How can married couples avoid the IHT trap?

Prudential’s Gerry Brown looks at how married couples can limit the IHT beneficiaries have to pay.

The UK inheritance tax (IHT) code provides significant advantages for married couples and those in civil partnerships.

Transfers between spouses enjoy unlimited exemption from IHT.

However, there is an exception to this rule. Where the recipient is non-UK domiciled, the exemption is restricted to £55,000 over a lifetime. The excess will be a potentially exempt transfer (PET), unless another exemption can be availed of.

The exemption is available only to married couples and those in civil partnerships. A long-term relationship, no matter how long-term, no matter how stable, is not a marriage.

Tax planning opportunity

Gabrielle – a minor celebrity – has significant assets (£5m) and is terminally ill with cancer. She doesn’t trust her boyfriend Brian to adequately provide for her children, but she doesn’t want her children’s inheritance reduced by a 40% tax charge.

The following planning strategy could well help:

Gabrielle and Brian marry. Contributions from celebrity magazines go to Brian, as although Gabrielle is determined that he should not benefit from her wealth, he should be rewarded for his part in her planning strategy.

Gabrielle establishes an ‘interest in possession’ trust in her will. This trust will ‘inherit’ all of her assets on death.

An interest in possession trust is one where a named beneficiary is entitled to receive the income generated by the trust fund.

The will states that the ‘interest in possession’ will be held by Gabrielle’s widower.
The person who has the ‘interest in possession’ is treated as owning the trust fund for IHT purposes. Following Gabrielle’s expected death, this will be Brian.

Spouse exempt

At this point Gabrielle dies and the provisions of her will take effect. The trust comes into existence.

The transfer to the trustees – from Gabrielle – is ‘spouse exempt’.

Immediately before her death, Gabrielle owned her £5m worth of assets; following her death, her trustees own the assets – but for IHT purposes only they are treated as being owned by her widower, Brian.

The trustees, appointed by Gabrielle, have the power to change the holder of the ‘interest in possession’.

Power of appointment

This power – usually known as a power of appointment – must be given by Gabrielle to her trustees. It will be expressly set out in the trust deed. Inclusion of such a power makes the trust very flexible. Gabrielle will have provided her trustees with a ‘letter of wishes’, setting out how she would like them to administer the trust. Such a letter does not bind the trustees but Gabrielle has chosen trustees – her lawyer and her accountant – who will follow her wishes as far as possible.

The trustees exercise their power to ‘remove’ Brian’s ‘interest in possession’. He makes a potentially exempt transfer (PET) – or more accurately, a PET is forced on him.

Interest in possession

The person who has the ‘interest in possession’ is treated as owning the trust fund for IHT purposes. Before the trustees exercised their power of appointment, Brian was treated as owning the trust fund; immediately after, he wasn’t.

His IHT estate fell by the value of the trust fund (£5m). This is an IHT potentially exempt transfer – strange but true! Assuming Brian survives for seven years, this will not cause a problem. Should Brian die within that seven year period, the trustees will have to pay nearly £2m IHT. They should have a suitable term assurance in place to cover this.

The trust fund is then held for the children (absolutely or on bare trust).
Following Brian’s ‘removal’, the trust fund will be held for the children in equal shares. This status cannot be changed thereafter. The children will get their shares of the trust fund on reaching age 18. Their entitlement cannot be denied or deferred.

The trust fund is not in the ‘relevant property regime’ – there are no 10 yearly or exit charges.

The trustees do not have to worry about IHT on the trust fund. The trust fund is treated as being in the children’s estates for IHT purposes.

This strategy has achieved Gabrielle’s objectives. Her wealth has passed to her children without an IHT charge and her husband has not directly benefited from it.

Investment advice

The only downside is that the children will have come into wealth at an early age. Unfortunately, should Gabrielle attempt to ‘tie up’ her wealth in trust for a longer period, the IHT spouse exemption on her death will not be available. Gabrielle can only hope that her children will receive suitable investment advice so that the inheritances will not be dissipated.

The trustees could consider making yearly contributions of £3,600 gross into pensions for the children. The contributions would qualify for tax relief, so at current rates a ‘net’ contribution of £2,880 would attract a government subsidy of £720.

An added advantage – from the trustees’ viewpoint – is that the children could not directly benefit until they reached age 55.