Your Will is one of the most important legal documents you will ever enter into. Primarily it is about succession, that is, what you want to happen to your property and assets following your death. But alongside this there are normally more or less tax efficient ways of achieving your objectives. So your Will is also about tax planning and tax efficiency.
The purpose of this note is to flag up some of the tax issues which commonly arise in connection with preparation of wills and which need to be taken into account alongside the succession issues.
Gifts by will between spouses or civil partners
Outright or on trust?
Does the person making their Will ("the testator") want to leave their property and assets to their surviving spouse or civil partner1 outright and absolutely, for the survivor to do with as he/she wishes? Or alternatively does the testator wish to give only a life interest to his/her spouse, with gifts following that to, say, the children. This is largely a question of whether the testator wishes to specify what should happen to his/her estate following the death of his/her surviving spouse. This may be of particular concern where the Testator has children from a previous marriage for whom he/she wishes to make a provision by Will.
What are the tax implications of leaving assets outright or on trust?
Assets left by a testator either outright or on a life interest trust for his/her surviving spouse are within the spouse exemption from inheritance tax ("IHT") (although the exemption is limited to £55,000 for gifts from a UK domiciled individual to his/her spouse domiciled outside the UK).
If the estate is left outright to the surviving spouse then the survivor has maximum flexibility in making provision for the children or other beneficiaries. Such provision can be either by life time giving or by Will. Outright lifetime gifts are potentially exempt transfers ("PETs") so that there should be no ("IHT") provided the survivor lives seven years from the date of any such gifts. For IHT this is therefore an efficient way of passing assets to the next generation. Note, however, that if the survivor makes onward gifts in accordance with any wishes (whether or not in writing) expressed by the deceased such onward gifts may be read back into the testator's will for IHT resulting in loss of the spouse exemption on the testator's death. Care is therefore needed. Note too that such lifetime gifts give rise to capital gains tax ("CGT") which cannot be deferred by making a hold over election. Therefore if CGT is an issue any such lifetime gifts should be considered soon after the testator's death, with a view to minimising any gains.
Furthermore the testator's surviving spouse will be able to create so-called immediate post death interests ("IPDIs") for the children in his/her own Will. In some circumstances there may be tax or other advantages of such IPDIs – see further below under "Providing for testator's children and grandchildren".
On the other hand, if the testator wishes to control devolution of his/her estate after the death of the surviving spouse, then a life interest (provided it qualifies as an IPDI) for the survivor might be more appropriate. Tax considerations relevant to this are:
- IHT planning can be undertaken by the trustees partly terminating the IPDI in favour of children. Outright distribution to a child will be a PET. There is in principle CGT on distribution of non-cash assets with no CGT hold over relief available. Therefore if CGT is an issue any such distributions should be considered soon after the Testator's death, with a view to minimising any gains.
- If appropriate the trust could simply be terminated and capital given to the surviving spouse, so achieving the same effect as if an outright gift had been given to the surviving spouse in the testator's will. Overall therefore the IPDI provides more flexibility than an outright gift to the surviving spouse.
What if a UK domiciled testator leaves assets to a non UK domiciled spouse?
If a UK domiciled testator leaves all or part of his/her estate on death to a non-UK domiciled spouse the IHT spouse exemption is limited to £55,000. In such cases, therefore, an amount left to the surviving spouse which exceeds the aggregate of the testator's available nil rate band and the £55,000 exemption is chargeable at 40%. However, if the surviving spouse is and remains domiciled outside the UK, non UK property owned by him/her would be "excluded property" outside the UK IHT net.2
In this situation the testator could consider establishing a discretionary trust in his/her Will. Although there would be IHT on the testator's death, and the property held in such trust could never constitute "excluded property" falling outside the UK IHT net, the discretionary trust provides flexibility to make distributions to the surviving spouse and/or to the children (especially if they are domiciled outside the UK). Alternatively if the spouse has become domiciled by the time of the testator's death, the discretionary trustees can make an appointment to him/her within two years (but not within the first three months) after the death which is read back into the Will thereby retrospectively enabling the spouse exemption to be claimed.
Survivorship clauses – in or out?
A beneficiary's entitlement under a Will is often subject to him/her surviving for, say, 30 days from the testator's death. One reason for this is to avoid the testator's estate having to be administered twice if spouses, say, die close together. However, if spouses die in circumstances, such as a car accident, in which it cannot be known which of them died first, the Law of Property Act 1925 provides that the younger is deemed to die second. If the survivorship clause is omitted in this scenario and if the Will of the older spouse so provides, the older spouse's estate passes to the estate of the younger. Because of the way the IHT legislation works in this scenario, the estate of the older spouse escapes IHT altogether. There is therefore a significant IHT advantage in omitting the survivorship clause in this case. There are, however, succession implications because omitting the survivorship clause means that the estate of the older spouse will pass under the Will of the younger spouse, which might not be appropriate if, say, the older spouse wishes to benefit children of a previous marriage. There are other scenarios in which the survivorship clause works disadvantageously for IHT purposes. It is therefore relevant to consider use or omission of survivorship clauses in each case.
Providing for the testator's children and grandchildren
There are a number of options each with different tax and succession implications.
Trusts for bereaved minors ("TBMs")
A TBM can be set up only for the testator's own children. Its advantages are that, following the testator's death, there is no further IHT during the lifetime of the trust, even in the (unlikely) event of a beneficiary's death. Furthermore, the CGT holdover relief is available on distributions out of the trust to defer any CGT that would otherwise accrue. The trust can be structured so as to benefit from the minor's own income tax rates.
The disadvantages of such a trust are that each beneficiary must receive the capital and income of his/her share at (or before) age 18 and there are restrictions on how the income and capital may be applied in the meantime.
This kind of trust might nevetheless be appropriate for smaller estates and/or where the testator wishes to minimise IHT and is not concerned about the child getting capital at 18.
18-25 trusts
Such trusts can be set up only for the testator's own children. The main advantage over TBMs is that the age of capital vesting can be deferred to age 25. There is no IHT on the beneficiary's death under 18. However, the trust is liable to IHT exit charges at a maximum rate of 4.2% on capital distributions once the beneficiary has attained 18 (although there are no ten year anniversary charges in this type of trust). The terms of the trust are relatively restrictive. This form of trust is suitable for testators who do not wish their children to receive capital at 18 but are happy to let them receive it on or before 25 and are not concerned by the 4.2% IHT exit charges.
Immediate post death interests for children ("IPDIs")
An IPDI is a trust which gives an income entitlement to the beneficiary. In order to count as an IPDI the trust interest must take effect immediately on the testator's death. So if a testator sets up an IPDI for his/her surviving spouse (which as mentioned above, gets the benefit of the IHT spouse exemption) any trusts taking effect after the death of the surviving spouse for the children or other beneficiaries cannot take effect as IPDIs. Subject to that a testator can set up an IPDI in his/her Will for any beneficiary, including spouse and nephews, nieces and grandchildren. Unlike TBMs and 18-25 trusts, IPDIs are not therefore limited to the testator's own children.
The advantage of an IPDI is that there are no IHT charges on distributions to the beneficiaries. There is however IHT if the beneficiary dies. CGT in principle applies on distributions of non-cash assets to the beneficiaries and no hold over relief is available. The beneficiary's own income tax rate will apply, rather than the trustees' 50% rate.
An IPDI might be appropriate if the testator wishes to defer capital vesting beyond age 18 but wishes to avoid the IHT exit charges associated with 18-25 trusts or discretionary trusts.
Discretionary will trusts for children
A discretionary trust can last for as long (up to 125 years) as the trustees decide, there is no IHT on the death of any beneficiary and CGT can be held over on distributing capital. The disadvantages are that the IHT regime for discretionary trusts applies so that there are ten year anniversary charges on the trust fund and exit charges on capital distributions to beneficiaries, both charges applying at a current maximum rate of 6%. As far as income tax is concerned the 50% trustee rate applies although lower tax rate paying beneficiaries may reclaim income tax. This form of trust may be suitable for a testator who wishes to provide a higher vesting age for the beneficiaries but who does not want the children to receive income interests. It may also be suitable for testators setting up trusts for children other than their own, say nephews and nieces or grandchildren.
Related settlements
Trusts set up on the same day by the same person are treated as related for the purposes of calculating IHT ten yearly and exit charges. If a testator sets up two or more trusts in his Will they are automatically related as the trusts are established on the same day (the date of the testator's death) by the same person (the testator). This could happen, for example, if in his/her will the testator sets up a trust for the children and a separate trust for grandchildren. In calculating the ten year anniversary and exit charges (described above) for discretionary trusts the value held in any "related settlements" must be taken into account, which is likely to result in a higher tax rate (up to the maximum of 6%). Testators therefore need to be aware of the situations in which related settlements arise. In some cases steps can be taken to avoid them.
One way for a testator to avoid related settlements in his will is to set up what is called a "pilot trust" in his lifetime. He can then add property to such trust by his will. Because the pilot trust is set up initially in the testator's lifetime it should not be related to any other trusts set up by the testator in his will. There are a number of variations on this kind of planning which can be used to minimise ongoing IHT charges in relation to trusts in wills.
A special rule applies where a testator sets up in his will an initial interest in possession for his spouse followed by, say, a discretionary trust for the children. In that situation, for purposes of calculating ten year anniversary and exit charges on the discretionary trust for the children, that trust is deemed to commence only upon the surviving spouse's death. For purposes of calculating ten year anniversary and exit charges it is not therefore related to any other trusts in the testator's will. It is, however, related to any trusts set up by the surviving spouse in her will.
Maximising exemptions and reliefs
Careful planning is needed to maximise the exemptions for gifts to spouses and to charity and the reliefs for business and agricultural property. For example, if a testator leaves a specific legacy of business property to his/her spouse, the business property relief is entirely wasted because the spouse exemption applies in any event. In such a case it would be more tax effective to give the business property by specific gift to, say, children or other non-exempt beneficiaries, so ensuring that the business property relief is fully utilised. The residue of the estate could be left to the surviving spouse.
Business property relief might also be wasted if the residue of the estate is divided between say, a surviving spouse and a child. In such a case the business property relief is apportioned between the spouse and the child. The part apportioned to the spouse will effectively be wasted. A specific gift of the business property to the child would be more tax effective.
If in practice the surviving spouse needs the business property, then to avoid wasting the IHT spouse exemption, more sophisticated will planning might be needed. For example the will could leave non-business property to the spouse but with power for the spouse or his/her trustees to purchase the business property after the testator's death. Both the spouse exemption and the business property relief are thereby maximised on the testator's death. Another option in such circumstances is to leave the business property by specific legacy to a discretionary trust of which the surviving spouse can be a beneficiary. This provides flexibility whilst maximising the business property relief.
How should the will allocate the payment of inheritance tax between exempt and non-exempt beneficiaries?
If the testator leaves £1 million equally between a charity and his son, should all of the IHT come out of the son's share, so that he receives less than the charity? Or should the son and the charity receive equal amounts after payment of IHT? Care is needed to ascertain the testator's intentions and to reflect them in the Will whilst also satisfying the requirements of the IHT legislation.
Nil rate bands
On death a testator has the benefit of a so-called nil rate band. If available in full the amount of the nil rate band is £325,000 and this amount can therefore pass free of IHT on death. The amount of nil rate band available at death is reduced by any chargeable transfers by the deceased in the seven years before death. If the testator leaves everything to his/her spouse and has made no lifetime chargeable transfers, the nil rate band is unused. Under rules introduced in 2007, if the testator's nil rate band is unused, it can be claimed by the personal representatives ("PRs") of the testator's surviving spouse. This is called the transferable nil rate band. In such a case the surviving spouse's estate benefits from two nil rate bands, his/her own and that of his/her pre-deceased spouse. This means that (in the current tax year 2010/2011) up to £650,000 of nil rate band is available on the surviving spouse's death. However, the estate of a deceased individual may only enjoy the benefit of one transferable nil rate band.
Care is needed to ensure that the benefit of the transferable nil rate band is maximised. By law a testator may benefit from a maximum of two nil rate bands (his/her own plus one transferable nil rate band from a predeceased spouse). Particular issues can therefore arise where one or both spouses in a marriage have had previous marriages to spouses who died leaving their respective nil rate bands unused. For example before marrying Mr Smith, Mrs Smith was married to Mr Brown, whose nil rate band was unused at death.
Assuming Mr Smith dies before Mrs Smith there are potentially three nil rate bands available eventually for Mrs Smith's estate (ie in addition to her own nil rate band her PRs can also claim a nil rate band from one of her two husbands).. However, given that only two nil bands may be used on Mrs Smith's death, how can she and Mr Smith plan their Wills to avoid wasting one of these nil rate bands? One possibility is for Mr Smith to set up a nil band trust in his Will so using his own nil rate band. On Mrs Smith's later death her PRs can then still claim Mr Brown's nil rate band which would otherwise be wasted. The appropriate solution will depend on the circumstances of each case and careful planning is needed.
Conclusion
This briefing note indicates some of the issues that can more commonly arise when planning and preparing Wills for testators whose estates exceed the nil rate band. As can be seen, achieving a tax efficient Will requires careful attention to a person's individual circumstances. A "one size fits all approach" is often not the best solution.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.