  This is an “all or nothing” restriction.  If a business is 51% trading and 49% investment it is possible to get relief for the entire value of the business.  If, on the other hand, the business is 51% investment and 49% trading there is no relief at all. 

Trusts

What are trusts for?

There are three main reasons for creating trusts. In some cases, more than one of these reasons may apply:

• A receptacle for gifts. A trust allows flexibility as to who ultimately benefits. Sometimes this can be combined with tax savings. Trusts used to offer a number of IHT-saving opportunities but these are much reduced since the changes made to the IHT trust rules in 2006.
• Protection of children, young adults or other vulnerable beneficiaries. Obviously, a four year old cannot directly control assets and someone must look after those assets for them, particularly if one or both parents have died.
• Control of succession. The most common example is a twice-married man who wants his will to benefit both his (second) wife and the children of his first marriage.  More traditionally, historic properties are often subject to trusts keeping them within a specific family or attached to a specific inherited title.

Trusts are also often used for charities, pensions, for providing benefits to employees and for certain other commercial uses, but these are not covered here.

IHT and trusts

Since the changes made to the IHT rules for trusts in 2006, there are two main categories of trust for IHT purposes, an interest in possession trust and a relevant property trust. Confusingly, some trusts with interests in possession are no longer within the interest in possession regime, but are in the relevant property regime.

Interests in possession

An interest in possession means the right to the income of a trust. Where the trust includes residential property, that right may mean the right to live in that residence.

Before the 2006 changes, all interests in possession came within the same IHT regime. The rule was that the beneficiary entitled to an interest in possession was, for virtually all IHT purposes, treated as owning the assets of the trust. If the individual beneficiary’s interest in possession was the right to only a fraction of the trust’s income, they would be treated as owning an equivalent fraction of the trust assets.

This treatment (which I now call the “old” interest in possession regime) still applies to interest in possession trusts which were already in existence on Budget Day (22 March) 2006. But it only applies to interests in possession beginning after Budget Day 2006 if the new interest is either a transitional serial interest or an immediate post-death interest. 

(There is also a special form of trust for certain disabled people under which the disabled beneficiary can still be treated as having an old-style interest in possession for the purposes of IHT, whether or not they have a right to the income.)

Until 5 October 2008 a transitional serial interest could be created by replacing an interest in possession that existed on Budget Day 2006 with a new interest in possession in the same trust. 

This rule no longer applies but, on the death of a beneficiary who had an interest in possession on Budget Day 2006, an interest in possession which immediately arises for that beneficiary’s widow or widower is also a transitional serial interest. It may still be possible to arrange this under the terms of a trust.

An immediate post-death interest is an interest in possession arising under the terms of a will or, where someone dies without a will, under the intestacy rules. It is also possible to create an immediate post death interest through a variation within the two years after death.

Except for the limited rules on trusts for the disabled it is now impossible to create a lifetime trust which is within the old interest in possession regime.

So all other lifetime trusts, whether a beneficiary has an interest in possession or not, will now be within the relevant property regime. 

Changes to a trust within the lifetime of a beneficiary with an interest in possession will now move the trust from the old interest in possession regime into the relevant property regime. For IHT that change will usually involve a chargeable transfer by the beneficiary, which is subject to immediate 20% IHT. This can happen even if the beneficiary’s right to income continues, but is a newly created interest.

The relevant property regime

The relevant property regime has always applied to discretionary trusts and other trusts where no individual had the right to income. Since Budget Day 2006 the regime will apply to more and more trusts.

Relevant property trusts pay 6% IHT on the value of the trust assets every ten years.  The 6% ten-year charge is not quite as expensive as it may appear, because most trusts, like individuals, have their own nil-rate allowance up to the £312,000 threshold.

So that the ten-year charge is not avoided by winding a trust up immediately before the ten year anniversary, there is also an “exit charge”. This charge is at a fraction of 6%, proportionate to the time that has passed since the last ten-year anniversary of the trust. The exit charge is normally calculated by reference to the value of the trust assets on the last ten-year anniversary or their value when they were transferred into the trust. When values are rising, an exit charge on the day before a ten-year anniversary is usually much less than the ten-year charge on the next day.

Other forms of trust

The 2006 changes have introduced some other new names for trusts including trusts for bereaved minors and age 18-to-25 trusts. These trusts usually arise only under the will of a parent, for the benefit of their minor children. There is no IHT while the child is under 18. A bereaved minor’s trust must end on the beneficiary’s 18th birthday. An age 18-to-25 trust is subject to a modified form of the relevant property regime to the extent assets stay within the trust after a beneficiary turns 18. Age 18-to-25 trusts could also be created, before 6 April 2008, by the variation of a trust which was formerly within the regime for accumulation and maintenance trusts.

Bare trusts are a category of their own. These are nominee arrangements where the beneficiary of the trust could, if he wished, insist on the trustees transferring the trust assets to him. Almost invariably, the tax treatment of bare trusts reflects the underlying ownership and ignores the fact that there is any kind of trust.

Trusts and Capital Gains Tax

Capital Gains Tax (“CGT”) applies to trusts in much the same way as it applies to individuals, but both the creation of a trust and transferring assets out of a trust can be significant events for CGT.  Trusts have only half the annual CGT exemption given to individuals and this exemption is subdivided further where the settlor of the trust has also created other trusts.

Trusts and Income Tax

There are special Income Tax rules for trusts.  Broadly speaking three different Income Tax regimes can apply:

• Where the settlor of a trust remains a beneficiary or a potential beneficiary, all the trust’s income is taxed as if it were the settlor’s personal income.
• In other cases, where a beneficiary is entitled to the income of a trust (or to a share of that income) the income is directly taxed as that individual beneficiary’s personal income.
• Finally, if the settlor has no potential interest in the trust and there is nobody with the right to receive the income, the trustees pay a special trust rate of Income Tax which is currently 40%. This is to increase to 45% from 6 April 2011. As and when income is distributed from the trust to individual beneficiaries, it then becomes the beneficiaries’ income for Income Tax purposes and, subject to various complex rules, the beneficiaries can claim credit for the tax that the trustees have paid.

Planning for IHT

Use exemptions

Does the individual have surplus income which could be the subject of a regular gift, perhaps to fund a savings plan or insurance policy outside the individual’s IHT ownership?

Each of husband and wife can give away £3,000 each tax year. 

In addition, each can give up to £250 to any individuals. For a married couple with several grandchildren or great grandchildren, gifts of £250 by each of the couple to each of those children can add up to a lot.

Use the nil rate band

Wealthy grandparents often fund their grandchildren’s school fees. Can the grandparents afford to give away assets to fund these fees?

Suppose a married couple owns an investment property worth £600,000 which produces an income of £50,000 per year and that both are higher-rate tax payers. After 40% tax their net income from the investment is £30,000. 

If the property is given to a trust used for their grandchildren’s education, the same income can become the grandchildren’s personal income for tax purposes. The first £6,035 of each grandchild’s income is completely free of income tax and the next £36,000 taxed at only 20%, compared with 40% in the grandparent’s hands.

By giving the asset away the grandparents may remove £600,000 from the value liable to IHT on the death of the second of them, saving £240,000.

CGT may be an issue.  Any gain can be 'held over' at the time of a gift to trust but the gift to the trust loses the tax-free uplift on death.  Even so, the rate of CGT is 18% compared with 40% IHT and is only paid when action is taken to sell the property. CGT is not inevitable in the way that IHT on death is.

Will planning

For wealthy individuals trusts in wills have many benefits. The flexibility is particularly useful because no one can predict with any certainty what circumstances will be relevant at the time of death. For example, if one of the children is in business or matrimonial difficulties a large inheritance may be vulnerable to creditors or to an estranged spouse or partner.

Married couples with joint assets worth less than two nil rate bands no longer need to include special provisions in their will, since they can take advantage of the transferable nil rate band. 

Couples with more substantial assets, or assets (such as land with development prospects) likely to grow in value, will still find a “nil rate band trust” helpful.  This trust used to be included in most married couples' wills, before the introduction of the transferable nil rate band, to ensure that the allowance given to the first spouse to die was not wasted.

Example

Husband and wife own house worth £690,000 as tenants in common in equal shares.
 
H dies in the current tax year when the nil rate band is £312,000.
 
Suppose W dies a few years later when the value of the property and the nil rate band have both increased by some 33% so that the house is then worth £920,000 and the nil rate band is £415,000. 

Since W was a widow the nil rate band is doubled and £830,000 of the house’s value is free of IHT. 40% IHT on the balance of £90,000 is £36,000.

But if H had left a will including a nil rate band trust, the taxable value of the house could have been reduced by splitting it into two halves, when a discount of at least 10% applies. 
 
After H’s death his half of the £690,000 house is worth no more than £310,500 (£345,000 less 10%). So all of this share can go to the trust. It is still available for W to live in, but not treated for IHT as belonging to her.
 
When W dies her half of the £920,000 house is worth no more than £414,000 (£460,000 less 10%). This is less than the £415,000 nil rate band available to her.

So there is no IHT on the house, saving £36,000.

Similar trusts for assets qualifying for 100% business or agricultural relief can capture relief on the death of the first of a couple to die, even if the relief is no longer available when the second dies. On the other hand, if the surviving spouse continues to run the business or farm concerned, a judicious exchange of assets can allow the same relief to be used a second time on the death of the survivor.

The family home

If one or more adult children share their parent’s home, a gift by the parent of a part-share to the children can be kept outside GROB and POAT problems.

For children who do not live with their parents it is essential for the parents to pay a market rent for what is given away, although this can be a gift of a part-share and a rent proportionate to the part-share given away. This can give the children an Income Tax bill but, as with the gift of an investment property described above, it may be possible to make the gift to a trust and use grandchildren’s Income Tax exemptions.

Where a home enjoys particularly large gardens, or has valuable features such as stables, paddocks, access to rivers or the sea etc, it may be possible to reduce the value of the property kept in the parents' hands by a careful physical division of the property.

Commercial equity release can provide an immediate boost to income whose cost is considerably reduced by the ultimate IHT saving.  With care, similar arrangements can be made within the family, if one or more children is able to help support their parents.

Second homes and other properties

Whether an additional property is a second home, a holiday home or a pure investment (whether residential or commercial) it is often sensible to buy it within the shell of a trust. 

Initially the parents can keep all the income from the trust for themselves but, if they subsequently want to give it away, can remove it from their IHT ownership without a CGT problem. 

In the case of residential properties, there may be opportunities for a young adult beneficiary to make use of CGT main residence relief, which is not available to the original owners.

Using business and agricultural reliefs

Even if 100% relief from IHT is available at present, this may not always be the case in the future, whether because of changes in the nature of the business, sale of the business, or future changes in tax rules.

If assets qualify for 100% relief, a lifetime gift to a trust involves no immediate tax, however large the value given away. A quirk in the rules means that a gift with a value below the IHT threshold is immediately free of IHT, without any seven-year risk period and without any other effect on the donor’s tax-free band.

Where only 50% relief is available, it may be possible to rearrange assets to increase relief to 100%.

Pension funds

Some business owners and senior executives accumulate pension funds worth many hundreds of thousands, or even millions, of pounds. If the individual dies before fully drawing on the pension this fund will usually be returned to the individual’s estate. Where this is a possibility, it is always worth creating a “by pass” trust to ensure that the funds do not go into the IHT ownership of the individual’s spouse, but are available for the spouse’s benefit without being treated as belonging to him or her.

Post death planning

If trusts have been created in the will, these can usually be varied, within two years of death, without adverse tax consequences. 

If no trusts have been included in the will, a beneficiary can take assets out of his IHT ownership by varying the will within two years of the death. This can either be an absolute gift or can be within a trust, from which the original beneficiary can continue to draw without GROB or POAT problems.

In the period immediately following the death of a wealthy couple a careful review needs to be made as to whether to use the tax-free amount of the first to die or allow it to be transferred to the survivor. Second and third marriages have interesting results.