Tax Efficient Wills
The signing of a Will is without doubt one of the most important legal documents we should all complete and they can also be extremely tax efficient, depending on how they are written. Inheritance tax (IHT) effective wills are crucial for anyone who owns assets worth more than the IHT threshold or for those leaving money to a beneficiary who owns assets worth more than the threshold. This Note considers the most important matters that should be taking account of for those who wish to protect their assets and save IHT.
Although tax is of paramount importance to those affected it should also be remembered that no-one has to make a Will by law. However, writing a Will is the only way we can make sure our Estate is passed on to family and friends exactly as we wish. If we die without a Will, our assets will be distributed according to a set of complex legal rules which can lead to very unsatisfactory results.
INHERITANCE TAX AND SPOUSES*
Assets left by one spouse to the other, whether outright or on a Life Interest Trust, are free from IHT except where the surviving spouse is not domiciled in the UK. When this occurs the IHT spouse exemption is limited to £55,000 in addition to the normal nil-rate band of £325,000. There are special Wills for those affected by this rule but they are outside the scope of this Note.
For couples who have married remember each person has their own nil-rate band and so if the first Testator who dies leaves everything to his or her spouse, and has not made any lifetime gifts within the last seven years not covered by an exemption or a relief, their nil-rate band will be unused. In these circumstances it can be claimed by the Executors of the Will of the surviving spouse. It does not matter when the first spouse dies but the surviving spouse must have died on or after the 9th October 2007. The survivor’s Estate will therefore benefit from two nil-rate bands, his or her own nil-rate band and that of his or her predeceased spouse. In the current tax year, the combined value of two nil-rate bands is £650,000.
Where a married person was formerly widowed and was left their former spouses’ Estate, they cannot only utilise their former spouses’ nil-rate band but also their own. Usually, a Nil-Rate Band Trust would have to be included in their Will to capture both nil-rate bands.. Careful planning is needed in such cases and the way each Will is written will very much depend upon the circumstances of each case to ensure use is made of both nil-rate bands and the assets in the Estate end up in the right hands. See below for further details.
SURVIVORSHIP CLAUSES IN WILLS
These clauses are common place and provide that a spouse or other beneficiary must survive the Testator by a stated period, usually 30 days, in order for that person to benefit under the Will. They are used to prevent devolution and taxation problems relating to deaths at or near the same time. Such a short period should not delay or hinder the administration of the Estate and are effective for IHT purposes and can, if desired, be increased to up to six months. Where spouses use such clauses there are no adverse IHT consequences provided the Estates of each spouse contains sufficient assets for each to utilise their IHT nil-rate band. There are many instances where this is not the case and very careful consideration must be given as to whether a survivorship clause should be included in both Wills. This point is often overlooked. Survivorship clauses are commonly inserted in Wills as a matter of routine without their potentially negative IHT outcome being properly considered.
The inclusion of a survivorship clause in a Will in inappropriate circumstances could result in an unwanted IHT bill of £130,000. A Deed of Variation or a Disclaimer can sometimes solve the problem after the Testator’s death but it is always better for the Will to be prepared correctly in the first place.
OUTRIGHT GIFTS OR TRUSTS ?
A Testator who is either married or in a permanent relationship must decide whether to leave his property and assets to his/her other half outright or to use a trust so he can specify what should happen to the assets following the survivor’s death. Trusts are frequently employed when there are children from a previous marriage or where the Testator wishes to guard against his or her surviving spouse or partner from marrying again and leaving his assets to a new spouse or partner.
OUTRIGHT GIFTS TO SURVIVING SPOUSE
Assets left outright to a surviving spouse are exempt from IHT and the survivor will have maximum flexibility in making ongoing provision for children, grandchildren or other beneficiaries. The survivor should review their Will and update it as necessary. They should also consider passing on assets by lifetime giving. Outright lifetime gifts are potentially exempt transfers and so no IHT will be payable if the survivor lives for seven years after the gift. Such gifts are therefore an efficient way of passing assets down to the next generation but beware, if the survivor makes those gifts according to directions from their deceased spouse, there could be a resulting loss of part of the IHT exemption for where this happens such gifts may be treated as if they had been made by the deceased spouse. Extreme care is needed by the surviving spouse if he or she is expected to make ongoing gifts out of his or her inheritance.
Capital Gains Tax should not be too much of a problem on lifetime gifts made soon after the death of the first spouse for the value of assets is unlikely to have changed if the gifts are made relatively quickly.
TRUSTS FOR THE SURVIVING SPOUSE
If the first spouse to die wishes to specify to whom his or her assets are to be inherited after the death of the surviving spouse a Trust for the survivor would be appropriate. There are three basic forms of suitable trust. A Fixed Life Interest Trust (Fixed Trust), a Flexible Life Interest Trust (Flexible Trust) and a Discretionary Trust. Under a Fixed Trust the survivor is entitled to the use and benefit of all of the assets in the trust for the rest of their life or until the happening of an earlier event such as re-marriage or co-habiting. The capital is looked after by trustees and the income is paid to the survivor who is also entitled to live in any property in the trust and to move to another property if that they wish to do so.
Flexible Trusts are similar to Fixed Trusts but with the addition of flexible powers that allow the trustees to break the trust and either give assets to the survivor or to those who are due to inherit following the death of the survivor or a combination of the two. The trustees of the Will of the first spouse to pass away can terminate part of the trust and redistribute assets to an alternative beneficiary free of IHT at the date of transfer. This can be a very useful way to pass on assets to children after the first death and is much more tax efficient than leaving assets directly to them.
A Discretionary Trust is used when the Testator wishes to retain maximum flexibility over how both the assets and income of his estate are distributed and wishes to avoid the value of assets held in trust being added to the value of the estate of the beneficiary of the trust when he or she eventually passes away thereby leading to an avoidable IHT charge. Under a Discretionary Trust no-one has a fixed right to receive any benefit from the Will and it’s the trustees who decide who gets what and when they are to receive it. This type of trust is favoured by those who want to maximise tax benefits and maintain maximum flexibility over the distribution of their estate. It is absolutely essential that the Testator can rely on the trustees to act according to the circumstances that prevail after the Testator’s death and in accordance with his or her wishes which must be written down and given to the trustees. If a Testator has such trustees available this type of trust can be very beneficial indeed. It will allow the trustees to take account of changes in circumstances or tax law very easily. The crucial element is the written instructions to the trustees which are often badly drafted and, in some cases, omitted altogether.
WILLS FOR COHABITEES
With no spouse exemption available on gifts between cohabitees any assets passing on death will be subject to IHT if they are worth more than the nil-rate band. Straightforward nil-rate band trusts can be very useful when the first person to pass away wants to leave his/her partner’s assets for their lifetime or a shorter period and then specify who is to inherit them after their partner’s death. This avoids the bunching effect, which would lead to a greater IHT charge on the second death if, instead of using a trust, the assets had been left outright to the survivor. For those with assets worth more than the nil-rate band it is worth thinking about placing the whole estate into a discretionary trust with the surviving partner being named as the principal beneficiary. This would nearly always lead to the largest IHT saving but there are other considerations and these need to be borne in mind.
LEAVING MONEY TO CHILDREN AND GRANDCHILDREN
If parents are content for their children to inherit immediately following the death of the survivor of them and when they come of age at 18, their Wills should contain a form of trust for the children known as a ‘Bereaved Minor’s Trust’. If the children are already all 18 no such trust is needed. However, many parents and grandparents prefer to postpone the age of inheritance to 21, 25 or indeed even later in some instances. If a child’s inheritance is to be distributed to them at an age greater than 18 there are different types of trusts that apply and potential adverse IHT consequences.
18-to-25 TRUSTS FOR CHILDREN
These trusts are often found in the Wills of parents who seek to increase the age on which their children are to inherit to an age between 18 and 25. However, by dong this the cost of delaying the child’s inheritance is an additional IHT charge on top of the 40% standard death rate. If the age of 25 is used the child’s inheritance can suffer an extra 4.2% tax liability. This form of trust is suitable therefore for those who do not wish their children to have the right to receive anything until a specified age, not exceeding 25, and believe that their child’s inheritance is best managed by the Trustees of their Will until then and accept the price of delay is an extra 4.2% IHT bill. These trusts are of particular interest to parents whose children have impaired life-expectancy and the parents want to retain the ability to pass on the inheritance if their child dies before the age of 25 rather than have it pass under the child’s own Will.
FIXED INTEREST TRUSTS FOR CHILDREN (IPDIs)
As an alternative to an 18-to-25 Trust a Will can leave money to children or grandchildren through an ‘IPDI Trust’. The main advantage of such trusts is that they avoid the 4.2% IHT charge which applies to an 18-to-25 trust. Furthermore, such trusts are more efficient than 18-to-25 trusts for income tax purposes and so are often preferred by Testators. Unlike trusts for bereaved minors and 18-to-25 trusts, IPDIs are not limited to gifts to the Testator’s own children so they can be used to benefit grandchildren, siblings, nephews or nieces or any other beneficiary selected by the Testator who is not old enough to simply have their inheritance paid to them straightaway.
Although there is no IHT charge when the beneficiary finally inherits, there is one drawback in that IHT is potentially payable on the trust asset if the beneficiary dies before inheriting but given that the beneficiary is a child, the possibility of a death under the age of 25 is, in practice, extremely remote so this should not be regarded as a significant disadvantage. Income tax is paid on any income from the trust at the beneficiaries’ own rate rather than at the trustees’ standard rate of 50%. This a major advantage over an 18-to-25 trust.
GIFTS TO CHARITIES
It has long been the case that any money left to charity by a Will is free of Inheritance Tax. For anyone passing away after 6 April 2012 a lower general rate of Inheritance Tax of 36% is to be applied to an Estate where 10% or more of the 'net Estate' is left to charity. Broadly speaking, the net value of an Estate will be the assets less the deceased's available Nil-Rate Band and any other non-charitable exemptions and reliefs, such as Spouse exemption or Business Property/Agricultural Property Relief.
For married couples we would recommend that any substantial charity bequests take place on the second death when the estate is taxable in order to avoid wasting the benefit of the 36% rate.
AGRICULTURAL PROPERTY RELIEF AND BUSINESS PROPERTY RELIEF
These reliefs are extremely valuable and range from 50% to 100% of the value of either the agricultural or business asset. The conventional wisdom is that if agricultural or business assets are left to a spouse the IHT relief is entirely wasted because assets left to a spouse are free of IHT in any event. It would be far more tax effective for the Testator to give the business or agricultural property by specific gift to his children or grandchildren or to other non-exempt beneficiaries and to give only his remaining assets to his spouse for there will be no IHT on such a valuable transfer of assets to his children. Splitting agricultural property or business assets between a spouse or civil partner and children also wastes the relief, for in those circumstances the relief is apportioned between the survivor and the children.
Of course, a surviving spouse may feel less than well provided for if all of the business or agricultural assets are not left to him/her. Where it is known that the surviving spouse might need access to them to live comfortably it is probably best to leave the agricultural or business assets to a Discretionary Trust with the surviving spouse and all the children and grandchildren being named as the beneficiaries. The Trustees must be given clear instructions that they should regard the spouse as the primary beneficiary, if that be the case. The use of a Discretionary Trust in this way guarantees the surviving spouse’s standard of living whilst, at the same time, sheltering in the assets from a subsequent IHT charge should there be a change in the IHT Relief rules or the business or agricultural assets are sold off and replaced by other assets which do not enjoy the benefit of IHT reliefs. The usual caveats relating to trusts however must always be borne in mind along with the wishes of the surviving spouse and the needs of the business.
Careful planning is required, not only in the drafting of the Will but also during the lifetime of the owner of the business/agricultural assets for the IHT relief that can apply on death must not be taken for granted. It is quite possible for what appear to be business or agricultural assets to fail to qualify for the relief so judicious lifetime planning is essential.
HOLIDAY HOME BUSINESSES
For anyone who owns a holiday lettings business, e.g. a holiday home which is let as holiday accommodation to the general public, there is a very important Inheritance Tax relief which needs to be assessed and which can be preserved for the benefit of future generations by appropriate clauses being inserted into a Will.
GIFTS TO CHARITIES
Will drafting in favour of a charity is relatively straightforward if the entire Estate is left to a UK registered charity. Such legacies are completely exempt from IHT. The position is not so straightforward if the Estate is to be divided between charities and individuals. There are complex IHT rules which apply and special care is needed in the drafting of the Will to satisfy both the Testator’s intentions and the requirements of the IHT legislation. For those who do want to benefit their family and charity it is quite possible to draft a Will leaving a gift of the nil-rate band sum to the family and the remainder of the Estate to charity. This would avoid the payment of any IHT whatsoever but remember that the nil-rate band will change in the future. It may be extended to £1 million or reduced to £100,000. If a change was brought in by a future Government this would have dramatic consequences if the value of the family gift was aligned to the nil-rate band.
WILL TRUSTS FOR A BENEFICIARY SUFFERING FROM A DISABILITY
There are specific rules contained in the tax legislation which can be used to good effect if assets are left to a beneficiary suffering from a disability as defined by the Inheritance Tax Act. A straightforward Discretionary Trust can be used but a variation on such trust is needed if valuable tax reliefs are not to be lost. The main purpose behind leaving assets to such a trust is to ensure that the assets are administered by responsible trustees on the beneficiary’s behalf, to save IHT and to avoid the beneficiary losing means tested benefits.
NIL-RATE BAND DISCRETIONARY WILL TRUSTS
Before Tuesday 9 October 2007 the use of Nil-Rate Band Discretionary Will Trusts was widespread. Since that date the unused nil-rate band of the first spouse to die can be carried over and added to the nil-rate band of the survivor. The surviving spouse so-called ‘inherits’ the nil-rate band and its value is uplifted to the level that applies when the surviving spouse dies. In this way the Executors of the Will of the surviving spouse can potentially deduct two full nil-rate bands from the value of the assets of the survivor before having to pay any IHT.
This transfer of the nil-rate band applies to all widows, widowers or civil partners where their spouse or civil partner has already died irrespective of the date of death.
The impact of these changes on couples preparing tax-efficient Wills is quite dramatic as it is no longer necessary to include a Discretionary Will Trust in their Wills as a matter of course to save IHT. But it should be remembered there are often reasons other than IHT savings for such trusts to be found in Wills and these may well still apply notwithstanding the changes in the law.
MORE THAN TWO NIL-RATE BANDS
Where one spouse dies and the surviving spouse remarries, it is possible to acquire the unused nil-rate band of more than one deceased spouse. However, this only applies up to a limit of one additional nil-rate band. In such circumstances the most tax efficient form of Will for a remarried spouse is to include a legacy to a Discretionary Will Trust to use up the transferable nil-rate band. There are three possible scenarios where double nil-rate bands apply. Each needs to be analysed very carefully because of the rule that no-one is allowed more than two nil-rate bands.
CASE ONE
‘H’ has one nil-rate band and ‘W’ has two nil-rate bands because she had been widowed before she married ‘H’. If ‘H’ gives his Estate to ‘W’ he will not use his own nil-rate band and all of it will be entirely wasted. ‘H’ should therefore include in his Will a legacy of his nil-rate band to a Discretionary Will Trust and leave the residue of his Estate to ‘W’ or to a Trust for her. By doing this, ‘H’ will use his nil-rate band which would otherwise be lost. By using the transferable nil-rate bands in this way the IHT saving is £390,000.
CASE TWO
‘H’ has two nil-rate bands for was widowed before he married ‘W’. To avoid wasting his double nil-rate band ‘H’ should include a legacy equal to a single nil-rate band to a Discretionary Will Trust and leave the residue of his Estate to ‘W’ or into Trust for her benefit. This will ensure that one half of ‘H’s double nil-rate band is used by the gift to the trust and the other half is used by the transfer to ‘W’ who will then acquire a double nil-rate band. By using the transferable nil-rate bands in this way the tax saving is again £390,000.
CASE THREE
‘H’ and ‘W’ each have two nil-rate bands as they were both widowed before they married each other. If ‘H’ leaves his Estate to ‘W’ his entire double nil-rate band is wasted. The best solution in this scenario will generally be for ‘H’ to give a legacy equal to the double nil-rate band to a Discretionary Will Trust and any remaining assets outright to ‘W’ or into Trust for her benefit. This will ensure that ‘H’ uses his double nil-rate band and ‘W’ will also be able to claim the benefit of two nil-rate bands on her death. By using their transferable nil-rate bands and doubling up in this way the IHT saving is £520,000. An even greater saving can be achieved by the use of pilot trusts but they are outside the scope of this note.
In each of the above three cases it is of course an absolute necessity that if transferable nil-rate bands are to be fully utilised the person in question must own assets of sufficient value. Where a person owns assets less than one full nil-rate band or, where applicable, two full nil-rate bands, it may be necessary for a there to be a transfer of assets between ‘H’ and ‘W’ or ‘W’ and ‘H’ to ensure that full advantage can be taken of this tax relief.
DEED OF VARIATION
If straightforward Wills have been made where each spouse leaves everything to the other and an untransferable nil-rate band is therefore being wasted, the survivor could make a Deed of Variation, within two years of the first spouse’s death, so as to use the nil-rate band. It is far better however for the Wills to be prepared correctly in the first place and so whilst a Deed of Variation could resolve the problem it is not an ideal solution.
*All references in this Note to spouses include civil partners and references to marriage include civil partnerships.