Does Your Will Still work?

First, however, it will be essential to have an understanding of how the tax provisions apply on a death and a summary is therefore set out below. This is followed by more detailed guidance for creating a tax-efficient will.

Inheritance tax on death

Inheritance tax ('IHT') on personally held assets has a relatively simple charging structure. There is a nil rate band which has been increased for the 2007/08 tax year to £300,000. Once a person's estate exceeds the nil rate band, IHT on death is payable at 40 per cent on the excess. Any gifts to individuals made in the seven years prior to the donor's death, less the annual exemption £3,000 if available and if not covered by another exemption, become chargeable to tax. However, if the gift was made more than three years before the donor's death, the tax (if any) on the gift is reduced by a tapering provision. Note that the reduction is not in the amount of the gift, but only on the tax payable in respect of it. Lifetime gifts which become chargeable on death are primarily allocated to the nil rate band, pushing the estate on death into the chargeable band at which 40 per cent tax is payable. The result of this position is that a lifetime gift of £300,000 in cash which is made six-and-a-half years prior to death achieves no tax saving at all unless any of it is within an exemption, because the gift absorbs the nil rate band, leaving the balance of the testator's estate to pay tax at 40 per cent.

Capital gains tax on death

No capital gains tax is payable on personally held assets at the time of death. Instead all accrued gains are wiped out and the base cost of the assets are re-set to their respective open market values at the time of death. This rule continues to apply following the 2006 Finance Act.

The rule also applies to assets held in trust for a person for his or her lifetime, where the trust in that person's favour was made before 22 March 2006 or where there had been substituted a new interest in possession trust before 6 April 2008. The rule will not, however, apply to new lifetime trusts created after March 2006. Instead assets in these new trusts will benefit from capital gains tax 'hold over relief'; this means that the assets can, by election made jointly by the trustees and the beneficiary, pass out of the trust at their capital gains tax base costs, rather than the market value at the time the trust is wound up.

Existing wills

In recent years most people have preferred to keep the provisions of their will relatively simple, and, wherever possible, to avoid the use of trusts. A simple will provides for all assets to pass to the spouse or civil partner, if he or she survives, and if not assets then pass direct to children, or into trust for them if they are minors to be paid to them after they have attained the age of eighteen.

This simple type of will was often embellished, on receipt of professional advice, by the use of what is known as a 'nil rate band trust'. This was a method of dealing with the problem by which the nil rate band of the first to die of husband and wife was wasted if all the assets pass to the surviving spouse, because there is an outright exemption for gifts in such circumstances. These trust clauses are no longer required as the proportion of the deceased spouse's nil rate band which was not used on death can be claimed by the surviving spouse. The new rule applies to the estate of a widow or widower who dies after 9 October 2007 regardless of the date on which their husband/wife died. The number of times an individual has been widowed does not matter, since the unused percentage of nil rate bands for any number of deceased spouses can be combined, to achieve up to 100%. In its simplest form, the traditional will leaving everything to the surviving spouse is no longer inefficient for tax purposes, since the surviving spouse will be able to use combined nil rate bands of £600,000 against their estate on death.

However, lifetime planning remains unchanged because the transfer of exemptions only applies to the estate on death. Therefore if £400,000 is given to a trust during a lifetime, £100,000 of that gift is subject to Inheritance Tax immediately.

Although the new rules are effective from 9 October 2007, the legislation for the details is not going to be finalised for several months, and it may be best to wait until the new rules are finalised before making changes to existing wills.

More complex wills

More complex wills have often been required particularly where one or more of the parties to a marriage has previously been divorced so that there are children of a previous marriage to be considered. In such a case it might be appropriate to set up a trust of the testator's estate on death so that the income, or the use of the testator's share in the family home, can be enjoyed by the surviving spouse for life, and thereafter the estate may be payable to the children of the previous marriage.

Will trusts have also been appropriate where the testator wishes to provide for another member of the family, or a close acquaintance, for his or her life, and thereafter the assets may be distributable to different beneficiaries. Also those enjoying substantial wealth through landed estates have commonly felt it appropriate to tie up the assets in trust following their death in order to protect the estate from the claims of creditors, or to prevent it being dissipated by falling into the hands of a beneficiary not capable of managing it effectively.

In the past, only discretionary trusts have incurred periodic charges to inheritance tax. These are calculated according to a complex formula which gives a maximum tax rate of 6 per cent, and the charge arises every ten years with a proportionate charge being applied if capital funds are paid out between 10-yearly charge dates. As noted below, these periodic charges will now be applied to certain other types of trust.

After the 2006 Budget

Will trusts may still be tax efficient following the 2006 Budget, but Government policy is to prevent assets being held in trust over different generations.
Trusts which will not bear periodic inheritance tax charges are:

1. Trusts in favour of another individual to receive the income for life. If the trust is in favour of the surviving spouse, the spouse exemption will apply. The funds in the trust will form part of the life tenant's inheritance tax estate, just as they did prior to the 2006 Budget.
2. Trusts for bereaved minors: a will trust in favour of the testator's own infant children who must receive their inheritance on attaining the age of eighteen will be free of inheritance tax charges once it is set up and running, although it does not benefit from any exemption from inheritance tax as regards inheritance on the testator's estate. These rules will apply equally if the bereaved minor's trust does not commence until the expiry of an initial trust in favour of another individual, such as the surviving spouse.

The trust may alternatively delay entitlement to the funds until the child is aged 25 but in that event periodic inheritance tax charges apply after the child's 18th birthday.

Trusts for children

Many parents will not be happy about their children taking what might be a significant inheritance at the age of 18 and would much prefer entitlement to be delayed, or even left to the discretion of a trustee. It may be feared that the child may either spend the money unwisely, or else be discouraged from pursuing a successful career of his/her own because of inheriting funds from a parent's estate.

There is a variety of solutions to this problem, but the detailed rules contain pitfalls and it is vital that professional advice is sought in drawing up the terms of the will. An outline of the possible options follows below.

Bereaved minors

As mentioned above, a will trust for the testator's own children who take their inheritance at the age of 18 is one of the favoured categories of trust. It might be thought unsuitable because of the early age of entitlement, but the trustees of the fund can be given the power to resettle the funds upon trust for the child to receive the income for his or her life. It will be seen therefore that although the legislation envisages that the child must take his or her legacy at the age of 18, it also permits the trustees of the legacy fund to withhold it, and to create an interest in possession trust for the child instead. If they do this, the ongoing trust will be subject to inheritance tax 10-yearly charges, depending on the size of the trust fund; but these can be quite modest, and in some cases there may be nothing payable at all. Those who are willing to leave funds to be paid out at the discretion of their trustees may find this to be a good solution.

Age 18 to 25 trusts

Many testators may, however, decide that, no matter what the circumstances are, they do not want their children to take a legacy fund at the young age of 18. The legislation offers the alternative of a trust under which the children take at the latest by the age of 25. It is safest to provide for the income to be accumulated whilst the beneficiary is under the age of 18, as otherwise the trust might fail some of the detailed conditions. On distribution of the funds after the beneficiary's 18th birthday, some inheritance tax liability may arise, depending on the total value of the fund, but the maximum rate is set at 4.2 per cent.

Interest in possession trusts

It is commonly thought that infant children cannot have an entitlement to receive the income from a legacy fund, but this is not in fact so. A will can set aside a fund for the benefit of a young child with the income to be distributed as belonging to the child when it arises, but of course payment would be made to a parent or guardian to apply it for the child's benefit or invest it on his or her behalf. The advantage of a trust of this type is that it incurs no inheritance tax charges throughout its life and it can continue indefinitely without any date being set for the child to receive the legacy fund absolutely. The trustees of the fund could therefore decide when the time is right to terminate the trust and pay out the capital to the child. Whilst this type of trust avoids any inheritance tax problems, the downside is that on distribution out to the beneficiary, all capital gains on underlying investments are treated as being realised and capital gains tax liability might therefore become due. There is no possibility of 'holding over' the gains so that the beneficiary takes the investments at their original cost prices, except in the case of certain business assets (for which there is a detailed definition).

In these circumstances, trustees could consider investing in single premium life assurance bonds. These produce no income so there would be nothing to distribute to the parent or guardian and when the trust is terminated, the bond can simply be assigned to the beneficiary without any tax liability. The only drawback with these products is that they may be subject to rather high commission charges and they generate tax liabilities internally which will tend to affect the overall performance of the bond.

Children's trusts: generally

It should be borne in mind that bereaved minors' trusts and age 18 to 25 trusts can only be set up by the will of a parent of the child concerned. Other family members, such as grandparents, cannot set up these trusts and in such cases it is probably best for the child's legacy fund to be held on interest in possession trusts as described above. There is no need for it to be stated at what age the beneficiary should take the legacy fund absolutely, but if the testator does want to state what the age should be, there is no reason why he or she should not do so.

Reviewing existing wills

It is important to note that the date on which a particular will was executed is of no consequence whatsoever. The will only takes effect on the date of death, and accordingly some wills which have been tailored for tax efficiency in the past may now need to be redrawn to conform with the new rules where the testator is still alive. In these circumstances, the position may be assisted by a post-death deed of variation of the will, although there are limits on what can be achieved with such deeds; in particular, the potential interests of infant children under a will cannot be varied unless it is clear that the variation can only operate in their favour.

New wills

Testators now face difficult choices if they wish to provide for any form of trusts in their wills.

As regards trusts for infant children of their own, these can either provide that the funds must be distributed absolutely to the children as and when they attain the age of eighteen, in which case no inheritance tax ten yearly charges will apply to the trust.

Alternatively it may be felt that this age is too young for children to receive their inheritance outright, and it would be better to delay it until the age of 25; this type of trust will be free of inheritance tax whilst the beneficiaries are under the age of 18 but will incur the periodic inheritance tax charge on the value of the trust funds in excess of the nil rate after they attain the age of 18. If the trust funds are likely to be within the nil rate band, it will not matter which type of children's trust is used.

An interest in possession trust set up by a will for a beneficiary will continue to enjoy the inheritance tax régime which has applied hitherto. As a result, the assets forming the trust fund will be part of the beneficiary's inheritance tax estate. If the funds remain in trust until the death of the life tenant, there will be a chargeable transfer for inheritance tax purposes at that stage and the trust funds will be aggregated with the funds in the beneficiary's own free estate in order to determine how much inheritance tax is payable on the total. If the combined assets exceed the inheritance tax nil rate band at that time, tax at 40 per cent (assuming no change in the rate of inheritance tax) will be payable on that excess, and will be apportioned between the free estate and the trust funds according to the overall value of each.

If the life interest is terminated before the beneficiary dies, there will be a potentially exempt transfer if the funds pass out of the trust absolutely to another individual. There is also a potentially exempt transfer when the interest in possession terminates in lifetime and the trust fund is therefore held on continuing trusts for the infant children of the testator until they become eighteen.

There are now no special provisions for grandparents who provide for their grandchildren under the age of 18 in their wills. So, the value put into the trust on the death of the grandparent will bear inheritance tax in the normal way, and thereafter it will often be appropriate for the funds to be held on interest in possession trusts for the beneficiary.

Generally

These notes refer to married couples, but they apply equally to civil partnerships.

The 2006 and 2007 changes will clearly have a major impact on the drafting of wills, and affected testators should reconsider the terms of their existing wills as soon as possible.

FOR GENERAL INFORMATION ONLY

Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed merely to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.

Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.