Leaving assets to charity

Gifts to charity will be exempt from Inheritance Tax (IHT). If at least 10% of an individual’s net estate is left to charity, any IHT due on the remainder of the estate will be paid at a reduced rate of 36% instead of 40%.

To avoid the need continually to revise the amount of charitable donations written in a Will, a clause with an appropriately worded formula can be included in a Will to ensure that it will always meet the 10% test.

Discretionary Trust (DT) Wills

If an unmarried couple leave everything to each other then, on the death of the first partner, there would be no spouse exemption available and so IHT could arise in the estate because everything above the nil rate band would be subject to IHT. IHT could also arise in the estate of the surviving partner because the estates of the two partners would then be aggregated and everything above the nil rate band would be subject to IHT. In short, the same assets are potentially being subjected to IHT twice.

In order to avoid the same assets being subjected to IHT twice, it is possible for the first partner to die to leave the estate to beneficiaries other than the surviving partner, such as their children. Then, on the death of the surviving partner, the value of their estate would be lower, and if it were within the nil rate band it would be free of IHT. Whilst avoiding aggregating the two estates in this way results in an IHT saving, it could also result in the surviving partner’s financial needs not being met. The way to avoid aggregating the two estates whilst still allowing the surviving partner access to the assets in the estate is a Discretionary Trust Will (DT Will).

With a DT Will, the entire estate would be left to the trustees to administer for a widely defined group of beneficiaries which would typically include any surviving partner, children and grandchildren. A discretionary trust is one where no beneficiary has a right to income or capital from the trust fund. Instead, as the name suggests, the trustees have the discretion to decide how much income or capital (if any) to pay to each of the beneficiaries but without the value of the trust fund forming part of their estate for IHT purposes. Whilst it is possible to guide the trustees on how to exercise their discretion by preparing a Letter of Wishes, the ultimate decision on how (or even whether or not) to exercise their discretion rests with the trustees. Trustees must act unanimously, and so just one trustee may have the ability to prevent payments from the trust fund even if all the other trustees agree. Choice of trustees is therefore crucial.

Having a DT Will is of particular benefit in the following situations:

Highly appreciating assets

If the value of assets in the estate of the first partner to die were to grow at more than the rate of increase in the nil rate band then IHT may be payable on the death of the surviving partner. A DT can take any growth in the value of the assets outside of the estate of the surviving partner.

Care fees planning

If the surviving partner receives long term care, a DT protects assets from care home fees given that the trust assets cannot be taken into account in a financial assessment.

Those who have previously been married or if the surviving partner marries

The surviving partner is free to change their Will so as to leave their estate to beneficiaries who the first partner to die may not have wanted to benefit, for example to children from a previous marriage. Similarly, if the surviving partner were to marry then any Will is automatically cancelled. A DT provides some measure of protection for the beneficiaries chosen by the first partner to die because the trust assets cannot be transferred away from those beneficiaries.

If beneficiaries become bankrupt or divorce or receive means-tested benefits

The surviving partner, or the ultimate beneficiaries of the estate, may become bankrupt or divorce or receive means-tested benefits. A DT can provide a measure of protection because the trust assets do not belong to the beneficiaries and so could not be taken into account in bankruptcy proceedings or any claim for means-tested benefits, and may similarly be disregarded in divorce proceedings.

Loss of mental capacity

If the surviving partner were to lose the mental capacity to manage their financial affairs, a DT provides a fund from which the trustees can meet their financial needs until the Deputyship application to the Court of Protection is concluded, or any Power of Attorney can be used.

Further IHT planning opportunities

A DT can provide the opportunity to take further IHT planning measures, following the death of the first partner, for those couples who have assets of more than twice the nil rate band. If, for example, the trustees were to lend the trust fund to the surviving partner who then gives that sum away, the gift will fall outside of their taxable estate if they live for seven years, yet the loan to the trustees remains outstanding and so is deducted from their taxable estate on death, so long as it is actually repaid.

Securing Business Property Relief (BPR) and / or Agricultural Property Relief (APR)

If the first partner to die has assets which qualify for BPR or APR, the relief will be lost if those assets are left to the surviving partner and subsequently sold, since the previously IHT-free assets will be taxable cash in the estate of the surviving partner. Any assets which may qualify for BPR or APR should therefore be given to a separate discretionary trust in the Will (sometimes referred to as a “Business Trust Fund”) of which the surviving partner is one of the potential beneficiaries. The trustees then have the following options:

• If the tax office determines that the assets qualify for BPR or APR, the trustees can choose to continue with the trust, whether the assets held in trust are retained or sold
• If the tax office determines that the assets qualify for BPR or APR, the trustees can sell those assets to the surviving partner. If the surviving partner then owns those assets for two years, BPR or APR will be available on the surviving partner’s death. At the same time, the cash held within the trust would fall outside of the surviving partner’s taxable estate. This is often known as “double dipping”
• If the tax office determines that the assets do not qualify for BPR or APR, the trustees can “appoint” (that is, transfer) those assets to the surviving partner, but the spouse exemption would not apply (as would be the case with a married couple)

Potential issues with DT Wills

It is important that the joint estate of the two partners is evenly divided between them. A jointly owned property is generally held as Joint Tenants so that, on the death of the first partner, the property passes automatically to the surviving partner regardless of the content of any Will. The Joint Tenancy should therefore be split so that the property is owned as Tenants-in-Common in equal shares, and each partner can then leave their share of the property to the DT in the Will. Jointly held cash and investments should similarly be split.

The DT is subject to the taxation rules applicable to trusts – including IHT anniversary and exit charges – which may be less advantageous than the rates for personal taxation.

The surviving partner does not own the DT assets outright. A discretionary trust is one where no beneficiary has a right to income or capital from the trust fund. Instead, the trustees have the discretion to decide how much income or capital (if any) to pay to each of the beneficiaries. Whilst it is possible to guide the trustees on how to exercise their discretion by preparing a Letter of Wishes, the ultimate decision on how (or even whether or not) to exercise their discretion rests with the trustees. Trustees must act unanimously, and so just one trustee may have the ability to prevent payments from the trust fund even if all the other trustees agree. Choice of trustees is therefore crucial.

If the surviving partner has rent-free occupation of a property part-owned by the DT, the tax office may say that this is an “interest in possession”. This would result in that part of the property owned by the DT being added to the estate of the surviving partner, and defeat the object of the DT. Alternatively, the tax office may rely on the fact that any increase in the value of that part of the property owned by the DT would be subject to Capital Gains Tax (CGT) even though the property is the surviving partner’s main residence.

For these reasons, the DT should be implemented using one of the following methods:

• The Debt Scheme; or
• The Charge Scheme; or
• Appointment from the DT to an Interest in Possession (IIP) trust.

The Debt Scheme

With the Debt Scheme, the Will of the first partner to die establishes a DT and provides for the entire estate to pass to it. All the assets in the estate, including any property, are transferred to the surviving partner who in return gives an IOU to the trustees for an amount equal to the value of the trust fund. The IOU owed to the trust is deductible from the taxable estate of the surviving partner on their death, so long as it is actually repaid.

The surviving partner may have given chargeable consideration for the transfer of the property, meaning Stamp Duty Land Tax is payable. There are also circumstances where the tax office disregard the IOU as an artificial debt. So, the Charge Scheme is preferable to the Debt Scheme.

The Charge Scheme

With the Charge Scheme, instead of the assets in the estate being transferred to the surviving partner in return for an IOU, the executors in the estate can offer the IOU to the DT trustees which results in a charge (that is, a mortgage) being put on the property in favour of the DT trustees for an amount equal to the trust fund. The property is then transferred to the surviving partner subject to that charge which reduces the value of the property held in the estate of the surviving partner, so long as the charge is actually repaid.

The surviving partner does not provide any chargeable consideration for the transfer of the property, but receives it subject to the charge, and so no Stamp Duty Land Tax is payable. Further, the surviving partner does not incur the debt owed to the DT trustees, and so there is no artificial debt (unless the debt exceeds the value of the property).

If the surviving partner moves house then the charge is secured on the new property by the surviving partner, and so an artificial debt may arise. Whilst the solution to this problem for a married couple is in the drafting of the Will (which establishes a further trust that makes use of the spouse exemption for IHT), this is not possible with an unmarried couple due to the fact that the spouse exemption is not available. The artificial debt problem cannot therefore be avoided if the surviving partner wishes to move house. Due to this potential problem with the Charge Scheme, an appointment from the DT to an interest in possession trust is preferable to it.

To use the Debt or Charge Schemes, the Will appoints separate executors and DT trustees so that the offer by the executors to the DT trustees of an IOU (rather than actual assets), and acceptance of that offer, is not seen as artificial. The executors and DT trustees should not be exactly the thesame people. The surviving partner should not be an executor, but can be a DT trustee. It is advisable to have independent executors given that the executors decide whether or not to offer the IOU to the DT trustees.

Appointment from the DT to an Interest in Possession (IIP) trust

An alternative to the Debt or Charge Schemes is to “appoint” (that is, transfer) the DT to an IIP trust for the surviving partner. An IIP trust is one where the beneficiary (known as the life tenant) has no right to the trust capital, but instead has an immediate right to the trust income (after tax and expenses) as it arises, or to enjoy or occupy any trust property (whether or not it produces income) without the trustees having to make any further decision to confer such a right. On the death of the life tenant, the trust capital passes to other beneficiaries (known as the remaindermen). The IIP trustees are given a “power of appointment” which allows them to pass capital to any of the beneficiaries (whether the life tenant, the remaindermen, or otherwise).

Historically, with all IIP trusts, on the death of the life tenant, the trust assets formed part of the life tenant’s estate and were subject to IHT. This was in contrast to discretionary trusts which were taxed under the “relevant property regime” and so, on the death of any beneficiary, the trust assets did not form part of the beneficiary’s estate and were not subject to IHT. As such, an appointment from a DT to an IIP trust would have been disastrous for IHT purposes.

Now, however, almost all new Will trusts are taxed under the relevant property regime for IHT purposes and so, on the death of any beneficiary, the trust assets do not form part of the beneficiary’s estate and are not subject to IHT. One exception to this general rule is an “Immediate Post-Death Interest” (IPDI) trust – such as IIP trust for a surviving partner which arises immediately after the death of the deceased partner – which is not taxed under the relevant property regime for IHT purposes and so on, on the death of the life tenant, the trust assets form part of the life tenant’s estate and are subject to IHT.

To appoint the DT to an IIP trust within two years of the date of death of the deceased partner would have the effect of the new trust being “read back” into the Will of the deceased partner so that it would become an IPDI. The trust assets would then form part of the surviving partner’s estate and be subject to IHT as though the surviving partner owned the capital of the IPDI trust fund outright. If, however, the appointment from the DT to the IIP trust occurs more than two years after the date of death of the deceased partner then the new trust will not be “read back” into the Will of the deceased partner. The trust assets would not then form part of the surviving partner’s estate and so would not be subject to IHT; but at the same time the trust assets will be part of the surviving partner’s assets for CGT purposes and the principal private residence relief can be claimed on a future sale of the property. This helps avoid CGT on any increase in the value of the property from the second anniversary of the deceased partner’s death to the date of death of the surviving partner (or earlier sale of the property).

The DT trustees should not confer rights of occupation – actually or notionally – on the surviving partner within two years of the date of death of the deceased partner, and so:

• The Title Deeds to the property should not be amended during this period to show the part ownership by the DT, which helps with the argument that the executors have not concluded the administration of the deceased partner’s estate, and so the DT trustees could not have granted anyone rights in the property; and / or
• The surviving partner could pay rent (or “compensation”) to the DT trustees for residing in that part of the property owned by the DT for the period from the date of death of the deceased partner up to the date of the appointment from the DT to the IIP trust. Any such rent / compensation will be subject to income tax.

There may be a charge to CGT from the date of death of the deceased partner up to the date of the appointment from the DT to the IIP trust if the property has increased in value.

In spite of these points, the rules which restrict the deduction of liabilities mean that an appointment from the DT to an IIP trust is preferable to the Debt or Charge Schemes.

Pilot Trusts

Historically, to avoid IHT anniversary and exit charges on any part of an individual’s estate which was to be held in trust post-death, the individual could set up a number of trusts (known as “Pilot Trusts”) during their lifetime, and divide that part of the estate to be held in trust between the Pilot Trusts given that each trust had its own nil rate band.

However, from 6 April 2015, the same-day addition (SDA) rules will prevent settlors from obtaining IHT advantages by increasing the value of assets in more than one trust on the same day. The exceptions are where the trusts were created before 10 December 2014 and the settlor makes no additions on or after that date; or where the settlor makes additions by Will on his death before 6 April 2016 without changing his Will on or after 10 December 2014.