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Mark McLaughlin CTA (Fellow) ATT TEP, General Editor of TaxationWeb, outlines the potential use and some potential inheritance tax pitfalls of discretionary will trusts to hold an interest in the family home.

Introduction

The Inheritance Tax (IHT) changes to trusts introduced in Finance Act 2006 did not alter the discretionary trust regime of chargeable events. However, legislation dealing with discretionary will trusts was changed (IHTA 1984, s 144). Practitioners may need to take those amendments into account when advising on the IHT consequences of trusts in wills.

Discretionary will trusts

Discretionary will trusts provide potential flexibility, as well as an opportunity to save IHT.  For example, in the case of married couples (or civil partnerships) such trusts are often used for legacies up to the IHT nil rate band (currently £285,000) on the first death, where an outright legacy or interest in possession to the surviving spouse would otherwise fall within the spouse exemption (IHTA 1984, s 18). The assets transferred to the trustees may comprise cash or investments. However, very often the only asset available is the deceased’s interest in the family home (in which case ‘debt’ or ‘charge’ arrangements may be considered, which are outside the scope of this article).

IHTA 1984, s 144 (‘Distributions etc from property settled by will’) allows a discretionary will trust to be converted into other forms of trust if the distribution is made within two years following the testator’s death, such as an ‘immediate post-death interest’ (IPDI). An IPDI is an interest in possession, to which the same IHT treatment applies as for ‘old’ (pre-22 March 2006) interests. An IPDI for the surviving spouse is subject to the spouse exemption.

Interest in possession?

Before the FA 2006 changes, where the deceased left an interest in the family home to a nil rate band discretionary trust, HMRC may have argued that the surviving spouse’s occupation of the property constituted an interest in possession, based on their Statement of Practice 10/79. That interest in the family home would therefore form part of the spouse’s estate on death. Whether HMRC will contend that allowing the surviving spouse to occupy the family home constitutes an IPDI following FA 2006 remains to be seen.

To prevent the possibility of an IPDI being read back into the will in those circumstances (i.e. so that the spouse exemption applies, and the benefit of the IHT nil rate band is lost on the first death), the personal representatives could delay the appropriation of the deceased’s share of the family home to the trustees for (say) two years and one day. The trustees could then exercise their powers to permit the surviving spouse to occupy. An interest in favour of the surviving spouse after the two year period from death (i.e. an express interest, or a deemed interest) falls outside s 144, and also the conditions for an IPDI (in IHTA 1984, s 49A).    

However, if the surviving spouse is a disabled person, an interest in the family home can still form part of their estate, under special rules applying to disabled trusts for IHT purposes (IHTA 1984, s 89-89B). The ‘debt’ or ‘charge’ arrangements mentioned earlier could therefore be considered instead, although other tax implications would then need to be addressed, such as the IHT anti-avoidance rule for debts between spouses (FA 1986, s 103), e.g. where the surviving spouse had made lifetime cash gifts to the deceased.

10-year IHT charge

If the value of the deceased’s share in the family home exceeds the available nil rate band, a proportionate interest could be transferred instead. It is possible that the surviving spouse may still occupy the family home at the discretionary trust’s ten year anniversary. If the value of the property interest exceeds the nil rate band, an IHT liability may arise at ten-yearly intervals. The prospect of increases in house prices exceeding increases in the nil rate band is realistic, and should not be overlooked. There may be insufficient funds in the discretionary trust to meet an IHT liability, and this may cause unexpected problems for the surviving spouse. If so, it may be that children or other family members could lend funds to the trustees, particularly if they are potential legatees of the surviving spouse’s estate. In any event, the IHT charge may be sufficiently small to be considered worthwhile compared with the alternative of a potential 40% liability on the surviving spouse’s death.

It should be remembered that the discretionary will trust must be properly constituted and administered, to prevent HMRC Inheritance Tax (previously Capital Taxes) arguing that the arrangement is a sham. The trustees must carry out their duties, which should be recorded in writing.

Mark McLaughlin CTA (Fellow) ATT TEP

The above article is taken from ‘Busy Practitioner’, a monthly journal from Tottel Publishing. To order a subscription to ‘Busy Practitioner’
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