Discretionary Trust, Wills & Inheritance Tax

Although any unused nil rate band is transferred to a surviving spouse or civil partner, making provision for a discretionary trust in your will could still be worthwhile.

How do the inheritance tax rules work?

The first slice of any individual’s estate, including gifts that they have made in the last seven years, is generally free of inheritance tax. This slice, referred to as the ‘nil rate band’, was increased to £312,000 from 6^th April 2008. Inheritance tax is charged at 40% on the amount that exceeds the nil rate band.

Any unused nil rate band can now be transferred to a surviving spouse or civil partner. This means that where the second death occurs on or after 9^th October 2007, the benefit of any unused nil rate band on the death of the first spouse is transferred to the estate of the surviving spouse, even where the first death occurred before 9^th October 2007.

The amount of the nil rate band potentially available for transfer will be based on the proportion of the nil rate band that was unused when the first spouse died. The following examples explain how this works:

Example 1

On the first death none of the original nil rate band (say £150,000) was used because the entire estate was left to a surviving spouse and benefited from the spouse exemption. If the nil rate band when the surviving spouse dies is £350,000, the available nil rate band on the second death would be increased by 100% to £700,000.

Example 2

If on the first death the chargeable estate is £150,000 and the nil rate band was £300,000, then 50% of the original nil rate band would be unused. If the nil rate band when the surviving spouse dies is £350,000, then the total nil rate band available on the second death would be increased by 50% to £525,000.

The amount of nil rate band that can be accumulated by any one surviving spouse is limited to the value of the nil rate band in force at the time of their death. This means the maximum anyone is entitled to is double the nil rate band on their death.

Why include a discretionary trust in your will?

Previously, well advised couples might have included a discretionary trust in their will to utilise the nil rate band on the first death rather than wasting it by passing assets to the surviving spouse under the spouse exemption. Although any unused nil rate band can now be transferred to the surviving spouse or civil partner, there are still circumstances where this type of planning remains beneficial.

These circumstance include:

• complex succession plans, particularly where there is a second marriage and/or step children
• estates containing assets where the value is expected to grow faster than the anticipated future increases in the nil rate band allowance
• estates containing assets eligible for business property relief or agricultural property relief.

What is a discretionary trust?

A discretionary trust is a very flexible type of trust. The trustees of the trust own the trust’s property on behalf of the beneficiaries. The beneficiaries need not all even be born at the time the trust is created.

The trustees can pay out income or capital to any one or more of the beneficiaries entirely at their own discretion. No beneficiary has a right to demand income from a discretionary trust.

How do I provide for the survivor?

The surviving spouse or civil partner can be included as one of the beneficiaries of the trust. The trustees can be empowered to pay out income or the underlying capital to the surviving spouse or civil partner at their discretion. Thus the surviving spouse or civil partner can enjoy both the income and capital of the trust.

How do you guide the trustees?

This is usually achieved by leaving a ‘letter of wishes’ with the will. Such letters are quite usual and are read alongside the will, though they are not binding on the trustees. It is quite normal for such a letter to state that the first aim for the trust is to ensure adequate provision is made for the surviving spouse or civil partner for the remainder of his or her days. The letter will usually say what is desired to happen thereafter, such as passing assets to the children.

How does the trust operate?

The executors will pass the assets that are to be the trust property to the trustees. Very often, the trustees are the same people as the executors. In this case, they simply own the property as trustees as opposed to holding it as executors.

The trustees will then need to register the trust with HM Revenue and Customs (HMRC) who will send a short form for the trustees to complete. This enables HMRC to register the trust.

Is the trust subject to tax in the normal way?

Yes. The trustees are subject to income and capital gains tax in the same way as individuals. After a deduction for the trust’s management expenses, the trust income is taxed at 40% (32.5% for dividends). In addition, capital gains are also subject to tax after deducting the trustees’ annual exemption which is, at most, half that of an individual.

The trustees will receive a tax return in exactly the same way as an individual. The filing deadlines and the dates for the payment of tax are exactly the same as for individuals.

Distributions of income to beneficiaries, including the surviving spouse or civil partner, will suffer income tax in the hands of the beneficiary but with a credit for the tax paid by the trustees. To the extent that the tax paid by the trustees exceeds the income tax liability arising to the beneficiary on such income, a tax refund will be made to the beneficiary. Capital can be appointed to beneficiaries tax free in all but exceptional circumstances.

A discretionary trust is subject to inheritance tax every 10 years after the creation of the trust. The rate at which the tax is paid at current rates is not more than 6% of the market value of the trust’s assets at the time of the charge and a nil rate discretionary trust will often escape tax altogether.

There is also a charge when assets cease to be held on discretionary trust, eg if assets pass out of trust to a beneficiary. In this case, the charge to inheritance tax is based on:

• the value of the property leaving the trust
• the proportion of the period of 10 years for which the assets have been held on discretionary trust since the last 10 year charge
• the rate of tax at the last 10 yearly charge

but subject to any inheritance tax reliefs available at the time.

What sort of property should be included in the trust?

In many instances, it will not matter what property is included in the trust. However, where a person holds business or agricultural property, significant tax advantages can be obtained in structuring legacies between the trust and a surviving spouse or civil partner and further tax planning advice should be sought. Further advice should also be sought where all or part of the nil rate band legacy will need to be satisfied by a transfer of the family home, as additional structuring will be required to ensure that the planning remains effective. Drafting of the clauses can be critical to ensure that no unexpected tax charges arise eg stamp duty land tax.

Who should I nominate as trustees?

This is a very personal decision. Essentially, you will probably want to choose trusted family members or close friends. You should check that the people you nominate are willing to act for you. You might also wish to include a professional trustee, though this may be dependent on the complexity of your affairs. Trusts and wills are often written on very flexible terms allowing trustees greater discretion in their management. The increasing complexity of modern trust and tax law as well as the reluctance of many people to become involved in decisions that require not only a professional competence but also an independent detachment from family dynamics means that an independent trust company may be the best choice – especially as the trust company is always there and doesn’t die, retire or take holidays. Grant Thornton Trust Company Limited was incorporated as a wholly–owned subsidiary of Grant Thornton UK LLP to act as trustee and executor working alongside your usual Grant Thornton contact.

What other matters should I consider?

This factsheet is a summary of the legal position in England and Wales. Different legislation may apply in Scotland, Northern Ireland and other jurisdictions.

It is important that you understand the implications of making a will that includes a nil rate band discretionary trust. You need to understand what the particular inheritance tax implications are of you owning a particular piece of property. You should ensure that all areas are considered so that your trustees will administer the trust in accordance with your wishes and instructions.

It is important to review your will every few years to take account of changing circumstances and relationships. Apart from these regular reviews, it is essential to reconsider your intended bequests after separation or divorce. Furthermore, remarriage generally revokes an existing will in its entirety, which may leave children of the former marriage without any claim on your estate.

Who should I contact?