Minimising an Inheritance Tax liability

Passing assets to beneficiaries using a trust

You may decide to use a trust to pass assets to beneficiaries, particularly those who aren’t immediately able to look after their own affairs. If you do use a trust to give something away this removes it from your estate, provided you don’t use it or get any benefit from it. But, bear in mind that gifts into trust may be liable to Inheritance Tax.

Trusts offer a means of holding and managing money or property for people who may not be ready or able to manage it for themselves. Used in conjunction with a will, they can also help ensure that your assets are passed on in accordance with your wishes after you die.

When writing a will, there are several kinds of trust that can be used to help minimise an Inheritance Tax liability. On 22 March 2006 the government changed some of the rules regarding trusts and introduced some transitional rules for trusts set up before this date.

A trust might be created in various circumstances, for example:

– when someone’s too young to handle their affairs
– when someone can’t handle their affairs because they’re incapacitated
– to pass on money or property while you’re still alive
– under the terms of a will
– when someone dies without leaving a will (England and Wales only)

What is a trust?
A trust is an obligation binding a person called a trustee to deal with property in a particular way for the benefit of one or more ‘beneficiaries.’

Settlor
The settlor creates the trust and puts property into it at the start, often adding more later. The settlor says in the trust deed how the trust’s property and income should be used.

Trustee
Trustees are the ‘legal owners’ of the trust property and must deal with it in the way set out in the trust deed. They also administer the trust. There can be one or more trustees.

Beneficiary
This is anyone who benefits from the property held in the trust. The trust deed may name the beneficiaries individually or define a class of beneficiary, such as the settlor’s family.

Trust property
This is the property (or ‘capital’) that is put into the trust by the settlor. It can be anything, including:

land or buildings
investments
money
antiques or other valuable propertyThe main types of private UK trust:

Bare trust

In a bare trust the property is held in the trustee’s name but the beneficiary can take actual possession of both the income and trust property whenever they want. The beneficiaries are named and cannot be changed.

You can gift assets to a child via a bare trust while you are alive, which will be treated as a Potentially Exempt Transfer (PET) until the child reaches age 18, (the age of majority in England and Wales), when the child can legally demand his or her share of the trust fund from the trustees.

All income arising within a bare trust in excess of £100 per annum will be treated as belonging to the parents (assuming that the gift was made by the parents). But providing the settlor survives 7 years from the date of placing the assets in the trust, the assets can pass Inheritance Tax free to a child at age 18.

Life interest or interest in possession trust

In an interest in possession trust the beneficiary has a legal right to all the trust’s income (after tax and expenses), but not to the property of the trust.

These trusts are typically used to leave income arising from a trust to a second surviving spouse for the rest of their life. On their death, the trust property reverts to other beneficiaries, (known as the remaindermen), who are often the children from the first marriage.

You can, for example, set up an interest in possession trust in your will. You might then leave the income from the trust property to your spouse for life and the trust property itself to your children when your spouse dies.

With a life interest trust, the trustees often have a ‘power of appointment’ which means they can appoint capital to the beneficiaries, (who can be from within a widely defined class, such as the settlor’s extended family), when they see fit.

Where an interest in possession trust was in existence before 22 March 2006, the underlying capital is treated as belonging to the beneficiary or beneficiaries for Inheritance Tax purposes, for example, it has to be included as part of their estate.

Transfers into interest in possession trusts, after,
22 March 2006 are taxable as follows:

20 per cent tax payable based on the amount gifted into the trust at the outset, which is in excess of the prevailing nil rate band;

10 years after the trust was created, and on each subsequent 10 year anniversary, a periodic charge, currently 6 per cent, applied to the portion of the trust assets, which is in excess of the prevailing nil rate band.

The value of the available ‘nil rate band’ on each 10 year anniversary may be reduced, for instance, by the initial amount of any new gifts put into the trust within 7 years of its creation.

There is also an exit charge on any distribution of trust assets between each 10 year anniversary.

Discretionary trust

The trustees of a discretionary trust decide how much income or capital, if any, to pay to each of the beneficiaries but none has an automatic right to either. The trust can have a widely defined class of beneficiaries, typically the settlor’s extended family.
Discretionary trusts are a useful way to pass on property while the settlor is still alive and allows the settlor to keep some control over it through the terms of the trust deed.

Discretionary trusts are often used to gift assets to grandchildren, as the flexible nature of these trusts allows the settlor to wait and see how they turn out before making outright gifts.

Discretionary trusts also allow for changes in circumstances, such as divorce, re-marriage and the arrival of children and step children after the establishment of the trust.

When any discretionary trust is wound up, an exit charge is payable of up to 6 per cent of the value of the remaining assets in the trust, subject to the reliefs for business and agricultural property.

Accumulation and maintenance trust

An accumulation and maintenance trust is used to provide money to look after children during the age of minority. Any income that isn’t spent is added to the trust property, all of which later passes to the children.

In England and Wales the beneficiaries become entitled to the trust property when they reach the age of 18. At that point the trust turns into an ‘interest in possession’ trust. The position is different in Scotland, as, once a beneficiary reaches the age of 16, they could require the trustees to hand over the trust property.

Accumulation and maintenance trusts which were already established before 22 March 2006, and where the child is not entitled to access the trust property until an age up to 25, could be liable to an Inheritance Tax charge of up to 4.2 per cent of the value of the trust assets.

It has not been possible to create accumulation and maintenance trusts since 22 March 2006, for Inheritance Tax purposes. Instead, they are taxed for Inheritance Tax as discretionary trusts.

Mixed trust

A mixed trust may come about when one beneficiary of an accumulation and maintenance trust reaches 18 and others are still minors. Part of the trust then becomes an interest in possession trust.

Trusts for vulnerable persons

These are special trusts, often discretionary trusts, arranged for a beneficiary who is mentally or physically disabled. They do not suffer from the Inheritance Tax rules applicable to standard discretionary trusts and can be used without affecting entitlement to state benefits, however strict rules apply.

Tax on income from UK trusts

Trusts are taxed as entities in their own right. The beneficiaries pay tax separately on income they receive from the trust at their usual tax rates, after allowances.

Taxation of property settled on trusts

How a particular type of trust is charged to tax will depend upon the nature of that trust and how it falls within the taxing legislation. For example a charge to Inheritance Tax may arise when putting property into some trusts, and on other chargeable occasions for instance when further property is added to the trust, on distributions of capital from the trust, or on the 10 yearly anniversary of the trust.

Alternative Investment Market shares

Reducing an Inheritance Tax liability on an estate

Investing in Alternative Investment Market (AIM) shares is one way of reducing an Inheritance Tax liability on an estate. Qualifying AIM shares offer more Inheritance Tax relief than some other assets and qualify as ‘business property investments.’ If property is held as AIM shares in certain trading companies, for a period of at least 2 years, it becomes eligible for Inheritance Tax Business Property Relief at 100 per cent and will fall out of the estate for Inheritance Tax purposes. This relief is a relief by value, the shares are treated as having no value for Inheritance Tax purposes.

Not all AIM companies are eligible for Business Property Relief however. To qualify, a company must be a trading company carrying out the majority of its business in the UK. Businesses trading in land or securities, or receiving a substantial amount of income from letting property or land, are excluded. Also, it must not be listed on another recognised stock exchange. If a company qualified for Inheritance Tax relief when the shares were bought, but was subsequently disqualified under these criteria, investors must reinvest their holdings into new qualifying shares within 6 months to retain the Business Property Relief exemption.

Investing in the AIM will suit financially secure people with other liquid capital who can invest widely enough to bear the risks involved. AIM shares can be unpredictable and invest in smaller, less established companies with fewer investors than other stock markets, so share prices can be volatile, rising or falling rapidly. You should always receive professional advice before considering this option to mitigate a potential Inheritance Tax liability.

Legal documents

Applying for probate

If you are an executor of someone’s will you may need a legal document called a ‘grant of probate’ to enable you to sort out the deceased person’s affairs. If there is no will, a close relative can apply for a ‘grant of letters of administration.’ In Scotland different procedures apply for a death.

If there’s more than one executor it’s common to agree that one will apply for the grant and sort out the will. However up to 4 executors can apply jointly and sort out everything together.

You can ask a solicitor to apply for the grant for you. There may be a charge to provide this service, so it’s a good idea to check first.

If you apply for probate without a solicitor, the forms you need to complete depend on where the person lived and whether or not you expect Inheritance Tax to be due on the estate. Inheritance Tax is paid when the taxable value of the deceased person’s estate (after exemptions) is over the £325,000 threshold (applies for deaths in the 2009/10 tax year).

Financial reasons to make a will

Putting it off could mean that your spouse receives less
It’s easy to put off making a will. But if you die without one your assets may be distributed according to the law rather than your wishes. This could mean that your spouse receives less, or that the money goes to family members who may not need it.

There are lots of good financial reasons for making a will:

you can decide how your assets are shared out, if you don’t make a will, the law says who gets what

if you aren’t married or in a civil partnership (whether or not it’s a same sex relationship) your partner will not inherit automatically, so you can make sure your partner is provided for

if you’re divorced or if your civil partnership has been dissolved you can decide whether to leave anything to an ex-partner who’s living with someone else

you can make sure you don’t pay more Inheritance Tax than necessary

If you and your spouse or civil partner owns your home as ‘joint tenants’ then the surviving spouse or civil partner automatically inherits all of the property

If you are ‘tenants in common’ you each own a proportion (normally half) of the property and can pass that half on as you want

A solicitor will be able to help you should you want to change the way you own your property.
Planning to give your home away to your children while you’re still alive

You also need to bear in mind if you are planning to give your home away to your children while you’re still alive that:
gifts to your children unlike gifts to your spouse or civil partner aren’t exempt from Inheritance Tax unless you live for 7 years after making them

if you keep living there without paying a full market rent (which your children pay tax on) it’s not an ‘outright gift’ but a ‘gift with reservation’ so it’s still treated as part of your estate, and so liable for Inheritance Tax

from 6 April 2005 onwards you may be liable to pay an Income Tax charge on the ‘benefit’ you get from having free or low cost use of property you formerly owned (or provided the funds to purchase)

once you have given your home away your children own it, it becomes part of their assets; so if they are bankrupted or divorced, your home may have to be sold to pay creditors or to fund part of a divorce settlement

if your children sell your home, and it is not their main home, they will have to pay Capital Gains Tax on any increase in its value

If you don’t have a will there are rules for deciding who inherits your assets, depending on your personal circumstances. The following rules are for deaths on or after 1 July 2009 in England and Wales, the law differs if you die intestate (without a will) in Scotland or Northern Ireland. The rates that applied before that date are shown in brackets.

If you’re married or in a civil partnership and there are no children
The husband, wife or civil partner won’t automatically get everything although they will receive:

personal items, such as household articles and cars, but nothing used for business purposes

£400,000 (£200,000) free of tax or the whole estate if it was less than £400,000 (£200,000)

half of the rest of the estate

The other half of the rest of the estate will be shared by the following:

surviving parents

if there are no surviving parents, any brothers and sisters (who shared the same two parents as the deceased) will get a share (or their children if they died while the deceased was still alive)

if the deceased has none of the above, the husband, wife or registered civil partner will get everything

If you’re married or in a civil partnership and there were children

Your husband, wife or civil partner won’t automatically get everything, although they will receive:

personal items, such as household articles and cars, but nothing used for business purposes

£250,000 (£125,000) free of tax, or the whole of the estate if it was less than £250,000 (£125,000)

a life interest in half of the rest of the estate (on his or her death this will pass to the children)

The rest of the estate will be shared by the children.

If you are partners but aren’t married or in a civil partnership

If you aren’t married or registered civil partners, you will not automatically get a share of your partner’s estate if they die without making a will.

If they haven’t provided for you in some other way, your only option is to make a claim under the Inheritance (Provision for Family and Dependants) Act 1975.

If there is no surviving spouse/civil partner
The estate is distributed as follows:

to surviving children in equal shares (or to their children if they died while the deceased was still alive)

if there are no children, to parents (equally, if both alive)

if there are no surviving parents, to brothers and sisters (who shared the same two parents as the deceased), or to their children if they died while the deceased was still alive

if there are no brothers or sisters then to half brothers or sisters (or to their children if they died while the deceased was still alive)

if none of the above then to grandparents (equally if more than one)

if there are no grandparents to aunts and uncles (or their children if they died while the deceased was still alive)

if none of the above, then to half uncles or aunts (or their children if they died while the deceased was still alive)

to the Crown if there are none of the above

It’ll take longer to sort out your affairs if you don’t have a will. This could mean extra distress for your relatives and dependants until they can draw money from your estate.

If you feel that you have not received reasonable financial provision from the estate, you may be able to make a claim under the Inheritance (Provision for Family and Dependants) Act 1975, applicable in England and Wales. To make a claim you must have a particular type of relationship with the deceased, such as child, spouse, civil partner, dependant or cohabitee.

Bear in mind that if you were living with the deceased as a partner but weren’t married or in a civil partnership, you’ll need to show that you’ve been ‘maintained either wholly or partly by the deceased,’ this can be difficult to prove if you’ve both contributed to your life together. You need to make a claim within 6 months of the date of the Grant of Letters of Administration.

Valuing an estate

Accurately reflecting what those assets would receive in the open market

When valuing a deceased person’s estate you need to include assets (property, possessions and money) they owned at their death and certain assets they gave away during the 7 years before they died. The valuation must accurately reflect what those assets would reasonably receive in the open market at the date of death.

Valuing the deceased person’s estate is one of the first things you need to do as the personal representative. You won’t normally be able to take over management of their estate (called ‘applying for probate’ or sometimes ‘applying for a grant of representation/ confirmation’) until all or some of any Inheritance Tax that is due has been paid.

But bear in mind that Inheritance Tax is only payable on values above £325,000 for the 2009/10 tax year.

The valuation process
This initially involves taking the value of all of the assets that they own, together with the value of:

their share of any assets that they own jointly with someone else: for example a house that they own with their partner

any assets which are held in a trust, from which they had the right to benefit

any assets which they had given away, but in which they kept an interest: for instance, if someone gives a house to their children but still lives in it rent-free

certain assets which they gave away within the last 7 years

Next from the total value above deduct everything that the deceased person owed, for example:

any outstanding mortgages or other loans

unpaid bills

funeral expenses

(If the debts exceed the value of the assets owned by the person who has died, the difference cannot be set against the value of trust property included in the estate.)

You will be left with the value of all of the assets, less the deductible debts, to give you the estate value.

If you don’t know the exact amount or value of any item, such as an Income Tax refund or household bill, you can use an estimated figure. But rather than guessing at a value, try to work out an estimate based on the information available to you. You’ll find instructions about how to show estimates on the form you complete.

The forms on which you’ll need to record the valuation will differ, depending on the expected valuation amount. You complete a form IHT205 for estates where you don’t expect to have to pay Inheritance Tax (called ‘excepted estates’) and a form IHT400 where you do expect to have to pay. The forms vary for excepted estates in Scotland.

You should be able to value some of the estate assets quite easily, for example, money in bank accounts or stocks and shares. In other instances, you may need the help of a professional valuer (or chartered surveyor for valuing a property). If you do decide to employ a valuer, make sure you ask them to give you the ‘open market value’ of the asset. This represents the realistic selling price of an asset, not an insurance value or replacement value.

If the affairs of the estate are complicated, you may want to work with a solicitor to help you value the estate and pay any tax due. If you’re not using a solicitor you can ask HMRC to use form IHT400 to work out any Inheritance Tax due.

Forms you need to complete
There are different forms to complete, depending on the value of the estate. Once you’ve completed the relevant tax forms, you also need to complete the relevant probate form.