29 September 2013

Inheritance Tax Strategy 8 - Tax Planning in Wills


First Death Discretionary Trusts

I have blogged on this subject before (here), and if you are new to the subject I'd recommend starting with that posting and then coming back here. Below, I explore some of the same ideas, in a bit more detail.

If you are a couple, then you get a problem known as “bunching”. The first of you dies, leaving everything to the survivor. The survivor then has all the assets bunched into his or her tax estate, and is comparatively richer, and therefore more exposed to inheritance tax. A better approach is for whichever of the couple dies first to give away any items which will be tax free on that first death.

If the couple can’t afford to give away the assets in question outright (for example to the children), a good approach is to create a discretionary trust, in the will itself, the terms of which are that the survivor can benefit from it if need be. The trust’s job is to take assets which would otherwise have been inherited by the survivor, and instead hold them in a kind of “cocoon” where they do not belong to the survivor, but can be made available to the survivor if he or she has need of them. It is important that only non-taxable assets go into them, however, since the trust itself is a taxable beneficiary: if you inadvertently leave a taxable asset to it, you pay 40% tax, unnecessarily, on the first death.

Under the old (pre-2008) rules, trusts of this kind were very popular in wills, where they were usually called “nil-band discretionary trusts”. So, if you have one in your wills already, the big decision is whether to keep it, or to simplify the wills by removing it (i.e. simply leaving everything to each other on the first death). My advice to clients on this point is that you don’t need to remove it. It does no harm as it is, at least from a tax viewpoint, because when the first death comes the trustees can decide at that time either to implement the trust, or simply to wind it up in favour of the survivor.

The points to consider are:

a. First death discretionary trusts are only there for married couples and civil partners. If you are single, widowed or divorced they are not for you. (But this doesn’t mean, necessarily, that I wouldn’t advise you to have a discretionary trust in your will for some other reason.)

b. You no longer need one of these trusts to take advantage of two nil-bands, so a married couple (or civil partners) with total wealth below two nil bands (2 x £325,000 = £650,000) really no longer have an inheritance-tax problem. Therefore if you are in that bracket, you can ignore (c), (d) and (e) below.

c. You do need a first death discretionary trust if your wealth includes:

              i.            APR assets (see Strategy 7);

              ii.           BPR assets (see Strategy 6); or

              iii.          a pension fund (which I'll discuss in a future blog).

              As you might expect, the bigger the size of your IHT problem, and the bigger the size of those assets, the more worthwhile a first-death discretionary trust is.

              Alternatively, you can achieve the same tax effect by doing anything else which gets rid of the non-taxables on the first death (such as outright legacies to children or grandchildren).

d. You do need a first death discretionary trust, also, if you or your spouse (or both) have been widowed in the past. In that case, clever use of the discretionary trust can allow you to claim not just your own two nil-bands but ALSO the nil-band(s) of your former spouse(s).

e. In the case of pensions, one or more trusts created in lifetime might be needed, depending upon the amounts involved, instead of, or in addition to, a will trust.

Spouses and Civil Partners

In technical language, the types of discretionary trust we have just been discussing are “relevant property trusts”. The good thing about them is that they aren’t human beings and therefore they can’t die, so once money is in one it can never suffer that 40% “tax whammy” which this series of blogs is all about. The bad things about them are:

i. giving money to one in your lifetime leads to an immediate upfront inheritance tax charge at 20%: to use the technical terminology, it is a “lifetime chargeable transfer”, not a “potentially exempt transfer” like other gifts are;

ii. it is not a spouse or a charity, so it’s a taxable beneficiary of your will, and in the absence of other reliefs any money left to it will be taxed at 40%; and

iii. it suffers “ten-year charges” and “exit charges” at rates up to 6% - these will be the subject of a future blog.

An alternative type of trust is called an “immediate post-death interest” - usually abbreviated to “IPDI”. This happens where some person is entitled to income, from the date of the death. The good things about them are, firstly, that where the beneficiary entitled to the income is a spouse or civil partner, the gift to the IPDI is spouse exempt, and secondly, that there are no ten-year and exit charges. The bad thing about them is that they are taxed in tandem with that beneficiary’s inheritance tax affairs: which means they are added into the beneficiary’s tax estate – and therefore taxed at up to 40% – on the beneficiary’s death.

So, armed with all that background information, we can conclude:

1.           a.           that leaving anything non-taxable to a relevant property trust on the first death is a good thing, because the “bad” consequences of doing so are fairly limited, and the good consequence is that the money is protected from forming part of the second-death estate, and therefore avoids the 40% tax; and

              b.           that leaving anything that will be taxable to a relevant property trust on the first death is a bad thing because we suffer 40% tax on it straight away, unnecessarily; and

2.           a.           putting non-taxables onto an IPDI would be a bad thing, because we are wasting the spouse exemption, and aggregating those assets with the second death estate where they will [probably] eventually suffer 40% tax; and

              b.           putting taxables onto an IPDI is a good thing because we can use the spouse exemption to avoid tax on the first death.

So, in a big-money estate, that’s the best way to structure the will on the first death. Two flexible trusts in favour of the family as a whole, the first a relevant property trust for non-taxable assets, the second an IPDI for taxable assets.

And in a really complicated estate, one where you honestly don’t know whether there will be BPR or APR assets, or what their values might be, or whether all of them will get 100% relief or only 50% relief, you do something which on the face of it looks simpler, namely to have just one trust in the will, a fully discretionary one which takes everything. Then, when the first death actually comes and you have a perfect picture of the assets and their tax relief, the trustees of that trust “appoint out” an IPDI – something they are allowed to do within two years of the death – of the taxables, leaving a relevant property trust of the non-taxables.

Naturally, it doesn’t end there. You could still have a potential second-death IHT liability on the assets of the IPDI and on any assets owned by the survivor in his or her own name. That is where all the other strategies mentioned in my blog come in. In particular, the trustees of the IPDI need to think, on a regular basis, about whether they can afford to use the “large gifts” strategy in favour of lower generations of the family, without depriving the surviving spouse of assets he or she might need.

28 September 2013

Inheritance Tax Strategy 7 - Use Your “Agricultural Property Relief”


Agricultural Property Relief is usually abbreviated to “APR”.

Agricultural assets are often free of inheritance tax.  The rules are quite complicated, but very broadly:

A. Farmers get 100% APR on farmland and buildings which they farm themselves, if they’ve owned the land for 2 years. (100% relief means no tax to pay at all.)

B. Agricultural landowners usually get 50% APR on land which is tenanted by someone else, if they’ve owned the land for 7 years.

Remember that if you’re a farmer you’re also in business, so Business Property Relief is relevant to you, as well.

There are lots of things I could say about Agricultural Property Relief, but these are the highlights:

1. You only get APR on the “agricultural value” of your land. Agricultural value is what the property would be worth if it were only ever used for farming. For example, imagine you’ve got a farm which would be worth £1million to another farmer, but you’ve actually obtained planning permission to build some houses on it, and you intend to sell it for £2million to a developer for that purpose. The value is £2million, but you only get APR on £1million, and the other £1million is taxable.

2. Just like BPR (see Strategy 6), it is easy to “waste” (rather than “use”) your APR. So, my advice is the same as in the previous strategy, and here it is again in bold type:

DON’T WASTE YOUR “APR” WHEN YOU DIE!!!

             As before, you “use” APR either by passing assets directly to a lower generation or by putting them on a first death discretionary trust, and you “waste” APR by leaving assets outright to a surviving spouse or civil partner.